The new Companies Ordinance (Cap 622) requires certain public companies and companies not qualified for simplified reporting to prepare a more comprehensive directors’ report which includes a business review. This article aims to highlight the disclosures required under Schedule 5 to the new Ordinance, and to discuss the criteria for exemption from preparing a business review.
The commencement of operation of the new Companies Ordinance (NCO) on 3 March last year signifies a new era for company law in Hong Kong. In respect of the disclosure of corporate information, the NCO introduces a new requirement for a company to present a business review in the directors’ report, unless exempted. Section 388 of the NCO states the directors’ duty to prepare a directors’ report that, amongst other matters, complies with Schedule 5 to the NCO.
As further explained below, Schedule 5 to the NCO sets out the minimum contents of the business review. The business review is an analytical and forward-looking review of the company or group that provides information about the development, performance and position of the business of the company or group. Section 388 and the requirement to prepare a business review apply to financial years beginning on or after 3 March 2014.
It should be noted that Section 388(6) states that a director of a company who fails to take all reasonable steps to secure compliance with the requirement to prepare a business review commits an offence and is liable to a fine of HK$150,000. In addition, Section 388(7) states that if a director wilfully fails to take such reasonable steps to secure the compliance, the director is liable to a fine of HK$150,000 and to imprisonment for six months. Therefore, it is imperative that directors plan in advance and take action to ensure full compliance with this requirement.
On 6 February 2015, the Stock Exchange of Hong Kong Ltd published its conclusions to its consultation ‘Review of Listing Rules on Disclosure of Financial Information with Reference to the New Companies Ordinance and Hong Kong Financial Reporting Standards and Proposed Minor/Housekeeping Rule Amendments’. In respect of the disclosure of financial information, the amendments to the Listing Rules associated with the consultation conclusions align the requirements in Main Board Rules Appendix 16 and the GEM Rules equivalent with the disclosure provisions in the NCO. Accordingly, the business review disclosure requirement under the NCO will also be applicable to all listed issuers (that is, whether or not they are incorporated in Hong Kong). The amendments to the Listing Rules will be applicable for annual reports with accounting periods ending on or after 31 December 2015. Early adoption is permitted but issuers should not adopt the revised Rules prior to the effective date of Part 9 ‘Accounts and Audit’ of the NCO (that is, the first financial year beginning on or after 3 March 2014).
Contents of a business review
Schedule 5 to the NCO sets out the minimum contents of a business review. Paragraph 1 of Schedule 5 states that a directors’ report for a financial year must contain a business review that consists of:
a. a fair review of the company’s business
b. a description of the principal risks and uncertainties facing the company
c. particulars of important events affecting the company that have occurred since the end of the financial year, and
d. an indication of likely future development in the company’s business.
Paragraph 2 of Schedule 5 states that, to the extent necessary for an understanding of the development, performance or position of the company’s business, a business review must include:
a. an analysis using financial key performance indicators (KPIs)
b. a discussion on:
- the company’s environmental policies and performance, and
- the company’s compliance with the relevant laws and regulations that have a significant impact on the company, and
c. an account of the company’s key relationships with its employees, customers and suppliers and others that have a significant impact on the company and on which the company’s success depends.
Paragraph 3 of Schedule 5 states that disclosure is not required for information about impending developments or matters in the course of negotiation if the disclosure would, in the directors’ opinion, be seriously prejudicial to the company’s or group’s interests. However, ‘seriously prejudicial’ is not defined in the NCO and is therefore subject to judgement.
In accordance with Section 388(2) of the NCO, if the company is a holding company in a financial year and the directors prepare annual consolidated financial statements for the financial year, the directors’ report should be a consolidated report. In terms of the business review, this means that the directors’ report would need to cover the business review of both the company and all of its subsidiaries included in the consolidated financial statements.
A business review under the NCO is not only a historical fair review of the business of a company or group (as the case may be), it also covers important events that have occurred from the end of the financial year to the date of the directors’ report. In addition, it is a forward-looking review that indicates the ‘likely future development’ of the business. But what do all these mean?
What are the guiding principles?
In July 2014, the Hong Kong Institute of Certified Public Accountants (HKICPA) issued Accounting Bulletin 5: Guidance for the Preparation and Presentation of a Business Review under the Hong Kong Companies Ordinance Cap 622’, at the invitation of the Companies Registry. Accounting Bulletin 5 sets out guiding principles for business reviews prepared and presented for the purposes of compliance with Schedule 5. These guiding principles include the following:
- 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.
As the business review forms part of the directors’ report to be approved by the directors, the review should reflect the directors’ view of the business and be consistent with information which the directors use in managing the reporting entity. These may include the strategic priorities of the reporting entity, the management of capital, the financial risk management strategies of the reporting entity, and any KPIs monitored by the directors in managing and allocating resources, and in assessing performance.
Directors should consider which matters should be included in the business review in order to provide members with relevant and material information that is necessary for an understanding of the development, performance and position of the reporting entity. In considering materiality, directors should consider both qualitative and quantitative aspects in the particular circumstances. As explained in Accounting Bulletin 5, where the nature and circumstances of a matter are of sufficient importance, it could be the qualitative aspect rather than the quantitative aspect alone that determines whether there should be separate disclosure.
Other factors to be considered include the legality, sensitivity and potential consequences of a transaction or event and the parties involved. For example, the monetary amount at which an item becomes material may be significantly lower for items such as unlawful transactions, fines and penalties than for items under the company’s normal operations. Given the fact that annual reports get thicker under the ever- increasing disclosure requirements, the inclusion of too much information in the business review may obscure judgements and will not promote understanding.
An indication of likely future development
While stakeholders are interested in the historical analysis of the company’s performance for the financial year, they will probably be even more interested in the future development of the company. Schedule 5 requires the business review to include an indication of the likely future development in the company’s business. Accordingly, the business review should analyse the main trends and factors that directors consider likely to impact future prospects. These trends and factors will vary according to the nature of the business and the external environment in which the business operates, but could include the development of known new products and services or the benefits expected from capital investment. Significant assumptions underlying the main trends and factors should be disclosed.
Given the uncertain nature of some forward-looking information, in particular elements that cannot be objectively verified but have been disclosed in good faith, directors may want to include a statement in the review to treat such elements with caution, explaining the uncertainties underpinning such information.
Exemption from preparing a business review
A frequently asked question is under what criteria can a company claim exemption from preparing a business review for the directors’ report under the NCO? Section 388(3) sets out three criteria:
- the company falls within the reporting exemption to qualify for a simplified directors’ report and simplified financial statements for the financial year (as governed
by Sections 359 to 366 of, and Schedule 3 to, the NCO) (the Reporting Exemption); or
- the company is a wholly owned subsidiary of another body corporate in the financial year; or
- the company is a private company that does not fall within the Reporting Exemption for the financial year, and a special resolution (as defined in Section 564) is passed by the members to the effect that the company is not to prepare a business review required by Schedule 5 for the financial year.
For the purposes of claiming exemption from preparing a business review, a company needs only to satisfy any one of the three exemption criteria set out above. Therefore, if a company satisfies either criterion (2) (it is a wholly owned subsidiary) or criterion (3) (it is a private company and its members have passed a special resolution), it is not necessary to consider whether the company would also have been able to claim exemption under criterion (1) (to consider whether it would also have fallen within the Reporting Exemption under the NCO). This means that in practice, if the intention is only to claim exemption from preparing a business review (but not to claim exemption to qualify for simplified financial reporting), given the complexity of the size tests and stringent shareholder approval requirements (if applicable) for the Reporting Exemption, it will generally be more straightforward for a private company to ask its members to pass a special resolution in accordance with Section 388(3)(c) (see criterion (3) above). In this situation, there is no need to seek to test whether the company is eligible for the Reporting Exemption under the NCO. However, if the intention is to claim exemption from preparing a business review and exemption to qualify for simplified financial reporting at the same time, the relevant size tests and shareholder approval requirements (if applicable) for the Reporting Exemption must be met.
Another question frequently asked is if a company is eligible for the Reporting Exemption under the NCO but voluntarily chooses to prepare its financial statements in compliance with full Hong Kong Financial Reporting Standards instead of the SME Financial Reporting Framework and Financial Reporting Standard (Revised 2014) (SME- FRF & SME-FRS) issued by HKICPA, can it still claim exemption from preparing a business review under criterion (1)?
Yes, in this situation, the company can still claim exemption from preparing a business review under Section 388(3)(a). This exemption from preparing a business review does not depend on whether or not the financial statements are prepared in accordance with the SME-FRF & SME-FRS.
Some further facts regarding the above three exemption criteria.
• Unlike criteria (1) and (3), criterion (2) is not limited to just private companies. Accordingly, a public company (as defined in Section 12 of the NCO) that is a wholly owned subsidiary of another body corporate can obtain the exemption from preparing a business review.
• ‘Body corporate’ under criterion (2) means a company formed and registered under the NCO or an existing company formed and registered under the predecessor Companies Ordinance, and a company incorporated outside Hong Kong (but excludes a corporation sole). Accordingly, a company which is a wholly owned subsidiary of an overseas incorporated company will satisfy criterion (2).
• Under Section 388(4)(b), the special resolution for opting out of the business review requirement in accordance with criterion (3) must be passed at least six months before the end of the financial year to which the directors’ report relates. As an example, for private companies with a December year-end, the business review requirement under Section 388 will first come into effect for financial statements for the year ending 31 December 2015. Should these private companies wish to opt out of the preparation of a business review in accordance with criterion (3) for that financial year, the special resolution would need to be passed by the end of June 2015.
• The ‘special resolution’ under criterion (3) may be passed in relation to a financial year, or a financial year and every subsequent financial year. Therefore in practice, a company fulfilling the requirements under criterion (3) may want to pass one special resolution covering the current year and every subsequent year, and the resolution will remain in force until it is revoked in a subsequent year. In addition, according to FAQ (Accounts and Audit) Q17 issued by the Companies Registry, Section 622 states that a copy of the special resolution is required to be delivered to the Registrar of Companies for registration within 15 days after it is passed.
Although the requirements set out in Schedule 5 are not lengthy and may initially sound simple to some companies, they may be difficult to apply in practice. Judgement is required to determine what information should be included in the business review. For a holding company with subsidiaries, preparing a balanced and understandable consolidated review may take some time. Accordingly, planning ahead is a key success factor. Directors should consider seeking professional advice if in doubt as to their obligations regarding the preparation and presentation of the business review.
Ernest Lee, Partner, Professional Practice, EY Hong Kong.
Ernest Lee is a member of the Professional Development Committee of the HKICS. The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms. The HKICPA ‘Accounting Bulletin 5’, which gives guidance on preparing a business review, is available on the HKICPA website: www.hkicpa.org.hk.