During the 2023 proxy season, reports indicate that many recently established companies had to fix financial statements and improve internal controls.
The United States witnessed a remarkable surge in IPOs, reaching a historic high of 1,035 in 2021, up from just 232 in 2019, according to Statista. This spike was largely driven by the proliferation of SPACs (Special Purpose Acquisition Companies), also known as "blank-check companies," securing funding.
SPACs were seen as a quicker and more cost-effective method to raise capital compared to traditional IPOs. They would sell shares on a stock exchange and then merge with a private company, typically within two years, in what's called a de-SPAC transaction.
IPO Challenges and Accounting Errors
However, due to regulatory scrutiny, compliance challenges, global economic fluctuations, and difficulties in obtaining favorable valuations, the number of U.S. IPOs sharply dropped to only 181 last year.
In the first half of this year, U.S. IPOs raised $8.8 billion, marking an 87% increase compared to the same period in 2022 but still only about one-tenth of the $84.2 billion raised in the first half of 2021, according to EY. In the first half of the previous year, U.S. IPOs raised a modest $4.7 billion.
EY noted that the SPAC market declined significantly in the first six months of this year, with the total number of transactions falling by 70% compared to the same period last year. Proceeds during this period also dropped from $14.7 billion to $2.7 billion, an 82% decline.
Investor enthusiasm for SPACs has waned due to accounting irregularities. Restatements across all types of companies surged by 289% to 1,470 in 2021 compared to the previous year, according to Audit Analytics. If SPACs were excluded, the number of restatements would have decreased by 10%.
Newer companies, whether funded through SPACs or traditional IPOs, are more susceptible to errors and oversights that lead to restatements. These organizations are often still refining their internal controls, implementing accounting policies, building teams, and considering or adopting technology solutions.
Analyzing SEC filings since 2020, it was found that newly public companies tended to restate their financials due to errors in five areas: revenue recognition, deferred tax assets and liabilities, leases, equity awards, and earnings per share.
Inadequate Adaptation to New Requirements
Newly public companies are more likely to have problems with their internal controls. These companies are still figuring out how to manage their finances, set rules for their operations, build their teams and use new technology. These ongoing changes can make them more vulnerable to mistakes in their controls, financial errors, and the need to fix these issues.
Typical Spots for Repeating Information
According to reports filed with the SEC by newly public companies since 2020, they often had to make corrections to their financial statements in five specific areas. These areas usually need specialized knowledge in accounting and reporting. These areas include how they record their revenue, handle deferred tax assets and liabilities, deal with leases, manage equity awards, and calculate earnings per share (EPS).
Takeaways from Recent IPOs
Breaking down the main reasons companies have to redo their financial reports, there are three common issues that keep coming up in discussions with finance leaders from newly public companies:
The rules for accounting were really complicated, and companies had to use a lot of judgment and guesswork to follow them.
Dealing with these complicated rules often meant doing things manually or using many different schedules and spreadsheets that weren't well-organized, which made mistakes more likely.
The people in charge of accounting didn't always have the right knowledge, experience, or skills, which isn't unusual for a new public company trying to follow these unfamiliar rules.
According to CFOs, having a finance team with the right skills and the right financial tools to handle the needs of a publicly traded company is super important for a successful IPO and beyond. It's not just about the team, though; it's also about having the right processes, technology, and control systems in place.
The CFOs also mentioned that there's a shortage of talented finance and accounting people, and this shortage affects how well they can set up their systems, analyze accounting issues, create strong control systems, and prepare financial statements that meet SEC and GAAP rules. When planning for resources, they should think about finding other ways to get the accounting and reporting skills they need.
What To do for Remediation
Accounting corrections are usually linked to how well a company manages its internal controls as it grows. However, even well-prepared companies may need to correct their financial records at times. When this occurs, it's crucial to act swiftly and systematically:
Make a plan.
Check what resources you have.
Examine the mistake.
Find out why internal controls didn't work.
Keep everyone informed.
Finish the necessary paperwork.
Fix and enhance.
Preventing Financial Mistakes and Maintaining Control
How can you make your accounting team stronger and better prepared to prevent a similar problem in the future? To do this, you'll need to create a flexible and skilled team, establish good controls and rules, and have a plan to fix problems before they get worse.
Adopting compliance and financial reporting software will help prevent these mistakes and improve collaboration.
Companies need to regularly check if their internal rules and safeguards are good enough. Changes in technology, rules, and business situations may mean they need to evaluate the risks again and maybe make new rules or change existing ones to handle those risks. If they don't do this, they might have to fix even more problems later on.
Final Thoughts
With the significant increase of over 150% companies restating their financial results during the 2023 proxy season, there has been a rise in accounting issues. This rise also placed added pressure on audit committees.
The surge of the companies going public was linked to the increase in these errors, specifically through SPACs or traditional initial public offerings (IPO) and a lot of these newly public companies are still developing their means to establish a robust internal accounting control.