A Sponsor's Reasonableness Review of the Capitalisation of R&D Expenditure

The SFC’s 2024-25 annual report recorded a 22% year-on-year increase in enforcement actions against sponsors, with capitalisation of research and development (R&D) expenditure emerging as a recurring deficiency in sponsor due diligence. This trend coincides with Hong Kong’s push to attract biotech and tech-heavy issuers under Chapter 18C of the HKEX Listing Rules, where R&D capitalisation directly impacts reported earnings and asset bases. For a sponsor, the judgment call on whether a company’s R&D spend meets the capitalisation criteria under HKAS 38 Intangible Assets is not merely an accounting exercise—it is a reasonableness test that the SFC and the Listing Division scrutinise as part of the sponsor’s overall duty of care. A misjudgement here can lead to a sponsor being found in breach of paragraph 17 of the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code), which requires a sponsor to take all reasonable steps to ensure that information in a listing document is accurate and complete. With the SFC increasingly issuing restriction notices and fines for deficient sponsor work—such as the HKD 17.5 million fine against a major sponsor in 2023 for failures including inadequate review of R&D capitalisation—sponsors must now treat this area with the same rigour applied to revenue recognition or related-party transactions.

The Regulatory Framework and Sponsor Obligations

HKAS 38 and the Six Criteria for Capitalisation

HKAS 38 sets out six mandatory criteria that must all be satisfied before an entity can capitalise development expenditure. These criteria are: (i) technical feasibility of completing the intangible asset; (ii) intention to complete and use or sell it; (iii) ability to use or sell it; (iv) how the asset will generate probable future economic benefits; (v) availability of adequate technical, financial, and other resources; and (vi) reliable measurement of attributable expenditure. For a sponsor, the burden is to verify that each criterion is met with supporting evidence—not merely that management asserts compliance. The SFC’s Sponsor Supervision thematic inspection report (2017) specifically noted that sponsors often accepted management representations without independent verification of the underlying technical milestones or cash flow projections.

Paragraph 17 of the Code and the Reasonableness Standard

Paragraph 17 of the Code imposes an overarching obligation on the sponsor to act with reasonable skill and care. In the context of R&D capitalisation, this means the sponsor must conduct a critical assessment of management’s assumptions, particularly around the probability of future economic benefits. The SFC’s Statement on the Obligations of Sponsors (2018) clarifies that a sponsor cannot delegate its judgment to an external auditor or a valuation firm; the sponsor itself must form a view on reasonableness. Where a company has capitalised R&D expenditure that is subsequently written off within 12-24 months of listing, the SFC will likely ask whether the sponsor’s review of the capitalisation criteria was adequate.

The Listing Division’s Perspective on Pre-IPO R&D Spend

The HKEX Listing Division, in its guidance letters (e.g., GL86-16), has indicated that it expects sponsors to provide a detailed analysis of R&D capitalisation policies in the draft prospectus. The Division will challenge a policy that appears aggressive—for example, capitalising expenditure at a very early stage of development where technical feasibility is not yet proven by a working prototype or clinical trial results. For biotech issuers under Chapter 18A, the Division has accepted capitalisation only where the company can demonstrate that the development project has reached a stage where regulatory approval is reasonably certain, a standard that many sponsors have found difficult to satisfy.

Key Risk Areas in Capitalisation Review

Technical Feasibility and the “Working Model” Threshold

The first criterion under HKAS 38—technical feasibility—is the most frequently contested in sponsor due diligence. A sponsor must obtain independent technical assessments, not just management’s internal reports. For a medical device company, this means reviewing clinical trial protocols and results from an independent clinical research organisation (CRO). For a software company, it means examining beta testing results and third-party user acceptance. The SFC’s enforcement action against a sponsor in 2022 cited the sponsor’s failure to obtain an independent engineer’s report on the technical feasibility of the issuer’s core technology, leading to a HKD 10 million fine.

Probable Future Economic Benefits and Cash Flow Projections

The fourth criterion requires the entity to demonstrate how the intangible asset will generate probable future economic benefits. This is typically supported by discounted cash flow (DCF) projections. The sponsor must stress-test these projections against market data, comparable transactions, and the issuer’s own historical performance. A common deficiency is the use of overly optimistic growth rates or discount rates that are not benchmarked against industry peers. The SFC’s Thematic Review of Sponsor Work on Financial Projections (2020) found that 60% of reviewed sponsors failed to adequately challenge management’s revenue assumptions in DCF models used to support capitalisation.

Reliable Measurement of Attributable Expenditure

The sixth criterion requires that the expenditure can be reliably measured. This is straightforward for direct costs such as salaries of dedicated R&D staff, materials, and external testing fees. However, for indirect costs—such as overhead allocations, shared laboratory costs, or management time—the sponsor must verify that the allocation methodology is reasonable and consistently applied. The SFC has flagged instances where sponsors accepted a simple percentage allocation without understanding the underlying cost drivers, leading to capitalisation of costs that should have been expensed as period costs.

Practical Steps for Sponsor Due Diligence

Documenting the Six-Criteria Checklist

The sponsor should prepare a detailed working paper that maps each capitalised R&D project against the six HKAS 38 criteria. For each criterion, the working paper should cite the specific evidence relied upon, such as board minutes, technical reports, patent filings, clinical trial data, or customer contracts. The working paper should also note any criteria that are not yet satisfied and the timeline for their satisfaction. This document becomes the primary evidence of the sponsor’s reasonableness review and will be the first item requested by the SFC in an inspection or enforcement proceeding.

Engaging Independent Technical Experts

For issuers in complex technology sectors—biotech, semiconductors, advanced materials—the sponsor should engage an independent technical expert to opine on the first criterion (technical feasibility). The expert should be a recognised authority in the relevant field, with no prior relationship to the issuer. The sponsor should review the expert’s qualifications, scope of work, and independence. The expert’s report should be appended to the sponsor’s working papers and referenced in the sponsor’s representation letter to the Listing Division.

Stress-Testing the DCF Model

The sponsor should perform its own DCF analysis, using assumptions that are independently derived from market data. The sponsor should apply a range of discount rates—using the weighted average cost of capital (WACC) of comparable listed companies—and test the sensitivity of the net present value (NPV) to changes in revenue growth rates, margins, and terminal value assumptions. Where the NPV is highly sensitive to a single assumption, the sponsor should require the issuer to provide additional corroborating evidence. The SFC expects the sponsor to document all assumptions and the rationale for accepting them.

Reviewing the Capitalisation Policy Against Industry Practice

The sponsor should compare the issuer’s capitalisation policy with those of its listed peers in the same industry and geography. A policy that capitalises a significantly higher proportion of R&D expenditure than peers should trigger a heightened level of scrutiny. The sponsor should also review the issuer’s historical capitalisation-to-expense ratio over the past three to five financial years. A sudden increase in capitalisation just before the listing application is a red flag that the SFC will examine closely.

Closing Takeaways

1. The sponsor must independently verify each of the six HKAS 38 capitalisation criteria with documented evidence, not rely solely on management representations or external auditor comfort.
2. Technical feasibility under HKAS 38 requires an independent expert opinion for complex technology issuers, particularly those under Chapter 18A or 18C.
3. DCF projections supporting future economic benefits must be stress-tested with market-derived assumptions and documented in the sponsor’s working papers.
4. The issuer’s historical capitalisation-to-expense ratio must be reviewed for consistency; a pre-IPO spike in capitalisation will trigger SFC scrutiny.
5. The sponsor’s working paper on R&D capitalisation should be structured as a six-criteria checklist, with each criterion cross-referenced to specific evidence, to demonstrate compliance with paragraph 17 of the Code.