How to Get Your Critical Pre-IPO Accounting House Measures In-Order
A business that is planning on going public is required to follow a new significant host of complex accounting requirements and parameters. These parameters range, from issues with financial statements to having more than adequate key performance indicators (KPIs) in the respective business’ management’s discussion and analysis (MD&A), to providing metrics surrounding extremely technical and precise accounting issues. Companies in the pre-IPO stage will often be bombarded with most of these items for the very first time and referencing, let alone comprehending relevant SEC requirements can be a headache. We have discovered that businesses can approach the IPO process far more effectively by planning ahead and focusing on several critical accounting issues that have raised many red flags in the past.
A business with an understandable IPO plan which comprehends the aforementioned historically challenging accounting issues, that will severely limit any shocking surprises encountered during the IPO process, is necessary. Focusing on these accounting items in early IPO stages will lessen the chances of any delays during SEC phases. As worldwide current volatile markets have displayed, companies must have flexibility surrounding the timeframe of their IPO, in order to take advantage of the best market timing.
Common Accounting Intricacies to Beware of
From our perspective, there are numerous complex accounting areas that warrant extra focus and attention; these issues must be analyzed and assessed in the early IPO planning process. We are going to focus on five different accounting realms which will help your business prepare, while minimizing issues, for your upcoming IPO. These areas include the following:
- Pro Forma Financial Information
- Business Financial Statements
- SEC S-X Rule 3-05
- Other Technical Accounting Intricacies
1)Pro Forma Financial Information
Pro forma financial data must be provided to show the impact of any IPO structuring transaction. Besides material acquisitions, S-X Article 11 also states that a business must provide pro forma financial information in a numerous lesser known situations:
- If the registrant was ever part of another entity
- Disposition of a large portion of a business
- Roll up of transactions
- Acquisitions of one or more real estate operations
- Any other material financial events or transactions that investors should know
Because pro forma financial information is provided to demonstrate the continuing impact of a transaction, SEC rules require the following:
- A high-level pro forma balance sheet as of the end of the most recent period where a consolidated balance sheet of the issuer is required; this is waived if such transaction is already reflected in that balance sheet.
- A high-level pro forma income statement for the issuer’s most recent fiscal year and the most interim period of the issuer; this is waived if such transaction is already reflected in that balance sheet.
Please note that the SEC takes a particular interest in pro forma adjustments and statements because these statements more often than not involve a large degree of judgment calls.
2)Business Financial Statements
Additional financial statements are normally requested if an IPO registration indicates that a “predecessor” entity exists. According to SEC Regulation C’s Rule 405, a “predecessor” is defined very broadly. The title of a “predecessor” is required when “a registrant succeeds to substantially all of the business (or a separately identifiable line of business) of another entity (or group of entities) and the registrant’s own operations before the succession appears insignificant relative to the operations assumed or acquired.”
Management needs to consider many factors when determining if a predecessor should consider, such as:
- Size of the entities
- Value of the entities
- Order in which entities were acquired
- If the acquired entity could be the primary driver of the entire enterprise’s operations
When a predecessor is indeed identified, a registration statement absolutely must include the predecessor’s financial statements and/or information. It can be very challenging to identify a predecessor and pre-IPO businesses should be aware of this requirement as they are finalizing their corporate structure.
Businesses looking to go public must prepare a Management discussion and analysis (MD&A) for inclusion in the S-1. This MD&A should focus on the historical performance of the company so investors can draw potential conclusions on future performance. The MD&A must provide a narrative explanation of comprehensive financials especially earning and cash flows, combined with other relevant statistical data; the MD&A should essentially allow potential investors to view the company through the same lense that management views it so future business developments can be understood.
Also, with the increased usage of non-GAAP techniques by registrants allowed to be presented in SEC filings, the SEC has stringent guidelines and absolutely prohibited practices concerning non-GAAP techniques and has markedly increased scrutiny in this area. Registrants should take close note of this fact because many pre-IPO companies have been struggling to meet SEC mandates.
It’s also worth noting that the SEC wants MD&As with metrics benchmarked against industry norms and conform to the industry standards. Do not be creative in this area.
4) SEC S-X Rule 3-05
S-X RULE 3-05, otherwise known as the Financial Statements of Other Entities is a notoriously burdensome regulation which requires a public company to include audited financial statements in its respective SEC registration submission for any “significant” business it has acquired or plans to acquire. Submitted for either one, two, or three years, depending on acquisition significance, a balance sheet, a statement of income, a statement of cash flows and related disclosures must be included. In summary, pre-IPO businesses need to ask the following questions of themselves:
- Is a “business” being acquired?
- How significant is the acquired business?
- Has the acquisition occurred or is it probable?
If it is determined that an acquisition has indeed occurred, the significance of said acquisition must be analyzed. The SEC utilizes three tests to make that conclusion:
- Asset Test – compares the potential acquisition’s total assets to the acquirer’s pre-acquisition consolidated total assets.
- Investment Test – compares the purchase price of the potential acquisition (with some SEC-required adjustments) to the acquirer’s pre-acquisition total assets.
- Income Test – compares the potential acquisition’s consolidated “pretax income” to the acquirer’s pre-acquisition consolidated pretax income.
After all, three tests are performed, and the significance level of the target is calculated based on the highest percentage reached in any of the three tests, thus triggering reporting requirements under Rule 3-05.
5) Other Technical Accounting Intricacies
Businesses operating in more than one line or in more than one geographic area normally include separate operating data and revenues for each segment. A segment is defined as a portion of a larger business which may earn revenue or incur expenses; segment financial data is usually only reviewed by the enterprise’s management and only released on a discrete basis. Whether an enterprise has segments is largely determined as per how management runs its business. Aggregating segments is a highly specific process which is very reliant on judgment calls.
Revenue recognition rules have always been subject to SEC scrutiny for newly public companies. Brand new revenue recognition rules, which have always raised the eyebrow of the SEC, have been issued by FASB and are expected to go into effect very soon. Complying with these new regulations is critical.
Impairment issues are usually industry specific and many pre-IPO businesses are challenged by asset value impairment issues. However, companies have been finding it far more challenging to value their businesses and respective underlying assets. Combine this with mass global chaos, unpredictable markets, and interest rates- impairment triggering events can happen often. Should a business encounter such a triggering event, be prepared to explain everything to the SEC using U.S. GAAP.
Despite tremendous benefits, the IPO process is extremely intricate, time-consuming and must be completed in a virtually flawless fashion. To endure, these challenges, your business should employ a trusted financial advisor and CPA to work through your accounting issues and help you avoid any accounting pitfalls. Even after your company goes public, you will need to be cognizant and knowledgeable on all post-IPO listing and reporting requirements. Thomas Huckabee, CPA of San Diego is a full-service accounting firm and can answer all your questions pertaining to IPOs, and more.