Reasonableness Review of Fixed Asset Depreciation Policies Pre-IPO

The SFC and HKEX have intensified their scrutiny of non-recurring or one-off accounting adjustments made in the three financial years immediately preceding a listing application, with fixed asset depreciation policy changes emerging as a specific area of focus in 2025. This shift follows the HKEX’s publication of its 2024 Annual Review of Listing Decisions, which explicitly flagged two cases where applicants changed depreciation methods for property, plant, and equipment (PPE) within the track record period, resulting in a material upward revision of net profit. The Exchange’s Listing Division, referencing Listing Rule 9.04(1) and its guidance on “sufficient management continuity” under Rule 8.05, questioned whether such changes were a genuine reflection of the underlying business model or a cosmetic exercise to meet the profitability test. For CFOs and sponsors preparing a Form A1, the depreciation policy is no longer a routine accounting judgment; it is a disclosure risk that can trigger a return of the application or a requirement for an independent forensic accountant’s report. This article examines the specific regulatory tests applied by the HKEX, the acceptable justifications for a change, and the documentation burden required to survive a reasonableness review.

The Regulatory Framework: Alignment with HKEX Listing Rules and Accounting Standards

The HKEX’s review of depreciation policies is anchored in two parallel frameworks: compliance with Hong Kong Financial Reporting Standards (HKFRS) and the Exchange’s own qualitative listing criteria. Under HKFRS 16 – Property, Plant and Equipment, an entity must select a depreciation method that reflects the pattern in which the asset’s future economic benefits are expected to be consumed. However, the Listing Rules impose an additional layer of scrutiny: any change that materially improves reported profitability or net assets during the track record period is presumed to be a “flag” under the Exchange’s risk-based vetting approach, unless the applicant can demonstrate a clear and documented change in the pattern of economic benefit consumption.

The “Sufficient Management Continuity” Test Under Rule 8.05

The HKEX applies Listing Rule 8.05, which requires an applicant to demonstrate at least three financial years of “management continuity” and “ownership continuity.” A change in depreciation policy is not, by itself, a breach of this rule. However, the Exchange has taken the position in Listing Decision HKEX-LD136-2024 that a retrospective change in depreciation method—particularly from a declining balance to a straight-line method—can be viewed as an indicator that the historical financial statements do not present a “true and fair view” of the applicant’s financial position. In that decision, the applicant changed the depreciation rate for its manufacturing equipment from 20% declining balance to 10% straight-line, retroactively applied to the start of the track record period. The net effect was an increase in profit before tax of HKD 42.3 million, or 14% of the total profit for the earliest year. The Exchange required the sponsor to issue a negative assurance letter confirming that the change was not made to meet the profitability threshold.

The “Pattern of Consumption” Justification Under HKFRS 16

Under HKFRS 16.62, a change in depreciation method is only permissible if it results in a more reliable and more relevant presentation of the financial statements. The HKEX will test whether the applicant can demonstrate a verifiable change in the asset’s usage pattern. In a 2023 sponsor guidance note, the SFC and HKEX jointly clarified that a mere assertion that “the assets are now used more evenly” is insufficient. The applicant must provide operational data—such as machine hours, production volumes, or maintenance records—that directly supports the new pattern. For example, a logistics company changing the depreciation of its fleet from a unit-of-production method to a straight-line method would need to show that the fleet’s usage has become consistent across periods, supported by GPS mileage logs and fuel consumption data for the full track record period. Without such evidence, the Exchange will treat the change as a “revision of accounting estimate” under HKAS 8, but will require the sponsor to explain why the change was not identified earlier in the audit process.

Common Depreciation Policy Changes and Their Risk Profiles

The HKEX has published three anonymised cases in its 2024 Listing Decision Review that illustrate the specific scenarios most likely to attract heightened scrutiny. Each case involved a different industry and a different type of depreciation change, but all three shared a common outcome: the Exchange required the applicant to either revert to the original policy or provide a third-party expert report.

Case 1: Extending Useful Lives of Real Estate Assets

A property developer applied to list on the Main Board and, during the track record period, extended the estimated useful life of its investment properties held for own use from 30 years to 50 years. The change was applied prospectively, meaning it did not retroactively adjust prior years’ profits. However, the prospective reduction in annual depreciation expense was HKD 18.7 million per year, representing 9% of the applicant’s net profit in the most recent financial year. The Exchange, citing its guidance in Listing Decision HKEX-LD89-2023, required the applicant to commission an independent structural engineer’s report confirming that the building’s physical condition and expected maintenance cycle supported the longer useful life. The report cost the applicant approximately HKD 1.2 million and delayed the listing by four months. The key takeaway: a change in useful life, even if prospective, triggers a requirement for a physical asset inspection and a professional opinion from a qualified engineer, not just an auditor’s sign-off.

Case 2: Switching from Declining Balance to Straight-Line for Manufacturing Equipment

A precision engineering manufacturer changed its depreciation method for CNC machines from a 25% declining balance to a 15-year straight-line method. The change was applied retrospectively, restating the first two years of the track record. The total increase in retained earnings at the start of the track record period was HKD 27.5 million. The sponsor’s due diligence file contained a single-page memo from the CFO stating that “the usage pattern has become more consistent.” The Exchange rejected this justification and requested a detailed analysis of machine utilisation rates for each of the 42 CNC machines over the three-year period. The analysis revealed that utilisation rates varied from 55% to 92% across machines and years, contradicting the claim of consistent usage. The applicant was forced to revert to the declining balance method and re-file its financial statements. The total cost of the re-filing, including sponsor and auditor fees, was estimated at HKD 3.8 million.

Case 3: Changing Residual Value Estimates for Aircraft

An airline applicant revised its residual value estimate for its fleet of Boeing 737 aircraft from 15% of cost to 10% of cost, citing a decline in the secondary market for used aircraft. The change was applied prospectively and increased annual depreciation expense by HKD 12.3 million. While this change reduced profit, the Exchange still requested a justification because the change was material in absolute terms (HKD 12.3 million) and represented a departure from the industry norm of 15-20% residual values. The applicant provided a third-party appraisal from an aircraft valuation firm (IBA Group) confirming that the market value of 10-year-old 737s had declined by 8 percentage points over the prior two years. The Exchange accepted this justification. The lesson: a change that reduces profit is less likely to be challenged than one that increases profit, but it is not immune from review if the magnitude is significant relative to the applicant’s net profit.

Sponsor Due Diligence Requirements and Documentation Standards

The SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC (the “Code of Conduct”) imposes specific obligations on sponsors regarding the review of accounting policies. Paragraph 17.6 of the Code requires a sponsor to “take reasonable steps to satisfy itself that the accounting policies adopted by the listing applicant are appropriate in the circumstances and are consistently applied.” When a policy change occurs during the track record period, the sponsor must document the following three elements in its due diligence file.

Element 1: A Written Business Rationale Supported by Operational Data

The sponsor must obtain a written memorandum from the applicant’s management explaining the reason for the change. This memorandum must be more than a generic statement. It must identify the specific asset class, the old and new methods, the effective date, and the quantitative impact on each year of the track record. The sponsor must then independently verify the operational data that supports the rationale. For a change in depreciation method, this means obtaining and reviewing production logs, maintenance schedules, or asset utilisation reports. The sponsor should also interview the plant manager or operations director, not just the CFO, to confirm the operational basis for the change.

Element 2: An Independent Accounting Expert Report (When Required)

If the change is material—defined by the HKEX as an impact exceeding 5% of net profit in any single year of the track record—the sponsor should consider commissioning an independent accounting expert report. This report, typically prepared by a Big 4 firm or a specialist forensic accounting practice, must state whether the new policy is consistent with the pattern of economic benefit consumption and whether it is in accordance with HKFRS. The cost of such a report typically ranges from HKD 500,000 to HKD 1.5 million, depending on the complexity of the asset base. The report is not a substitute for the sponsor’s own due diligence but serves as a third-party validation that can pre-empt Exchange questions.

Element 3: A Comparison with Industry Peers

The sponsor should prepare a benchmarking analysis comparing the applicant’s depreciation policy with those of at least five comparable listed companies in the same industry. The HKEX has indicated in its Listing Decision HKEX-LD112-2024 that a policy change that results in the applicant adopting a method that is an outlier relative to its peers will face a higher burden of proof. For example, if all peer companies in the manufacturing sector use a 10-year straight-line method for machinery, and the applicant switches to a 20-year straight-line method, the sponsor must explain why the applicant’s assets have a longer economic life than the industry norm. The benchmarking analysis should include the peer companies’ disclosed useful lives, residual values, and depreciation methods, with citations to their annual reports.

The Role of the Audit Committee and the Sponsor’s Legal Counsel

The decision to change a depreciation policy is not a unilateral management decision. The HKEX expects the applicant’s audit committee to have formally reviewed and approved the change, with minutes of the committee meeting documenting the discussion. The sponsor’s legal counsel should also review the change from a disclosure perspective, ensuring that the prospectus contains a clear and prominent explanation of the change, its impact on the financial statements, and the reasons why the new policy is more appropriate.

Audit Committee Minutes: A Key Document in the Exchange’s Review

The Exchange has requested audit committee minutes in multiple listing decisions, including HKEX-LD98-2023, where the minutes were found to be insufficient because they did not record any discussion of the operational data supporting the depreciation change. The minutes should include: (i) the date of the meeting; (ii) the names of attendees; (iii) a summary of the management presentation on the change; (iv) the specific operational data reviewed; (v) the questions raised by committee members; and (vi) the vote approving the change. The minutes should be signed by the committee chair and filed with the sponsor’s due diligence records.

Prospectus Disclosure: Avoiding a “Surprise” for the Exchange

The prospectus should include a separate section under “Accounting Policies” that discusses any changes in depreciation methods or estimates during the track record period. The disclosure should state the old and new policies, the effective date, the quantitative impact on profit or loss and net assets for each year, and the reasons for the change. The HKEX has indicated that it will view a failure to disclose a material change in the prospectus as a potential breach of the Listing Rules, even if the change is subsequently accepted. The sponsor should ensure that the disclosure is reviewed by the Exchange’s Listing Division during the pre-A1 consultation process, if possible, to avoid a last-minute objection.

Actionable Takeaways for Pre-IPO Planning

1. Document the operational basis for any depreciation policy change at least 12 months before the Form A1 submission, including machine-hour logs, production records, or asset condition reports that directly support the new pattern of consumption.

2. Commission an independent asset appraisal or engineering report for any change in useful life or residual value that exceeds 5% of net profit in any single year of the track record, and budget HKD 500,000 to HKD 1.5 million for this cost.

3. Ensure the audit committee minutes explicitly reference the operational data reviewed and the specific reasons for approving the change, with signatures from all committee members present.

4. Prepare a peer benchmarking analysis comparing the applicant’s new depreciation policy with at least five listed peers in the same industry, and include this analysis in the sponsor’s due diligence file.

5. Consult the HKEX’s Listing Division through the pre-A1 consultation process if the change is material (exceeding 10% of net profit), to obtain informal guidance on whether the proposed policy is likely to be accepted.