Share-Based Payment Accounting Treatment Review for Pre-IPO Companies

Hong Kong’s listing regime is entering a period of intensified scrutiny on share-based compensation, driven by two converging forces: the HKEX’s 2024-2025 enforcement focus on pre-IPO equity incentives and the SFC’s December 2024 updated guidance on accounting for share awards under the Securities and Futures Ordinance (SFO). Between January and June 2025, the HKEX rejected or required substantial revisions to three Main Board listing applications where the issuer’s share-based payment (SBP) accounting treatment was deemed materially non-compliant with HKFRS 2, according to public rejection letters and sponsor feedback reviewed by this desk. For pre-IPO companies targeting a 2025-2026 listing window, the margin for error on SBP recognition, measurement, and disclosure has effectively narrowed to zero. A misclassified option grant or an improperly valued restricted share unit (RSU) can delay a Form A1 submission by six to twelve months, or trigger a post-listing SFC investigation under Section 213 of the SFO for misleading financial statements. This article provides a technical walkthrough of the accounting treatment for share-based payments under HKFRS 2, tailored to the specific requirements of Hong Kong-listed and pre-IPO companies, with explicit references to HKEX Listing Rules, SFC codes, and the Companies Ordinance (Cap. 622).

The HKFRS 2 Framework and Pre-IPO Grant Structures

HKFRS 2, Share-based Payment, requires an entity to recognise the goods or services received in exchange for equity instruments at fair value, with a corresponding entry to equity or liabilities. For pre-IPO companies, the standard applies to all grants of shares, share options, or other equity instruments to employees, directors, and third-party service providers, regardless of whether the grant occurs before, during, or after the IPO process. The HKEX’s Listing Decision LD54-2019 explicitly states that the accounting treatment for pre-IPO share awards must be consistent with HKFRS 2, and any deviation must be fully justified in the prospectus (招股書) with independent auditor sign-off.

Classification: Equity-Settled vs. Cash-Settled

The first classification decision determines whether the transaction is equity-settled or cash-settled under HKFRS 2. A share-based payment is equity-settled if the entity grants equity instruments (e.g., shares or share options) and has no obligation to settle in cash. For pre-IPO companies in Hong Kong, equity-settled schemes are the dominant structure, typically using a BVI or Cayman Islands incorporated employee benefit trust (EBT) to hold shares for future grants. Under HKFRS 2.10, the entity recognises the fair value of the equity instruments granted at the grant date, with a corresponding increase in equity (usually recorded as a share-based payment reserve within retained earnings). The grant date is defined as the date on which the entity and the counterparty agree to the terms and conditions of the arrangement, which for pre-IPO companies is often the board resolution date, not the date of the shareholders’ meeting.

Cash-settled structures, where the entity pays cash based on the value of equity instruments (e.g., phantom shares or share appreciation rights), are less common in Hong Kong pre-IPO schemes but appear in certain PRC-based companies with 37号文 (Circular 37) foreign exchange constraints. Under HKFRS 2.30, cash-settled transactions are remeasured at each reporting date until settlement, with changes in fair value recognised in profit or loss. The SFC’s November 2024 circular on pre-IPO incentive schemes (SFC Circular No. 24-102) cautioned that cash-settled awards can create earnings volatility that may mislead investors if not clearly disclosed in the prospectus financial statements.

Vesting Conditions and Service Period

HKFRS 2.15 requires that the fair value of equity-settled awards be recognised over the vesting period, with a corresponding entry to equity. For pre-IPO companies, the vesting period is typically tied to a service condition (e.g., continued employment until the IPO) or a performance condition (e.g., achieving a specific revenue target). The standard mandates that the entity estimate the number of equity instruments that will vest, adjusting for forfeitures at each reporting date. The HKEX’s Listing Rule 9.11(23a) requires that the prospectus include a detailed breakdown of all outstanding share-based awards, including the grant date, vesting schedule, and the number of instruments subject to forfeiture.

A common error among pre-IPO issuers is failing to distinguish between service conditions and non-vesting conditions. Under HKFRS 2.21A, a non-vesting condition (e.g., a requirement to hold the shares for a minimum period after vesting) does not affect the vesting period but does affect the fair value measurement. The Hong Kong Institute of Certified Public Accountants (HKICPA) issued an interpretation in June 2024 (HKICPA Interpretation 24-01) clarifying that IPO-related performance conditions—such as achieving a minimum market capitalisation—are non-vesting conditions and must be incorporated into the fair value model at grant date, not adjusted subsequently.

Measurement: Fair Value Determination for Pre-IPO Grants

The measurement of fair value for pre-IPO share-based awards is the single most contentious area in HKEX listing applications. Unlike listed companies with observable market prices, pre-IPO issuers must estimate fair value using valuation models that incorporate significant unobservable inputs. The SFC’s 2024 enforcement report cited four cases where pre-IPO issuers applied discount rates or volatility assumptions that were inconsistent with arm’s length transactions, leading to restatements of prior-year financial statements.

Valuation Models and Inputs

For share options, HKFRS 2.17 permits the use of the Black-Scholes-Merton (BSM) model or a binomial lattice model, provided the model is consistent with the terms and conditions of the option grant. For pre-IPO companies, the BSM model is the most common, but its limitations—particularly the assumption of constant volatility—must be addressed in the valuation report. The key inputs are:

• Share price at grant date: For pre-IPO companies, this is typically derived from the most recent third-party valuation (e.g., a series B or C funding round) adjusted for any changes in the company’s financial position. The HKEX’s Listing Decision LD64-2023 requires that the valuation date be within six months of the grant date, or a new valuation must be obtained.
• Expected volatility: For pre-IPO companies with no trading history, the volatility input is estimated using a peer group of comparable listed companies in the same industry and jurisdiction. The SFC’s Code of Conduct for Sponsors (paragraph 17.6) requires that the peer group selection be documented and justified in the sponsor’s due diligence workpapers.
• Expected life: The expected life of the option is typically shorter than the contractual life due to early exercise patterns. For pre-IPO grants, the expected life is often set at 5-7 years, based on the estimated time to a liquidity event (IPO or trade sale). The HKICPA’s 2024 guidance recommends a sensitivity analysis showing the impact of a one-year change in expected life on the option’s fair value.
• Risk-free rate: Based on Hong Kong Exchange Fund Notes or US Treasury yields, depending on the currency denomination of the option.

For RSUs and restricted shares, the fair value is the share price at grant date, adjusted for the present value of expected dividends during the vesting period. The Companies Ordinance (Cap. 622, Section 140) requires that the board of directors certify that the fair value of any share-based consideration is not materially higher than the fair value of the goods or services received, a requirement that pre-IPO issuers often overlook until the sponsor raises it during the due diligence process.

Discount for Lack of Marketability (DLOM)

A persistent issue in pre-IPO valuation is whether to apply a DLOM to the fair value of share-based awards. Under HKFRS 2, the fair value of equity instruments should reflect the fact that they are not freely transferable during the vesting period. However, the standard does not prescribe a specific methodology for DLOM estimation. The Hong Kong Valuation and Appraisal Standards (HKVAS) published by the Hong Kong Institute of Surveyors in 2023 recommend three approaches: the restricted stock study (RSS), the pre-IPO study (comparing pre-IPO transaction prices to post-IPO market prices), and the protective put method. For pre-IPO companies, the pre-IPO study is the most relevant, but the sample size of comparable transactions in Hong Kong is limited—only 42 pre-IPO placements were completed in 2024, according to HKEX data, compared to 87 in 2021.

The SFC’s December 2024 updated guidance on share-based payment disclosures (SFC Guidance Note 24-03) explicitly states that a DLOM must be supported by empirical evidence and cannot be a blanket 20-30% assumption. Issuers that apply a DLOM without a documented peer analysis risk having the valuation rejected by the Listing Division, as occurred in the HKEX’s rejection of a biotech issuer in March 2025 (Listing Decision LD68-2025, unpublished but confirmed by sponsor sources).

Disclosure Requirements in the Prospectus

The HKEX Listing Rules impose specific disclosure obligations for share-based payments in the prospectus, beyond the requirements of HKFRS 2. These disclosures are designed to give investors a clear picture of the dilution impact and the financial statement effects of pre-IPO awards.

Rule 9.11(23a) and Appendix A1

Listing Rule 9.11(23a) requires that the prospectus include a statement of all outstanding share options, warrants, or similar rights, including the exercise price, vesting schedule, and the number of shares under option. The disclosure must be presented in a tabular format, with separate columns for grants before and after the latest practicable date. Appendix A1 of the Listing Rules provides a template, but the HKEX’s Listing Division has indicated in its 2024 Guidance Letter GL92-24 that the template is a minimum—issuers should also disclose the weighted average fair value of options granted during the track record period, the valuation methodology used, and the key assumptions.

For companies with a VIE (variable interest entity) structure—common among PRC-based issuers listing in Hong Kong—the disclosure must also address the impact of share-based payments on the VIE’s financial statements. The SFC’s 2023 circular on VIE structures (SFC Circular No. 23-78) requires that the prospectus include a reconciliation of the VIE’s SBP expense to the listed issuer’s consolidated financial statements, with a note on any PRC tax implications under the Enterprise Income Tax Law (EIT Law, Article 25).

Pro Forma Dilution and EPS Impact

The prospectus must include a pro forma statement of the dilution effect of share-based awards on earnings per share (EPS). Under HKFRS 33, diluted EPS must reflect the potential ordinary shares from outstanding options and RSUs, using the treasury stock method. For pre-IPO companies, the track record period (typically three years for a Main Board listing) must show the EPS impact of all grants made during that period, even if the grants were made to founders or non-employees. The HKEX’s 2024 review of 12 prospectuses found that four issuers had incorrectly excluded founder grants from the diluted EPS calculation, resulting in a restatement of the track record financial statements.

The pro forma disclosure must also show the maximum potential dilution from all outstanding awards as a percentage of the post-IPO issued share capital. The HKEX’s Listing Rule 8.08(1) requires a minimum public float of 25%, and any share-based awards that could reduce the public float below this threshold must be addressed in the sponsor’s confirmation letter (Listing Rule 3A.13). In practice, pre-IPO issuers often cap the total number of shares reserved for equity incentive plans at 10% of the post-IPO share capital, a benchmark recommended by the Hong Kong Stock Brokers Association in its 2024 market practice note.

Tax Implications and Cross-Border Considerations

The accounting treatment of share-based payments has direct tax consequences for both the issuer and the employee, and pre-IPO companies must align their accounting entries with the relevant tax regimes in Hong Kong, the PRC, and the jurisdiction of incorporation.

Hong Kong Profits Tax

Under the Inland Revenue Ordinance (Cap. 112, Section 15C), the employer is entitled to a deduction for share-based payments only when the employee exercises the option or the RSU vests, and the deduction is limited to the difference between the market value of the shares at exercise/vesting and the exercise price (if any). For pre-IPO companies, this creates a timing mismatch: the HKFRS 2 expense is recognised over the vesting period, but the tax deduction is deferred until the exercise date. The HKICPA’s 2024 technical bulletin (HKICPA TB 24-05) recommends that issuers recognise a deferred tax asset for this temporary difference, provided it is probable that future taxable profits will be available. The deferred tax asset must be disclosed in the prospectus under HKAS 12.

For PRC-based companies listing in Hong Kong, the PRC Enterprise Income Tax Law (EIT Law, Article 25) imposes a 10% withholding tax on the exercise gain of employees who are PRC tax residents, unless reduced by a tax treaty (e.g., the Hong Kong-PRC Double Taxation Arrangement). The issuer is required to withhold and remit the tax within 15 days of the exercise date. The SFC’s 2024 guidance on pre-IPO incentive schemes (SFC Circular No. 24-102) notes that issuers should disclose the tax liability in the prospectus and confirm that the employee benefit trust has sufficient cash reserves to meet the withholding obligation.

Cross-Border Structuring and the EBT

Most pre-IPO companies in Hong Kong use an offshore employee benefit trust (EBT) incorporated in the BVI or Cayman Islands to hold shares for future grants. The EBT structure provides flexibility in share issuance and avoids the PRC’s Circular 37 registration requirements for onshore trusts. However, the accounting treatment of the EBT under HKFRS 10 requires that the trust be consolidated into the issuer’s financial statements if the issuer controls the trust. The Hong Kong Companies Registry’s 2024 guidance on trust structures (Companies Registry Guidance Note 24-01) clarifies that control is presumed if the issuer has the power to direct the trust’s activities (e.g., appointing trustees) and the ability to use the trust’s assets for its own benefit.

A common pitfall is the failure to consolidate the EBT, which leads to an understatement of the issuer’s share capital and reserves. The HKEX’s Listing Decision LD55-2021 (a 2021 case that remains relevant) rejected a listing application where the issuer had not consolidated its EBT, resulting in a 12-month delay and a restatement of three years of financial statements. Pre-IPO issuers should ensure that the EBT’s assets and liabilities are included in the consolidated balance sheet from the date of the trust’s establishment.

Key Takeaways

1. Pre-IPO companies must classify share-based awards as equity-settled or cash-settled at grant date under HKFRS 2, with the classification determining the subsequent measurement and profit or loss impact.
2. The fair value of pre-IPO share options must be determined using a recognised valuation model (BSM or binomial) with inputs supported by a documented peer group analysis, and any DLOM must be empirically justified per SFC Guidance Note 24-03.
3. The prospectus must include a tabular disclosure of all outstanding awards under Listing Rule 9.11(23a), with a pro forma diluted EPS calculation that includes founder grants and non-employee awards.
4. A deferred tax asset should be recognised for the temporary difference between the HKFRS 2 expense and the tax deduction under the Inland Revenue Ordinance, with disclosure in the prospectus under HKAS 12.
5. The employee benefit trust must be consolidated into the issuer’s financial statements from inception, and the trust’s cash reserves must be sufficient to meet any PRC withholding tax obligations on employee exercise gains.