Procedures and Methods for the Sponsor in Reviewing the Applicant's Asset Impairment Testing

The SFC’s 2024-25 enforcement priorities, outlined in its Annual Report published in June 2025, have placed sponsor due diligence on asset impairment testing under heightened scrutiny. The regulator specifically flagged deficiencies in how sponsors challenge management’s assumptions in goodwill impairment models, a recurring issue in recent enforcement actions. This focus follows a series of high-profile listing applications where post-IPO impairment charges materially misrepresented the financial position of newly listed entities, directly undermining investor confidence in Hong Kong’s listing regime. For sponsors holding SFC Type 6 (advising on corporate finance) and Type 6A (sponsor) licences, the margin for error has narrowed significantly. The SFC’s 2024 thematic review of sponsor work on impairment testing found that in 40% of sampled cases, the sponsor’s documentation did not adequately demonstrate independent challenge of the applicant’s cash flow forecasts, discount rates, or terminal value assumptions — the three pillars of any value-in-use model under HKAS 36. This article sets out the procedural framework and methodological standards a sponsor must adopt when reviewing an applicant’s asset impairment testing, drawing on the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code of Conduct), the Sponsor Regulation under the Listing Rules, and published Listing Decisions.

The Regulatory Framework for Sponsor Review of Impairment Testing

The sponsor’s obligation to review an applicant’s asset impairment testing is not a standalone requirement but flows from the overarching duty of care imposed by paragraph 17 of the Code of Conduct. This paragraph requires a sponsor to “exercise due skill, care and diligence” in conducting its work, which necessarily extends to verifying the reasonableness of material accounting estimates embedded in the applicant’s financial statements.

The Sponsor’s Duty Under Paragraph 17 of the Code of Conduct

Paragraph 17 of the Code of Conduct, specifically paragraph 17.6, mandates that a sponsor must take reasonable steps to ensure that all material information in the listing document is accurate and complete in all material respects. Asset impairment testing, particularly for goodwill, intangible assets, and property, plant and equipment, constitutes material information because an impairment charge — or the absence of one — directly affects the applicant’s net asset value, earnings, and compliance with the profit test under Main Board Rule 8.05.

The SFC’s Guidelines for Sponsors (December 2022 edition) further elaborates that the sponsor must “critically assess” the assumptions and methodologies used by the applicant’s management in preparing impairment tests. The SFC’s enforcement record demonstrates that a rubber-stamping approach — accepting management’s cash flow projections without independent verification — is a breach of paragraph 17. In SFC v. [Redacted Sponsor] (2023), the Market Misconduct Tribunal found the sponsor liable for failing to challenge a 15% revenue growth rate assumption in the applicant’s goodwill impairment model, which was inconsistent with the industry’s 3% CAGR over the preceding three years.

Linkage to the Listing Rules and HKAS 36

The Listing Rules do not prescribe a specific methodology for impairment testing, but they require the listing document to contain financial information that complies with Hong Kong Financial Reporting Standards (HKFRS). HKAS 36 Impairment of Assets sets the accounting standard, and the sponsor must ensure the applicant’s application of HKAS 36 is consistent with the facts disclosed in the listing document.

Main Board Rule 11.07 requires the sponsor to “take reasonable steps to ensure that the listing document contains all information necessary to enable an investor to make an informed assessment of the issuer’s financial position.” Where impairment testing is material, the sponsor must verify that the applicant has identified all cash-generating units (CGUs) to which goodwill has been allocated, that the recoverable amount is measured correctly (either fair value less costs of disposal or value in use), and that the discount rate used reflects the time value of money and the specific risks of the asset.

The Listing Decision LD-2024-001, published by HKEX in February 2024, addressed a case where the applicant allocated goodwill to a single CGU covering three distinct business lines with different risk profiles. The Exchange rejected the application on the basis that the sponsor had not challenged the management’s aggregation of CGUs, which masked impairment risk in one of the business lines. This decision codifies the principle that the sponsor’s review must extend to the structural integrity of the impairment model itself, not merely the numerical inputs.

Methodological Standards for Reviewing Cash Flow Projections

The most common area of sponsor deficiency identified in SFC inspections is the review of cash flow projections used in value-in-use models. The SFC’s 2024 thematic review found that 35% of sampled sponsors did not document any independent verification of the applicant’s revenue growth rates, despite these rates being the primary driver of the recoverable amount.

Verifying Revenue Growth Rate Assumptions

The sponsor must first obtain the applicant’s board-approved five-year financial budget, which forms the basis of the cash flow projections under HKAS 36. The sponsor should then perform a backward-looking analysis, comparing the applicant’s historical revenue growth rates over the past three to five years against the projected rates in the impairment model. Where the projected rate exceeds the historical CAGR by more than 200 basis points, the sponsor must obtain a written justification from management, supported by external market data.

For example, if an applicant projects a 12% revenue CAGR for the next five years, but its historical CAGR over the preceding three years was 5%, the sponsor must identify the specific drivers of the acceleration — new contracts, market expansion, product launches — and verify each driver against independent sources. This verification should include: (1) signed customer contracts or letters of intent; (2) third-party market research reports (e.g., from Gartner, IDC, or Frost & Sullivan) that support the growth rate; and (3) a sensitivity analysis showing the impact on the recoverable amount if the growth rate reverts to the historical average.

The sponsor’s working papers must document this analysis. The SFC’s Guidelines for Sponsors states that “the absence of documented challenge to management’s assumptions will be treated as an absence of challenge” — a presumption that has been applied in enforcement actions since 2022.

Challenging Discount Rate Calculations

The discount rate, typically the weighted average cost of capital (WACC) of the specific CGU, is the second most common area of sponsor failure. The SFC’s 2024 thematic review found that 30% of sampled sponsors accepted the applicant’s WACC calculation without verifying the underlying inputs, such as the risk-free rate, equity risk premium, beta, and cost of debt.

The sponsor must independently calculate the WACC using the capital asset pricing model (CAPM) and compare it to the applicant’s figure. The risk-free rate should be derived from the yield on Hong Kong Exchange Fund Notes or US Treasury bonds with a tenor matching the projection period (typically 10 years). The equity risk premium should be sourced from reputable databases such as Damodaran’s annual survey or Bloomberg’s WACC function. The beta should be calculated using a peer group of at least five comparable listed companies in the same industry and geographic market.

Where the sponsor’s independent WACC calculation differs from the applicant’s by more than 50 basis points, the sponsor must require management to explain the discrepancy and adjust the model accordingly. If management refuses, the sponsor must disclose the variance and its potential impact on the recoverable amount in the sponsor’s declaration under Main Board Rule 11.08.

Terminal Value Assumptions and Growth Rates

The terminal value often constitutes 60% to 80% of the total recoverable amount in a value-in-use model, making the terminal growth rate assumption highly sensitive. HKAS 36 requires the terminal growth rate to be consistent with the long-term growth rate of the industry, the economy, or the market in which the CGU operates.

The sponsor must verify that the terminal growth rate does not exceed the long-term nominal GDP growth rate of the jurisdiction where the CGU operates. For a Hong Kong-based CGU, the sponsor should reference the HKMA’s Annual Report (2024 edition), which projects a long-term nominal GDP growth rate of 3.5% to 4.0% for Hong Kong. For a PRC-based CGU, the sponsor should reference the National Bureau of Statistics’ long-term projections, which as of 2025 stand at approximately 4.5% nominal.

If the applicant uses a terminal growth rate exceeding these benchmarks, the sponsor must require a justification supported by independent industry reports. The sponsor should also run a sensitivity analysis showing the impact of a 50-basis-point reduction in the terminal growth rate on the recoverable amount. If a 50-basis-point reduction causes the recoverable amount to fall below the carrying amount, the sponsor must flag this as a material risk in the listing document.

Review of External Valuations and Specialist Reports

Where the applicant engages an external valuer to perform the impairment test — typically using the fair value less costs of disposal method — the sponsor’s review must extend to the valuer’s qualifications, methodology, and independence.

Assessing the Valuer’s Qualifications and Independence

The sponsor must verify that the external valuer holds a valid practising certificate from the Hong Kong Institute of Surveyors (HKIS) for property valuations, or a relevant professional qualification from the Royal Institution of Chartered Surveyors (RICS) or the American Society of Appraisers (ASA) for business valuations. The sponsor should also confirm that the valuer is independent of the applicant, applying the same independence standards as under the SFC’s Fund Manager Code of Conduct (paragraph 5.2), which prohibits a valuer from having a direct or indirect interest in the asset being valued.

The sponsor should obtain a written independence confirmation from the valuer, dated within three months of the valuation date. If the valuer has provided other services to the applicant (e.g., tax advisory or financial due diligence) within the preceding 24 months, the sponsor must assess whether this creates a self-review threat under the HKICPA’s Code of Ethics for Professional Accountants.

Verifying Valuation Methodology and Key Inputs

The sponsor must review the valuer’s valuation report to ensure that the methodology is appropriate for the asset type. For property, plant and equipment, the depreciated replacement cost method is common for specialised assets, while the market comparable approach is used for general-purpose assets. For intangible assets, the multi-period excess earnings method (MPEEM) or the relief-from-royalty method is standard.

The sponsor should cross-check the key inputs against independent data. For example, if the valuer uses a capitalisation rate for a property valuation, the sponsor should verify the rate against the HKIS’s Property Valuation Standards and comparable transactions in the same district. If the valuer uses a royalty rate for an intangible asset, the sponsor should confirm the rate against the RoyaltyStat database or the ktsource database, both of which are accepted by the SFC as authoritative sources.

The sponsor must document any material discrepancy between the valuer’s inputs and the independent benchmarks. If the discrepancy exceeds 10%, the sponsor should require the valuer to provide a written explanation and, if the explanation is unsatisfactory, consider engaging a second valuer to perform an independent review.

The Sponsor’s Own Sensitivity Analysis

Even where an external valuer is engaged, the sponsor cannot delegate its duty of care to the valuer. The SFC’s Guidelines for Sponsors explicitly states that “the sponsor remains responsible for the accuracy and completeness of the listing document, regardless of whether the work is performed by the sponsor or by third-party experts.”

The sponsor must therefore perform its own independent sensitivity analysis on the valuer’s model. This analysis should test the impact of a 10% adverse change in each key assumption — revenue growth rate, discount rate, terminal growth rate, and capitalisation rate — on the recoverable amount. If any single assumption change causes the recoverable amount to fall below the carrying amount, the sponsor must disclose this as a key risk factor in the listing document and require the applicant to include a sensitivity table in the accountant’s report.

Documentation Standards and Working Paper Requirements

The SFC’s inspection regime focuses heavily on the sponsor’s working papers. The absence of documented analysis is treated as evidence that the analysis was not performed, a principle established in the SFC’s Disciplinary Action against [Redacted Sponsor] (2021).

The “Four-Eyes Principle” in Impairment Review

Paragraph 17.6 of the Code of Conduct requires that “at least two persons” within the sponsor firm review the listing document and the underlying due diligence. For impairment testing, this means the principal sponsor and a second sponsor — typically the head of corporate finance or the sponsor’s compliance officer — must independently review the impairment model and the sponsor’s challenge documentation.

The working papers should clearly show the independent review, with each reviewer’s comments, questions, and resolutions documented in a sign-off sheet. The SFC expects the sponsor to have a documented escalation process: if the second reviewer identifies a material issue (e.g., an unsupported growth rate or an incorrect discount rate), the issue must be escalated to the sponsor’s internal risk committee, and the resolution must be documented.

Time-Stamped Documentation of Management Challenges

The sponsor should maintain a log of all management challenges related to impairment testing, with time-stamped entries showing the date of the challenge, the management response, and the sponsor’s conclusion. This log serves as the primary evidence of the sponsor’s independent challenge, which the SFC will request during an inspection.

The log should include at least the following entries: (1) challenge to the revenue growth rate, with the sponsor’s independent calculation and management’s justification; (2) challenge to the discount rate, with the sponsor’s independent WACC calculation; (3) challenge to the terminal growth rate, with the sponsor’s independent benchmark; and (4) challenge to the CGU aggregation, with the sponsor’s analysis of whether the CGU is appropriate under HKAS 36.

Disclosure in the Sponsor’s Declaration

The sponsor’s declaration under Main Board Rule 11.08 must confirm that the sponsor has taken reasonable steps to ensure that the listing document contains all material information. For impairment testing, the sponsor should include a specific statement in the declaration that the sponsor has reviewed the applicant’s impairment testing, challenged management’s assumptions, and found the assumptions to be reasonable based on the evidence obtained.

If the sponsor identifies any material uncertainty regarding impairment — for example, a goodwill balance that is sensitive to a single key assumption — the sponsor must require the applicant to disclose this uncertainty in the risk factors section of the listing document. The SFC’s Guidelines for Sponsors (paragraph 3.2) states that “failure to disclose a material impairment risk in the listing document may constitute a breach of the disclosure obligations under the Listing Rules.”

Actionable Takeaways for Sponsor Compliance

1. Adopt a standardised impairment review checklist that mandates independent verification of revenue growth rates, discount rates, terminal growth rates, and CGU aggregation, with each verification step requiring a time-stamped sign-off from both the principal sponsor and a second reviewer.

2. Maintain a separate impairment challenge log in the sponsor’s working papers, documenting each management challenge, the independent data source used, and the resolution, to ensure the SFC’s “absence of documented challenge equals absence of challenge” presumption cannot be applied.

3. Perform an independent sensitivity analysis for every material impairment model, testing the impact of a 10% adverse change in each key assumption, and require the applicant to disclose any scenario where the recoverable amount falls below the carrying amount.

4. Verify the external valuer’s independence and qualifications by obtaining a written independence confirmation dated within three months of the valuation date, and cross-check the valuer’s key inputs against established databases such as RoyaltyStat or the HKIS Property Valuation Standards.

5. Include a specific impairment testing statement in the sponsor’s declaration under Main Board Rule 11.08, confirming that the sponsor has reviewed the applicant’s impairment testing, challenged management’s assumptions, and found the assumptions to be reasonable based on the evidence obtained.