In the first few weeks of the year, nine companies began to pitch their initial public offerings to prospective investors, according to Dealogic. And in March, Snap shares opened for public trading with a market cap of about $33 billion, according to cnbc.com.
Companies that are planning to go public are subject to a host of new and complex accounting requirements. These range from issues with financial statements, to providing sufficient key performance indicators (KPIs) in Management’s Discussion and Analysis (MD&A), to providing data concerning highly technical accounting issues. Pre-IPO companies will frequently deal with many of these issues for the first time and can find the SEC requirements quite burdensome. Companies can tackle the process much more effectively by planning early and giving added attention to the accounting issues that have historically raised the most red flags.
Beware of the more common accounting complexities: There are several accounting areas that warrant extra attention that need to be considered early in the planning process. Frequently, the accounting issues that are the most problematic are those that are particularly complex or subject to conflicting or subjective interpretations. We have identified five areas that warrant added attention. These areas include the registrant’s financial statements, S-X Rule 3-05, KPIs, certain technical accounting issues, and pro forma financial information.
I. The registrant’s financial statements
Prior to an IPO, the management team needs to consider the appropriate structure for the entity going public, and it may choose to restructure to gain tax advantages or for other business reasons. Pre-IPO companies need to be aware that this restructuring may trigger the requirement for additional financial statements if a “predecessor” entity is deemed to exist. The definition of “predecessor” in Rule 405 of Regulation C is very broad for registration statement purposes.
Because the existence of a predecessor is considered meaningful to investors, that entity’s financial information must be included in the registration statement. Pre-IPO companies should be cognizant of this requirement as they are finalizing their corporate structure. This can be a tricky area since significant judgment may be required in classifying a predecessor, and it can be challenging to identify the proper set of financial statements to include in the registration statement.
II. TS-X Rule 3-05 – Financial statements of other entities
Under this potentially burdensome rule, a public company must include audited financial statements in its SEC registration statements for any “significant” business it has acquired or plans to acquire. These audited statements must be submitted for either one, two, or three years depending on the significance of the acquisition and must include a balance sheet, a statement of income, a statement of cash flows, and related disclosures.
Once the company has determined that an acquisition has taken place, the significance of that acquisition must be analyzed using an investment test, an asset test, and an income test. All three tests must be performed. The significance level of the target is ultimately calculated based on the highest percentage reached in any of the three tests.1
Why is this rule so problematic? This requirement tends to pose significant challenges for pre-IPO companies because the targets they purchase are frequently young companies themselves, with a less sophisticated approach towards financial statement requirements.
III. Define KPIs to support management’s reporting requirements
Companies seeking to go public are required to prepare an MD&A for inclusion in the S-1, which discusses the historical performance of the business from which investors can draw guidance for future performance. In addition, management will also be tasked with preparing information about business performance and future prospects to potential investors during the “roadshow.” This will include information contained within the S-1, but with additional statistics and quantitative metrics that can be used to illustrate the company’s performance and financial condition and to discuss future growth.
The KPIs need to effectively communicate business performance compared with peer companies and provide information necessary for an understanding of the future plans of the business. Pre-IPO companies should be aware that the SEC has steadily expanded the line-item disclosure requirements for the MD&A, adding specific requirements for off-balance-sheet arrangements, long- term contractual obligations, certain derivatives contracts and related-party transactions, as well as key accounting policies.
This requirement may be challenging because companies that are not used to meeting the expectations of stockholders or analysts may struggle to adequately explain their business model. In addition, many pre-IPO companies may use unique metrics that are not used by similar companies in their industries. That tends to be a mistake. The SEC is looking for MD&A metrics benchmarked against industry norms that conform to the industry standard or to those used by the company’s closest competitors.the deal is completed.
IV. Technical accounting issues
Certain technical accounting issues demand added attention from the pre-IPO finance team. These areas have become SEC favorites when it comes to added scrutiny.
These accounting issues usually involve new rules, and/or those areas that may be subject to multiple or subjective interpretations. Companies who do not spend enough time on these issues risk a complicated comment period and may even find themselves issuing a restatement.
1. Revenue recognition - Revenue recognition rules have always been subject to SEC scrutiny for newly public companies. New revenue recognition rules have recently been adopted by the FASB and the IASB and will soon become effective. Companies need to ensure they are complying with the new rules and are using established and accepted mechanisms for recognizing revenue, even in cases where new business models are being used. This is one area that will likely receive even more attention from the SEC moving forward. In addition, adoption dates vary for public and private companies and newly public companies need to ensure that they are ready to meet the public company time lines.
2. Segment reporting - In addition to all of the consolidated financial information, companies that are engaged in more than one line of business or operate in more than one geographic area may also be required to include separate revenue and operating data for each of their business lines or geographic areas.
A key factor in determining whether an issuer has more than one operating segment is how management runs its business. Whether an issuer can aggregate operating segments is highly fact specific, involves certain judgment calls, and depends on factors such as economic similarity, the similarity of the products or services sold, the nature of the production process, customer type, distribution methods and the regulatory environment for the business. Management needs to establish guidelines for making these determinations and apply them consistently.
3. The issue of “cheap stock” – Another technically challenging SEC favorite is so-called “cheap stock.” Questions may arise when a pre-IPO company awards stock to employees during the 12 months before the IPO at valuations that are substantially lower than the IPO offering price. ASC 718 requires that the fair value of the equity given to employees be established on the grant date of the award, that the fair value be determined based on available information on the grant date, and that the grant date value will be recognized as a compensation expense during the employee’s employment.
In a pre-IPO context, the value of a stock award can vary greatly in a very short period of time and assumptions and projections may be subject to large variances. Some companies find themselves stumbling when they need to explain how a particular stock award was valued.
Companies are advised to understand the accounting rules before making stock-based compensation awards in the period leading up to an IPO and to use justifiable assumptions and/or an independent advisor to evaluate the award. Documenting all assumptions is key.
4. Impairment issues - Pre-IPO companies are often challenged with asset value impairment issues which tend to be industry specific. However, in general, companies have recently been finding it much more difficult to value their businesses and underlying assets. Global economic uncertainty and rapid shifts in interest rates and commodity prices, among other factors, have made it tougher than ever to accurately predict future revenue and profit numbers and underlying asset assumptions.
As they prepare to go public, companies need to evaluate the methodology used for evaluating impairment and impairment triggers on a quarterly basis. If there is an impairment event, companies should be prepared to calculate write-offs using industry-accepted standards.
V. Pro forma financial information
Another accounting area where companies are urged to spend added time concerns pro forma information. Pro forma financial information needs to be provided to reflect the impact of any IPO structuring transaction. In addition to a material acquisition, S-X Article 11 also requires pro forma financial information in a number of other situations, such as:
Pro forma adjustments can involve a high level of judgment and are therefore just the kind of accounting issue that the SEC staff may question. The finance team needs to determine whether pro forma financial information will be required and make sure that it is using widely accepted metrics when developing the company’s pro forma financial statements.
Going public has tremendous advantages. However, the process itself is time consuming and complex. Companies that are contemplating an IPO need to plan early and understand the requirements and challenges. Management can easily lose control of the process due to problems with complex accounting issues, which can cause delays or even a loss of shareholder confidence. While all filing requirements are important, paying particular attention to some of the more difficult accounting issues, and doing so as soon as possible, can help a company develop a coherent and effective IPO readiness plan that may avoid some of the most common accounting pitfalls.
Of course, in addition to focusing on these potentially perilous accounting issues, pre-IPO companies need to be cognizant of all post-IPO reporting and listing requirements. They should be prepared to establish an effective investor relations function, be prepared to issue accurate and timely 10-Ks and 10-Qs, be prepared to meet SOX compliance rules, and to meet all other rules and expectations that public companies need to follow.
Companies with under $1 billion in revenues that qualify for filing under the JOBS Act will only be required to submit up to two years of financial statements for recent, significant acquisitions.