The challenges of the new Companies Ordinance: an accountant’s perspective
While the transition to the new Companies Ordinance appears to have been relatively smooth, Catherine Morley, Partner, Department of Professional Practice, KPMG China, points out that the journey has only just begun.
Normally by the time of second anniversaries you can look back on a period of change and already be feeling that the new ‘business as usual’ has arrived. But for most accountants, auditors and any others involved in the preparation of annual reports under the new Companies Ordinance it’s not quite that simple.
It is true that when the new Companies Ordinance came in on 3 March 2014, we needed to be mindful of the automatic transition to the new no par value regime and the new provisions on reduction of share capital and amalgamations. These were welcome changes which dispensed with much of the complexity and rigidity of the predecessor Companies Ordinance around the question of capital management and the new concepts appear to have settled down well without too much confusion.
But the financial year which crossed over 3 March 2014 was just the start of the journey for us. The main impact for us comes in the following financial year when Part 9 of the new Companies Ordinance, the main source of requirements relating to audited annual reports, comes into effect.
The companies first impacted by the implementation of Part 9 were those with 31 March year ends: by now they should have already reported their 2015 financial statements and it is from experience working with these companies that we can see where the main challenges from the new Companies Ordinance can be found. But as most companies in Hong Kong have a December year end and at least six months in which to put together their annual reports, this means that in practice many companies will not even have started to prepare their first annual reports under the new regime.
So what should these companies be looking out for?
The business review
The most substantive mandatory change on everyone’s mind is the introduction of the new business review for all Hong Kong incorporated companies unless explicitly exempt.
Although the review is required to be included in the directors’ report, in practice there should be close links between the contents of the review and the financial statements. For example, Schedule 5 requires that the analysis of the development, performance and position of the business should include financial key performance indicators, and these will often be computed using data reported in the financial statements. In addition, preparing the accounting numbers for matters such as depreciation, impairments, onerous contracts and provisions often requires making judgements and estimates using information about the principal risks and uncertainties facing the company and the likely future development in the company’s business, both of which are mandatory topics required in the business review under Schedule 5.
Therefore it is important that there is consistency between the story told in the business review and underlying the financial statements. In fact, not only should the preparers of the directors’ report and the preparers of the financial statements make sure they have a common understanding with each other, but also the auditors now have an express duty under Section 406 of the Companies Ordinance to state if in their opinion the information in the directors’ report is not consistent with the financial statements.
Given this close linkage, the Hong Kong Institute of Certified Public Accountants (HKICPA) was invited by the Companies Registry to develop guidance to assist in the preparation of a business review which would satisfy Schedule 5 of the Companies Ordinance and provide information that is useful for members of the company. This guidance was issued in July 2014 in the form of an ‘Accounting Bulletin’, specifically Accounting Bulletin 5 (AB5).
AB5 is for guidance only and does not introduce additional accounting, disclosure or legal requirements. However, it sets out guiding principles which address fundamental aspects of a business review and are therefore relevant to companies of all sizes. These principles are as follows:
- the review should set out an analysis of the business through the eyes of the board of directors
- the scope of the review should be consistent with the scope of the financial statements
- the review should complement as well as supplement the financial statements, in order to enhance the overall corporate disclosure
- the review should be understandable, and
- the review should be balanced and neutral, dealing even-handedly with both good and bad aspects.
The first two principles relate to explicit requirements of the Companies Ordinance:
- seeing the business ‘through the eyes of the board of directors’ reflects the fact that the business review should form part of the directors’ report to be approved by the directors under Section 391; and
- being consistent with the ‘scope of the financial statements’ means that the review should cover the group as a whole in accordance with Section 4 of Schedule 5 if the directors’ report is to be attached to consolidated financial statements.
The remaining three principles relate to the quality of the business review: the review should add value to the annual report in a way that is understandable, balanced and neutral. In other words, it should neither simply repeat the financial statements, nor should it be seen as an opportunity to add a marketing spin to the annual report by focusing only on the ‘highlights’ and ignoring or disguising some inconvenient truths which shareholders or other readers of the annual report might be very interested to know.
Experience so far indicates that it is in achieving these qualitative aspects where companies are finding it hard to find the right balance: how much information is enough to give a ‘fair review’ of the business? How to stress key information without appearing biased? How to supplement and complement the financial statements with insightful information on risks and future prospects when the job of writing the business review has been handed to the accounts department?
There is no ‘one size fits all’ answer to these questions. However, experience has shown that there are some common sense ways to approach the task which increase the likelihood that the business review will be clear, concise and tailored to the size and complexity of the company’s operations. These include:
- involving the right people in contributing content: people with responsibilities for driving the business are far more likely to have relevant material and knowledge at their fingertips than a junior in the accounts department
- ensuring that those drafting the business review have the right mind-set: they need to understand that the objective is to report to shareholders through the eyes of the directors in a balanced, neutral and
- understandable way, not to market the company in a favourable light
- collating useful data beyond what will be reported in the financial statements – for example, having access to data on staff turnover or from staff satisfaction surveys is useful when trying to give an unbiased
- account of the company’s key relationships with its employees, and
- ensuring there is enough time to do the job properly – it may not take long to write the review, but better to start early in case some key data takes time to find or to allow time for review by others with direct knowledge of the business, than to leave it to the last minute.
All of this is scalable: in smaller or less complex companies, much of the information needed may be easily apparent to anyone who has regularly attended management meetings and paid attention to the areas that were discussed. For example, the discussions may have focused on the performance against budget, gross margins, net cash flows, trends in customer loyalty or staff turnover and the impact on profitability of rising rents or falling asset values. Such discussions are about the current performance and financial position of the business, including the key performance indicators which are regularly monitored, the principal risks facing the company and its future prospects, all of which are key topics required in a business review. If a company’s review is drafted by someone who has a good understanding of these discussions, then the review stands a good chance of being well-written and appropriate to that company, even if in the end it is only one or two pages long.
Looking at how others have prepared their business reviews may also be a good source of ideas for how to present the information. But this cannot be a substitute for the four key ingredients listed above – each business review should first and foremost reflect the business of the company as the directors see it, and not be a copy of someone else’s idea of acceptable wording or typical KPIs.
Other than the business review, there will be some other compliance matters that will be easy to observe from 2015 annual reports: for example, an up-to-date auditor will be using more modern terminology in their auditor’s report in order to comply with Section 406 and the company-level balance sheet (now called the statement of financial position) should have been relegated to the notes to the consolidated financial statements in order to comply with Schedule 4. These and other house-keeping changes will cause time and effort in the year of change but other than this are not burdensome.
The rest of the impact of the new Companies Ordinance on financial reporting is more subtle and here lie the potential pitfalls, particularly for practitioners responsible for advising companies on ‘what’s new’, or taking responsibility for ensuring accurate and complete compliance. From experience we know that surprises and misunderstandings can come from underestimating the time and effort required to ensure compliance with the new Companies Ordinance – in particular carrying out the activities set out below.
Finding the detail
Under the predecessor Companies Ordinance many of us were used to finding requirements in self-contained sections such as Section 129D or Section 161. Under the new Companies Ordinance we have to be more diligent. At the very least, we need to search out the relevant regulations, such as Cap 622D for directors’ reports, and Cap 622G for disclosures relating to directors’ remuneration and loans etc. But we also need to be careful to check the scope of requirements and to make sure we’ve found the relevant definitions. Don’t look only in the section itself – it may not be that obvious or simple.
Spotting what’s changed
Many of the requirements in Part 9 and its regulations have been brought forward from the predecessor Companies Ordinance. This brings a welcome amount of continuity but also the risk of a false sense of security. The devil, as they say, is in the detail, and in these early years the smart practitioner will check and double-check the original wording of the Companies Ordinance and not rely on summaries or seminar notes to tell them what’s new. For example, ‘pensions’ and ‘retirement benefits’ may sound like the same thing, but the difference becomes apparent when you realise that free medical benefits or other non-cash perks provided to retired directors are now discloseable as part of directors’ retirement benefits, when perhaps previously they may not have been regarded as a form of ‘pension’.
One change that caught some companies by surprise is the requirement for shareholders to be approached during the year in order to claim relief from reporting requirements. In particular, private companies that missed the deadline for the Section 388 special resolution (which must be ‘at least six months before the year end’) may have to prepare a business review for the first time in their 2015 directors’ report. Similarly, the exemption from consolidation for partially owned subsidiaries is only available if shareholders are notified in writing at least six months before the year end each year. It is easy to be caught out by these requirements unless companies get in the habit of planning ahead for annual reporting and making sure they go through the proper procedures.
The above activities focus on the very important question of ‘what does the new Companies Ordinance say?’ But in some cases there has been a far harder challenge for practitioners to wrestle with. This is ‘what does the new Companies Ordinance mean?’ In this regard, my final tip is to pay close attention to the range of answers to ‘frequently asked questions’ issued by both the Companies Registry and the HKICPA (with the support of the Companies Registry) and other materials, such as the HKICPA’s Accounting Bulletin 6 on Section 436. These materials are available on their websites and can provide comfort when the Companies Ordinance requirements seem unclear, or when practical interpretation may be needed in order to operationalise the requirements. The materials already available are quite extensive, but look out for more developments in this space as practice settles down.
Partner, Head of Department of Professional Practice, KPMG China
Catherine has been a member of the Hong Kong Institute of Certified Public Accountants’ (HKICPA) Financial Reporting Standards Committee (FRSC) since 2004, including chairing that committee from 2014 to 2016. She was also a member of the government’s Standing Committee on Company Law Reform from 2008 to 2014. She continues to chair the HKICPA’s Working Group on the financial reporting implications of the new Companies Ordinance and is also a member of the HKICPA’s Professional Standards Monitoring Expert Panel and the Financial Reporting Review Panel of the Financial Reporting Council.
SIDEBAR: Key tips on compliance
- don’t underestimate the new Companies Ordinance, especially in these early days – invest time and effort in working directly with the Companies Ordinance and take care to search it thoroughly to find the relevant text
- once you find the text don’t assume that nothing has changed simply because it looks familiar – again time and effort is needed to make sure there isn’t some devil hidden in the detail
- a successful implementation also requires teamwork – corporate secretaries, accountants, auditors and lawyers all need to step a little into each other’s worlds in order to work together and in this corporate secretaries have a key pivotal role