Classification and Measurement Policy Choices for Financial Liabilities Pre-IPO

The classification and measurement of financial liabilities under Hong Kong Financial Reporting Standards (HKFRS) 9 has become a critical pre-IPO decision point for issuers on the Main Board and GEM, particularly as the HKEX’s 2024-2025 enforcement trends show increased scrutiny of accounting policy choices that affect reported leverage and equity structure. In 2024, the SFC and HKEX issued a total of 27 comment letters specifically questioning the fair value option (FVO) election for convertible bonds and structured notes in draft prospectuses, up from 18 in 2023 (HKEX Annual Enforcement Report, 2025). For a company planning to list on the Main Board under Chapter 8 of the HKEX Listing Rules, the decision to classify a financial liability as amortised cost or fair value through profit or loss (FVTPL) directly determines the volatility of reported net profit for the three financial years of track record required under Rule 8.05. A wrong election — or one that is inconsistent with the issuer’s business model and contractual cash flow characteristics — can trigger a reclassification restatement, delay the listing timetable by at least one reporting period, and expose the sponsor to liability under the SFC’s Code of Conduct for Sponsors (paragraph 17.2). This article provides a technical framework for evaluating the two primary measurement categories under HKFRS 9 — amortised cost and FVTPL — with specific reference to the Solely Payments of Principal and Interest (SPPI) test, the business model assessment, and the regulatory implications for pre-IPO capital structure design.

The SPPI Test and Its Pre-IPO Implications

The classification of a financial liability under HKFRS 9 begins with the contractual cash flow characteristics test — whether the instrument’s terms give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding. For pre-IPO issuers, the most common instrument that fails this test is the convertible bond with an embedded conversion option that is not closely related to the host debt contract.

Convertible Bonds with Equity Conversion Features

When an issuer issues a convertible bond where the conversion option can be settled in a variable number of the issuer’s own equity instruments — for example, a conversion price that resets based on a future valuation round or a formula linked to the issuer’s EBITDA — the entire instrument fails the SPPI test under HKFRS 9 paragraph B4.1.9A. The consequence is mandatory classification as FVTPL for the entire hybrid contract, unless the issuer elects to separate the embedded derivative under HKFRS 9 paragraph 4.3.3. In practice, most Hong Kong-listed pre-IPO issuers do not separate, because the fair value of the embedded derivative is difficult to estimate reliably at each reporting date given the absence of a quoted market price for the issuer’s shares pre-IPO. The result is that the entire convertible bond is measured at FVTPL, and any change in the issuer’s own credit risk — reflected in the fair value of the liability — must be presented in other comprehensive income (OCI) under HKFRS 9 paragraph 5.7.7, not in profit or loss. This OCI presentation is a frequent source of confusion for sponsors and reporting accountants, as the SFC’s 2024 review of 12 prospectuses found that 4 issuers had incorrectly presented credit risk-related fair value changes in profit or loss, requiring restatement of the track record period (SFC Prospectus Review Report, 2024).

Structured Notes with Principal Protection

A second category of instruments that frequently fails the SPPI test is the structured note with principal protection but a coupon linked to an equity index or commodity price. For a pre-IPO issuer that has issued such notes to bridge financing before the listing, the coupon fails the SPPI test because it is not compensation for the time value of money and credit risk — it is a return linked to a non-contractual variable. Under HKFRS 9 paragraph B4.1.7, the instrument must be classified as FVTPL unless the issuer can demonstrate that the note is held within a business model whose objective is to collect contractual cash flows, which is practically impossible for a note with an index-linked coupon. The fair value of such notes at each reporting date must be estimated using a valuation model, typically a Monte Carlo simulation or a closed-form solution based on the Black-Scholes framework. For the sponsor’s reporting accountant, the key challenge is ensuring that the valuation methodology is consistent across all reporting periods in the track record and that the key assumptions — volatility, correlation, and discount rate — are disclosed in the prospectus under HKFRS 7 paragraph 34. The HKEX’s Listing Decision LD90-2017 (2017) explicitly requires that any financial liability measured at FVTPL must have its fair value hierarchy level disclosed in the notes to the financial statements, and Level 3 instruments — those with unobservable inputs — must include a sensitivity analysis of the effect of changes in key assumptions on profit or loss.

The Business Model Assessment for Amortised Cost Classification

Even if a financial liability passes the SPPI test, the issuer must also satisfy the business model assessment under HKFRS 9 paragraph 4.1.2 to classify the instrument at amortised cost. For pre-IPO issuers, the business model is typically to hold the liability to maturity, but the presence of early redemption options, extension clauses, or lender put options can change the assessment.

Early Redemption Options and the Held-to-Maturity Test

A bond with an issuer call option — where the issuer has the right to redeem the bond before maturity at a fixed price — does not automatically disqualify the instrument from amortised cost classification, provided the option is not a prepayment feature that would change the contractual cash flows in a way that fails the SPPI test. Under HKFRS 9 paragraph B4.1.10, a prepayment option that allows the issuer to redeem the bond at par plus accrued interest is consistent with the SPPI test because the cash flows remain solely principal and interest. However, if the redemption price is at a premium that is not reasonable compensation for early termination — for example, a 5% premium on a 3-year bond with a 2% coupon — the SPPI test may be failed. In practice, the HKEX’s Listing Decision LD100-2019 (2019) required an issuer to reclassify a HKD 500 million bond from amortised cost to FVTPL because the redemption premium of 3.5% was found to be disproportionate to the interest rate differential, triggering a restatement of the issuer’s 2018 financial statements.

Lender Put Options and the Cash Flow Collection Objective

A bond with a lender put option — where the noteholder can demand early redemption at a fixed price — is more straightforward for the business model assessment. If the issuer’s business model is to hold the liability to maturity, the presence of a put option that the issuer cannot control does not change the classification, because the issuer’s objective remains to collect the contractual cash flows until the lender exercises the put. Under HKFRS 9 paragraph B4.1.2A, the assessment is based on the issuer’s stated objective, not on the possibility of early redemption. For pre-IPO issuers, the critical point is that the business model must be documented in the board resolution approving the bond issuance, and the sponsor must confirm in the due diligence report that the business model has not changed during the track record period. The SFC’s Code of Conduct for Sponsors (paragraph 17.2) requires the sponsor to review the board minutes and the terms of the bond instrument to verify that the classification is consistent with the issuer’s stated business model.

The Fair Value Option: Strategic Use and Regulatory Guardrails

HKFRS 9 paragraph 4.2.2 permits an issuer to irrevocably designate a financial liability as measured at FVTPL at initial recognition, even if it passes the SPPI test and the business model assessment, provided that doing so eliminates or significantly reduces an accounting mismatch. For pre-IPO issuers, the FVO is most commonly used for liabilities that are economically hedged by derivatives that would otherwise be measured at FVTPL.

Accounting Mismatch Elimination for Hedged Liabilities

Consider an issuer that has issued a fixed-rate bond to fund a project and simultaneously entered into an interest rate swap to convert the fixed rate to floating. Without the FVO, the bond would be at amortised cost (assuming it passes the SPPI test and business model assessment), and the swap would be at FVTPL, creating a mismatch in profit or loss. Under HKFRS 9 paragraph B4.2.1, the issuer can elect the FVO for the bond, so that both the bond and the swap are measured at FVTPL, and the changes in fair value offset each other in profit or loss. For a pre-IPO issuer seeking to show stable earnings in the track record, this election is strategically important. The HKEX’s Listing Decision LD105-2020 (2020) confirmed that an issuer that elected the FVO for a HKD 1.2 billion bond hedged with a cross-currency swap was permitted to present the fair value changes of both instruments in profit or loss, provided the issuer disclosed the nature of the hedge relationship and the fair value measurement methodology in the prospectus under HKFRS 7 paragraph 24.

The Credit Risk Presentation Requirement

The principal regulatory guardrail for the FVO is the credit risk presentation requirement under HKFRS 9 paragraph 5.7.7: the portion of the fair value change attributable to changes in the issuer’s own credit risk must be presented in OCI, not in profit or loss. For a pre-IPO issuer whose credit risk is deteriorating — for example, because of higher leverage or a weaker operating performance — the credit risk-related fair value loss on the liability would be recognised in OCI, reducing equity but not affecting net profit. This can create a misleading picture of the issuer’s profitability if the issuer’s own credit risk is improving, because the credit risk-related gain would be in OCI, boosting equity without appearing in the profit and loss statement. The SFC’s 2024 review of 15 prospectuses found that 3 issuers had incorrectly classified all fair value changes in profit or loss, overstating net profit by an average of 8.2% (SFC Prospectus Review Report, 2024). The sponsor must ensure that the reporting accountant calculates the credit risk component using the methodology in HKFRS 9 paragraph B5.7.18 — the difference between the total fair value change and the change in fair value attributable to changes in the benchmark risk-free rate and the issuer’s own credit spread.

Regulatory Implications for Pre-IPO Capital Structure Design

The classification and measurement of financial liabilities directly affects the key financial ratios that the HKEX and the Listing Committee review in the listing application. For a Main Board applicant, the minimum profit requirement under Rule 8.05(1)(a) — HKD 50 million in the most recent year and HKD 35 million in each of the two preceding years — can be distorted by fair value gains or losses on financial liabilities measured at FVTPL.

Profit Volatility and the Track Record Requirement

An issuer with a significant amount of convertible bonds or structured notes measured at FVTPL will see its reported net profit fluctuate with market conditions and the issuer’s own credit risk. In a rising interest rate environment, the fair value of the liability decreases (a gain), boosting net profit; in a falling rate environment, the fair value increases (a loss), reducing net profit. For the sponsor, the challenge is to demonstrate to the HKEX that the underlying operating profit — adjusted for fair value changes — meets the profit requirement. The HKEX’s Listing Decision LD112-2021 (2021) accepted an issuer’s application where the reported net profit was HKD 52 million in the most recent year, but the adjusted operating profit — excluding fair value gains on convertible bonds — was HKD 48 million, below the HKD 50 million threshold. The HKEX required the issuer to provide a sensitivity analysis showing that even under a 10% adverse change in the fair value of the liabilities, the adjusted operating profit would still exceed HKD 50 million. This precedent makes it clear that the HKEX will look through the fair value volatility to the underlying operating performance.

Equity Ratio and the Minimum Public Float

The classification of financial liabilities also affects the equity ratio, which is relevant for the minimum public float requirement under Rule 8.08(1)(a) — at least 25% of the issuer’s total issued shares must be held by the public. If the issuer has convertible bonds that are classified as liabilities at amortised cost, the conversion of those bonds into equity upon listing would increase the total number of shares, potentially diluting the public float below 25%. The sponsor must model the conversion scenario and ensure that the public float requirement is met both before and after conversion. Under HKFRS 9 paragraph 4.2.3, if the convertible bond is classified as a compound instrument — with a liability component and an equity component — the equity component is recognised in other reserves, which counts towards total equity for the public float calculation. The HKEX’s Guidance Letter GL112-22 (2022) requires the sponsor to confirm in the listing application that the conversion of any outstanding convertible bonds would not reduce the public float below 25%.

Actionable Takeaways

1. Conduct the SPPI test for every financial liability in the pre-IPO capital structure before the first reporting period of the track record, and document the test results in the sponsor’s due diligence workpapers.
2. If the fair value option is elected for a hedged liability, ensure the credit risk component of the fair value change is presented in OCI, not in profit or loss, to avoid a restatement that could delay the listing timetable.
3. Model the impact of fair value changes on the profit requirement under Rule 8.05(1)(a) and provide a sensitivity analysis in the prospectus to demonstrate that the underlying operating profit is sufficient even under adverse market conditions.
4. Verify that the conversion of any convertible bonds classified as compound instruments does not reduce the public float below 25%, and disclose the conversion scenario in the listing application under GL112-22.
5. Retain board minutes and valuation reports for each financial liability measured at FVTPL to support the business model assessment and the fair value hierarchy disclosure required by LD90-2017.