Valtech’s Insight: Elevating Valuation Quality by Digging into AFRC Report

AFRC Compliance Financial Reporting

In Hong Kong, Valtech Valuation is committed to delivering high-quality valuation support for financial reporting, even when the subject matter is complex and challenging. A valuation becomes particularly demanding when:

• The asset or interest is inherently difficult to value
• The valuation outcome is highly material to the financial performance of a company
• There is significant uncertainty surrounding key inputs and assumptions

Despite these challenges, our role is to construct a systematic and defensible valuation process that aligns with the requirements of applicable accounting and financial reporting standards on best effort basis. We also recognize that every valuation parameter may be subject to scrutiny, and therefore we prepare accordingly.

To stay ahead of regulatory expectations and industry developments, we continuously monitor guidance from relevant authorities and proactively enhance our valuation methodologies to maintain a high standard of quality and compliance.

Key Directions Required By the AFRC

In 2024 Annual Investigation and Compliance Report, the Accounting and Financial Reporting Council (AFRC) provided the following key advice.

Auditors are often presented with management budgets or forecasts, or valuation reports prepared by management’s experts. These materials should be critically evaluated by:

(a) Challenging the parameters and assumptions adopted, such as comparing with historical data, benchmarking with metrics of industry peers, and performing retrospective review of management’s ability to prepare accurate forecasts for at least the same or longer period;

(b) Considering the competence, capabilities, and objectivity of the expert, including their qualification, work experience, technical expertise, and factors that might impair an expert’s objectivity such as fee dependence and long-term business relationship;

(c) Evaluating the appropriateness of the expert’s work, including the purpose of the expert’s report and sources of information relied upon by the expert for preparation of the report.

Evidence is fact, not what management or its expert says. Turning a blind eye misses errors of all kind; questioning things you ought to be questioning put troubles behind.

Valtech’s Interpretation and Recommendations

(a) Acceptance of Client’s Valuation Expert
Auditors should request that clients appoint only valuation experts who are capable of clearly explaining and justifying the parameters and assumptions adopted in their analyses. The review process should involve a robust challenge of the valuation, including:

• Comparison with historical data
• Benchmarking against industry peers
• Retrospective review of past projections versus actual outcomes

These approaches help ensure that the valuation conclusions are well-supported and reasonable.

(b) Cost Considerations and Recognition of Valuation Expertise
While cost is understandably a concern, both auditors and clients must recognize that retaining a competent team of valuation specialists requires a reasonable budget. Qualified business valuation professionals typically possess a strong background in accounting and finance, as well as industry-recognized credentials. These qualifications are highly valued not only in valuation but also across banking and investment sectors.

Therefore, selection of experts should not be driven solely by cost considerations. Instead, a structured evaluation process should be in place to assess the competence, capabilities, and objectivity of potential experts—covering their qualifications, experience, and technical proficiency.

Valtech takes pride in its competent team and its culture of continuous learning and development. Our valuation think tank for financial reporting currently comprises:

• 4 Hong Kong CPAs
• 6 Chartered Financial Analysts (CFAs)
• 2 Accredited in Business Valuation (ABV) professionals

(c) Critical Review of Valuation Reports by Auditors
Auditors should critically assess the valuation report provided by the expert. For example, a report based on “market value” may not meet the requirements of HKAS 36 – Impairment of Assets, which specifies that impairment testing must use the higher of Value-in-Use (VIU) or Fair Value Less Costs of Disposal (FVLCD). Market value alone may not be appropriate if it does not align with these prescribed bases. Also, it is important to check if the business valuation subject is exactly the subject matter (e.g. cash generating unit) requiring impairment assessment.

Evidence and Professional Judgment

As a guiding principle: evidence should be based on facts, not merely on statements by management or its appointed expert. Turning a blind eye risks overlooking critical errors. Conversely, asking the right questions helps resolve issues before they become problems.

At Valtech, we recognize the challenge—valuation often involves a degree of professional judgment. Even when evidence is provided, its relevance and linkage to the subject matter can be open to challenge. Our observation is that regulators generally favor valuation inputs that are as direct and certain as possible. Historical data and retrospective evidence are typically preferred. Nevertheless, ECL and valuation are inherently forward-looking. Expectation of future can never be something certain or factual. Our general recommendation is that credible and direct data source is preferred. Also, well recognised estimation method or model is preferred.

Further Readings:

Hong Kong FRC Audit Cases on Valuation, Impairment & ECL (2019–2023)

The Accounting and Financial Reporting Council (AFRC), has investigated and reported on numerous audit failures in recent years. This report compiles inspection and disciplinary cases from 2019 to 2024 where auditors failed to obtain sufficient appropriate audit evidence or other serious deficiencies were found, focusing on valuations, impairment testing, and expected credit losses (ECL).

Summary Analysis and Trends

Regulatory Focus and Trends:

The AFRC has consistently identified audits of valuations and impairments as high-risk areas. Many cases above show auditors failed to obtain sufficient appropriate evidence for management’s estimates, whether for asset valuations, goodwill and investment impairments, or ECL on financial assets. A recurring theme is the lack of professional skepticism – auditors often relied too heavily on management’s representations or expert reports without independent corroboration. In several investigations, the engagement quality control reviewers also did not detect or challenge these audit failures. The regulator has stressed that such negligence is serious because it can lead to material misstatements going undetected. For example, one disciplinary case noted that insufficient evidence and skepticism contributed to a material profit overstatement and loss misstatement in consecutive years.

Common Deficiencies:

The cases reveal common audit deficiencies in impairment testing and valuation work. Auditors frequently did not thoroughly test key assumptions in valuation models (e.g. projected revenues, discount rates, growth rates) or assess the competence of valuation experts. In one case, an auditor failed to note a company’s investment had lost over half its value for more than a year – a clear trigger for impairment under accounting standards. Others failed to properly verify inputs to goodwill impairment analyses or to perform required “look-back” analyses on prior estimates. In the ECL domain, inspections found auditors sometimes did not robustly challenge how management grouped assets by credit risk or rebutted the default assumptions (such as the 90-days-past-due presumption), nor did they adequately test forward-looking adjustments in ECL models. Such lapses mean the auditor may miss expected credit loss understatements, especially important in the adoption of HKFRS 9. The AFRC’s 2022 Interim Inspection Report specifically flagged “insufficient evaluation of management’s application of accounting standards for … expected credit loss” as a prevalent issue.

Conclusion:

Across 2019–2023, the Hong Kong audit regulator repeatedly found that audit firms fell short in gathering evidence for valuations, impairment tests, and ECL estimates. The pattern of deficiencies – from goodwill write-downs to credit loss allowances – reveals a need for auditors to strengthen their procedures in high-judgment areas. Encouragingly, the AFRC’s stepped-up inspections and enforcement indicate a more proactive stance. Audit firms are expected to heed these findings by improving their audit planning, use of experts, and skeptical evaluation of management’s estimates, thereby enhancing audit quality and restoring public trust in financial reporting.

Sources: The information above is drawn from official AFRC press releases, inspection reports, and annual review publications, which detail the cases and regulatory responses.