|
Internal controls
 Sponsor's
pre-IPO due diligence on the internal controls environment of a listing applicant's management and accounting systems?
We wrote about this topic in the Autumn 2005 Issue of Insight after The Stock Exchange of Hong Kong Limited (HKEx) included a new provision in the listing rules effective as of 1 January 2005, that require the sponsor of a listing applicant to conduct reasonable inquiries (due diligence) to enable them to make a declaration under the terms of rules 3A.14 to 3A.16. Part of these rules state that, after having made reasonable due diligence inquiries, the sponsor must confirm that they have reasonable grounds to believe and do believe that:
the new applicant has established procedures, systems and controls (including accounting and management systems) which are adequate having regard to the obligations of the new applicant and its directors to comply with the Exchange Listing Rules and other relevant legal and regulatory requirements (in particular rules 13.09, 13.10, 13.46, 13.48 and 13.49, Chapters 14 and 14A and Appendix 16) and which are sufficient to enable the new applicant's directors to make a proper assessment of the
financial position and prospects of the new applicant and its subsidiaries, both
before and after listing. (Listing Rules 3A.15 (5))
As most IPO Sponsors have an investment banking background, they may not have all the necessary skill sets and experience to perform such due diligence assignments and they often seek assistance from accounting firms to assist them to undertake such inquiries. Recently, the Hong Kong Institute of Certified Public Accountants (HKICPA) issued the technical bulletin: "Assistance Options for New Applicants and Sponsors in Connection with Internal Controls over Financial Reporting", it has been posted on the HKICPA's website at:
www.hkicpa.org.hk/index.php/assurance
It is probably a good time to revisit this topic and share our experiences and thoughts on this subject. The HKICPA technical bulletin serves as a guide for accounting firms to provide such assistance to sponsors and listing applicants and describes the typical forms of assistance that sponsors and listing applicants can access to meet their requirements and circumstances. The options listed in the HKICPA discussion paper include preparing or conducting a Long Form Report; Agreed-Upon Procedures; or an Assurance Engagement.
A Long Form Report allows the sponsor and listing applicants to agree the scope of work and the form of the report with the accountant who is providing the assistance. It generally includes gathering information on the listing applicant's internal controls environment for financial reporting and carrying out tests on the effectiveness of the internal controls. Usually the report identifies any deficiencies in the design and operating effectiveness of the controls together with recommendations for improvement. This type of report does not provide an assurance of the effectiveness of the listing applicant's internal control environment.
An Agreed-Upon Procedures exercise is very similar to the Long Form Report. The requirement to specify the level of detail of the procedures that need to be performed distinguishes an Agreed-Upon Procedures exercise from a Long Form Report. An Agreed-Upon Procedures report states factual findings on the specific procedures performed. Like the Long Form Report, it does not provide an assurance of the effectiveness of the listing applicant's internal control environment.
An Assurance Engagement requires the accountant to express an overall opinion of the effectiveness of the design and operation of the listing applicant's internal controls activities.
Most of the pre-IPO internal controls due diligence services that Grant Thornton's Business Risk Services has provided to sponsors and their listing applicants over the last three years have been in the nature of a Long Form Report. Agreed-Upon Procedures reports are less popular as it is difficult to agree a set of specific procedures to be conducted in assessing the listing applicant's internal controls systems and activities with the sponsor and listing applicant prior to an opportunity to get a thorough understanding of the listing applicant's internal control environment. It is uncommon to undertake an Assurance Engagement in respect of due diligence for a listing applicant's internal control environment as most sponsors and listing applicants do not see it as being cost and time effective and there is no requirement to do so.
The typical scope of work of our pre-IPO internal control due diligence services includes:
|
1.
|
assessing the listing applicant's existing corporate governance polices and procedures by comparing them with the Code on Corporate Governance Practices incorporated in Appendix 14 of the main board listing rules. Though this is not a specific
pre-IPO requirement, it is a requirement for a listed issuer. We always recommend our clients to conduct such an assessment as good corporate governance practices are the foundation of an effective internal control environment. It is critical that a listing applicant implements such practices
before the listing and continues to carry out them
after the listing.
|
|
2.
|
performing a review of the existing policies, procedures, systems and controls to determine if the listing applicant complies with the listing rules 13.09, 13.10, 13.46, 13.48 and 13.49, Chapters 14 and 14A and Appendix 16. This is part of the specific requirement as specified in Listing Rules 3A.15 (5).
|
|
3.
|
then determining with the sponsor and the listing applicant the key business areas and identifying the key processes and systems that needed to be included in our detailed review of the control design and operating effectiveness through analysing the business and financial information against a set of criteria relating to materiality, complexity, etc. Key business processes usually include sales, purchases, costing, cash management, etc.
|
Our review always includes financial closing and reporting procedures as the requirement focuses on
financial controls and budgeting and forecast processes, as it is important that the listing applicant has an effective system in place for determining its future
prospects. It is also important to include general IT controls in the scope of our work as effective general IT controls are a pervasive element of the entire internal control environment.
We hope this article provides some insights to our readers who are interested in this topic. We are looking forward to working closely with all stakeholders and our capital market community to further develop our services to assist the continuous development of Hong Kong as an international financial
centre.
Patrick Rozario
Business Risk Services
patrick.rozario@gthk.com.hk
|