Going public has tremendous advantages, but the process is time-consuming and complex. Accounting issues can easily derail the process and impact shareholder confidence if management isn’t prepared with a coherent IPO plan. Many pre-IPO companies are dealing with these reporting standards for the first time and can find the SEC’s regulatory process confusing and burdensome.
We have found that the key to minimizing delays in the SEC comment phase is focusing on the accounting items early. Recent volatile markets have shown the need for companies to file for IPO when the best market conditions are present. Resolving accounting issues early on will allow companies to file at the most opportune moment.
Learn more by reading our indepth report on the journey from startup to IPO.
Several accounting issues are particularly problematic due to inherent complexities or conflicting interpretations. In our experience, there are five accounting areas that have historically raised the most red flags with the SEC. These warrant extra attention in early stages of the planning process.
- Registrant’s Financial Statements
Before filing for an IPO, companies may decide to reorganize or combine different entities for various reasons, including gaining tax advantages. Pre-IPO companies need to designate all “predecessors” and the registration statement must include predecessor’s financial information.
Determining what constitutes a “predecessor” company can be tricky, however. The SEC’s definition is broad and open to interpretation. Management should consider the order of acquisition, size and value of entities, and ultimately if that entity will be a driver of the business’ operations.
Once a predecessor is identified, it can be also challenging to figure out what financial statements need to be included. Significant judgement can be required to make these decisions.
- Financial Statements of Other Entities
Under S-X Rule 3-05, public companies must include audited financial statements of any “significant” businesses they’ve recently acquired or plan to acquire. These audited statements must be submitted for one, two, or three years depending on the “significance.”
Again, figuring out what’s “significant” is open to interpretation. Once the company has determined that an acquisition has occurred (or is probable), the SEC uses three tests to measure the significance. The “investment test,” “the asset test” and “the income test” must be performed and significance level is calculated based on a combination of all three. Pre-IPO companies should be aware that if an acquisition is ruled significant in any of the three it can trigger reporting requirements.
The measurements from these tests may offer vastly different results. For instance, a big increase in assets doesn’t necessarily mean an equal increase in operating income. Companies that are planning on going public should be aware of this and analyze the impact at the time of acquisition.
- Key Performance Indicators to Support Management’s Reporting Requirements
Pre-IPO companies have to disclose how the business has performed in the past so investors have some guidance about the future. Management is required to carefully select key performance indicators, or KPIs, that clearly reflect the company’s historical performance from which investors can draw guidance on future performance.
These KPIs will be included in narrative form in management’s discussion and analysis (MD&A). While the SEC’s guidelines for the MD&A may seem straightforward, many pre-IPO companies struggle to produce a document that falls within the requirements. A common mistake is using unique metrics that are not used by similar companies in the industry.
Starting early is advantageous. Having these requirements in mind early on will allow companies to set a consistent reporting standard that will be easy to explain in response to SEC comments.
- Technical Accounting Issues
The SEC tends to focus on certain technical issues, usually involving new rules or those that lend themselves to multiple or subjective interpretations. Companies that don’t spend enough time on these issues risk a complicated comment period and may even find themselves subject to issuing a restatement. Restatements in the first few quarters after a company goes public can result in a huge loss of public confidence, a decline in stock price, and questions from suppliers and/or customers. Recovering from such a public event may take months or even years.
Common technical accounting issues include:
- Revenue Recognition
- Segment Reporting
- The issue of “Cheap Stock”
- Impairment Issues
- Pro Forma Information
Another accounting area that deserves special attention concerns pro forma information. Pro forma financial information needs to be provided to reflect the impact of any IPO structuring transaction. It is intended to illustrate the continuing impact of a transaction.
Pro forma adjustments can involve judgment calls, so they are often the subject of SEC scrutiny. So companies need to decide whether pro forma financial information will be required and use widely accepted metrics when developing the financial statements.
In addition to focusing on these five potentially perilous accounting issues, pre-IPO companies also need to be cognizant of post-IPO reporting and listing requirements. They will immediately be expected to meet all rules and expectations of public companies, so they should plan to establish an investor relations function to issue all accurate and timely reports to comply with SOX compliance rules.
Explore the various stages of growth for startups and how to prepare to go public. Read our indepth report, The Entrepreneur’s Roadmap: From Concept to IPO.
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