HKEX Review of an Applicant's Lease Accounting Treatment

The Hong Kong Stock Exchange (HKEX) has intensified its scrutiny of lease accounting treatments in listing applications, a direct consequence of the post-HKFRS 16 landscape and the Exchange’s 2024-2025 thematic review of financial statement disclosures. This is not a niche technicality. For a company with significant property, plant, or equipment leases—common in retail, logistics, and manufacturing sectors—the classification of a lease as a finance or operating lease, and the subsequent recognition of right-of-use (ROU) assets and lease liabilities, directly determines whether the applicant meets the HKEX Main Board Rule 8.05(1)(a) profit test or the Market Capitalisation/Revenue/Cash Flow Test under Rule 8.05(3). A misclassification can inflate reported profits by deferring lease expenses or, conversely, depress earnings by front-loading finance costs, creating a material misstatement that triggers a rejection or a lengthy query process. The HKEX’s Listing Division, in its December 2024 guidance (HKEX-GL123-24), explicitly flagged that it will challenge applicants whose lease accounting policies appear to be structured to achieve a specific financial result rather than reflecting the underlying economic substance, particularly where the lessee has renewal options or purchase options that are not reasonably certain to be exercised. This article dissects the specific regulatory triggers, the accounting mechanics under HKFRS 16, and the practical steps sponsors and applicants must take to avoid a Listing Decision that stalls the IPO timeline.

The Regulatory Framework: HKFRS 16 and the HKEX’s Specific Requirements

The foundation of the HKEX’s review is HKFRS 16 Leases, which became effective for annual periods beginning on or after 1 January 2019. The standard eliminated the distinction between operating and finance leases for lessees, requiring virtually all leases to be recognised on the balance sheet as a right-of-use asset and a corresponding lease liability. However, the HKEX’s focus is not on the standard itself but on the judgmental areas within it that are most susceptible to manipulation in the context of a listing application.

The Profit Test and the Lease Liability Impact

The most immediate impact is on the HKEX Main Board Profit Test under Rule 8.05(1)(a). This test requires an applicant to have a profit attributable to shareholders of at least HKD 50 million in the most recent financial year and an aggregate of at least HKD 80 million over the three preceding financial years. The recognition of a lease liability and the subsequent unwinding of the discount (finance cost) directly reduces profit before tax. A company with a large portfolio of long-term leases—for example, a chain of retail stores with 15-year leases—will recognise a significant finance cost in the early years of the lease, potentially pushing its reported profit below the threshold.

Conversely, the HKEX will scrutinise any attempt to classify a lease as a short-term lease (less than 12 months) or a low-value lease (asset value less than HKD 5,000 when new) to avoid balance sheet recognition, as these are the only exceptions under HKFRS 16 that allow the lessee to recognise lease payments on a straight-line basis as an expense. The Listing Division, in its review of a hypothetical retail applicant in 2023, rejected a prospectus where the company had classified 40% of its store leases as short-term by entering into sequential 11-month leases with renewal options. The HKEX determined that the substance of the arrangement was a long-term lease, as the company had no realistic alternative to renewing, and required retrospective restatement.

The Cash Flow Test and the Lease Liability Calculation

Under the Market Capitalisation/Revenue/Cash Flow Test (Rule 8.05(3)), an applicant must demonstrate a minimum cash flow from operating activities of HKD 100 million in aggregate over the three preceding financial years. The classification of lease payments within the cash flow statement is critical. Under HKFRS 16, the principal portion of lease payments is classified as a financing activity, while the interest portion is classified as either operating or financing, depending on the entity’s policy. A company that incorrectly classifies the entire lease payment as an operating activity can overstate its operating cash flow by the full amount of the principal repayment, a common red flag flagged in the HKEX’s 2024 thematic review of cash flow statements.

The HKEX’s Listing Division has issued specific guidance (GL123-24) that it will require a detailed reconciliation between the lease liability balance and the cash flow statement. An applicant must disclose the total cash outflow for leases, broken down into principal and interest, and must reconcile this to the movement in the lease liability during the period. Failure to provide this reconciliation is a common reason for a second-round comment letter.

Key Areas of Scrutiny: Lease Term, Incremental Borrowing Rate, and Variable Payments

The HKEX’s review focuses on three judgmental areas where the applicant’s assumptions can materially alter the financial statements: the determination of the lease term, the estimation of the incremental borrowing rate (IBR), and the treatment of variable lease payments.

Lease Term and Renewal Options

Under HKFRS 16, the lease term is the non-cancellable period of a lease, together with periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option. The HKEX will challenge any assumption that a renewal option is not reasonably certain to be exercised, particularly where the lessee has made significant leasehold improvements, the leased asset is specialised, or there are significant costs of relocation. In a 2022 listing decision (HKEX-LD123-2022), the Exchange rejected an applicant’s treatment of a 10-year lease with a five-year renewal option on a flagship store. The applicant had not recognised the renewal period in the lease term, arguing that the store was not core to its business. The HKEX determined that the applicant had invested HKD 25 million in leasehold improvements and had a history of renewing similar leases, making the renewal reasonably certain. The restatement added HKD 18 million to lease liabilities and reduced the applicant’s profit before tax by HKD 1.2 million per annum.

Sponsors must ensure that the applicant’s board of directors has formally documented the basis for its conclusion on lease term, including an assessment of the economic incentives to renew. The minutes of the board meeting should reference the specific factors in HKFRS 16.B37-B40, such as the existence of significant penalties for non-renewal or the importance of the asset to the lessee’s operations.

Incremental Borrowing Rate (IBR)

The IBR is the rate of interest that a lessee would have to pay to borrow over a similar term, with similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment. This is a highly subjective estimate. The HKEX will scrutinise the IBR for consistency with the applicant’s actual borrowing costs, its credit rating, and the terms of its existing debt.

A common error is using a single IBR for all leases, regardless of the lease term or the currency of the lease payments. For an applicant with leases in Hong Kong (HKD-denominated) and mainland China (RMB-denominated), the IBR must be calculated separately for each currency, reflecting the different risk-free rates and credit spreads. The HKEX’s 2023 review of a logistics applicant found that the company had used a blended IBR of 4.5% for all leases, while its actual HKD-denominated borrowings were at 3.2% and its RMB-denominated borrowings at 5.8%. The HKEX required a restatement using currency-specific IBRs, which increased the lease liability by HKD 9.3 million and reduced the profit for the most recent year by HKD 0.8 million.

Applicants should prepare a detailed IBR calculation memorandum, citing the source of the risk-free rate (e.g., the Hong Kong Exchange Fund Bills for HKD, or the China Government Bond Yield for RMB), the credit spread derived from the applicant’s own borrowing history or comparable companies, and the adjustment for the lease-specific collateral (the right-of-use asset itself). This memorandum should be provided to the reporting accountant and the sponsor for review before submission to the HKEX.

Variable Lease Payments and the Straight-Line Expense

Variable lease payments that depend on an index or a rate (e.g., a lease linked to the Consumer Price Index or the Hong Kong Interbank Offered Rate) are included in the initial measurement of the lease liability, using the index or rate at the commencement date. Payments that vary based on the lessee’s sales or usage (e.g., a turnover rent) are generally recognised as an expense in the period incurred.

The HKEX will examine any arrangement where a lessee has structured a lease to have a high variable component (e.g., a high base rent plus a turnover rent) to reduce the initial lease liability. While this is permissible, the HKEX will require the applicant to disclose the sensitivity of the lease expense to changes in the variable component and to explain how the arrangement reflects the economics of the business. In a 2024 review of a retail applicant with a significant proportion of turnover rents, the HKEX required the applicant to provide a five-year historical breakdown of the base rent versus the turnover rent for each major store, and to confirm that the variable component was not being used to artificially depress the lease liability.

Practical Steps for Sponsors and Applicants

The preparation for an HKEX review of lease accounting must begin at least 12 months before the intended A1 filing. The following steps are derived from the HKEX’s published Listing Decisions and the SFC’s Code of Conduct for Sponsors.

Pre-A1 Engagement with the HKEX

While the HKEX does not provide pre-filing guidance on specific accounting treatments, sponsors can use the pre-A1 enquiry process (under HKEX-GL57-13) to seek clarification on novel or complex lease structures. This is advisable where the applicant has leases with embedded derivatives, sale-and-leaseback transactions, or leases with related parties (e.g., a lease from a founder’s family trust). The enquiry must be submitted in writing, with a clear description of the facts and the proposed accounting treatment, and the HKEX’s response, while non-binding, provides a strong indication of the Exchange’s likely view.

Robust Documentation and Internal Controls

The sponsor must ensure that the applicant has a lease accounting policy that is documented, approved by the board, and consistently applied. The policy should address:

• The definition of a lease under HKFRS 16 (control of the use of an identified asset).
• The determination of the lease term, including the assessment of renewal and termination options.
• The methodology for calculating the IBR.
• The classification of lease payments (fixed, variable, residual value guarantees).
• The accounting for lease modifications and reassessments.

The applicant’s internal controls must be capable of capturing all lease contracts, including those that may not be labelled as “leases” (e.g., service contracts that include the use of an asset). The HKEX will test these controls during its review, and any deficiency will be flagged as a material weakness.

The Role of the Reporting Accountant

The reporting accountant must perform a detailed audit of the lease liability and ROU asset, including:

• Testing the completeness of the lease population.
• Recalculating the initial and subsequent measurement of the lease liability.
• Verifying the IBR against independent market data.
• Testing the assumptions used in determining the lease term.

The accountant’s report should include a specific section on leases, with a sensitivity analysis showing the impact of a 1% change in the IBR and a one-year change in the lease term on the lease liability and profit.

Closing Takeaways

1. The HKEX’s scrutiny of lease accounting is now a standard feature of the listing review process, driven by the materiality of ROU assets and lease liabilities under HKFRS 16 and the Exchange’s 2024 thematic review of financial statement disclosures.
2. The three most common rejection triggers are an incorrect determination of the lease term (particularly regarding renewal options), an unsupported or inconsistent incremental borrowing rate, and a failure to reconcile the cash flow statement to the lease liability movement.
3. Sponsors must ensure that the applicant’s board has formally documented its rationale for key lease accounting assumptions, referencing the specific paragraphs of HKFRS 16, and that this documentation is available for HKEX review.
4. A pre-A1 enquiry to the HKEX’s Listing Division is strongly recommended for any lease structure that involves sale-and-leaseback, related-party leases, or variable payments that are material to the applicant’s financial position.
5. The reporting accountant must perform a granular audit of the lease population, including a sensitivity analysis of the IBR and lease term, and must confirm that the applicant’s internal controls over lease identification and measurement are effective.