HKCFEF Limited and the contributing law firms, accountants and sponsors are not offering these due diligence guidelines as legal, financial or professional advice or services and they should not be relied upon as such. These due diligence guidelines should not be used as a sole basis for any decision, action or inaction and are not meant to serve as a substitute for the advice of qualified professionals.
Due Diligence Guidelines –
Code of Conduct Paragraphs
1. Standard for Due Diligence on Accountants
1.1.1 At the time of issue of a listing document, a sponsor as a non-expert, after performing the due diligence set out in paragraph 17.7, should have no reasonable grounds to believe and should not believe that the information in the experts reports is untrue, misleading or contains any material omissions. [Paragraph 17.5(c) of the Code of Conduct]
1.1.2 The performance of each of the procedures in paragraph 17.7(a) to (d) should be to the standard expected of a sponsor which is not itself expert in the matters dealt with in the relevant accountant’s report. [Paragraph 17.7(e) of the Code of Conduct]
1.2.1 For purposes of the listing application, the listing applicant is required to engage an accountant to assist with accounting and financial matters relating to the application. The sponsor is expected not to have the specialised knowledge and skills that an accountant possesses and may rely on the work performed by the accountant provided that the sponsor can satisfy itself that such reliance can be placed.1
1.2.2 In order for the sponsor to satisfy itself that reliance can be placed on the accountant, the sponsor should conduct due diligence work on the accountant and its work product. The typical due diligence work required under the Listing Rules includes reviewing material financial information in the listing document (the due diligence requirements for which are discussed in Chapter 12 “Due Diligence Guidelines – Financial”) as well as interviewing and obtaining a comfort letter from the accountant.2
1.2.3 In assessing whether it has performed appropriate due diligence work on the accountant, the sponsor should evaluate whether it has reasonable grounds to believe and does believe, to the standard expected of a sponsor which is not itself an expert in the matters dealt with in the accountant’s report, that the accountant can meet the qualification criteria set out in the declaration to be provided by the sponsor to the Stock Exchange pursuant to Appendix 19 to the Listing Rules.3 These qualification criteria, which are similar to the due diligence procedures set out in Paragraph 17.7(a) to (d) of the Code of Conduct which the sponsor should also adhere, include:
(a) any material factual information on which the accountant states that it is relying on or the sponsor believes the accountant is relying on and any supporting or supplementary information given by the accountant or the listing applicant to the Stock Exchange, for the purposes of any part of the accountant’s report, is true in all material respects and does not omit any material information;4
(b) all material bases and assumptions5 on which the accountant’s report are founded are fair, reasonable and complete;
(c) the accountant is appropriately qualified, experienced and sufficiently resourced to give the relevant opinion;
(d) the accountant’s scope of work is appropriate to the opinion given and the opinion required to be given in the circumstances;
(e) the accountant is independent from the listing applicant and its directors and controlling shareholder(s); and
(f) the listing document fairly represents the views of the accountant and contains a fair copy of or extract from the accountant’s report.
If the qualification criteria described above are met, the sponsor’s duties will be satisfied under Paragraph 17.5(c) of the Code of Conduct as long as the sponsor has no reasonable grounds to believe and does not believe that the information in the accountant’s report is untrue, misleading or contains any material omissions.
1.2.4 The standard expected of a sponsor which is not itself an expert in the matters dealt with in the accountant’s report is whether the sponsor can satisfy itself of compliance with the regulatory requirements in relation to the disclosure in the listing document.6
1.2.5 Since the information and opinion provided by the accountant may affect the listing application significantly and will also be included in the listing document, the sponsor should encourage the accountant to actively participate in drafting sessions and other due diligence meetings, in each case insofar as the discussions relate to accounting and financial matters. The accountant may have insights into the business and operations of the listing applicant, which can be helpful in ensuring that the disclosures are accurate and balanced.
1.2.6 The standards required of a sponsor in performing due diligence on accountants under paragraphs (c) and (d) of Appendix 19 to the Listing Rules, section 40 and paragraph 43 of Schedule 3 of the Companies Ordinance, and the typical due diligence enquiries required under paragraphs 12 and 14 of Practice Note 21 to the Listing Rules, respectively, are reproduced in Appendix I.
1.3 Recommended Steps
1.3.1 Under the Listing Rules, the sponsor is obligated to review and assess the financial information to be published in the listing document. Typical due diligence includes reviewing material financial information, including but not limited to the financial statements of the listing applicant, and the financial statements of subsidiaries of the listing applicant and other companies that are material to the Group’s financial statements, as well as the internal financial records, tax certificates (and supporting documents to such tax certificates) and PRC tax related filings of the listing applicant.7 For further guidance on financial due diligence on subsidiaries of the listing applicant, please refer to Chapter 12 “Due Diligence Guidelines – Financial”. In exceptional circumstances, the sponsor may wish to examine the internal financial records of the listing applicant if the sponsor has identified particular issues and it appears to the sponsor that examination of particular records would assist in addressing those particular issues.
1.3.2 The sponsor should conduct oral due diligence with the accountant prior to filing the listing application with the Stock Exchange and may make such further enquiries of the accountants as it deems appropriate.
(a) HKSIR 400 states that prior to any interviews/due diligence sessions, the accountant should have reached an understanding and agreement with the listing applicant and the sponsor relating to its engagement, in particular, any consent required from the listing applicant for the accountant to participate in interview/due diligence sessions, any undertaking from the listing applicant’s management to be present in the meeting, any restriction on the accountant from talking to the sponsor openly or to discuss any management letters or internal control letters issued previously.8
(b) The sponsor should interview the listing applicant’s principal accountants (i.e., external auditor and/or reporting accountant) and, where material, other unaffiliated accountants (i.e. unaffiliated with the principal accountants) who have performed an audit or review of the accounts of any subsidiary or acquired entity or related entity of the listing applicant that makes a substantial contribution to the financial position or operations of the Group.9
(c) The accountants will typically request, and the sponsor may agree to provide, a list of questions addressed to the accountant (and, if available, the latest draft of the listing document) in advance of any interviews/due diligence sessions and the accountant may meet with the listing applicant to discuss the intended responses.10
(d) The sponsor may generally rely on any written or oral statement made by the accountant during the interviews/due diligence sessions except if there are other facts or matters which raise concerns relating to the statements made by the accountant, the sponsor should conduct further enquiries necessary (as well as obtaining relevant supporting information and documents where necessary) to satisfy itself that these concerns are addressed.
(e) A list of questions for accountants that may serve as a useful starting point in the preparation of questions for accountants is attached as Appendix II. Although additional questions may be called for based on the unique circumstances in particular transactions, if the sponsor has asked these questions and received responses it considers to be satisfactory, it should, as a general matter, have done sufficient work to address the issues raised.
(f) As a profession, accountants have placed limits on the scope and the nature of the oral due diligence in which they are willing to engage. HKSIR 400 states that an accountant will normally confine its comments to matters properly relating to the engagement. These limitations are discussed in section 6 below. Appendix II has been prepared with these limitations in mind after discussion with senior representatives of the accounting profession.
1.3.3 The sponsor should obtain a comfort letter from the accountant and:11
(a) Ensure that the comfort letter is in the customary form called for by HKSIR 400. HKSIR 400 limits the extent of comfort that can be provided by the accountant as follows:
(i) the accountant can properly report in its professional capacity only on matters to which its professional expertise is substantially relevant;
(ii) the procedures such as those contemplated in a comfort letter provide the accountant with a basis for reporting no more than a list of procedures performed and the findings of those procedures, or providing limited assurance on subsequent changes. Such limited procedures may bring to the sponsor’s attention significant matters affecting the financial information, but they do not provide assurance that the sponsor will learn of all information that it may wish to know;
(iii) the accountant can agree to report on a procedure such as comparing information contained in a listing document to a schedule prepared by the listing applicant’s management, but only if the information in the schedule has been derived from accounting records subject to the listing applicant’s internal controls, policies and procedures of which the accountant has knowledge;
(iv) the accountant is generally not in a position to comment on matters primarily involving the exercise of business judgment of the listing applicant’s management. It should be appropriate for the accountant to comment on management’s explanation of such changes only if they have obtained the necessary information by performing a separate assurance engagement in accordance with Hong Kong Standards on Auditing and Assurance;
(v) the accountant generally will not comment on information subject to legal interpretation, such as beneficial share ownership or contracts, or on matters such as engineering data or mineral reserves;
(vi) the accountant generally will not comment on matters merely because they happen to be present and are capable of reading, counting, measuring, or performing other functions that might be applicable;
(vii) the accountant generally will comment on quantitative information other than financial information only when: (A) it has been obtained from accounting records that are subject to internal controls, policies and procedures of which the accountant has knowledge; or (B) it has been the subject of a separate assurance engagement performed in accordance with Hong Kong Standards on Auditing and Assurance;
(viii) the accountant generally will comment on the change period solely based on the limited procedures actually performed with respect to that period and is limited to reporting changes in amounts and should avoid addressing the reasons for such changes; and
(ix) limited assurance may only be provided on subsequent changes when the financial statements from which the changes are being measured have been subject to an audit or a review in accordance with standards within the Hong Kong Framework for Assurance Engagements.12
(b) Consider the procedures which the accountant proposes to perform, bearing in mind that the list of procedures in HKSIR 400 is not exhaustive and that additional or different procedures may be appropriate for certain items.
(c) Consider additional due diligence enquiries directly with, and additional representations and warranties from, the listing applicant if:
(i) negative assurance on the change period is not available;13
(ii) there are important line items for which change period comfort will not be available; or
(iii) there are important line items on which the accountant will not provide comfort.
(d) Review the comfort letters on profit forecast, indebtedness, working capital and unaudited pro forma financial information against the information known by the sponsor with respect to the listing applicant and discussing with the accountant to determine whether:
(i) the comfort letters have been prepared by the accountant in accordance with the applicable standards;
(ii) the statement of indebtedness has been reviewed by the accountant and the accountant has issued a comfort letter stating whether it has obtained confirmations with respect to the Group’s bank loans, reviewed reconciliations of these loans to the records of the Group, obtained written representations from management of the listing applicant concerning indebtedness of the Group, and whether nothing has come to the accountant’s attention to indicate that adjustments should be made to the statement of indebtedness;
(iii) the working capital forecast memorandum has been reviewed by the accountant and the accountant has issued a comfort letter stating whether in their opinion the cash flow projections have been properly compiled on the basis of the assumptions made and/or the working capital statement has been made by the directors of the listing applicant after due and careful enquiry;
(iv) the profit forecast or pro forma financial information has been properly compiled;
(v) the profit forecast has been presented on a basis or the basis of the pro forma information is consistent with the accounting policies of the listing applicant; and
(vi) whether there is any reason to believe that any assumptions that have been used or relied upon by the accountant in preparing the comfort letters are unrealistic.
1.3.4 Sample questions for the accountants as part of the due diligence exercise relating to the procedures performed by the accountants, profit or working capital forecast and the comfort letters are included in Appendix II.
1. Paragraph 50 of the Report on Sponsor Theme Inspection Findings of March 2011, which states that “while a sponsor is not expected to identify and deal with issues in such a manner that require specialised knowledge and skills which a reasonable person in the place of the sponsor does not possess, it is only appropriate for a sponsor to rely on the work performed by third party professionals and/or experts if it could satisfy itself that it is reasonable to rely on such information and advice.” Paragraph 5.3(a) of the CFA Code provides that “where reliance on the work of independent experts or other professionals is planned, a Corporate Finance Adviser (including an independent financial adviser) should, inter alia, undertake reasonableness checks to assess the relevant experience and expertise of the firm of experts or other professionals and to satisfy itself that reliance could fairly be placed on their work.”
2. Paragraphs 12 and 14 Practice Note 21 to the Listing Rules.
3. Paragraph (c) of Appendix 19 to the Listing Rules. Similar requirements are imposed under sections 40(2)(d)(i) and (ii) of the Companies Ordinance in relation to establishing a defence to civil liability for a material prospectus misstatement in an expert report.
4. Paragraph (c) of Appendix 19 and Paragraph 14(c) of Practice Note 21 to the Listing Rules. This requirement under the Listing Rules is, on its face, more onerous than the requirement imposed under Paragraph 17.7(b) of the Code of Conduct. In practice, sponsors do not typically independently verify the underlying financial information of the issuer, nor does the Stock Exchange expect sponsors to do so, rather, the view of the Stock Exchange appears to be that the audit work performed by a reporting accountant constitutes adequate verification. In July 2005, the Stock Exchange provided informal guidance stating that “for the purpose of the reporting accountants’ opinion that “historical financial information included in a prospectus as a whole gives a true and fair view”, the Exchange accepts that reasonable assurance from conducting their engagement in accordance with the relevant accounting standards constitutes “verification” of the factual information on which they rely to reach the requisite view. Accordingly the Exchange does not expect sponsors to verify the financial information relied on by the reporting accountant in reaching the “true and fair view” for the purpose of Rule 3A.16(1), Paragraph (c)(i) of Appendix 19 and Paragraph 14(c) of Practice Note 21.” The reference to Listing Rule 3A.16(1) should be disregarded after 1 October 2013. Paragraph 14(d) of Practice Note 21 to the Listing Rules also requires the sponsor to assess whether formal or informal representations made by the listing applicant to the accountant in relation to the accountant’s report are consistent with the sponsor’s knowledge of the listing applicant. Please refer to paragraph 5.2.2 for further details.
5. According to Paragraph 17.7(c) of the Code of Conduct, in the case of financial information of a person, bases and assumptions refer to the critical accounting policies and estimates of that person.
6. Paragraph 27 of the HKMA Report on Thematic Examinations of Sponsor Activities of November 2011.
7. Paragraph 12(b) of Practice Note 21 to the Listing Rules. Paragraph 20 of Form M104 (a form for new listing application required to be submitted with Form A1) also requires the sponsor to provide to the Exchange a summary of material findings of the sponsor and the reporting accountant in assessing whether the underlying financial information of the group’s PRC companies used for the preparation of the accountant’s report is consistent with (i) all the relevant regulatory filings or reports filed with the appropriate competent government authorities; and (ii) where applicable, the information on related party transactions as shown in the financial statements of the relevant related parties. Such summary is required to set out all the relevant regulatory filings/reports reviewed, the method of retrieval of such filings/reports, the amount and nature of any material differences noted, the reasons for any such differences and whether the sponsor is satisfied that such differences have been properly dealt with by adjustments to the financial statements, disclosure or other follow-up action.
8. Paragraphs 60 and 61 HKSIR 400 “Comfort Letters and Due Diligence Meetings”. It may be prudent for the sponsor to document the consent of the listing applicant to the accountant providing to the sponsor copies of management letters and internal control letters previously issued by the accountant.
9. Paragraph 12(b) of Practice Note 21 to the Listing Rules.
10. Paragraph 62 of HKSIR 400 “Comfort Letters and Due Diligence Meetings” (as amended in December 2012).
11. Paragraph 12(b) of Practice Note 21 of the Listing Rules. Since Practice Note 21 to the Listing Rules was adopted, HKSIR 400 has been amended to permit “negative assurance” to be provided in comfort letters in some circumstances.
12. According to paragraph 8 of AATB 3 “Implementation Guidance on Revised Hong Kong Standard on Investment Circular Reporting Engagements (HKSIR) 400 Comfort Letters and Due Diligence Meetings”, when considering whether to provide comfort on financial information as of a listing applicant’s year-end date or on subsequent changes in financial statement items where the cut-off date is at or within a few days of the year-end, unless the audit is substantially complete at the cut-off date, accountants will exercise extreme caution before they: (i) provide “tick-mark” comfort on information as at or ending on a year-end date; (ii) read management accounts ending on the financial year end date in order to provide change period comfort; or (iii) enquire of management and provide negative assurance with respect to change period comfort using a cut-off date on, or within a few days before or after, the financial year end. Where the cut-off date extends beyond the listing applicant’s financial year-end, the accountants may provide bifurcated comfort (negative assurance based on reading pre year-end management accounts and procedures and factual findings comfort to the cut-off date) provided that the overall change period does not exceed the parameters discussed in endnote 13 below.
13. According to paragraphs 4 through 6 of AATB 3 “Implementation Guidance on Revised Hong Kong Standard on Investment Circular Reporting Engagements (HKSIR) 400 Comfort Letters and Due Diligence Meetings”, in determining the “maximum” change period appropriate for providing negative assurance, accountants should refrain from providing such assurance for an equity offering when the change period is longer than six months. Such “maximum” change period may need to be shortened in certain circumstances (e.g., to 135 days where the equity offering also involves a concurrent Rule 144A exempt offering in the United States). The factors that the accountants may take into account in assessing the “maximum” change period may include: (i) whether or not the listing applicant is publicly listed (and therefore publishes financial information on a regular basis that is subject to regulatory review and scrutiny); (ii) the length of the accountants’ relationship with the listing applicant; and (iii) the accountants’ assessment of the quality of the listing applicant’s internal controls over financial reporting. However, in all cases, accountants should generally refrain from providing negative assurance for change period comfort when the cut-off date is nine months or more from the latest balance sheet date upon which the accountants have performed an audit or review.
HKCFEF Limited and the contributing law firms, accountants and sponsors are not offering these due diligence guidelines as legal, financial or professional advice or services and they should not be relied upon as such. These due diligence guidelines should not be used as a sole basis for any decision, action or inaction and are not meant to serve as a substitute for the advice of qualified professionals. See here for the full terms and conditions.