Deloitte's Roadmap: Initial Public Offerings
Preface
Preface
We are pleased to present the 2023 edition of
Initial Public Offerings. Preparing for an IPO1 can be a complex, time-consuming, and often costly process. Accordingly, this
Roadmap addresses financial reporting, accounting, and auditing considerations to
help companies navigate challenges related to preparing an IPO registration
statement and ultimately going public.
The SEC has continued to modernize
its disclosure requirements for companies entering the public markets. In addition
to its final rulemaking (as addressed in this Roadmap), the SEC is actively working
on finalizing new requirements related to SPAC transactions and climate-related disclosures that could affect companies
entering the public markets. Accordingly, registrants should ensure that they are
ready to respond to changing conditions in the financial markets, as well as the
SEC’s new disclosure requirements, as they plan for their IPOs.
For further details on the SEC’s proposal related to SPAC transactions, see
Deloitte’s October 2, 2020 (updated April 11, 2022), Financial Reporting Alert.
Be sure to
check out On the Radar (also available as a stand-alone publication),
which briefly summarizes emerging issues and trends related
to the accounting and financial reporting topics addressed
in the Roadmap.
We hope you find this Roadmap useful as you
prepare for your IPO.2 If you have questions or concerns, please visit Deloitte’s IPO Readiness and Execution Services site or
contact a Deloitte partner listed in the contacts section of this publication.
Footnotes
1
For a list of abbreviations used in this publication, see
Appendix
E.
2
Note that this Roadmap is
not a substitute for consulting with professional advisers on complex
accounting and reporting questions and transactions associated with an
IPO.
On the Radar
On the Radar
After a record-breaking year for initial public offerings (IPOs) and
special-purpose acquisition companies (SPACs) in 2021, the market began slowing down
significantly in 2022 amid various challenges, including volatile markets;
geopolitical conflicts; inflation; and supply chain issues. The capital markets have
continued to remain slow into 2023. In light of such challenges, private companies
continue to evaluate the methods used to go public. Such methods include a
“traditional” IPO, in which a private company sells its equity in a public
underwritten offering. However, over the past several years, nontraditional IPOs
have become more popular. Rather than undertaking traditional IPOs, many private
operating companies choose to merge with SPACs to raise capital or use other
financing alternatives, such as direct listings, which have also become more
frequent. Companies can also go public by registering debt securities, distributing
shares in a spin-off transaction, or registering securities issued by real estate
investment trusts (REITs).
Before a company commences a public offering of securities, it must
file a registration statement with the SEC under the applicable securities laws.
Both the form used to file the registration statement and the filing and review
process will depend on the nature of the offering. Companies undertaking a
traditional IPO can voluntarily submit a draft registration statement to the SEC
staff for confidential, nonpublic review. The ability to submit confidentially is a
significant benefit because it allows companies to keep potentially sensitive
information from customers or competitors until later in the IPO process.
Confidential initial submissions are subsequently filed publicly no later than 15
days before (1) a roadshow or (2) the requested effective date of the registration
statement if no roadshow is planned.
Once submitted to or filed with the SEC, a registration statement is
reviewed by the staff of the SEC’s Division of Corporation Finance (the “Division”),
which will generally complete its initial review and furnish its first set of
comments within 27 calendar days. The company then responds to each of the staff’s
comments and reflects edits to the draft registration statement in an amended
filing, which the staff will also review. A company can expect several rounds of
comment letters containing follow-up questions on responses to original comments as
well as additional comments on new information included in the amended registration
statement. After the initial review, subsequent comments are typically furnished
within two weeks. For more information about typical SEC staff comments, see
Deloitte’s Roadmap SEC Comment
Letter Considerations, Including Industry Insights.
Identifying the Required Financial Statements
A company must determine what financial statements are required in the
registration statement. While this determination may appear straightforward,
additional complexities may arise because a company may first need to determine
the legal entity that will become the SEC registrant. For example:
- A company may succeed to substantially all of the business of another entity (or the “predecessor”) for which financial statements are required.
- A company may be a carved-out entity that previously existed only as a subset of a larger parent entity or may be a combination of individual entities joined to form a larger public company.
- A company, a subsidiary, or a subset of subsidiaries may issue securities, guarantee securities, or otherwise have dividend restrictions that trigger requirements for the inclusion of separate financial statements or financial statement schedules in the IPO registration statement.
Further, a registrant may need to consider whether separate
financial statements or pro forma financial information is required for
“significant” business acquisitions, dispositions, or equity method
investments.
The financial statement periods to be included in the IPO registration statement
depend on the company’s characteristics and the timing of the document’s
submission. Smaller reporting companies (SRCs) and emerging growth companies
(EGCs) generally have the option of presenting only two years of audited annual
financial statements in a traditional IPO, while all other entities must present
three years. Further, under SEC regulations, the financial statements in an IPO
must meet certain age requirements as of each registration-statement filing date
as well as when the registration is declared effective; otherwise, the financial
statements will be considered “stale.” In general, the financial statements in
an IPO filing must not be more than 134 days old (i.e., the gap between the date
of filing or effectiveness and the date of the latest balance sheet cannot be
more than 134 days). However, third-quarter financial statements are considered
timely through the 45th day after the most recent fiscal year-end, after which
the audited financial statements for the most recent fiscal year are required.
Thus, a company that fails to file a registration statement before one of these
critical cut-off dates will be required to include additional financial
statement periods in the registration statement; in such cases, there may be a
significant delay in the company’s preferred IPO timeline.
A Public Entity’s Application of U.S. GAAP and SEC Regulations
Certain provisions of U.S. GAAP for public entities differ from those for
nonpublic entities. Notably, public business entities (PBEs) are generally
required to adopt new accounting standards before private companies. Although
companies that meet the EGC criteria can elect to use private-company adoption
dates for new accounting standards, other entities (i.e., non-EGCs) undertaking
an IPO typically must use public-company adoption dates for all accounting
standards.
In addition, a company undertaking an IPO must present financial
statements that are consistent with public-entity accounting principles and must
comply with the disclosure requirements for public entities for all periods
presented. The following are examples (not all-inclusive) of topics for which
the accounting principles or disclosures may apply to public entities but do not
apply to nonpublic entities:
-
Earnings per share.
-
Segment reporting.
-
Temporary equity classification of redeemable securities.
-
Certain income-tax-related disclosures.
-
Certain disclosures related to pensions and other postretirement benefits.
Once a company is considered a PBE (even if it qualifies as an
EGC and elects to use private-company adoption dates), it is no longer permitted
to apply private-company accounting alternatives, such as the amortization of
goodwill, or practical expedients permitted for non-PBEs, such as use of a
risk-free rate for leases. Therefore, any previously elected private-company
alternatives or non-PBE practical expedients would need to be retrospectively
eliminated from the company’s historical financial statements before such
statements can be included in its registration statement.
Further, public entities are subject to various SEC rules and regulations that
may affect the financial statements and related disclosures (e.g., the
additional disclosure requirements of Regulation S-X). Some of these
requirements are broadly applicable, and some apply only to entities in certain
industries. Therefore, a nonpublic entity’s previously issued financial
statements will typically need to be revised for all periods presented to
reflect the additional SEC disclosure requirements. However, an entity that
meets the SRC criteria may be eligible to apply scaled disclosure requirements.
SRCs generally do not have to apply the disclosure provisions of Regulation S-X
in their entirety except when specified.
Audit Considerations for Public Companies
Audits of private companies are subject to AICPA auditing standards. However,
auditors of issuers undertaking an IPO must apply PCAOB auditing standards and
will need to perform additional procedures and issue a new auditor’s report that
refers to these standards. Note that in a filing submitted for
confidential review to the SEC, the auditor’s report will typically
refer to both AICPA and PCAOB auditing standards.
Because the SEC’s and PCAOB’s independence rules are generally more restrictive
than the AICPA’s, both the auditor and management, with oversight from the audit
committee, need to determine whether (1) there is possible noncompliance with
the SEC’s and PCAOB’s independence rules or (2) there are conflicts of interest
before the entity undertakes an IPO.
Post-IPO Periodic Financial Reporting and Internal Control Requirements
After a registration statement is declared effective, a company is required to
file quarterly reports on Form 10-Q and annual reports on Form 10-K. As a public
company, a registrant must also file a current report on Form 8-K that discloses
various material events that occur between its periodic reports.
A public company will need to address two types of controls and procedures in its
post-IPO filings with the SEC:
-
Internal control over financial reporting (ICFR) — ICFR refers to procedures a company performs to reasonably ensure compliance with its policies related to preparing financial statements in accordance with U.S. GAAP and Regulation S-X. Management must annually file a report on the effectiveness of its ICFR. Moreover, non-EGC accelerated and large accelerated filers must generally include an auditor’s attestation report on the effectiveness of ICFR in their annual reports. However, all new public companies can apply a phase-in exception under which management’s report and the auditor’s attestation are not required before the second annual report (i.e., until a registrant has been required to file or has filed a Form 10-K for the prior fiscal year). Certain additional exceptions may also apply.
-
Disclosure controls and procedures — These are a broader set of controls that largely encompass ICFR and are designed to provide assurance that information that the registrant must disclose in reports that it files or submits under the Securities Exchange Act of 1934 (the “Exchange Act” or “1934 Act”) is recorded, processed, summarized, and reported within the periods specified.
Companies also must continue to comply, on a quarterly basis,
with reporting requirements related to material changes to ICFR and disclosure
controls and procedures. In addition, in quarterly and annual reports, the
registrant’s principal executive and principal financial officer (typically the
CEO and CFO) must file certifications prescribed by Sections 302 and 906 of the
Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act” or “Sarbanes-Oxley”).
SPAC Transactions
After increasing significantly in recent years, SPAC
transactions have begun to slow down. If contemplating use of a SPAC transaction
to go public, management should be aware of the differences between a
traditional IPO and a SPAC transaction from a financial reporting and auditing
perspective, as well as the potential impact of the SEC’s May 2022
proposed requirements related to SPAC transactions. The
table below outlines the areas of potential differences between the two types of
transactions.
Key Differences Between Traditional IPOs and SPAC
Transactions
|
---|
Financial statement periods required in the registration
statement/proxy statement
|
The ability to confidentially submit the registration
statement/proxy statement
|
The requirement to include pro forma information
|
The potential requirement to include prospective
financial information
|
The timing of the initial periodic reporting obligation
after the IPO or SPAC transaction
|
The reporting requirements related to ICFR
|
This Roadmap addresses financial
reporting, accounting, and auditing considerations to
help companies navigate challenges related to preparing
an IPO registration statement and ultimately going
public. Entities should also consider Deloitte’s October
2, 2020 (updated April 11, 2022), Financial
Reporting Alert for guidance on
entering into a SPAC transaction as an alternative to
undertaking a traditional IPO.
Contacts
Contacts
|
John Wilde
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 415 783 6613
|
|
Pat Gilmore
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 410 843 3242
|
|
Lisa Mitrovich
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 202 220 2815
|
|
Doug Rand
Audit & Assurance
Managing Director
Deloitte & Touche
LLP
+1 312 758 6144
|
|
Will Braeutigam
Audit & Assurance
Partner
Deloitte & Touche LLP
+1 713 982 3436
|
|
Barrett Daniels
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 408 704 4176
|
|
Previn Waas
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 408 704 4083
|
Chapter 1 — Introduction to Initial Public Offerings
Chapter 1 — Introduction to Initial Public Offerings
1.1 Key Laws That Govern the Securities Industry
Public companies are subject to a number of complex securities laws, many of which also affect the IPO
process. The sections below introduce certain key securities laws relevant to securities offerings and
public-company reporting.
1.1.1 Securities Act of 1933
The first major federal securities regulation passed was the Securities Act of 1933 (the “Securities Act” or the “1933
Act”). According to the SEC’s Web site, the two
main goals of the Securities Act are to (1) “require that investors receive
financial and other significant information concerning securities being offered
for public sale” and (2) “prohibit deceit, misrepresentations, and other fraud
in the sale of securities.” To accomplish those objectives, the 1933 Act
addresses the registration requirements for securities and required disclosures
in registration statements. Generally, an entity must register with the SEC all
securities offered in the United States (i.e., a public offering) or “must
qualify for an exemption from the registration requirements” (i.e., a private
offering). Under the Securities Act, essential information must be provided to
investors in a public offering. Such information includes (1) descriptions of
“the company’s properties and business” and of “the security to be offered for
sale” and (2) the company’s management and financial information (e.g.,
financial statements certified by an independent registered public accounting
firm). The Securities Act also establishes a legal liability framework to
protect investors from losses when there is “incomplete or inaccurate
disclosure” of material information.
1.1.2 Securities Exchange Act of 1934
Shortly after the 1933 Act was signed into law, Congress passed the 1934 Act.
The Exchange Act resulted in the creation of the SEC, an
independent body whose mission, as stated on its Web site, is (1) “protecting
investors”; (2) “maintaining fair, orderly, and efficient markets”; and (3)
“facilitating capital formation.” The SEC is responsible for overseeing the U.S.
securities markets and certain primary participants. Further, under the Exchange
Act, the SEC has the power to enact and enforce securities regulations,
including disciplinary rights (e.g., prosecution of insider trading), as well as
to require that companies with publicly traded securities periodically report
certain information.
Both the Securities Act and the Exchange Act have been subject to interpretation
and numerous amendments since their enactment. For example, some amendments have
resulted from legislation released in response to a financial crisis, such as
the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (“Dodd-Frank”). Other amendments, such as those related
to the Jumpstart Our Business Startups (JOBS) Act (enacted in 2012), are
intended to open access to the public markets. Such additional legislation is
summarized below.
1.1.3 Sarbanes-Oxley Act
Sarbanes-Oxley was passed in the wake of a number of large,
public financial scandals, including those at Enron and WorldCom. On its
Web site, the SEC
states that Sarbanes-Oxley “mandated a number of reforms to enhance corporate
responsibility, enhance financial disclosures and combat corporate and
accounting fraud.” Among the most significant changes were mandating personal
liability for certain executive officers; implementing protections for
whistleblowers; and requiring management — and, in many circumstances, the
external auditor — to report on the adequacy of a company’s ICFR. Sarbanes-Oxley
also established the PCAOB to oversee and regulate the activities of the
auditing profession.
1.1.4 Dodd-Frank Act
Dodd-Frank was enacted in response to a financial crisis
that culminated in 2008. As discussed on the SEC’s Web site, the purpose of Dodd-Frank is to protect
consumers from abusive financial services practices by reshaping various aspects
of the U.S. regulatory system, including, but not limited to, “consumer
protection, trading restrictions, credit ratings, regulation of financial
products, corporate governance and disclosure, and transparency.”
1.1.5 JOBS Act
The JOBS Act, signed into law on April 5, 2012, significantly
affects the financial markets and IPOs. The act indicates that its objective is
to “increase American job creation and economic growth by improving access to
the public capital markets for [EGCs].” The most notable change brought about by
the JOBS Act is the creation of the EGC, a new type of issuer that may take
advantage of numerous regulatory and reporting accommodations. The JOBS Act was
subsequently amended by the Fixing America’s Surface Transportation (FAST)
Act of 2015, which, among other provisions, expanded the
accommodations given to EGCs. See Section 1.6 for more information about
EGCs and Appendix C
for a summary of key accommodations available to EGCs.
1.2 Types of Issuers
The requirements for an IPO can vary from company to company. Factors that may affect the
requirements include:
- Whether the company is a domestic issuer or a foreign private issuer — This publication focuses on the IPO requirements for domestic issuers. The requirements for foreign private issuers considering an IPO may significantly differ from those for their domestic counterparts. However, foreign private issuers can elect to file under domestic rules if they wish. A U.S.-based company issuing shares will always be considered a domestic issuer; however, a foreign-based company may not always qualify as a foreign private issuer. For a summary of criteria for qualifying as a foreign private issuer and related accommodations, see Section 6100 of the SEC’s Financial Reporting Manual (FRM).
- Whether the company qualifies as an SRC — A company may qualify as an SRC on the basis of its public float1 and its annual revenue. The SEC filing requirements for SRCs are significantly scaled back from those for larger companies. Section 1.5 and Appendix B include an overview of SRCs and the related accommodations. Other sections of this Roadmap generally do not specifically address the unique requirements for SRCs.
- Whether the company qualifies as an EGC — A private company undertaking an IPO will generally qualify as an EGC if it (1) has total annual gross revenues of less than $1.235 billion during its most recently completed fiscal year and (2) has not issued more than $1 billion of nonconvertible debt over the past three years. As discussed above, EGCs are afforded many accommodations that can assist with the IPO process, many of which are addressed in the applicable sections of this Roadmap. Section 1.6 and Appendix C summarize these accommodations.
Once a company completes a public offering and becomes an SEC registrant, it
will also need to determine its SEC filer status as a large accelerated filer, an
accelerated filer, or a nonaccelerated filer, which will further affect the
company’s filing obligations and deadlines. A company undertaking an IPO will
initially be considered a nonaccelerated filer since large accelerated or
accelerated filers must have filed at least one annual report and must have been
subject to the requirements of Sections 13(a) and 15(d) of the 1934 Act for at least
12 months. Accordingly, a registrant generally cannot be considered a large
accelerated or accelerated filer for its first Form 10-K filing as a public company.
See Chapter 7 for
further discussion of filer status and considerations related to the post-IPO
impacts of each filer status.
Footnotes
1
Paragraph 1340.2 of the FRM defines public float as
“[t]he aggregate worldwide market value of its voting and non-voting
common equity held by non-affiliates.” Therefore, debt-only
registrants are nonaccelerated filers.
1.3 Types of IPOs
An IPO represents a private company’s initial registration of debt or equity securities with the SEC.
However, there are many ways in which a company can become public, including:
- Sale of newly issued common shares to the public — The most common type of IPO is the registration and sale of common stock to the public by filing a registration statement on Form S-1 under the 1933 Act. This type of IPO will typically generate offering proceeds for the issuer and result in the registration and public trading of the issuer’s shares once the IPO is completed.
- The exchange of debt securities previously issued in a private transaction for registered debt securities — Debt securities initially sold through a private placement offering (e.g., under Securities Act Rule 144A2) are subject to certain resale restrictions in accordance with the Securities Act. To facilitate greater liquidity, the securities issued in a private placement may include registration rights, which require the issuer to exchange the private securities for registered securities within a set period of time. This is often referred to as an “A/B” exchange offer, and the new securities are typically registered on Form S-4.
- The registering of currently outstanding equity securities — In a manner similar to that in the scenario described above, registration may be a means of achieving liquidity for shares previously issued through private placements, such as Regulation A or D offerings. Under Section 12(b) of the Exchange Act, for a class of security to trade on a national securities exchange, it must be registered. Or, in contrast to a voluntary registration, an entity might otherwise be compelled to register outstanding shares under Section 12(g) of the Exchange Act, which contains certain size thresholds that trigger mandatory registration.3 In either circumstance, the class of securities is typically registered on Form 10.
- The distribution of shares in a spin-off transaction by a public company — When a public company issues a subsidiary’s shares to its shareholders via a dividend, the subsidiary (or “spinnee”) becomes an independent entity. To facilitate the subsequent trading of the spinnee’s shares on a national securities exchange, a Form 10 may be used to register these shares.
- The registering of securities that are issued by REITs, including “blind pool” offerings — A Form S-11 may be used to register shares in an SEC filing by REITs, whose business is acquiring or holding real estate for investment purposes. REITs may also file “blind pool” registration statements (typically also on a Form S-11) to sell securities to purchase real estate operations that are not identified.
- The registering of securities that are issued by a SPAC — A Form S-1 may be used for the initial registration and sale of shares of a SPAC, a newly formed company that will use the proceeds from the IPO to acquire a private operating company (which generally has not been identified at the time of the IPO). To complete the acquisition of a private operating company, the SPAC may file a proxy statement on Schedule 14A or a combined proxy and registration statement on Form S-4 (see Section 1.7). Within four days of the closing of the acquisition of the private operating company, the SPAC must file a “super Form 8-K” that includes all of the information required in a Form 10 registration statement of the private operating company.
Other related transactions, including reverse mergers, put-together transactions, drop-down
transactions, and split-offs, can similarly result in the registering of securities. When considering
registering securities with the SEC for the first time, companies are encouraged to consult with their SEC
legal counsel to determine the appropriate SEC form to use to register such securities. Regardless of the
nature of the IPO transaction or the type of securities registered, upon effectiveness, the issuer will be
“public” and will therefore be required to begin complying with the periodic reporting requirements of
the Exchange Act (e.g., filing of Forms 10-K, 10-Q, and 8-K).
Footnotes
2
For a list of the titles of standards and other
literature referred to in this publication, see Appendix
D.
3
Registration of a class of security is generally
required when (1) there are 2,000 or more record holders of an
equity security (or, alternatively, 500 or more nonaccredited
investors) and (2) a company has over $10 million in total
assets.
1.4 The IPO Registration Statement
Note that each activity in the timeline is discussed further below.
1.4.1 Registration Statement Filing and Review Process
The timeline above provides an overview of the IPO process from inception to
closing for a typical 1933 Act registration statement. The IPO process typically
begins with an organizational meeting, commonly referred to as an “all-hands”
meeting, to plan the IPO process, establish a timeline, and coordinate
responsibilities (see A in the timeline above). While the nature of the IPO may
vary, before an entity may commence a public offering of securities, the entity,
or “registrant,” must file a registration statement with the SEC under the
applicable securities laws (see B in the timeline above). The registration
statement contains extensive financial and business-related disclosures about
the entity and the securities being offered. A registrant provides such
disclosures in accordance with (1) Regulation S-X, which sets forth the SEC’s
reporting requirements for the financial statements, and (2) Regulation S-K,
which sets forth the SEC’s reporting requirements for information outside the
financial statements. Common disclosures required in a typical IPO registration
statement are summarized in Appendix A. Once submitted to or filed with the SEC, an IPO
registration statement is processed and reviewed by the staff of the Division
(see C in the timeline above). The purpose of the review is to determine whether
the registration statement complies with the SEC’s disclosure requirements. The
SEC does not evaluate the merits of securities offerings or reach a conclusion
about whether they are “good” investments; rather, the Commission evaluates the
appropriateness of the disclosure provided. A company can generally expect the
staff to complete its initial review and furnish the first set of comments
within 27 calendar days. The company would then respond to each of the SEC’s
comments and reflect requested edits, as well as any other updates, in an
amended IPO registration statement, which the SEC will also review. After the
initial filing, the SEC’s review time can vary significantly but typically is
within two weeks. A company can expect several rounds of comment letters with
follow-up questions on responses to original comments as well as additional
comments on new information included in the amended registration statement.
Depending on the length of time between amendments, financial statements and other information included in the registration statement may need to be updated to reflect subsequent periods. Certain information, such as estimated pricing of the IPO and related disclosures, may not be known as of the initial filing date and therefore is not added until a later amendment. However, the SEC expects each draft of the registration statement to be substantially complete at the time of its submission, unless there are specific accommodations for omitting otherwise required information.
Once all the staff’s comments are cleared, a company will typically print a
preliminary prospectus, commonly referred to as a “red herring,” and go on a
“road show” to meet with and present to prospective investors; the IPO price
will then be determined (see D in the timeline above). After the road show, the
company and its counsel may request that the SEC declare the registration
statement “effective” at a certain date and time, after which the securities
will be registered and, if listed on an exchange, begin trading. Before the SEC
declares the registration statement effective, the entity will need to obtain
approval from the exchange on which it is expected to be listed (see E in the
timeline above). The IPO closing signifies the completion of the IPO, at which
time the company’s securities are admitted for trading on a stock exchange. As
part of the IPO process, the company's auditor will typically provide two
comfort letters to the underwriters — one upon effectiveness (see E in the
timeline above) and one upon the closing of the IPO (see F in the timeline
above), often referred to as a "bring-down" comfort letter. See Section 6.10 for further discussion.
While most registration statements will only become effective after the SEC comment process has
been completed and an effective date has been requested by the company and granted by the
SEC, registration statements on Form 10 filed in accordance with Section 12(b) of the 1934 Act are
automatically effective 30 days after certification by an applicable securities exchange. Registration
statements on Form 10 filed in accordance with Section 12(g) of the 1934 Act are automatically effective
60 days after the initial filing. Because a company will be required to begin complying with the periodic
reporting requirements of the 1934 Act after effectiveness, it is critical to understand and plan for the
effective date of any IPO registration statement.
Connecting the Dots
To avoid unnecessary surprises during the SEC’s review
process, management may want to establish a detailed response plan and
filing calendar. Because financial statements “go stale” after certain
dates, it is important to understand when this will happen and to
establish contingency plans in case the timing of amendments crosses
over stale dates. It may also be beneficial to engage all interested
parties (e.g., auditors, underwriters, legal counsel) in planning the
timeline. Management should anticipate various circumstances and be
realistic about the internal resources available to complete the
registration statement and respond to comment letters.
1.4.2 Nonpublic Review Process for Draft Registration Statements
Historically, registration statements filed with the SEC were immediately
accessible to the public via EDGAR, the SEC’s online public database. However,
as discussed in Section
1.6, EGCs may confidentially submit certain IPO registration
statements to the SEC. In 2017, the SEC extended a similar benefit to non-EGCs,
allowing them to also voluntarily submit draft IPO registration statements to
the SEC staff for nonpublic review. The ability to file nonpublicly is a
significant benefit because it allows companies to keep potentially sensitive
information from customers or competitors until later in the IPO process. It
also lets companies, on a nonpublic basis, respond to SEC comments, update the
draft registration statement, and continue to assess market conditions
throughout the IPO process. Companies that use this benefit can also delay or
withdraw the IPO, if desired, without public scrutiny.
While draft registration statements may be initially submitted nonpublicly, a
company will eventually be required to publicly file all previously submitted
drafts unless it elects to withdraw the IPO. Specifically, all comments and the
related responses, even if they were previously submitted nonpublicly, will be
posted to the SEC’s Web site no earlier than 20 business days after the
registration statement is declared effective. All nonpublic submissions of 1933
Act registration statements must be filed publicly4 no later than 15 days before (1) a road show or (2) the requested
effective date of the registration statement if no road show is planned.
Connecting the Dots
In the answer to Question 1 of its FAQs on the voluntary submission of
draft registration statements, the SEC staff states, in part:
The confidentiality provisions of Securities Act
Section 6(e)(2) are limited to certain draft registration statements
of Emerging Growth Companies. An issuer relying on the Division’s
policy should consider requesting confidential treatment under Rule
83 (17 CFR 200.83) for its draft registration statement and
associated correspondence when seeking a nonpublic review.
As a result, “confidential” draft registration
statements are reserved for EGCs. Other issuers may submit draft
registration statements “nonpublicly” and request that they be given
confidential treatment.
When submitting a draft registration statement for nonpublic review, companies
should consider the following:
- The draft registration statement must be “substantially complete.” It must contain a signed audit report from the company’s independent registered public accounting firm and meet all line item requirements applicable to the registration statement, unless a company is using certain permitted accommodations for omitting otherwise required information.5
- For a draft registration statement, companies do not need to include items such as the required signatures of executives and directors, the auditor’s consent, and the filing fee.
At the time of a company’s initial public filing, the registration statement should be:
- Devoid of any indications that the document is nonpublic.
- Complete (e.g., it should include signatures, signed audit reports, consents, exhibits, and any required filing fees).
- Accompanied by the contemporaneous filing of any previously submitted nonpublic draft registration statements.
Footnotes
4
For 1934 Act statements, the registration statement must
be filed no later than 15 days before the expected effective date of the
registration statement.
5
See Question 101.05 of the
SEC’s C&DIs on Securities Act forms.
1.5 Smaller Reporting Companies
1.5.1 What Are SRCs?
A registrant may qualify as an SRC on the basis
of either a public float test or a revenue test. The thresholds for
qualification as an SRC are as follows:
Criteria
|
Definition
|
---|---|
Public float test
|
Less than $250 million of public float
as of the last business day of the registrant’s second
fiscal quarter
|
Revenue test
|
Less than $100 million of revenue as of
the most recently completed fiscal year for which
audited financial statements are available and public
float less than $700 million as of the last business day
of the registrant’s second fiscal quarter
|
For initial 1933 Act or 1934 Act registration statements, public float is
measured as of a date within 30 days of the filing and is computed by
multiplying the estimated public offering price of the shares by the sum of (1)
the aggregate worldwide number of all shares outstanding held by nonaffiliates
before the filing of the registration statement and, in the case of a Securities
Act registration statement, (2) the number of such shares included in the
registration statement.
A company may qualify as both an SRC and an EGC (see Section 1.6); however,
unlike the five-year limit for qualifying as an EGC, there is no time limit for
qualifying as an SRC. Investment companies, asset-backed issuers, and
subsidiaries that are majority-owned by non-SRC registrants cannot qualify as
SRCs. An issuer that becomes an investment company or qualifies as an
asset-backed issuer is disqualified from being considered an SRC for its next
filing. Registrants should consider consulting with their legal counsel when
determining whether they qualify as SRCs.
1.5.2 Accommodations Applicable to SRCs
A key feature of reducing the reporting burden on SRCs is the scaling back of the requirements in both
Regulation S-X and Regulation S-K.
SRCs may be eligible to apply the scaled disclosure requirements as part of
their IPO. Under those requirements, SRCs do not have to disclose as many years
of audited financial statements and MD&A as non-SRCs. SRCs are also exempt
from the requirements for unaudited quarterly financial information after a
retrospective accounting change as well as qualitative and quantitative
information about market risk. See Chapter 4 for more information about the
disclosure requirements in Regulation S-K. For a more detailed analysis of the
scaled disclosure requirements for SRCs, see Appendix B. Topic 5 of the FRM also discusses the SEC
staff’s views on many SRC-related issues. Other than within this section and
Appendix B,
this Roadmap generally does not specifically address SRC requirements.
Companies that qualify as SRCs may choose to apply the scaled disclosure requirements on an item-by-item (or an “a
la carte”) basis. However, their disclosures should be consistent from year to year and must comply with
federal securities laws, including those that require disclosures not to be misleading.
Connecting the Dots
In determining which scaled disclosure requirements to
apply, eligible companies may wish to conduct outreach and consider the
information needs of their investors and other financial statement
users. Thus, eligible companies may consider weighing any potential cost
savings associated with the scaled disclosure requirements against not
disclosing information that investors may consider valuable.
1.5.3 Interaction of SRC and Accelerated Filer Status
After its IPO, a company could both (1) qualify as an SRC and be eligible for the
scaled disclosure requirements available to such a company and (2) be an accelerated
filer and subject to those requirements, including the shorter deadlines for
periodic filings and the requirement to include in the company’s filings an
auditor’s attestation report on ICFR, as required by Section 404(b) of
Sarbanes-Oxley. See Chapter 7 for further
discussion of filer deadlines and internal control requirements.
The table below further summarizes the initial assessment criteria
for SRC status on the basis of public float and revenue levels in the context of the
requirements in Section 404(b) of Sarbanes-Oxley.
Status
|
Definition
|
Sarbanes-Oxley Section 404(b)
Requirement
| |
---|---|---|---|
Public Float
|
Annual Revenues
| ||
SRC and nonaccelerated filer
|
Less than $75 million
$75 million to less than $700 million
|
No limit
Less than $100 million
|
No
No
|
SRC and accelerated filer
|
$75 million to less than $250 million
|
$100 million or more
|
Yes for non-EGCs; no for EGCs
|
1.6 Emerging Growth Companies
1.6.1 What Are EGCs?
An EGC is a category of issuers that was established in 2012 under the JOBS Act
and was granted additional accommodations in 2015 under the FAST Act. The less
stringent regulatory and reporting requirements for EGCs are intended to
encourage such companies to undertake public offerings. A private company
undertaking an IPO will generally qualify as an EGC if it (1) has total annual
gross revenues of less than $1.235 billion during its most recently completed
fiscal year and (2) has not issued more than $1 billion in non-convertible debt
in the past three years. Once a company completes its IPO, it must meet
additional criteria to retain EGC status.
1.6.2 Accommodations Applicable to EGCs
There are many potential benefits for registrants that file an IPO as an EGC. For example, EGCs:
- Need only two years of audited financial statements in an IPO of common equity.6
- May omit financial information (including audited financial statements) from an IPO registration statement if that financial information is related to periods that are not reasonably expected to be required at the time the registration statement becomes effective.
- May elect not to adopt new or revised accounting standards until they become effective for private companies.
- Are eligible for reduced executive compensation disclosures.
EGCs are not required to apply the above accommodations and may choose to provide some scaled
disclosures but not others. However, if an EGC has elected to opt out of the extended transition period
for complying with new or revised accounting standards, this election is irrevocable. Therefore, the
registrant, its advisers, and the underwriters should consider which EGC accommodations to use early in
the IPO process. The SEC expects EGCs to disclose, in their IPO registration statements, their EGC status
and to address related topics, such as the exemptions available to them, risks related to the use of those
exemptions, and how and when they may lose EGC status.
Certain scaled disclosure provisions that apply to EGCs may also be available
for other entities’ financial statements. For example, financial statements
required under SEC Regulation S-X, Rule 3-05 or Rule 3-09, may be omitted from
an IPO registration statement if that financial information is related to
periods that are not reasonably expected to be required at the time the
registration statement becomes effective. In addition, an issuer that was an EGC
at the time it initially submitted its IPO registration statement for SEC review
but that subsequently ceased to be an EGC is allowed to continue to use the
accommodations provided to EGCs until the earlier of either the date it
completes its IPO under that registration statement or one year after it ceased
to be an EGC.
After its IPO, provided that a registrant retains its EGC status, additional
accommodations are available for its ongoing reporting obligations. One of the
most significant of these accommodations exempts EGCs from the requirement to
obtain, from the entity’s independent registered public accounting firm, an
auditor’s report on the entity’s ICFR. EGCs are also exempt, unless the SEC
deems it is necessary, from any future PCAOB rules that may require (1) rotation
of independent registered public accounting firms or (2) supplements to the
auditor’s report, such as communications regarding critical audit matters
(CAMs), which are required for certain other issuers.7 See Chapter 7
for further discussion of the ongoing requirements a registrant must comply with
after its IPO is effective and the related EGC accommodations.
After going public, a registrant will retain its EGC status until the earliest of:
- The last day of the fiscal year in which its total annual gross revenues exceed $1.235 billion.
- The date on which it has issued more than $1 billion in nonconvertible debt securities during the previous three years.
- The date on which it becomes a large accelerated filer (which is an annual assessment performed on the last day of the fiscal year on the basis of public float as of the end of the second fiscal quarter). To be considered a large accelerated filer, the registrant must have filed at least one annual report and must have been subject to the requirements of Sections 13(a) and 15(d) of the 1934 Act for at least 12 months. Accordingly, the registrant generally cannot be considered a large accelerated filer for its first Form 10-K filing as a public company.
- The last day of the fiscal year after the fifth anniversary of the date of the first sale of common equity securities under an effective Securities Act registration statement for an EGC.
1.6.3 Loss of EGC Status and Impact on Adoption Dates for New Accounting Standards
An EGC may elect to adopt new accounting standards on the basis
of effective dates that apply to non-PBEs. However, such an election is
available only for as long as the entity qualifies as an EGC. An entity may lose
EGC status after the effective date for PBEs but before the effective date for
non-PBEs. As discussed in paragraph 10230.1 of the FRM, the SEC staff generally
expects an EGC that loses its EGC status to comply with the PBE requirements in
the first filing after loss of EGC status. Accordingly, a registrant that loses
EGC status before adopting a new standard should reflect such adoption as of the
beginning of the current fiscal year. Previously issued financial statements do
not need to be amended unless the standard requires full retrospective
application. Entities that lose EGC status during the IPO process would reflect
adoption of any deferred standards in their first periodic report (i.e., on Form
10-Q or Form 10-K) after the IPO. Entities that lose EGC status after their IPO
would reflect adoption of any deferred standards in their next periodic report
(i.e., on Form 10-Q or Form 10-K) after the loss of EGC status.
The staff encourages EGCs to (1) review their plans to adopt
accounting standards upon the loss of EGC status and (2) consult with the
Division if they do not believe that they will be able to comply with the
requirement to reflect new accounting standards on a timely basis.
Example 1-1
On December 1, 20X1, Entity A, which
qualifies as an EGC, initially submits its IPO
registration statement on a confidential basis. On March
1, 20X2, A publicly files its IPO registration statement
with financial statements for the year ended December
31, 20X1, and reports more than $1.235 billion in
revenue for the year then ended. However, A completes
its IPO on May 1, 20X2, and therefore is able to retain
EGC status through the completion of the IPO because
less than one year has passed since EGC status was lost
(i.e., on December 31, 20X1). Nevertheless, A must adopt
any accounting standard for which it delayed adoption
because of its EGC status. For example, if A delays
adoption of the new leasing standard in its registration
statement, it would be required to reflect the initial
adoption as of January 1, 20X2, in its Form 10-Q for the
quarter ended March 31, 20X2.
See Section
18.7 of Deloitte’s Roadmap Leases and Section 9.1.3 of
Deloitte’s Roadmap Current
Expected Credit Losses for examples illustrating the
adoption of ASC 842 and ASC 326 for EGCs and companies that subsequently lose
EGC status.
Footnotes
6
This accommodation is limited to an IPO of
common equity. As the SEC clarifies in paragraph
10220.1 of the FRM, an entity will generally need
to include three years of audited financial statements when
entering into an IPO of debt securities or filing an Exchange
Act registration statement, such as a Form 10, to register
securities.
7
CAMs are required for audits of all issuers except (1)
brokers and dealers; (2) registered investment companies other than
business development companies; (3) employee stock purchase, savings,
and similar plans; and (4) EGCs.
1.7 Special-Purpose Acquisition Companies
A SPAC is a newly created company that raises cash in an IPO and uses it to fund
the acquisition of one or more private operating companies. After the IPO, the
SPAC’s management looks to complete an acquisition of a target company within the
period specified in its governing documents (e.g., 24 months). If an acquisition
cannot be completed within this time frame, the cash raised in the IPO must
generally be returned to investors. Because SPACs hold no assets other than cash
before completing an acquisition, they are nonoperating public “shell companies” as
defined by the SEC. If a target is identified and the SPAC is able to successfully
complete the acquisition transaction, the private operating company target will
succeed to the SPAC’s filing status as a result of the merger. On the closing date
of the acquisition, the former private operating company, as the predecessor to the
SPAC registrant, becomes a public company and must be able to meet all the
public-company reporting requirements applicable to the combined company.
A SPAC’s shareholders are often required to vote on the merger transaction, so
the SPAC may file a proxy statement on Schedule 14A or a combined proxy and
registration statement on Form S-4 to effect the transaction. These documents must
include audited financial statements of the private operating target. The target’s
financial statements must comply with SEC rules and regulations, including
Regulation S-X and SEC Staff Accounting Bulletins, both of which govern presentation
and disclosures in the financial statements. At the September 2018 CAQ SEC Regulations Committee
joint meeting with the SEC staff, the SEC indicated that private operating company
SPAC target financial statements are expected to comply with public-company GAAP
disclosure requirements, including those related to segments and earnings per share
(EPS). Further, the SEC noted that such financial statements should include any
required financial statements for significant probable and consummated acquisitions
under Regulation S-X, Rule 3-05, “as if it were the private operating company’s
[IPO].” Further, because the private operating company is considered the predecessor
to the registrant, financial statements included in Form S-4 or the merger proxy
must be audited in accordance with PCAOB standards. In addition, the target’s
financial statements cannot reflect Private Company Council (PCC) accounting
alternatives or practical expedients applicable to non-PBEs and generally must
reflect the adoption of new accounting standards on the basis of the dates required
for public companies. However, we understand that the SEC staff will not object if a
target uses private-company (non-PBE) adoption dates if (1) the SPAC is an EGC that
has elected to defer the adoption of accounting standards by applying
private-company adoption dates, (2) the target would qualify as an EGC if it were
conducting its own IPO of common equity securities, and (3) the combined company
will qualify as an EGC after the transaction (see paragraph 10120.2 of the FRM for a discussion
of assessing EGC eligibility after the transaction). (Chapter 3 provides further guidance on
financial statement requirements.)
Audited financial statements should generally be presented for both
the SPAC and the target entity (or entities) for the three most recent fiscal years.
However, there are two scenarios in which the SEC staff would not object when a
registrant presents two years of annual financial statements rather than the
otherwise required three years:
-
SRCs — In a manner consistent with paragraph 1140.3 of the FRM, a target may provide two years of audited financial statements rather than three years if the target (1) is not an SEC reporting company and (2) would otherwise meet the definition of an SRC (e.g., it reported less than $100 million in annual revenues in its most recent fiscal year for which financial statements are available).
-
EGCs — In a manner consistent with paragraph 10220.7 of the FRM, a target may provide two years of audited financial statements rather than three years if all of the following apply: (1) the SPAC is an EGC, (2) the SPAC has not yet filed or been required to file its first Form 10-K, and (3) the target would qualify as an EGC if it were conducting its own IPO of common equity securities.Changing LanesIn March, 2022, the SEC issued a proposed rule that would expand the circumstances in which target companies may report two years of financial statements in a proxy/registration statement. Under proposed Regulation S-X, Rule 15-01(b), two years of the target’s financial statements would be permitted in a proxy/registration statement for transactions involving an EGC SPAC and a target that would qualify as an EGC if it were conducting its own IPO of common equity securities. This determination would no longer depend on whether the EGC SPAC has filed, or was already required to file, its first annual report.
The SPAC and its target must also comply with the requirements related to the
age of financial statements in SEC filings. (See Section 2.5 of Deloitte’s Roadmap SEC Reporting Considerations for
Business Acquisitions for further interpretive guidance on
the age of financial statements.) Within four days of the closing of the
acquisition, the combined company must file a Form 8-K (referred to as a “Super Form
8-K”) that includes all the information that would be required if the former private
operating company had registered securities on Form 10. There is no 71-day grace
period for providing audited financial statements of the formerly private operating
company in the Super Form 8-K, as there may have been if the acquisition had been
between two operating companies.8 Accordingly, the SPAC and the private operating target should take care to
ensure that the acquisition is not closed until all the financial information
required for the Super Form 8-K is available, including financial statements that
comply with the SEC’s age requirements and are audited in accordance with PCAOB
standards. Paragraph
12220.1 of the FRM provides more information about the
requirements related to the Super Form 8-K.
In addition, to avoid a gap or lapse in the target’s financial statement periods
after a transaction, the combined company may need to amend its Super Form 8-K to
provide updated financial statements of the target. For example, if the transaction
closes soon after the target’s fiscal quarter or year-end, the Super 8-K generally
will not include the target’s financial statements for the most recently completed
period. In such a case, the combined company will need to amend its Super 8-K to
provide the recently completed annual or interim period on or before the
registrant’s due date for its Form 10-Q or Form 10-K for that same period.
It can be complex to determine the ICFR attestation requirements that apply to management and the auditor after the close of a SPAC transaction. The phase-in exception in Regulation S-K, Item 308, for an IPO, under which management’s report and the auditor’s attestation on ICFR are not required before the second annual report, typically does not apply in a transaction with a SPAC. Further, if the SPAC is an EGC, the EGC status of the combined entity would also have to be assessed after the close of the transaction to determine whether the combined company could continue to qualify for the scaled disclosure requirements applicable to EGCs, including relief from the auditor’s attestation report. These transactions often involve a change in auditors, and if the SPAC’s year-end differs from that of the target, they may also involve a change in fiscal year-end. Given the complex reporting requirements associated with SPAC acquisitions, private operating companies contemplating such transactions should consider consulting with legal and financial reporting advisers as early as possible.
In addition to the matters discussed above, entities considering a
SPAC transaction should take into account key differences between the SEC reporting
requirements related to traditional IPOs (sale of newly issued common shares to the
public) and those for SPAC transactions, some of which are summarized in the table
below.
Topic
|
Traditional IPOs (Sale of Newly Issued Common Shares)
|
SPAC Transactions9
|
---|---|---|
Financial statement periods required in the IPO document
|
Two years of financial statements are required for SRCs and
EGCs.
Three years of financial statements are required for all
other registrants.
|
Two years of financial statements are
required if:
Three years of financial statements are required in all other
scenarios.
|
Adoption dates of accounting standards
|
EGCs can irrevocably elect to defer adoption of new
accounting standards on the basis of adoption dates used for
private companies (non-PBEs).
|
The target company may defer adoption of new accounting
standards only if (1) the SPAC is an EGC that has elected to
defer the adoption of accounting standards by applying
private-company adoption dates, (2) the target would qualify
as an EGC if it were conducting its own IPO of common equity
securities, and (3) the combined company will qualify as an
EGC after the transaction.
|
Confidential or nonpublic submissions of the
IPO document
|
Confidential or nonpublic submissions to the
SEC staff are allowed for all companies undertaking an IPO
(i.e., EGCs and non-EGCs). Such submissions, and any
associated SEC comment letter responses, may continue to be
submitted confidentially or nonpublicly until they must be
filed publicly as described in Section 1.4.2.
|
If a registrant files on Form S-4, the SEC
staff may agree to review the initial nonpublic draft Form
S-4 if it is submitted within 12 months of the SPAC’s IPO.
However, SEC comment letter responses and all subsequent
amendments must be filed publicly.
|
Pro forma information included in the IPO document
|
Pro forma information is not required unless the registrant
has other transactions for which pro forma information is
required in accordance with Regulation S-X, Article 11.
|
An entity must provide pro forma information for the
accounting impact of the (1) SPAC transaction and (2) any
other transactions for which pro forma information is
required in accordance with Regulation S-X, Article 11.
|
Prospective financial information included in the IPO
document
|
Prospective financial information (i.e., forecasted
information) is generally not presented.
|
Prospective financial information generally
must be presented if the boards of directors of the company
and SPAC used such forecasted information in evaluating the
transaction.
|
Initial quarterly periodic reporting obligation
|
The registrant becomes subject to the SEC’s periodic
reporting requirements beginning with the first quarterly or
annual period after consummation of the IPO. The first Form
10-Q, for the quarter after the most recent period included
in the registration statement, is due on the later of 45
days after the effective date or the date the Form 10-Q
would otherwise be due if the company had been a public
filer.
For example, if an IPO becomes effective on April 15, 20X1,
and includes financial statements through December 31, 20X0,
the first Form 10-Q required will be for the quarter ended
March 31, 20X1, and must be filed 45 days after April 15,
20X1.
|
The combined company retains the previous SEC reporting
obligations of the SPAC and must file financial statements
for quarterly or annual periods that end before the close of
the transaction on the basis of the SPAC’s filing deadlines,
without reference to the closing date of the transaction,
even if not included in the Super Form 8-K.
For example, if the SPAC transaction closes
on April 15, 20X1, the Super 8-K due within four days must
only include annual financial statements through December
31, 20X0. The combined company retains the SPAC’s
requirement to file a Form 10-Q for March 31, 20X1, for the
SPAC and an amended Super Form 8-K with the financial
statements of the target company for March 31, 20X1, by the
relevant Form 10-Q due date (i.e., 45 days for
nonaccelerated filers).
|
Ongoing reporting requirements related to ICFR
|
Management’s report and the auditor’s attestation on ICFR are
not required before the second annual report. The auditor’s
report may also not be required afterward to the extent that
the registrant is an EGC or nonaccelerated filer.
|
If the SPAC filed its first annual report
before the close of the transaction, management’s report on
ICFR is required in the next annual report after the close
of the transaction. However, as noted in Section
215.02 of the C&DIs on Regulation S-K,
the SEC may not object to the exclusion of management’s
report (and the auditor’s report) on ICFR depending on the
closing date of the transaction and other conditions. We
recommend that management consult with its legal counsel and
auditors before excluding reports on ICFR.
|
Changing Lanes
SEC Proposed Rules Released in March
2022
SPAC-Related Investor Protections
This proposed rule would “enhance investor
protections in [IPOs] by [SPACs] and in subsequent business combination
transactions between SPACs and private operating companies [also known as
de-SPAC transactions].” The objective of the proposed rule is to “more
closely align the financial statement reporting requirements in business
combinations involving a shell company and a private operating company [the
‘target’ company] with those in traditional [IPOs].” Accordingly, the
proposed amendments, if finalized, would change the requirements discussed
above, including those related to the financial statements that must be
provided in the registration statement, prospective financial information,
and ongoing reporting requirements.
When planning for SPAC transactions, entities should be
mindful of the unique considerations noted above as well as other specific
accounting and SEC reporting considerations, including the evolving
requirements outlined in the proposed rule. For additional information on
SPAC transactions, see Deloitte’s October 2, 2020 (updated April 11, 2022),
Financial Reporting
Alert.
Enhancements to Climate-Related Disclosure
Requirements
Under this proposed rule, public companies would
be required to enhance and standardize their climate-related disclosures.
Companies completing an IPO and private operating companies (targets)
merging with a registrant (including a SPAC) would be subject to the
proposed rule’s requirements. Disclosures for target companies would be
provided in the proxy statement or Form S-4 filed in advance of the
transaction. The proposed rule does not provide any exemption for EGCs
undertaking an IPO; therefore, such entities would be subject to the same
disclosure requirements as non-EGCs. For more information about the proposed
rule, see Deloitte’s March 21, 2022 (updated March 29, 2022), Heads Up.
SEC Final Rule Released in July 2023
Cybersecurity-Related Disclosures
In July 2023, the SEC issued a final rule that requires registrants to
provide enhanced disclosures about “cybersecurity incidents and
cybersecurity risk management, strategy, and governance.” However, the final
rule does not establish new disclosure requirements for registration
statements. Rather, the SEC reiterated its 2018 interpretive guidance, which states
that “[c]ompanies should consider the materiality of cybersecurity risks and
incidents when preparing the disclosure that is required in registration
statements.” See Deloitte’s July 30, 2023, Heads Up for more information about the final
rule and February 23, 2018, Heads Up for more information
about the interpretive guidance.
Footnotes
8
Under Item 2.01 of Form 8-K, a registrant is required to
file a Form 8-K to announce a significant business acquisition within four
business days of consummation and to include the required financial
statements within 71 calendar days.
9
The discussion herein applies to
SPAC transactions in which (1) a domestic SPAC
merges with a domestic target and (2) the SPAC has
identified only one target for the transaction. SPAC
transactions result in additional complexity when
foreign entities or multiple targets are involved.
In addition, we have recently observed new
structures in which either the target or a newly
formed company acquires the SPAC (e.g., a structure
frequently referred to as a “double dummy”
transaction). Such transactions may be viewed as the
IPO of the target and, thus, different
considerations may apply (e.g., two years of
financial statements may be appropriate if the
target qualifies as an EGC, and the confidential
filing process may be available for a longer
period).
1.8 Offerings Made in Accordance With Regulation A
Regulation A, as amended in 2015 (also referred to Reg A or Reg A+), provides an
exemption from the ordinary requirements of the Securities Act. This exemption
allows U.S. and Canadian companies to raise up to $75 million in a 12-month period
by issuing certain types of securities, including equity securities. Regulation A
requires that certain disclosure documents be submitted via EDGAR and allows for the
confidential review of offering documents. Two tiers of offerings are provided under
Regulation A:
- Tier 1, which consists of securities offerings of up to $20 million in any 12-month period, including no more than $6 million on behalf of the selling securities holders that are affiliates.
- Tier 2, which consists of securities offerings of up to $75 million in any 12-month period, including no more than $22.5 million on behalf of the selling securities holders that are affiliates.
For offerings of up to $20 million, the issuer can elect whether to proceed under Tier 1 or Tier 2. All issuers that pursue offerings in accordance with Regulation A are required to submit an offering statement on EDGAR that may be reviewed by the SEC staff. Before an issuer can begin selling securities, its offering statement must be “qualified” by the SEC and the issuer must receive a “notice of qualification,” which is similar to a notice of effectiveness in registered offerings. The offering statement includes a disclosure document and financial statements. While disclosures required in the offering statement are “scaled” or reduced to be in line with the size of the company, many are similar in nature to disclosures required under Form S-1.
Tier 2 issuers are required to include audited financial statements in their
offering documents and to file annual, semiannual, and current reports with the
Commission on an ongoing basis.10 In accordance with the form requirements for Regulation A, separate forms are
used for offerings (Form 1-A) and ongoing reporting requirements (Form 1-K, Form
1-SA, and Form 1-U for annual, semiannual, and current reports, respectively).
Except for securities that will be listed on a national securities exchange upon
qualification, purchasers in Tier 2 offerings must be either accredited investors or
be subject to certain limitations on their investment. For more information about
Regulation A offerings, see the “Amendments to Regulation A: A Small Entity Compliance
Guide” page on the SEC’s Web site.
Footnotes
10
While a Regulation A Tier 1 issuer must provide financial
statements in its offering document, such financial statements do not need
be audited unless the issuer’s financial statements were already audited for
other purposes. Regulation A Tier 1 issuers are not subject to ongoing
reporting requirements.
Chapter 2 — Identifying the Required Financial Statements for the Registration Statement
Chapter 2 — Identifying the Required Financial Statements for the Registration Statement
2.1 Introduction
One of the more challenging aspects of preparing for an IPO is
ensuring that the entity has identified the appropriate financial statements to
include in the filing. There are many considerations related to determining the
appropriate financial statements to include in the IPO registration statement. For
example, management will need to identify and prepare the financial statements both
for the registrant and for any predecessor entities (see Section 2.3). In addition to the complexities
associated with identifying the required financial statements for the registrant and
its predecessor(s), management must consider other potential financial statement
requirements that may result in additional meaningful historical financial
information for investors in the IPO. The specific requirements, discussed in
greater detail below, could be related to significant acquired or to be acquired
businesses and real estate operations (along with the related pro forma financial
information), equity method investments, guarantors of registered securities, or
entities that collateralize registered securities.
Before preparing the registration statement, entities are strongly
advised to consult with their independent auditors and legal counsel to determine
the appropriate financial statements to include. When the circumstances are
particularly complex, registrants may wish to submit a prefiling letter to the
Division to preclear the planned financial statement presentation and avoid
surprises or potential delays during the SEC’s review of their IPO filing.
Registrants may wish to seek modifications to their financial statement reporting
requirements when the application of a rule results in the requirement to provide
more information than the registrant believes is necessary. For example, a
registrant may submit a prefiling letter, referred to herein as a Rule 3-13 waiver,
in which it requests to omit the financial statements for a significant acquired
business, real estate acquisition, or equity method investment. See Section 2.4.5 for more
information about Rule 3-13 waivers.
2.2 Registrant Financial Statements
The first step in determining the financial statement requirements in an IPO is
to determine the registrant. The registrant is
typically the legal entity that is issuing
securities in the IPO and filing the registration
statement. Further, after the IPO, the registrant
will need to comply with the ongoing public
reporting requirements (e.g., annual reports on
Form 10-K, quarterly reports on Form 10-Q, and
current reports on Form 8-K), as described in
Chapter 7.
In many cases, an existing operating entity may proceed with an IPO in its current legal form and would
be identified as the registrant. Alternatively, the existing operating entity may undergo a corporate
reorganization before filing an IPO or before becoming a registrant. In other situations, a recently
organized entity may be formed as the registrant, and there may be a plan to combine it with one or
more operating entities before an IPO. All of these factors can affect which reporting entities’ financial
statements are required in the IPO.
Although the registrant’s
financial statements generally should be included
in the IPO registration statement, sometimes they
will not be sufficient. An entity may need to
carefully evaluate the formation, history, and
legal structure of the entities or businesses
involved in the IPO to determine which financial
statements are required. For example, an entity
may need to consider recently organized
registrants (see Section 2.2.1),
predecessor entities (see Section
2.3), carve-outs of existing legal
entities (see Section 2.3.1),
and “put-together” or “roll-up” transactions (see
Section 2.3.2), all of which are
discussed in more detail below.
2.2.1 Recently Organized Registrant Financial Statements
A recently organized entity (sometimes referred to as a shell company) with few
or no historical operations may be formed as the registrant to acquire one or
more operating companies upon or before the consummation of its IPO.
Generally, the financial statements of a recently organized registrant must be
presented in the IPO registration statement even
if it has no historical operations. In these
cases, an audited “seed money” balance sheet of
the newly formed registrant is presented,
typically as of the date of incorporation, to show
the initial capitalization of the entity.
Statements of operations, comprehensive income,
and cash flows may be omitted if there has been no
activity other than the formation transaction.
However, such financial statements must still
comply with the form, content, and updating
requirements of Regulation S-X. In some
circumstances, such as when the registrant is
capitalized on a nominal basis, a recently
organized registrant’s financial statements may be
omitted from a filing; in such cases, the
registrant would provide a statement indicating
that the recently organized entity has not
commenced operations and has no (or nominal)
assets or liabilities. For more information, see
Section 1160 of the FRM. Further,
paragraph 1220.4 of the FRM prescribes
the related age requirements for situations in
which a recently organized registrant’s financial
statements are provided. When a recently organized
registrant’s financial statements are included in
an IPO filing, additional predecessor financial
statements, as described in the paragraphs below,
will almost always be required.
One type of shell company is a SPAC, which is a newly created company that raises cash in an IPO to fund the acquisition of one or more private operating companies within a specified period. Generally, the companies to be acquired will not be identified until later and the financial statements of the operating companies therefore are not included in the IPO of the SPAC. Financial statements of the operating companies will be included in a post-IPO filing. See Section 1.7 for more information regarding SPACs.
2.3 Predecessor Financial Statements
If a registrant has not had substantive operations for all periods presented in an IPO registration
statement, it is important to consider whether the registrant has a “predecessor” company or business.
Section 1170 of the FRM indicates that the designation of an acquired business as a predecessor is
based on both of the following criteria:
- The registrant “succeeds to substantially all of the business (or a separately identifiable line of business) of another entity (or group of entities).”
- “[T]he registrant’s own operations before the succession appear insignificant relative to the operations assumed or acquired.”
A predecessor’s historical financial information is considered important to an
investing decision. As a result, the registrant’s financial statements and those of
its predecessor together should typically cover all periods required by Regulation
S-X, with no lapse in audited periods. Further, the predecessor financial statements
must be audited in accordance with PCAOB, not solely AICPA, standards and will be
required not only in the IPO but also in subsequent periodic reports.
The SEC staff believes that when a newly formed company (i.e., a “newco”) is
formed to acquire multiple entities in conjunction with an IPO, instances in which
there is no predecessor would generally be rare, even if the newco is substantive
and was deemed the accounting acquirer. The staff highlighted a number of factors
for registrants to consider in determining the predecessor, including (but not
limited to) (1) the order in which the entities are acquired, (2) the size of the
entities, (3) the fair value of the entities, and (4) the historical and ongoing
management structure. No one item is determinative on its own. In addition, the
staff has encouraged registrants to evaluate their determination of predecessors in
light of how management intends to discuss its business in the IPO registration
statement as well as whether financial information in its subsequent Forms 10-K
would provide sufficient information to investors.1 The staff noted that while there may be situations in which more than one
predecessor exists, it would be rare for no predecessor to be identified unless the
registrant is a start-up business. Carve-outs and entities in roll-up transactions
frequently meet the criteria to be identified as predecessors and are discussed
below in more detail.
2.3.1 Carve-Out Financial Statements
As described in Section
2.5.2.2, “carve-out financial statements” is a generic term used
to describe separate financial statements that are derived from the financial
statements of a larger parent company. A carve-out situation occurs when a
parent company segregates a portion of its operations and prepares a distinct
set of financial statements for the segregated portion in anticipation of a
sale, spin-off, or IPO of the “carve-out business.” Examples of a carve-out
business include an operating segment or multiple segments, all or part of a
subsidiary, and even a division or line of business of a larger parent company.
The carve-out business may not be in a separate, preexisting legal entity and
thus is often merged into a recently organized entity in an IPO.
In an IPO, it is critical that carve-out financial statements reflect the appropriate assets and operations
of the registrant or its predecessor so that the financial statements include all the costs of doing
business. Frequently, a carve-out business will involve multiple legal entities and include operations
that have not historically been reported separately. In determining the composition of the carve-out
financial statements, an entity should consider its specific facts and circumstances and may need to
use significant judgment. Carve-out financial statements should present information about all aspects
of the carve-out business’s historical results and operations (i.e., provide balanced and transparent
financial information that reflects all of the operation’s historical successes and failures). As a result, the
carve-out financial statements may even include certain assets or operations that are not part of the IPO
transaction. These financial statements may therefore reflect more than the entity in which the investor
ultimately invests. However, in this situation, a registrant would provide pro forma financial information
to adjust the historical carve-out financial statements to reflect only the net assets and operations
included in the IPO.
The SEC staff has acknowledged that the determination of which carve-out
financial statements to include in a registration statement can be complex.
Registrants therefore need to use judgment in making this determination,
particularly because (1) there may not be directly applicable SEC guidance on
this topic and (2) the accounting guidance (e.g., the guidance in ASC 505-60 on
determining the accounting spinnor and spinnee) may not be completely consistent
with the SEC’s reporting requirements. The SEC staff has also indicated that
financial reporting differences may arise depending on the legal form of the
transaction. Therefore, the form and content of these financial statements may
vary depending on the circumstances.
In determining what to include in the carve-out financial statements,
registrants may need to consider issues such as the parent’s existing reporting
structure (e.g., segments and reporting units), the nature and size of the
operations being carved out compared with the operations being retained by the
parent, and the legal structure of the carve-out. Registrants should also
consider the information in the “description of business” and MD&A sections
of their registration statements and whether such information, along with the
financial statements, gives investors a consistent, full, and transparent
picture.
Carve-out entities in an IPO will need to consider their compliance with
regulations governing other entities’ financial statements, including those in
Regulation S-X, Rules 3-05 and 3-09, related to acquisitions and equity method
investments, respectively. Such regulations will have to be considered on a
stand-alone basis because the level of significance of acquisitions and the
equity method investments to the carve-out entity may differ significantly from
the level of significance to its parent.
For additional considerations related to carve-out transactions, see Deloitte’s
Roadmap Carve-Out
Transactions.
2.3.2 Put-Together or Roll-Up Transactions
Regulation S-K, Item 901(c)(1), defines a “roll-up” transaction as “a transaction involving the combination
or reorganization of one or more partnerships, directly or indirectly, in which some or all of the investors
in any of such partnerships will receive new securities, or securities in another entity.” A “put-together”
is not specifically defined by the SEC but is discussed in paragraph 2025.12 of the FRM as a transaction
in which more than two previously unrelated businesses combine concurrently with an IPO. Such a
transaction normally occurs when a shell company is formed to purchase two or more businesses or an
operating entity acquires several entities at once. The proceeds from the IPO are generally used to fund
the acquisitions.
The terms “put-together” and “roll-up” are also sometimes used generically for other transactions
in which two or more smaller companies are combined to form a larger company before an IPO
transaction. One common example would be a scenario in which investors (often private equity firms)
acquire multiple smaller companies within the same market and combine them to form a larger
company, with a goal of achieving economies of scale or combining companies with complementary
capabilities. Regardless of the form of the transaction, there are many unique considerations related to
an IPO of an entity created through a “put-together” or “roll-up” transaction. Such considerations may
include:
- The timing of the mergers, which can range from acquisitions over a multiyear period before an IPO to acquisitions concurrent with, and contingent on, the closing of an IPO.
- Any preexisting commonality of ownership between the combining entities.
- Whether the combining entities are considered “related businesses” under SEC guidance.2
- Who the accounting acquirer is and how the mergers will be accounted for.
- Identifying the registrant and whether there is a predecessor (or potentially multiple predecessors).
- Whether financial statements of any combining entities may be required under Rule 3-05 in addition to the financial statements of the registrant and its predecessor(s). (See Section 2.5.3 for more information.)
Footnotes
1
If a business is not identified as a predecessor, it would
generally be evaluated under Regulation S-X, Rule 3-05. Therefore, in an IPO
registration statement, the financial statements of nonpredecessor entities
may be provided under Rule 3-05. However, for subsequent Forms 10-K, only
the financial statements of the registrant and its predecessor(s) would be
required.
2
Businesses are related if (1) they are under
common control or management or (2) their acquisitions depend on
each other or on a single common event or condition. See
paragraph
2015.12 of the FRM for more information.
2.4 Financial Statement Periods Presented
An entity must include in its registration statement audited annual financial statements and related
footnote disclosures for both the registrant and any predecessor(s). The number of periods to be
included depends on the registrant’s status as an EGC or non-EGC. In addition, depending on the
time that has elapsed between the most recent fiscal year-end and the filing of the registration
statement, an entity may be required to include unaudited interim financial statements and related
footnote disclosures. The periods to be presented for both annual and interim financial statements are
summarized in the table below. See Sections 1110 and 1120 of the FRM for more information about the financial statement requirements for annual and interim reporting periods, respectively.
Financial Statement Requirement | Non-EGCs | EGCs3 |
---|---|---|
Annual Financial Statements (Audited) | ||
Balance sheet | 2 years | 2 years |
Income statement | 3 years | 2 years |
Comprehensive income | 3 years | 2 years |
Cash flows | 3 years | 2 years |
Changes in shareholders’ equity | 3 years | 2 years |
Interim Financial Statements (Unaudited) | ||
Balance sheet | As of the end of the most recent interim period after the latest fiscal year-end
and the latest fiscal year-end | As of the end of the most recent interim period after the latest fiscal year-end
and the latest fiscal year-end |
Income statement | The period from the latest
fiscal year-end to the interim
balance sheet date and the
corresponding period in the prior
fiscal year | The period from the latest
fiscal year-end to the interim
balance sheet date and the
corresponding period in the prior
fiscal year |
Comprehensive income | Same as income statement | Same as income statement |
Cash flows | Same as income statement | Same as income statement |
Changes in shareholders’ equity4 | Same as income statement | Same as income statement |
2.4.1 Periods Required for Predecessor Entities
As indicated in paragraph 1170.2 of the FRM, the annual and interim financial statements for the registrant and its predecessor should collectively
be “as of” all dates and “for” all periods required by Regulation S-X, Articles 3 and 10, as shown in the
table above. When the registrant and its predecessor have already combined as of the IPO filing, the
predecessor’s financial statements are required for all periods before the succession (i.e., up to the date
of the combination), with no lapse or gap in audited periods. However, if the registrant and predecessor
have not yet combined as of the IPO filing, the predecessor would present all periods required as if it
was the registrant.
2.4.2 Interim Financial Statements
Article 10 outlines the financial statement requirements for interim reporting.
The interim financial statements and related footnotes may be presented on a condensed
basis in a level of detail allowed by Article 10 but will always need to contain
disclosure of any material matters that were not disclosed in the most recent annual
financial statements. While the interim financial statements in an IPO registration
statement may be unaudited, SEC regulations do not require that they be subject to a
review under PCAOB standards by the registrant’s independent registered public accounting
firm; however, a company’s underwriters will often require that such a review be performed
for due diligence or comfort letter purposes. The interim-period information may be
presented alongside the audited annual financial statements, with the interim information
clearly marked as unaudited. Alternatively, the interim-period information may be
presented as a separate set of unaudited financial statements. Because a company
undergoing an IPO may not have historically prepared interim financial statements, the
company should ensure that it has established proper controls and procedures for
accurately preparing such information.
2.4.3 Age of Financial Statements
In accordance with Regulation S-X, Rule 3-12, the financial statements in an IPO must meet certain age requirements as of each registration-statement filing date as well as when the registration is declared effective; otherwise, the financial statements will be considered “stale.” In general, the financial statements in an IPO filing must not be more than 134 days old (i.e., the gap between the date of filing or effectiveness and the date of the latest balance sheet cannot be more than 134 days). However, third-quarter financial statements are considered timely through the 45th day after the most recent fiscal year-end, after which the audited financial statements for the most recent fiscal year are required. See Section 1220 of the FRM for additional details.
The table below provides the dates on which financial statements become
“stale” for a calendar-year-end company undertaking an IPO during 2023 or 2024. That is,
financial statements for the respective financial statement period can be included in an
IPO registration statement up to the dates listed below. When filing an IPO registration
statement after these dates, an entity must update financial statements and other
financial information to comply with the SEC’s age requirements (i.e., an additional
unaudited interim period or audited fiscal year would be required).
First Quarter Ended March 31 (Unaudited)
|
Second Quarter Ended June 30 (Unaudited)
|
Third Quarter Ended September 30 (Unaudited)
|
Fiscal Year Ended December 31 (Audited)
| |
---|---|---|---|---|
Fiscal/calendar year 2023
|
August 14, 2023
|
November 13, 2023
|
February 14, 2024
|
May 13, 2024
|
Fiscal/calendar year 2024
|
August 12, 2024
|
November 12, 2024
|
February 14, 2025
|
May 14, 2025
|
2.4.4 Omission of Certain Financial Information From Draft Registration Statements
While each draft of a registration statement is generally expected to contain
all information required by SEC regulations, there is an accommodation available to
companies that allows them to omit financial statement periods in certain circumstances.
This accommodation was initially granted to EGCs as part of the JOBS Act but was
subsequently expanded by the SEC to include non-EGCs as well. Specifically, under the
accommodation, a non-EGC may omit financial information from a nonpublic draft
registration statement (see Section
1.4.2) for historical periods currently required if the company reasonably
believes that it will not be required to include these historical periods at the time of
the public filing. This provision is likely to apply when the SEC’s review process extends
through a financial statement stale date. When a non-EGC files publicly for the first
time, it must include all financial information required as of the public filing date.
Example 2-1
A non-EGC calendar-year-end company submits a draft
registration statement in December 20X7 and reasonably expects to file
publicly for the first time in April 20X8 when annual financial statements for
20X7, 20X6, and 20X5 will be required. In such a case, the company may omit
its 20X4 annual financial statements from its nonpublic draft registration
statement because the 20X4 annual financial statements will not be required at
the time of the first public filing. However, for either a confidential
submission or public filing more than 45 days after the 20X7 year-end, audited
20X7 financial statements must be included because those financial statements
will be required at the time of the first public filing and the company must
comply with the staleness requirements discussed in Section 2.4.3.
For non-EGCs, Question 101.05 of the SEC’s C&DIs on the Securities Act Forms clarifies that when evaluating which
interim periods to include in a draft registration statement, companies may omit interim financial
information if they reasonably believe that they will not be required to separately present such
information at the time they publicly file their registration statement. As a result, many initial draft
registration statements may not need to include interim financial statements when they are submitted
nonpublicly.
Example 2-2
A non-EGC calendar-year-end company submits a draft
registration statement in December 20X7 and reasonably expects to file
publicly for the first time in April 20X8 when annual financial statements for
20X7, 20X6, and 20X5 will be required. In such a case, the company may omit
its nine-month 20X7 and 20X6 interim financial statements from its nonpublic
draft registration statement because the company will not be required to
separately present those periods when it first publicly files its registration
statement in April 20X8. The annual financial statements for 20X7, 20X6, and
20X5 will be required (1) when the registration statement is filed publicly
for the first time in April 20X8 or (2) in any draft registration statement
submitted more than 45 days after the 20X7 year-end.
Example 2-3
A non-EGC calendar-year-end company submits a draft
registration statement in late August 20X7 and reasonably expects to file
publicly for the first time in December 20X7 when nine-month 20X7 and 20X6
interim financial statements will be required. In such a case, the company may
omit its six-month 20X7 and 20X6 interim financial statements from its
nonpublic draft registration statement because the company will not be
required to separately present those periods when it first publicly files its
registration statement in December 20X7. The nine-month 20X7 and 20X6 interim
financial statements, as well as the 20X6, 20X5, and 20X4 annual financial
statements, will be required (1) when the registration statement is filed
publicly for the first time in December 20X7 or (2) in any draft registration
statement submitted more than 134 days after June 30, 20X7.
In addition, the Division updated Question 1 of its C&DIs on the FAST
Act, and added a corresponding C&DI (Question 101.04) to the Securities Act Forms
C&DIs, to clarify the interim financial information required in draft registration
statements submitted by an EGC. Under the updated guidance, an EGC that submits a draft
registration statement can omit interim financial information that it reasonably believes
it will not be required to separately present at the time of the
contemplated offering. However, the appropriate interim
financial information would still be required in a registration statement that is publicly
filed.
Example 2-4
A calendar-year-end EGC submits a draft registration
statement in December 20X3. The company believes that its offering will
commence in April 20X4, at which time its 20X3 annual financial information
will be required. The company may omit its 20X1 annual financial information,
as well as its 20X2 and 20X3 interim financial information, from the draft
registration statement it submits in December 20X3.
If the company were to first file its registration statement publicly in
April 20X4 when its 20X3 annual financial statements are required, it would
not need to separately prepare or present interim financial information for
20X2 and 20X3. However, if the company were to publicly file its registration
statement in January 20X4, before its 20X3 annual financial information is
available, it may still omit its 20X1 annual financial information from this
registration statement but would need to include its 20X2 and 20X3 interim
financial information because, as indicated in Question 101.04 of the SEC’s
C&DIs on Securities Act forms, that information ”relates to historical
periods that will be included at the time of the public offering” (i.e., 20X3
annual financial statements).
Connecting the Dots
Non-EGC registrants would need to include all financial information
required at the time the registration statement is publicly
filed, and the SEC will not process a publicly filed registration statement if
such financial information is omitted. This guidance differs from the relief provided
by Section 71003 of the FAST Act, which allows EGCs to omit financial information (on
Form S-1) that they reasonably believe they will not be required to include in the
registration statement “at the time of the contemplated
offering” (emphasis added). While the examples in Sections 2.1, 2.2, and 2.3 specify periods for non-EGCs, an EGC could also use
similar accommodations.
A company that does not take advantage of the Division’s nonpublic
review process and elects to publicly file its initial registration statement would
not be allowed to omit from its initial registration statement financial information
that it reasonably believes will not be required at the time of the contemplated
offering. If a company believes that an accommodation would be appropriate in a
registration statement that is publicly filed, reasonable requests for such an
accommodation may be directed to the relevant office chief in the Division that is
responsible for performing the review.
See Appendix C for a summary of benefits available to EGCs and non-EGCs.
2.4.5 Rule 3-13 Waivers and Other Requests
Regulation S-X, Rule 3-13, gives the SEC staff the authority to permit the
omission or substitution of certain financial statements otherwise required under
Regulation S-X when doing so is “consistent with the protection of investors.” For
example, in an IPO, the registrant’s historical financial statements may exhibit
significant growth. In this case, certain acquisitions may not be material to the
registrant’s current operations. Therefore, when a registrant believes that the literal
application of the significance test leads to the provision of financial statements for an
acquired business under Rule 3-05 (or another requirement such as that for a significant
equity method investment under Rule 3-09) that are not material, not relevant, or not
meaningful to investors, the registrant may consider submitting — to the Division’s Office
of the Chief Accountant — a Rule 3-13 waiver request to omit or substitute certain
financial statements otherwise required by Regulation S-X. The staff has indicated that it
is also available to discuss potential waiver fact patterns by phone before a registrant
submits a waiver request. For additional guidance on Rule 3-13 waivers and other requests,
see Appendix B of Deloitte’s
Roadmap SEC Comment Letter
Considerations, Including Industry Insights.
Footnotes
3
Some EGCs may also qualify as
SRCs. See Section
1.5 and Regulation S-X, Article 8, for information and
reporting requirements for SRCs. The two-year accommodation for EGCs is
limited to an IPO of common equity. As clarified by the SEC in paragraph 10220.1 of the FRM, in an IPO of
debt securities or the filing of an Exchange Act registration statement
(e.g., a Form 10) to register securities, three years of audited financial
statements will generally be required.
4
May be presented in a footnote to the financial
statements. We believe that the analysis of changes in shareholders’ equity
is required for each period for which an income statement is presented and,
therefore, that both the year-to-date and corresponding interim period of
the prior fiscal year are required.
2.5 Financial Statements of Businesses Acquired or to Be Acquired (Rule 3-05)
When a significant business acquisition is consummated, or it is probable that
it will be consummated, the registrant may be required to file certain financial statements
of the acquired business or to be acquired business (acquiree) in accordance with Rule 3-05.
While existing registrants are subject to periodic reporting requirements for significant
acquisitions,5 a company is not subject to such requirements before an IPO. Therefore, in the context
of an initial registration statement, a company must evaluate recent acquisitions, as
further described below.
The following factors govern whether and, if so, for what period, the acquiree’s financial statements are required for a consummated or probable acquisition:
- Definition of a business — Rule 3-05 applies to an acquisition of a business. The definition of a “business” for SEC reporting purposes differs from the definition under ASC 805 for U.S. GAAP purposes and focuses primarily on the continuity of revenue-producing activities.6 Note that an acquisition can take many forms (i.e., acquisition of assets vs. acquisition of a legal entity) and that such forms typically will not affect the determination of whether the acquiree is a business.
- When the acquisition was
completed — The acquiree’s financial statements are not required once the
registrant’s audited financial statements reflect the operating results of the acquiree
for at least:
- Nine months if any of the results of the significance tests are greater than 20 percent but none are greater than 40 percent.
- A complete fiscal year if the results of any of the significance tests are greater than 40 percent.
- Significance — The highest level of significance based on the following three tests is used to
determine the financial statements, if any, that an entity is required to provide in the registration
statement:
- Investment test — The GAAP purchase price is compared with the total assets of the registrant on the basis of its most recent preacquisition annual financial statements. While the investment test stipulates the use of the aggregate worldwide market value (AWMV) of the registrant’s common equity (i.e., market capitalization) when available rather than total assets, companies undertaking an IPO would not yet have an observable AWMV and thus must use total assets. Once an entity completes its IPO, it should use its AWMV when performing the investment test. For example, if a registrant consummates an acquisition on March 15, 2022; completes its IPO on June 15, 2022; and consummates an acquisition on November 15, 2022, it should use total assets and AWMV to perform the investment test for the March and November acquisitions, respectively.
- Asset test — The registrant’s share of the acquiree’s total assets is compared with the registrant’s total assets on the basis of the most recent preacquisition annual financial statements of each company.
- Income test — The income test consists of an income component and a
revenue component:
- Income component — The registrant’s share of the acquiree’s pretax income from continuing operations7 is compared with the registrant’s pretax income from continuing operations on the basis of the most recent preacquisition annual financial statements of each company.
- Revenue component — If both the registrant and the acquiree have material revenue in each of the two most recently completed fiscal years, the revenue component is calculated by comparing the registrant’s share of the acquiree’s revenue with the registrant’s revenue on the basis of the most recent preacquisition annual financial statements of each company. If either the registrant or the acquiree does not have material revenue for each of the two most recently completed fiscal years, only the income component should be used.
- An acquiree will only be considered significant if both the income component and the revenue component (if applicable) exceed the significance threshold (i.e., 20 percent). When both components exceed the significance threshold, the lower of the two components is used to determine the number of periods for which the acquiree’s financial statements are required.
Pro forma financial information is generally required under SEC rules if the
acquiree is deemed to be significant. The significance tests in Rule 1-02(w) can be quite
complex. Entities are advised to consult with their independent auditors and legal counsel
when applying the tests in special circumstances. For more information about pro forma
financial information, see Section 4.4.
2.5.1 Preacquisition Financial Statements Required
The table below summarizes whether preacquisition financial statements are
required for an acquiree on the basis of the timing of the acquisition and the
significance threshold.8
Significance
|
Acquisition Closed
Before the Most Recent Full Fiscal Year Presented
|
Acquisition Closed
During the Most Recent Full Fiscal Year Presented
|
Acquisition Closed
After the Most Recent Full Fiscal Year Presented
|
Probable Acquisition (Not Yet
Consummated)
|
---|---|---|---|---|
20 percent or less
|
No
|
No
|
No
|
No
|
Exceeds 20 percent but not 40
percent
|
No
|
If the acquisition closed
during the first quarter, no; otherwise yes. See Section 2.5.1.1 for further details.
|
Yes — See Section 2.5.1.1 for further details.
|
No — See Section 2.5.1.2 for further details.
|
Exceeds 40 percent but not 50
percent
|
No
|
Yes — See Section 2.5.1.1 for
further details.
|
Yes — See Section 2.5.1.1 for further details.
|
No — See Section 2.5.1.2 for further details.
|
Exceeds 50 percent
|
No
|
Yes
|
Yes
|
Yes
|
2.5.1.1 Grace Period
Financial statements of a
significant acquired business that are not more than 50 percent significant (on the
basis of any of the three tests) are not required in a registration statement that is
filed or declared effective before the 75th day after the consummation of the
acquisition. (See paragraph
2040.1 of the FRM and the discussion of Company D in Example 2-5.) However, these
requirements may be accelerated if certain acquisitions are significant in the
aggregate, as noted below.
2.5.1.2 Aggregate
Separate financial statements
are generally not required for a significant probable acquisition whose significance
does not exceed 50 percent or for a significant consummated acquisition whose
significance does not exceed 50 percent within the grace period discussed above.
However, an entity must perform an additional test to calculate the aggregate
significance of (1) probable acquisitions whose significance does not exceed 50 percent;
(2) consummated acquisitions within the grace period whose significance is greater than
20 percent but not greater than 50 percent; and (3) any individually insignificant
(i.e., the significance does not exceed 20 percent) businesses acquired since the end of
the registrant’s most recently completed fiscal year presented.
The acquirees in all three of these categories are commonly referred to as individually
insignificant acquirees, and if their aggregate significance exceeds 50 percent, the
registration or proxy statement must include:
-
The audited preacquisition financial statements for the most recent fiscal year and interim period for any acquirees in categories 1 and 2 above whose significance exceeds 20 percent and that have not yet been filed.
-
Pro forma financial information to reflect the aggregate effects of all individually insignificant acquisitions (i.e., all three categories).
See Section 2.9 of Deloitte’s Roadmap SEC Reporting Considerations for Business
Acquisitions for more information. In addition, companies should
consult with their independent auditors and legal counsel in such circumstances.
2.5.1.3 Periods of Preacquisition Financial Statements Required
If preacquisition financial statements are
required, the significance level is used to
determine the periods as follows:
- Significance exceeds 20 percent but not 40 percent:
- One year of audited preacquisition financial statements.
- Interim financial statements (1) as of the acquiree’s last fiscal quarter-end completed before the closing of the acquisition and (2) for the year-to-date interim period ending on that date.
- Significance exceeds 40 percent:
- Two years of audited preacquisition financial statements.
- Interim financial statements (1) as of the acquiree’s last fiscal quarter-end completed before the closing of the acquisition, (2) for the year-to-date interim period ending on that date, and (3) for the corresponding year-to-date interim period in the prior year.
When the registrant’s audited balance sheet is
for a date after the consummation of the
acquisition, the separate balance sheet(s) of the
acquiree may be omitted, since the acquiree’s
balances are included in the acquiring company’s
balance sheet.
Example 2-5
Assume the following:
- Registrant A, a calendar-year-end company, is planning to file its initial registration statement on or around September 15, 20X6.
- Registrant A does not qualify as an EGC.
-
Registrant A will include its historical financial statements for the following periods in its initial registration statement:
- Audited balance sheets as of December 31, 20X5, and December 31, 20X4.
- Audited statements of operations, comprehensive income, cash flows, and changes in stockholders’ equity for each of the three years in the period ended December 31, 20X5.
- Unaudited financial statements as of and for the periods ended June 30, 20X6, and June 30, 20X5.
Registrant A made the following acquisitions:
Company
|
Acquisition Date
|
Highest Level of Significance
|
Years Required
|
Financial Statements Required9
|
---|---|---|---|---|
B
|
December 15, 20X4
|
60%
|
N/A
|
Because the acquisition of Company B occurred
before the most recent full fiscal year presented by Registrant A,
B’s preacquisition financial statements are not required.
|
C
|
January 15, 20X5
|
55%
|
2
| Because Company C has not been included in A’s audited results for a complete fiscal year, A must provide two years of preacquisition financial statements: C’s financial statements as of and for the years ending December 31, 20X4, and December 31, 20X3. |
D
|
July 15, 20X6
|
25%
|
1
|
While one year of audited financial statements
will eventually be needed, as of the initial filing date, no
financial statements of Company D are required on the basis of the
accommodation for recently consummated business acquisitions,
commonly referred to as the grace period, discussed in Section
2.5.1.1. In any amendment to the IPO registration
statement filed 75 or more days after the acquisition date of July
15, 20X6, audited financial statements as of and for the year
ended December 31, 20X5, as well as unaudited interim information
as of and for the six-month period ended June 30, 20X6, would be
required. In addition, if Company A completes its IPO during the
grace period, the required financial statements and pro forma
financial information must be filed on Form 8-K within 75 days of
the close of the acquisition.
|
2.5.2 Form of Financial Statements
Preacquisition financial statements of the acquiree are generally
prepared on the same basis as if the acquiree were a registrant, except that the level of
significance is used to determine the number of years of audited financial statements. The
financial statements must comply with Regulation S-X and SAB topics, including
requirements related to mezzanine equity (see ASC 480-10-S99-3A and SAB Topic 14.E) and separately
presenting revenue from products and services (see Regulation S-X, Rule 5-03(b)). However,
if the acquiree is not public, it does not need to comply with certain disclosure
requirements that only apply to issuers, such as those related to segments or EPS.
Some accounting standards differentiate between the accounting
disclosure requirements or adoption dates for PBEs and those for non-PBEs. Significant
acquirees whose financial statements are included in a registrant’s filing under Rule 3-05
are considered PBEs under U.S. GAAP10 Therefore, such acquirees should use PBE adoption dates and disclosure requirements
when preparing their financial statements. However, the SEC staff announced in 2017 that
it would not object if certain PBEs,11 when preparing financial statements of non-PBE acquirees, use the non-PBE effective
dates for the sole purpose of adopting the FASB's leasing standard. While the use of such
dates is permitted, once the standard is adopted, the financial statements must reflect
the PBE disclosures.
Management should be mindful of other accounting standards in which the adoption dates
for PBEs differ from those for non-PBEs. While EGCs may not be required to use the PBE
effective dates in adopting certain accounting standards, this accommodation does not
apply to acquiree financial statements under Rule 3-05.
In November 2019, the FASB issued ASU 2019-10, which provides a framework for
staggering the effective dates of future major accounting standards and amends the
effective dates of some new standards to give implementation relief to certain types of
entities. The standard introduces a new “two-bucket” framework for determining the
effective dates of future major accounting standards. Under the Board’s new framework, the
buckets are defined as follows:
- Bucket 1 — All PBEs that are SEC filers (as defined in GAAP), excluding SRCs (as defined by the SEC).
- Bucket 2 — All other entities, including SRCs, other PBEs that are not SEC filers, private companies, not-for-profit organizations, and employee benefit plans.
Significant acquirees whose financial statements are included in a
registrant’s filing under Rule 3-05 would qualify as “PBEs that are not SEC filers”;
therefore, such acquirees should use Bucket 2 adoption dates and disclosure requirements
when preparing their financial statements.
In addition, such acquirees should comply with the accounting and
disclosure requirements applicable to PBEs. Some standards permit practical expedients or
elections for non-PBEs (e.g., the use of a risk-free discount rate in lieu of the
incremental borrowing rate in the accounting for leases or the amortization of goodwill).
However, these expedients and elections may not be used in financial statements that an
entity prepares to meet the requirements of Rule 3-05. For example, at the October 2020 CAQ SEC Regulations Committee joint
meeting with the SEC staff, the staff discussed a situation in which (1) an acquired
company has adopted ASC 842 by using the risk-free-rate practical expedient and (2) a
registrant must evaluate the acquired company for significance and, in some cases, provide
this company’s separate financial statements. The SEC staff indicated that it would not
object if a registrant uses financial statements that reflect the risk-free-rate practical
expedient to measure significance, since doing so would result in greater ROU assets and,
thus, a higher measure of significance when the asset test is performed. The staff noted
that the risk-free-rate practical expedient should be “the only difference between those
financial statements and a PBE set of financial statements” but clarified that financial
statements provided in accordance with Rule 3-05 are PBE financial statements and thus may
not reflect this expedient. Therefore, before providing such financial statements in
accordance with Rule 3-05, a registrant would need to assess whether an adjustment to the
PBE rate is material and must be revised.
Generally, the annual financial statements for a significant acquisition
may be audited in accordance with AICPA standards.12 SEC regulations do not require registrants to audit or review interim financial
statements provided under Rule 3-05. However, the company’s underwriters will often
require that the interim information be reviewed by an independent registered public
accounting firm for due diligence or comfort letter purposes.
2.5.2.1 Full Financial Statements
In some instances, the acquisition may constitute only a portion of a legal
entity. If the acquired asset or group of assets represents substantially all of an
entity, the entire entity’s full audited financial statements are generally required. In
these circumstances, the registrant would remove any assets, liabilities, or operations
not acquired in the pro forma financial information presented.
2.5.2.2 Carve-Out Financial Statements
If the acquired asset or group of assets does not represent substantially all of
the selling entity, the selling entity’s financial statements may not be useful.
Therefore, the audited financial statements should only represent the selected parts of
the entity acquired, excluding the operations retained by the seller. These financial
statements are often referred to as carve-out financial statements. Carve-out financial
statements include, for the appropriate periods, balance sheets; statements of
operations, comprehensive income, and cash flows; changes in stockholders’ equity; and
the respective notes to the financial statements. The SEC staff believes that carve-out
financial statements should reflect (1) all assets and liabilities of the acquired
business even if the assets and liabilities that are directly related to the operation
of the acquired business are not acquired or assumed as part of the acquisition and (2)
all costs of doing business. For further discussion, see Deloitte’s Roadmap Carve-Out Transactions.
2.5.2.3 Abbreviated Financial Statements
In certain circumstances, carve-out financial statements may not be
practicable to prepare, such as when the acquired asset or group of assets is a small
portion or a product line of a much larger business and separate financial records were
not maintained. In such instances, the SEC staff may allow registrants to provide
abbreviated financial statements — that is, audited statements of assets acquired and
liabilities assumed (in lieu of a full balance sheet) and audited statements of revenues
and expenses (in lieu of a full statement of operations) — to meet the financial
statement requirements in Rule 3-05 provided that certain qualifying conditions and
presentation and disclosure requirements are met. Registrants may present such
abbreviated financial statements for an acquiree without seeking permission from the SEC
staff when the following qualifying conditions in Rule
3-05(e) are met:
- The assets and revenue of the acquiree represent 20 percent or less of the assets and revenue of the seller as of and for the most recently completed fiscal year.
- The acquiree’s financial statements have not been previously prepared.
- The acquiree was not a separate entity, subsidiary, operating segment,13 or division during the periods for which its financial statements would be required.
- The seller did not maintain the “distinct and separate accounts” that would be necessary to present financial statements that include the omitted expenses, and the preparation of such financial statements is impracticable.
When presented, abbreviated financial statements must also meet the presentation and
disclosure requirements in Rule
3-05(e)(2).
The title of the statement of revenues and expenses must be
appropriately modified to indicate that it omits certain expenses. The statement of
revenues and expenses must include all direct revenues and direct expenses associated
with the revenue-producing activities of the assets acquired and liabilities assumed.
Typically, the only costs excluded are those not directly connected to the
revenue-producing activity. For example, all related costs incurred by or on behalf of
the acquiree for the periods required to be presented must include costs of sales or
services, selling, distribution, and marketing as well as general and administrative
expenses, depreciation and amortization, and research and development expenses. As noted
in the response to Question 2 of SAB Topic 1.B, if the abbreviated financial statements include a
reasonable allocation of costs directly related to the revenue-producing activity
incurred by the seller on behalf of the business sold, the footnotes should contain
management’s assertion that the method used to allocate those costs is reasonable.
However, the registrant may exclude allocated corporate overhead expenses, certain
interest expense (i.e., interest expense for debt that will not be assumed by the
registrant), and income tax expense (collectively, “omitted expenses”).
In accordance with Rule 3-05(e)(2)(iii), the footnotes to the abbreviated financial
statements should include the following disclosures: (1) the nature of the omitted
expenses and why they were omitted, (2) an explanation of why it is impracticable to
prepare financial statements that include the omitted expenses, and (3) a statement that
the financial statements do not indicate the acquiree’s future financial condition or
operations because the omitted expenses have been excluded.
A registrant that presents abbreviated financial statements is not required to provide
a statement of cash flows. However, information (if available) about the acquiree’s
operating, investing, and financing cash flows must be included in the footnotes to the
financial statements.
When the qualifying conditions
are not met but a registrant nevertheless believes that such financial statements would
provide sufficient disclosures for investors, the registrant may request a waiver from
the SEC staff under Rule 3-13.
2.5.3 Other Considerations
In addition to the general financial statement
requirements related to the consummation of a significant business acquisition, other
considerations might affect the reporting requirements. The following table summarizes
such potential considerations:
Topic
|
Considerations
|
---|---|
Audited period less than a year
|
Regulation S-X, Rule 3-06, permits the use of an acquiree’s audited financial
statements for a period of nine to twelve months to satisfy one year of
financial statement requirements. For example, for a transaction that closed
in the fourth quarter (e.g., November 15, 20X6) for which one year of audited
preacquisition financial statements is required, a registrant could provide
audited financial statements for the nine months before acquisition (e.g., the
nine months ended September 30, 20X6) in lieu of audited financial statements
for the prior fiscal year (e.g., the year ended December 31, 20X5) and
unaudited information for the appropriate interim period (e.g., the nine
months ended September 30, 20X6).
|
Related businesses
|
Related businesses must be treated as a single business
acquisition in the assessment of significance. Businesses are related if (1)
they are under common control or management or (2) their acquisitions depend
on each other or on a single common event or condition. See Rule 3-05(a)(3)(i)-(iii).
|
Put-together transactions
|
When a put-together transaction14 occurs concurrently with an initial registration statement, a registrant
must first determine which entity is the acquiring entity. It must then
measure the significance of all other businesses in the put-together
transaction against that of the acquiring entity. Since these acquired
businesses are considered related under Rule 3-05(a)(3), a registrant must
aggregate all the other businesses (besides the acquiring entity) in the
put-together transaction and measure their significance against that of the
acquiring entity as if they were a single acquisition.
|
2.5.4 Omission of Financial Statements of Acquired Entities From Draft Registration Statements
In a manner consistent with the accommodations discussed in Section 2.4.4, a company may omit
from its draft registration statement Rule 3-05 financial statements (and the related pro
forma financial information discussed in Section 4.4) if the company reasonably believes that those financial
statements will not be required at the time of the public filing or contemplated offering,
as applicable.
Example 2-6
A calendar-year-end company that plans to submit a draft
registration statement in the fall of 20X7 completes a significant acquisition
in the fourth quarter of 20X6. The acquisition is significant in such a way
that one year of the acquiree’s financial statements would generally be
required under Rule 3-05. The company plans to update its draft registration
statement to include its 20X7 annual financial statements before a public
filing in 20X8. Thus, after that update, the acquired business will have been
part of the company’s financial statements for a sufficient amount of time to
eliminate the need for separate financial statements. In this scenario, the
staff of the Division will not delay its review of the draft registration
statement in the fall of 20X7 even though the acquiree’s financial statements
and the related pro forma financial information are omitted from the
submission.
Footnotes
5
Under Item 2.01 of Form 8-K, a registrant is required to file a Form
8-K to announce a significant business acquisition within four business days of
consummation and to include the required financial statements within 71 calendar
days.
6
Regulation S-X, Rule 11-01(d), states, in part, “[T]he term
business should be evaluated in light of the facts and circumstances involved and
whether there is sufficient continuity of the acquired entity’s operations prior to
and after the transactions so that disclosure of prior financial information is
material to an understanding of future operations. A presumption exists that a
separate entity, a subsidiary, or a division is a business.”
7
Regulation S-X, Rule 1-02(w), indicates that pretax income
from continuing operations is “consolidated income or loss from continuing
operations before income taxes (after intercompany eliminations)
attributable to the controlling interests.”
8
A company may be able to omit the financial statements of an
acquired business from its draft registration statement for certain periods. See
Section 2.5.4 for more
information.
9
Assumes that all acquired companies are
calendar-year-end companies and that the registrant is not
using the accommodation to omit the acquiree’s balance sheet,
when applicable.
10
Paragraph BC12 of ASU 2013-12 states that an entity meets the
definition of a PBE when it “is required by the SEC to file or furnish financial
statements or does file or furnish financial statements with the SEC” (e.g., its
“financial statements or financial information that is required to be or is included
in a filing with the SEC [, such as the information required under Regulation S-X,
Rules 3-09, 3-05, and 4-08(g)]”).
11
The relief only applies to a PBE that would not meet the definition of a PBE if it
were not for the fact that its financial statements or financial information is
included, or must be included, in another entity’s filing with the SEC.
12
In certain cases, if an acquired company is identified as a
predecessor (see Section
2.3), the audit must be performed in accordance with PCAOB standards.
13
In evaluating the “operating segment” condition above, a
registrant should consider the definition of that term in ASC 280 or IFRS 8, as
applicable. The operating segment condition for abbreviated financial statements
applies to all acquired businesses, whether public or private. Accordingly, a
company may have to evaluate whether the acquired entity would qualify as an
operating segment under ASC 280, if relevant.
14
See Section 2.3.2 for more information.
2.6 Financial Statements of Real Estate Operations Acquired or to Be Acquired (Rule 3-14)
When a registrant consummates, or it is probable that it will consummate, a
significant acquisition of real estate operations, the registrant may be required to
file abbreviated income statements for the acquired or to be acquired real estate
operations (acquiree) in accordance with Regulation S-X, Rule 3-14. Because the
information requirements under Rule 3-14 are different from those under Rule 3-05
(discussed above), it is critical to identify whether an actual or planned
acquisition is a real estate operation. In contrast to Rule 3-05, Rule 3-14 only
requires inclusion of preacquisition financial statements for a significant real
estate operation for the most recent year and applicable interim period, regardless
of significance. While existing registrants are subject to periodic reporting
requirements for significant acquisitions, an entity is not subject to such
requirements before an IPO. Therefore, in the context of an initial registration
statement, a company must evaluate certain acquisitions of real estate
operations.
Rule 3-14 applies to an acquisition of a real estate operation. The definition
of a real estate operation is distinct from the determination of a business for SEC
reporting purposes. Under Rule 3-14, “the term ‘real estate operations’ means a
business that generates substantially all of its revenue through the leasing of real
property” such as (1) office, apartment, and industrial buildings and (2) shopping
centers and malls. Below are two examples illustrating how an entity may distinguish
between a real estate operation that is required to present Rule 3-14 financial
statements and one that must present Rule 3-05 financial statements.
Example 2-7
Assume the following:
- Registrant A owns several apartment buildings for which it also serves as leasing agent and manager.
- Registrant A acquires Apartment Complex X from Company Y, which owns several apartment complexes.
In this example, X qualifies as a real
estate operation to A; therefore, A reports the acquisition
in accordance with Rule 3-14. Rentals are the principal
source of X’s revenue before the acquisition.
Assume instead that X was held by a limited
partnership that had no operations other than holding X and
related debt. If A acquired the limited partnership, the
same conclusion would apply.
Example 2-8
Assume the following:
- Registrant G owns and operates several golf courses.
- Registrant G acquires Golf Course Complex R, which consists of a golf course, hotel, and restaurant.
- In addition to charging greens fees for the use of the course, R obtains revenues from cart rentals, food and beverage sales, golf equipment sales, and hotel rooms.
Although the acquisition involves real
estate and rental revenue (i.e., greens fees and cart rental
fees), R’s revenues include food and beverage sales, sales
of golf equipment, and hotel room charges, which are highly
susceptible to variations attributable to market and
managerial factors. In this example, the acquisition of R
does not qualify as an acquisition of a real estate
operation. Therefore, G reports the acquisition in
accordance with Rule 3-05.
The financial statements and other related information needed for a REIT spin or REIT
conversion transaction may vary. (For more information, see Section 3.4.3 of Deloitte’s Roadmap SEC Reporting Considerations for Business
Acquisitions.) Registrants are increasingly performing REIT
conversions for “nontraditional” real estate operations, such as timber, hotels,
casinos, hospitals, golf courses, telecommunication infrastructure, and cold storage
facilities.
2.6.1 Periods of Financial Statements Required
There is only one significance test for Rule 3-14, the
investment test. When performing this test, a company compares the GAAP purchase
price with the acquirer’s total assets on the basis of its most recent
preacquisition annual financial statements. For a company undertaking an IPO,
the investment includes any debt secured by the property
that is assumed by the acquirer. Once a company completes its IPO, it will
measure significance by using the AWMV of common equity (i.e., market
capitalization) instead of total assets. The company will compare the GAAP
purchase price (excluding any debt assumed that is
secured by the acquired real estate operation) with market capitalization.
Companies undertaking an IPO should be aware that the method used to evaluate
significance for real estate operations will change upon completion of the IPO.
For acquisitions of real estate operations that exceed 20 percent significance
according to the investment test, an entity must include preacquisition
abbreviated income statements for one year and the subsequent year-to-date
interim period. The acquiree’s financial statements are not required once the
registrant’s audited financial statements reflect the operating results of the
acquiree for at least nine months. As a result, acquisitions that occurred in
the second or third back year of annual financial statements presented by the
registrant will generally not need to be presented in the separate
preacquisition financial statements.
Example 2-9
Registrant A acquires real estate operations on March
5, 20X4 (Property B); September 21, 20X4 (Property C);
and December 1, 20X4 (Property D). Each acquisition was
individually significant at the 20 percent level or
higher. All entities have December 31 fiscal year-ends.
Registrant A plans to file an initial registration
statement on June 1, 20X5.
Since Registrant A’s
audited financial statements for the year ended December 31,
20X4, will reflect more than nine months of postacquisition
audited results for Property B, no separate preacquisition
financial statements for Property B are necessary. For
Property C and Property D, given that each property was
individually significant at the 20 percent level or higher,
A is required to provide Rule 3-14 abbreviated financial
statements for:- Property C for the year ended December 31, 20X3 (audited), and the six months ended June 30, 20X4 (unaudited).
- Property D for the year ended December 31, 20X3 (audited), and the nine months ended September 30, 20X4 (unaudited).
Generally, the financial statements for a significant acquisition of real estate
operations may be audited in accordance with AICPA standards.
2.6.2 Other Considerations
If the significance of the aggregate of individually
insignificant real estate properties that are acquired, or whose acquisition is
probable, after the end of the most recently completed fiscal year for which the
registrant’s financial statement are presented exceeds 50 percent, pro forma
financial information for all of the individually insignificant real estate
operations must be provided. Further, separate audited abbreviated income
statements must be provided for significant (i.e., greater than 20 percent but
less than 50 percent significant) (1) consummated acquisitions of real estate
operations within the 75-day grace period and (2) probable acquisitions of real
estate operations. In accordance with the investment test, the registrant must
aggregate business acquisitions (i.e., under Rule 3-05) and real estate
operations acquisitions (i.e., under Rule 3-14). For more information about
individually insignificant acquisitions, see Section
3.4.2.3 of Deloitte’s Roadmap SEC
Reporting Considerations for Business Acquisitions.
In addition, the Securities Act and Exchange Act reporting requirements related to
“blind pool” offerings subject to SEC Industry Guide
5 are completely different with respect to real estate
acquisitions both during and after the distribution period, as discussed in
Chapter 3 of Deloitte's Roadmap
SEC Reporting Considerations for Business
Acquisitions. Blind pool offerings, also referred to as
nontraded REITs, are always nonaccelerated filers.
Registrants in the real estate industry will also need to prepare a Schedule III,
“Real Estate and Accumulated Depreciations,”and Schedule IV, “Mortgage Loans on
Real Estate,” as applicable.
Other important topics for registrants in the real estate industry to consider
are triple-net leases, which are discussed in Section
3.2.1.2 of Deloitte's Roadmap SEC
Reporting Considerations for Business Acquisitions, and
equity method investments, which are discussed in the section below.
2.7 Reporting Requirements for Equity Method Investees
Registrants with investments accounted for under the equity method (“equity
method investees” [EMIs]) should consider the reporting and disclosure requirements
in Regulation S-X, Rules 3-09, 4-08(g), and 10-01(b). These requirements ensure that
investors receive relevant financial information about significant EMIs. For
additional interpretive guidance on Rules 3-09, 4-08(g), and 10-01(b), see
Deloitte’s Roadmap SEC Reporting Considerations for
Equity Method Investees.
2.7.1 Separate Financial Statements (Rule 3-09)
For registrants that hold
interests in EMIs (including any that are accounted for by using the fair value
option15) that are considered significant, the investee’s separate financial
statements must be included in the IPO registration statement. An interest in an
EMI is considered significant if the results of either the investment test or
the income test under Rule 1-02(w) exceed 20 percent for any annual period
presented in the registrant’s financial statements. The following is a
description of the investment test and income test:
- Investment test — The registrant’s investments in, and advances to, the investee are compared with the registrant’s total assets as of the end of each fiscal year.
- Income test — The income test consists of an
income and revenue component.
- The income component is determined by comparing the absolute values of (1) the registrant’s equity in the investee’s pretax income or loss and (2) the registrant’s pretax income or loss.
- If both the registrant and the investee have material revenue in each of the two most recently completed fiscal years, the revenue component is calculated by comparing the registrant’s proportionate share of the investee’s revenue with the registrant’s revenue. If either the registrant or the investee does not have material revenue for each of the two most recently completed fiscal years, only the income component should be used.
If the EMI’s financial statements must be included in the registration
statement, they should be as of the same dates and for the same periods as the
audited consolidated financial statements that the registrant is required to
file (if the EMI and the registrant have the same year-end)16 and they must be audited for each year for which the results of either
significance test exceed 20 percent. The EMI’s comparative financial statements
for any years for which significance did not exceed 20 percent under either test
must still be presented, but they may be unaudited. While periods for which the
investment is not significant need not be audited, if such periods were audited,
professional standards may require an auditor to state this fact in its report.
If such periods were not audited, professional standards may also require an
auditor to state this fact in its report and, therefore, that the auditor
assumes no responsibility for them.
Example 2-10
Assume the following:
- Registrant A does not qualify as an EGC or an SRC and has a nonpublic EMI, Company B.
- In 20X5, 20X6, and 20X7, B was significant at the 15 percent, 18 percent, and 30 percent levels, respectively.
- Registrant A and Company B both have December 31 year-ends.
Registrant A is required to present
audited financial statements for B as of and for the
year ended December 31, 20X7, and either audited or
unaudited financial statements as of December 31, 20X6,
and for the years ended December 31, 20X6, and December
31, 20X5.
2.7.2 Summarized Financial Information (Rule 4-08(g))
Under Rule 4-08(g), a registrant must disclose summarized financial information
in the footnotes to its annual financial statements for all EMIs whose
significance, individually or in the aggregate, exceeds 10 percent in accordance
with any of the three significance tests in Rule 1-02(w). In addition to the
income test and the investment test (described above), the third test required
is the asset test, in which the registrant’s proportionate share of the total
assets of the EMI(s) is compared with the registrant’s total assets.
Under Regulation S-X, Rule 1-02(bb), summarized financial information should
include, at a minimum:
- Current and noncurrent assets, current and noncurrent liabilities, and (if applicable) redeemable preferred stock and noncontrolling interests.
- “Net sales or gross revenues, gross profit (or . . . expenses applicable to net sales or gross revenues), income or loss from continuing operations, net income or loss, and net income or loss attributable to the entity.”
Additional line items may be appropriate depending on the EMI’s industry as well
as its specific facts and circumstances.
Summarized financial information must be included in the notes to the financial statements for all
periods presented and may not be labeled as “unaudited.”
2.7.3 Summarized Interim Financial Information (Rule 10-01(b))
A registrant is not required to include separate financial statements of
significant EMIs for interim periods. However, if the individual significance of
any EMI is greater than 20 percent under the investment test or the income test
as of and for the appropriate interim periods presented, the registrant must
disclose summarized income statement information under Rule 10-01(b) (as
described in Section
2.7.2) in its interim financial statements. However, such
information need not be provided for any EMI that would not be required to file
quarterly information with the SEC if it were a registrant (e.g., an FPI).
Footnotes
15
See Section 3.1.3.6 of Deloitte's Roadmap SEC Reporting
Considerations for Equity Method Investees for
guidance on application of the fair value option in these
circumstances.
16
In accordance with Rule 3-09(b)(2), if the EMI and the
registrant have different fiscal year-ends, the separate financial
statements of the EMI may be as of the investee’s year-end.
2.8 Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered (Rules 3-10 and 13-01)
Under the Securities Act, guarantees of securities are considered to be
securities themselves. Therefore, all offerings of securities, as well as the
guarantees of such securities, must either be registered with the SEC or be exempt
from registration. A registrant must provide separate financial statements of each
subsidiary issuer or guarantor of debt securities registered or being registered
unless certain criteria are met (discussed below). Obtaining such separate financial
statements could be expensive and difficult. Therefore, in the context of an initial
registration statement related to guaranteed debt securities, a company must
carefully evaluate the reporting requirements in Regulation S-X, Rules 3-10 and
13-01. Rule 3-10 contains certain exceptions under which a registrant may provide
more limited financial information in lieu of full financial statements. If the
registrant qualifies for one of these exceptions, it may be eligible to provide, in
MD&A or a footnote to the financial statements of the parent company that issued
or guaranteed the security, either of the following types of alternative disclosures
in lieu of separate financial statements:
- Summarized financial information about the parent, issuer(s), and guarantor(s) as well as nonfinancial disclosures.
- Nonfinancial disclosures only.
Alternative disclosures may be provided in lieu of separate financial statements
if (1) each subsidiary issuer/guarantor is consolidated by the parent and (2) either
(a) the parent company issues or co-issues (on a joint-and-several basis with one or
more of its consolidated subsidiaries) securities that are guaranteed by one or more
consolidated subsidiaries or (b) a consolidated subsidiary issues or co-issues (with
one or more other consolidated subsidiaries of the parent company) the securities,
and the securities are fully and unconditionally guaranteed by the parent company.
For its initial registration statement, a registrant should evaluate the guarantor
structure as of the filing date of the registration statement to determine what
financial information is required by Rules 3-10 and 13-01. If the registrant
provides full financial statements, the periods presented should generally be the
same as those of the issuer for both annual and interim periods. However, if a
registrant provides summarized financial information, the periods presented should
be the most recent annual and year-to-date interim period (if applicable).
Rule 3-10 does not apply to private (nonregistered) securities, bank debt, or other private financings.
Thus, a private offering under Securities Act Rule 144A is not subject to Rule 3-10. However, if the private
144A offering of a guaranteed debt security includes registration rights, the issuer will need to comply
with Rule 3-10 at the time the private debt is exchanged for public debt.
For additional considerations related to guaranteed securities, see Deloitte’s
Roadmap SEC Reporting Considerations for Guarantees
and Collateralizations.
2.8.1 Summarized Financial Information
Registrants that provide summarized financial information should
disclose, at a minimum, the following captions:
- Current and noncurrent assets.
- Current and noncurrent liabilities.
- Redeemable preferred stock.
- Noncontrolling interests.
- Revenues.
- Gross profit (or costs and expenses applicable to net sales or gross revenues).
- Income (loss) from continuing operations.
- Net income (loss).
- Net income (loss) attributable to the entity.
An entity may need to disclose additional line items if such
disclosure would be material to an investor’s evaluation of the sufficiency of
the guarantee(s). The information may be presented on a combined basis; however,
to the extent that the information provided applies to one or more, but not all,
issuers and guarantors, separate disclosure of summary financial information may
be required for the relevant guarantors and issuers to the extent that such
disclosure is material. For example, if a subsidiary’s guarantee was not full
and unconditional, that fact would be disclosed and separate financial
information would be provided for the subsidiary unless such information can be
provided narratively.
A brief description of the basis of presentation must be provided and the
following policies should be reflected:
- Transactions between issuers and guarantors that are presented on a combined basis should be eliminated.
- Information for nonguarantors or nonissuers should be excluded.
- Separate presentation is required for transactions with, and amounts due from or due to, (1) nonguarantor subsidiaries (i.e., those amounts that do not arise from the issuers’ or guarantors’ investment in the nonguarantors) and (2) other related parties.
Summarized financial information may be omitted when not
material or in certain nonexclusive circumstances. While the specific
requirements depend on the guarantor structure, they generally apply to
circumstances in which all substantive entities are in the same legal position
with respect to the registered securities (i.e., all are co-issuers or all are
guarantors).
2.8.2 Nonfinancial Disclosures
When providing the alternative disclosures permitted by Rule
13-01, registrants will need to disclose nonfinancial information (to the extent
material) in addition to the financial information discussed in Section 2.8.1. Such
nonfinancial information includes a description of:
- The issuer(s) and guarantor(s) of the security.
- The terms and conditions of the guarantee(s).
- How the issuer(s) and guarantor(s) are structured.
- Other factors that may affect payments to holders of the guaranteed security, including contractual or statutory restrictions on dividends, guarantee enforceability, and the rights of a noncontrolling interest holder.
Beyond the requirements outlined above, disclosure of specific
facts and circumstances related to each guarantor is required if such
information would be material to investors and would help them understand the
sufficiency of the guarantee. Registrants must provide additional information to
the extent necessary, to ensure that their disclosures are not misleading. This
nonfinancial information should help investors in the guaranteed securities
understand the issuer(s), guarantor(s), and guarantee(s), as well as the
accompanying financial disclosures.
In addition, the identity of the issuer(s) and guarantor(s) must be listed in an
exhibit to the registration statement or periodic filing.
2.8.3 Recently Acquired Guarantors
A company should also be aware of the requirements of Rule 13-01(a)(5), which
applies to recently acquired subsidiary issuers or subsidiary guarantors. Under
Rule 13-01(a)(5), a registrant must provide separate preacquisition summarized
financial information of a significant subsidiary issuer or guarantor if the
subsidiary’s historical results have not been incorporated into the parent’s
most recent balance sheet included in the registration statement. To determine
significance under Rule 13-01(a)(5), a registrant would use the results of the
significance tests discussed above for significant acquisitions in accordance
with Rule 3-05.
2.9 Issuers of Securities That Collateralize Registered Securities (Rule 13-02)
Under Regulation S-X, Rule 13-02, a registrant must, to the extent
material, disclose summarized financial and other nonfinancial information for each
of its affiliates whose securities provide collateral for any class of securities
registered or being registered. In the context of an initial registration statement
related to an IPO of debt securities, this requirement may apply when the capital
stock (i.e., securities) of some or all of the registrant’s subsidiaries (i.e.,
affiliates) is pledged as collateral for the debt securities being registered.
The required disclosures must be presented in MD&A or in a
footnote to the registrant’s financial statements. The disclosures include (1)
summarized financial information for each affiliate whose securities are pledged
(the information may be presented on a combined basis) as of and for the most recent
annual and year-to-date interim period (if applicable) and (2) certain nonfinancial
disclosures.
For additional considerations related to collateralized securities, see Deloitte’s
Roadmap SEC Reporting Considerations for Guarantees
and Collateralizations.
Chapter 3 — Financial Statement Preparation and Disclosure Requirements
Chapter 3 — Financial Statement Preparation and Disclosure Requirements
3.1 Introduction
Certain provisions of U.S. GAAP for public entities differ from those for
nonpublic entities. Further, public entities are subject to various SEC rules and
regulations that may affect the financial statements and related disclosures (e.g.,
the additional disclosure requirements of Regulation S-X). Therefore, a nonpublic
entity’s previously issued financial statements are generally not sufficient for an
IPO and the financial statements will typically need to be revised for all periods
presented to reflect the public-entity accounting principles and additional SEC
disclosure requirements. In addition, audits for a private company are subject to
the auditing standards issued by the AICPA’s Auditing Standards Board; however, for
an IPO, the audit of the issuer must be performed in accordance with PCAOB auditing
standards. Therefore, the auditor will need to perform additional procedures and
issue a new auditor’s report that refers to PCAOB standards. In a filing submitted
for confidential or nonpublic review, the auditor’s report
will typically refer to both AICPA and PCAOB auditing
standards, as described in Section
6.7.1. See Chapter
6 for discussion of audit considerations under a PCAOB audit compared
with an AICPA audit.
Adopting public-entity U.S. GAAP and providing SEC-required disclosures do not
constitute the correction of an accounting error under ASC 250. Therefore, financial
statements that are revised to meet public-company requirements are not considered
“restated.” However, if an error is identified in previously issued financial
statements and corrected as part of an IPO, the disclosure requirements in ASC 250
should be considered. See Section
3.7 for additional discussion of the correction of errors and related
considerations associated with internal controls.
3.2 U.S. GAAP for Public Entities
The term “public entity” generally refers to an entity that files its financial
statements with the SEC. However, there are multiple definitions of this term in
U.S. GAAP. In an attempt to reduce complexity and diversity in practice related to
this term, the FASB issued ASU 2013-12 in December 2013. The ASU added the following
definition of PBE to the ASC master glossary:
A public business
entity is a business entity meeting any one of the criteria below. Neither a
not-for-profit entity nor an employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public
business entity solely because its financial statements or financial information
is included in another entity’s filing with the SEC. In that case, the entity is
only a public business entity for purposes of financial statements that are
filed or furnished with the SEC.
At the time ASU 2013-12 was issued, this definition of a PBE did not supersede
any similar existing definitions in the Codification (e.g., “public entity” or
“publicly traded company”). It first applied to the U.S. GAAP amendments made as
part of the FASB’s private-company decision-making framework developed in
collaboration with the PCC. Since that time, the FASB, EITF, and PCC have begun
using this new PBE definition in newly issued accounting and reporting guidance that
affects public entities differently from private entities or for which the required
effective date for PBEs differs from that for entities other than PBEs.
In an IPO, a registrant must present financial statements that are consistent
with public-entity accounting principles and must comply with disclosure
requirements for public entities for all periods presented. Examples of topics for
which the accounting principles or disclosures may apply to public entities but do
not apply to nonpublic entities include EPS; segment reporting; temporary equity
classification of redeemable securities; and certain disclosures related to business
combinations, income taxes, and pensions and other postretirement benefits. For a
more detailed discussion of accounting considerations for entities preparing for an
IPO, see Chapter 5.
Connecting the Dots
Entities should consider using a GAAP checklist that
incorporates SEC requirements in assessing the completeness and accuracy of
disclosures. Using an SEC-compliant GAAP checklist well in advance of
preparing financial statements may make it easier for an entity to draft new
required disclosures and to document management’s judgments in preparing
such disclosures.
3.3 Transition to New Accounting Standards
The transition provisions related to the adoption of a new accounting standard
for PBEs may differ from those for nonpublic entities, resulting in an earlier
effective date for some PBEs. Since entities, other than EGCs, undertaking an IPO
may be required to apply public-entity guidance for all periods presented in the
financial statements, a nonpublic entity may be required to retrospectively change
and accelerate its adoption date of a new accounting standard to that required for a
PBE.
EGCs are not required to accelerate the adoption of new accounting standards and
are allowed to adopt the new or revised accounting pronouncements as of the
effective dates for private companies or nonissuers (i.e., non-PBEs), provided that
such standards apply to nonissuers. However, an EGC that adopts a new standard on a
delayed basis must fully comply with all accounting and disclosure requirements
applicable to PBEs for that standard. See Section 1.6 for more information about
EGCs.
In November 2019, the FASB issued ASU 2019-10 as part of its implementation of a new “two-bucket”
framework for determining the effective dates for certain future major accounting
standards. Under this framework, the two buckets are:
- Bucket 1 — All PBEs that are SEC filers (as defined in U.S. GAAP), excluding SRCs (as defined by the SEC).
- Bucket 2 — All other entities, including SRCs, other PBEs that are not SEC filers, private companies, not-for-profit organizations, and employee benefit plans.
The FASB decided that for future major accounting standards, the
effective date for entities in Bucket 2 would be at least two years after the
effective date for entities in Bucket 1. Under this framework, a registrant may
qualify as an SRC in its IPO and thus may be eligible for a different adoption date
than entities in Bucket 1. Further, an entity that is filing an initial registration
statement would not be considered an SEC filer and thus would be in Bucket 2.
However, when the registration statement is declared effective, the entity would be
considered an SEC filer and would need to apply the Bucket 1 adoption dates unless
it qualifies as an SRC or EGC. As discussed at the July 2020 CAQ SEC Regulations Committee joint
meeting with the SEC staff, the SEC staff encourages, but does not require, use of
Bucket 1 adoption dates in the financial statements included in the IPO registration
statement.
The two examples below illustrate our understanding of the
application of the transition requirements for the new credit losses standard (ASC
326).
Example 3-1
Non-SRC/EGC Registrant
Files an Initial Registration Statement on Form
S-1
Registrant A is a calendar-year-end company
that does not qualify as an SRC or EGC. On March 1, 2021, A
files its initial registration statement on Form S-1, which
includes audited financial statements for the three years
ended December 31, 2020. Registrant A’s initial registration
statement is declared effective on May 10, 2021.
- Registrant A may apply the Bucket 2 adoption date for the financial statements included in its IPO registration statement and any pre-effective amendments. Therefore, such financial statements do not need to reflect the new credit losses standard. However, the SEC staff has continued to emphasize the importance of providing transition disclosures in accordance with SAB Topic 11.M (SAB 74) when adopting new standards, since such companies would expect to adopt the new guidance immediately after their IPO.
- Registrant A must apply the Bucket 1 adoption date for the financial statements included in filings after the initial registration statement is declared effective. Therefore, its financial statements included in its March 31, 2021, Form 10-Q must reflect the adoption of the new credit losses standard as of January 1, 2020.
Example 3-2
SRC/EGC Registrant Files
an Initial Registration Statement on Form S-1
Assume the same facts as in the example
above except that Registrant A qualifies as an SRC when it
files an initial registration statement.
- Registrant A may apply the Bucket 2 adoption date for the financial statements included in its initial registration statement. Therefore, such financial statements would not need to reflect the new credit losses standard.
- Registrant A may continue to apply the Bucket 2 adoption date for the financial statements included in filings after the initial registration statement is declared effective. Therefore, A may continue to apply the Bucket 2 adoption date for the financial statements included in its March 31, 2021, Form 10-Q.
- Registrant A will be required to adopt the new credit losses standard for fiscal years beginning after December 15, 2022, and interim periods therein.
Connecting the Dots
Non-EGC private entities may want to consider how their
timeline for a potential IPO may affect their plans related to adopting a
new accounting standard. For example, when a non-EGC calendar-year-end
private entity has elected to file an IPO after adopting a new accounting
standard by using the required effective date for non-PBEs or Bucket 2, the
SEC will require the entity to retrospectively adjust its financial
statements and accelerate its adoption date to the required PBE or Bucket 1
effective date. Accordingly, a non-EGC private entity that expects to file
an IPO may consider early adoption (unless it believes that it will qualify
as an SRC and the applicable standard also defers adoption dates for
SRCs).
The financial statement impacts of adopting ASC 842 are
significantly affected by the adoption date, since all lease liabilities are
discounted on the basis of the discount rate on that date. As discussed at
the July 2020 CAQ SEC Regulations Committee joint meeting with the SEC
staff, the SEC staff reiterated its view that “an IPO registration statement
of a non-EGC should apply the PBE adoption dates for all standards that
apply the PBE definition, including Topic 842. However, if an entity
believes it has a reasonable basis to support an alternative conclusion
under GAAP and SEC rules and regulations, the staff is available for
consultation.” Thus, even if a non-EGC undertakes an IPO several years after
adopting ASC 842 (e.g., an IPO in 2026 after adoption of ASC 842 in 2021),
it would need to push back the adoption date of ASC 842 to the PBE adoption
date if the difference in adoption dates would have been material.
3.4 PCC Accounting Standards and Practical Expedients Available to Non-PBEs
The PCC uses the private-company decision-making framework to advise the FASB on
the appropriate accounting treatment for private companies. Nonpublic companies may have
elected to apply alternative accounting standards developed by the PCC and issued by the
FASB. On its Web site, the FASB states that the PCC was formed in 2012
and is an advisory body whose mission is to “review and propose alternatives within GAAP to
address the needs of users of private company financial statements.” As a result of the
PCC’s activities, the FASB has issued accounting standards that have allowed private
entities to elect alternative accounting policies intended to reduce the complexity and cost
of financial reporting while maintaining decision-useful information for investors. Once a
company (even if it qualifies as an EGC) is considered a PBE, it is no longer permitted to
apply private-company accounting alternatives. Therefore, any previously elected
private-company alternatives would need to be retrospectively eliminated from the company’s
historical financial statements before such statements can be included in its IPO
registration statement.
Similarly, several accounting standards permit
non-PBEs to use certain practical expedients. For
example, non-PBEs are permitted to omit
disaggregation of revenue disclosures in
accordance with ASC 606 as well as to use a
risk-free rate in measuring their lease
liabilities. Companies undertaking an IPO are
considered PBEs and thus may not reflect any of
these practical expedients in their financial
statements filed with the SEC. EGC status only
allows companies to defer adoption of new
standards. Once it adopts a new standard, even an
EGC must comply with the requirements of that
standard that apply to PBEs.
An entity should use caution in implementing the alternative accounting policies
applicable to private entities if it expects that it may undergo an IPO or that its
financial statements may be included in another company’s IPO in the future (e.g., financial
statements of an acquiree under Rule 3-05 — see Section
2.5.2).
3.5 Changes in Accounting Principles
The presumption that an entity should not change an accounting principle, once
adopted, in accounting for events and transactions
of a similar type is basic to the preparation of
financial statements. An entity may change an
accounting principle only if management can
justify that the newly adopted accounting
principle is both acceptable and preferable.
Factors that may justify that an accounting
treatment is preferable include authoritative
literature, changes in the structure and economics
of principal transactions, industry practice,
business judgment, and business planning. However,
industry practice, in and of itself, may not
always demonstrate that an alternative principle
is preferable. Ultimately, whether a change is
preferable depends on the entity’s facts and
circumstances, and the burden of justification
rests with the reporting entity.
Once a company is public, a change in accounting principle generally also
results in the need for a preferability letter. A preferability letter is a letter
issued by the entity’s independent auditors and included in an SEC filing stating
that the auditor has also concluded that the accounting change is preferable. If a
change in accounting is made in conjunction with an IPO, the preferability letter is
not required because the entity was not yet public on the date the change was made.
The determination of whether a change in accounting policy is a change in accounting
principle involves judgment and careful consideration of the facts and
circumstances.
3.6 Regulation S-X
Regulation S-X contains many requirements related to providing specific disclosures on the face
of the financial statements or in the footnotes thereto. Some of these requirements are broadly
applicable, and some apply only to entities in certain industries. The most significant broadly applicable
requirements are contained in Article 4, which addresses disclosures related to topics that include, but
are not limited to, restrictions that limit the payment of dividends by the registrant, summarized financial
information of subsidiaries not consolidated, income taxes, and related-party transactions.
Industry requirements may also apply. These requirements can affect both presentation (e.g., specific
financial statement line items) and disclosures (e.g., requirements to include supplemental schedules).
The following sections of Regulation S-X contain the bulk of the industry-specific requirements:
- Article 4, “Rules of General Application” (includes specific requirements for oil- and gas-producing activities).
- Article 5, “Commercial and Industrial Companies.”
- Article 6, “Registered Investment Companies and Business Development Companies.”
- Article 7, “Insurance Companies.”
- Article 9, “Bank Holding Companies.”
By default, an entity is subject to the requirements for commercial and
industrial companies in Article 5, unless another article applies. Under Article 5,
a registrant must provide various line items and disclosures, when applicable, in
its balance sheet and income statement. For example, under Article 5, Rule 5-03(b),
an entity may be required to state separately, on the face of the income statement,
revenues (and associated cost of revenues) related to (1) product sales, (2)
rentals, (3) services, and (4) other revenue activities. A registrant must comply
with these SEC requirements in addition to any GAAP requirements.
At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments, the
SEC staff discussed income statement presentation and noted that as companies
evolve, some business models may not clearly be subject to the SEC’s financial
statement presentation requirements in Regulation S-X, Article 5, Article 7, or
Article 9. Therefore, the staff has accepted income statement presentations in
accordance with a hybrid of Article 5 and either Article 7 or Article 9 if such
presentation is more appropriate given the registrant’s facts and circumstances. For
example, the staff has not objected when a registrant in the financial technology
industry with material lending activity presents its financial statements by
applying a hybrid of Articles 5 and 9.
SRCs are eligible to apply the scaled requirements in Regulation
S-X, Article 8, when preparing their financial statements. SRCs typically are not
required to apply the disclosure provisions of Regulation S-X in their entirety
unless Article 8 indicates otherwise. See Section 3.6.2 and Appendix B for more information about the
disclosure requirements for SRCs.
3.6.1 Financial Statement Schedules
As discussed above, a registrant may need to include certain
financial statement schedules in its initial registration statement in
accordance with Regulation S-X. Article 12 covers the form and content
requirements for these schedules. For example, a registrant under Article 5 may
need to include Schedule II, “Valuation and Qualifying Accounts,” to illustrate,
by major asset class, a rollforward of all valuation and qualifying accounts and
reserves (e.g., allowances for bad debt, valuation allowance on deferred tax
assets [DTAs]) for each period for which an income statement is presented.
Inventory allowance is not typically considered a valuation and qualifying
account because a write-down of inventory to the lower of cost or market at the
close of a fiscal period creates a new cost basis that subsequently cannot be
marked up on the basis of changes in underlying facts and circumstances in
accordance with SAB Topic
5.BB.
While they may be presented separately, any required schedules are considered
part of the financial statements and must be audited. Many registrants prefer to
include the schedule information in the footnotes to the financial statements in
lieu of furnishing separate schedules. A registrant also needs to provide any
schedules applicable to predecessor entities in the registration statement.
Financial statement schedules are not needed for financial statements that are
required under Rule 3-05 for business acquisitions. However, when a registrant
is required to provide financial statements for EMIs in accordance with Rule
3-09, the form and content of those financial statements must be in compliance
with Regulation S-X, including the requirement to include financial statement
schedules if applicable.
3.6.2 Article 8, “Financial Statements of Smaller Reporting Companies”
As explained in Section
1.5.2, SRCs may be eligible to apply scaled disclosure
requirements. Regulation S-X, Article 8, addresses the scaled financial
statement disclosure requirements for SRCs. SRCs are generally not required to
apply the disclosure provisions of Regulation S-X in their entirety except when
Article 8 specifically indicates otherwise. However, SRCs are expected to
provide all information required by any applicable industry guides. Further, although Article 8 does not
contain any explicit disclosure requirements that apply to the financial
statement schedules described in Article 5, Topic 5 of the FRM provides
disclosure guidance for SRCs. This guidance advises issuers to consider whether
additional disclosure in MD&A may be appropriate if, for example, the
restricted net assets of an SRC’s consolidated subsidiaries are a significant
proportion of consolidated net assets and the amount and nature of those
restrictions have a material impact on liquidity. See Appendix B for more information about the
disclosure requirements for SRCs.
SRCs may also have additional time to adopt recently issued
accounting standards. See Section 3.3 for more information.
3.7 Restatements and Corrections of Accounting Errors
Financial statement restatements can be expensive and time-consuming. However, the level of effort and cost required to restate financial statements is often dwarfed by the loss of public confidence that can result from such restatements. An entity that is preparing its initial registration statement or another initial public filing for submission to the SEC will benefit from designing a thorough set of processes and internal controls that ensure the completeness and accuracy of its financial statements and from working with its auditors to provide assurance that the financial statements are free from material misstatement. This section discusses the evaluation of potential accounting errors, alternative responses to such errors, and other matters that apply to entities filing with the SEC for the first time.
3.7.1 Identifying Accounting Errors
ASC 250-10-20 defines a restatement as “[t]he process of revising previously
issued financial statements to reflect the correction of an error in those
financial statements.” Further, an error in previously issued financial
statements is defined as follows:
An error in recognition,
measurement, presentation, or disclosure in financial statements resulting
from mathematical mistakes, mistakes in the application of generally
accepted accounting principles (GAAP), or oversight or misuse of facts that
existed at the time the financial statements were prepared. A change from an
accounting principle that is not generally accepted to one that is generally
accepted is a correction of an error.
If the amount, presentation, or disclosure was not in accordance with the
applicable financial reporting framework, the SEC’s rules, or the applicable
basis of presentation in the originally issued financial statements, a
misstatement exists. However, as stated in Section 3.1, adopting public-entity U.S.
GAAP and providing SEC-required disclosures for the first time do not constitute
the correction of an accounting error under ASC 250.
3.7.2 Evaluating Accounting Errors
In evaluating accounting errors, an entity must consider the materiality of such
errors, including the omission of required disclosures and accounting
information, to determine whether the financial statements need to be restated.
When assessing materiality, an entity must consider all facts and circumstances related to a
misstatement. SAB Topic 1.M (codified in ASC 250-10-S99-1) indicates that “[i]n the context of a
misstatement of a financial statement item,” while the relevant facts and circumstances include “the size
in numerical or percentage terms of the misstatement, [they also include] the factual context in which
the user of financial statements would view the financial statement item” (e.g., disclosures). Therefore,
both quantitative and qualitative factors are important to assessing an item’s materiality. An entity
evaluates whether a restatement is necessary or appropriate on the basis of such factors.
If a misstatement does not have a material effect on
prior-period financial statements (i.e., the evaluation under the “rollover”
approach) and its correction in the current period would not have a material
effect on the current-period financial statements (i.e., the evaluation under
the “iron-curtain” approach), the prior-period financial statements ordinarily
would not be restated; instead, the misstatement would be corrected in the next
filing. For additional details related to the evaluation of errors under the
iron-curtain and rollover approaches, see Section
6.7.5.2.
On March 9, 2022, SEC Chief Accountant Paul Munter delivered a
speech on the importance of objectivity in
the assessment of the materiality of errors. Mr. Munter pointed out that in
determining whether an error is material, a registrant should consider “all
relevant facts and circumstances surrounding the error, including both
quantitative and qualitative factors.” He emphasized that the SEC is seeing more
registrants argue that a large quantitative error is not material as a result of
qualitative factors and indicated that, in the SEC’s view, it may be “difficult
for qualitative factors to overcome the quantitative significance of the error”
in such circumstances. Other common arguments that the SEC has not found
persuasive when considering registrants’ assessments of the materiality of
errors include:
- “Financial statements or specific line items . . . are irrelevant to investors’ investment decisions.”
- Errors in previously issued financial statements are not material because other registrants also made the error.
- One error is not material because it is offset by another error.
Mr. Munter also emphasized an error’s impact on the assessment of the
effectiveness over ICFR.
3.7.3 Corrective Action
In deciding whether a restatement is necessary or appropriate, an entity must
determine whether an accounting error (or accumulated errors) is material or
immaterial. This determination should include evaluation of both quantitative
and qualitative factors. For material errors, the entity must restate the
prior-period financial statements. When material errors are identified in
previously issued financial statements and there are persons who are currently
relying on, or who are likely to rely on, those financial statements and the
audit report, the entity should act in a timely manner to prevent further
reliance thereon. When preparing the restatement, the entity must comply with
the following requirements in ASC 250-10-45-23:
- “The cumulative effect of the error on periods prior to those presented shall be reflected in the carrying amounts of assets and liabilities as of the beginning of the first period presented.”
- “An offsetting adjustment, if any, shall be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period.”
- “Financial statements for each individual prior period presented shall be adjusted to reflect correction of the period-specific effects of the error.”
The following list comprises the primary disclosure and communication requirements for material
restatements:
- Inclusion, in the auditor’s report, of an additional paragraph referring to the restatement.
- Individual financial statements labeled “as restated.”
- Disclosures in the financial statements in accordance with ASC 250.
SAB Topic
1.N (SAB 108) also addresses “immaterial restatements,”
which may be necessary if a prior-period error (or errors) identified is not
material to the prior periods presented but is material to the current period if
the prior-period error (or accumulated errors) is corrected in the current
period. In this instance, the immaterial errors are corrected the next time
comparative financial statements are issued. The disclosure and communication
requirements for immaterial restatements differ from those described above in
the following ways:
- Financial statement column headings do not have to be labeled “as restated.”
- An additional paragraph in the auditor’s report is typically not necessary.
3.7.4 Impact on Internal Control
An entity must evaluate financial statement misstatements to determine whether they are indicative of
a deficiency in internal control. Further, a deficiency in internal control must be assessed to determine
whether it is related to a design or operating deficiency.
Once the control deficiency has been identified, its severity must be evaluated to determine the
disclosure requirements, communication requirements, or both. Appendix A of PCAOB AS 2201 provides
the following definitions to assist entities with this evaluation:
- “A deficiency in [ICFR] exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.”
- “A significant deficiency is a deficiency, or a combination of deficiencies, in [ICFR] that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.”
- “A material weakness is a deficiency, or a combination of deficiencies, in [ICFR], such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”
Registrants are not required to make a written assertion on ICFR in their initial registration statement filing or in the first filing of a Form 10-K after going public. However, the auditor’s requirement to communicate significant deficiencies and material weaknesses to those charged with governance still applies. In addition, after consulting with SEC counsel, it is likely that a registrant may need to disclose an identified material weakness in internal control in the risk factors section of the registration statement. For more information, see Chapter 6.
3.7.5 Additional IPO Considerations
Entities preparing an initial registration statement or another initial public filing for submission to the
SEC should also be aware of the following additional considerations:
- As stated in Section 1.4.1, depending on the length of time between amendments, financial statements and other information included in the registration statement may need to be updated to reflect subsequent periods. Such an update may include adding an additional year of audited financial statements. In some cases, an error or errors may be identified during the audit for the subsequent year (or years). Depending on the materiality of the error(s), figures may be restated after the initial registration statement has been submitted to the SEC. Once the effects of a correction of an error on prior periods have been disclosed in issued annual financial statements, disclosure of the restatement does not need to be repeated when the restated amounts are presented as prior-period comparative amounts in subsequently issued annual financial statements. In this context, interim financial information is not considered the equivalent of issued annual financial statements. In addition, the reissuance of financial statements that do not include any additional annual periods (e.g., a subsequent registration statement amendment that does not yet include an additional annual period of audited financial statements) does not meet this requirement, and the “as restated” or similar language should be retained to identify the period(s) restated. The restatement language may be removed once the subsequent issuance of annual audited financial statements is completed.
- Restatements can prolong the registration process because each amendment can result in additional SEC comments.
- CEOs and CFOs of newly public companies are subject to certain provisions of Sarbanes-Oxley and Dodd-Frank that may compel them to disgorge bonuses or other compensation earned during periods for which related financial information is subsequently restated. Specifically, under Section 304 of Sarbanes-Oxley, CEOs and CFOs may be required to return compensation received within the 12-month period following the public release of financial information if there is a restatement of such financial information because of material noncompliance, due to misconduct, with financial reporting requirements under the federal securities laws. In July 2015, the SEC issued a proposal that would “implement the provisions” of Section 954 of Dodd-Frank; specifically, in the event of a restatement, public companies would be required to develop and implement policies under which excess incentive-based compensation received by executives during a three-year look-back period can be recovered, regardless of whether misconduct occurred. Further, in October 2021, the SEC released a follow-up proposal that reopens the July 2015 proposal’s comment period “in light of developments since the publication of the Proposing Release and [the Commission’s] further consideration of the Section 954 mandate.”
Changing Lanes
In October 2022, the SEC issued a final rule
to implement the Section 954 mandate. The primary purpose of the final
rule is to ensure that executive officers do not receive “excess
compensation” if the financial results on which previous awards of
compensation were based are subsequently restated because of material
noncompliance with financial reporting requirements. Such restatements
would include those correcting an error that either (1) “is material to
the previously issued financial statements” (a “Big R” restatement) or
(2) “would result in a material misstatement if the errors were
corrected in or left uncorrected in the current report” (a “little r”
restatement).
Specifically, the final rule requires issuers to “claw back” excess
compensation for the three fiscal years before the determination of a
restatement regardless of whether an executive officer had any
involvement in the restatement. The final rule also requires an issuer
to disclose its recovery policy in an exhibit to its annual report and
to include new checkboxes on the cover page of its annual report to
indicate whether the financial statements “reflect correction of an
error to previously issued financial statements and whether [such]
corrections are restatements that required a recovery analysis.”
Additional disclosures are required in the proxy statement or annual
report when a clawback occurs. Such disclosures include the date of the
restatement, the amount of excess compensation to be clawed back, and
any amounts outstanding that have not yet been clawed back.
Companies must implement the mandatory compensation recovery policy no
more than 60 days after the effective date of the new listing rules of
their respective exchanges. On June 9, 2023, the SEC approved amendments
filed by the New York Stock Exchange and the Nasdaq, which extended the
effective date of the exchanges’ listing standards on the clawback rule
to October 2, 2023. Therefore, registrants must adopt their clawback
policies by December 1, 2023 (i.e., 60 days after the final rule’s
effective date).
For further details on the final rule, see Deloitte’s November 14, 2022,
Heads Up.
For more information about error corrections and restatements
related to SPACs, see Deloitte’s October 2, 2020 (updated April 11, 2022),
Financial Reporting
Alert.
3.8 Retrospective Items and “To-Be-Issued” Accountant’s Report in an IPO
In anticipation of an IPO, an entity may wish to present —
retrospectively in its financial statements — certain transactions that occur after
the date of such financial statements. Such retrospective presentation may include a
change in reportable segments (also see Section 4.9 of Deloitte’s Roadmap Segment Reporting), a
stock split (also see Section
5.6.2.1), a legal reorganization (also see Section 5.2.3), the reporting of a
discontinued operation under ASC 205-20, and certain accounting changes resulting
from the adoption of a newly issued standard (also see Section 3.3). In such limited circumstances,
the entity may be able to present the transaction retrospectively in its financial
statements earlier than normally permitted and would include a “to-be-issued”
accountant’s report, sometimes referred to as a “legend opinion,” on such financial
statements.
A to-be-issued accountant’s report is a draft report in the form
that will be used when the registration statement is declared effective by the SEC.
The draft report includes a preface (or legend), signed by the auditor, stating that
it expects to be in a position to issue the report in the form presented before the
registration statement is declared effective by the SEC. The draft report that
follows such a signed legend does not include the accountant’s signature, since the
underlying event discussed in the legend has not yet occurred and thus cannot be
audited as of the date of the preface (or legend).
The registration statement cannot be declared effective until the
preface (legend) is removed and the accountant’s report is finalized. Entities are
encouraged to consult with their independent accountants if they believe that the
requirements noted above are met. Once the preface (legend) is removed, auditors
typically would need to dual-date their audit opinions related to the retrospective
event.
Connecting the Dots
The most common use of a to-be-issued report in an IPO registration statement
is to reflect a stock split that has been approved by the board of directors
but has not been filed with the state in which the company is incorporated.
It will be finalized by the state shortly after the amended registration
statement is filed but before the IPO is completed. SEC preclearance is not
required in such circumstances. Registration statements that are filed after
the board of directors’ approval and the state filing do not need to include
a preface (legend).
Alternatively, assume that an entity enters into a
transaction to dispose of a component or group of components that meets the
discontinued-operations criteria in ASC 205-20 after the date of the
entity’s most recent financial statements but before the IPO registration
statement is filed. While professional standards would normally not permit
an entity to recast prior periods before issuing financial statements for a
period that includes the change, an entity may be able to do so in its IPO
registration statement by using a to-be-issued report. In this situation,
consultation with the SEC is suggested since the following conditions may
need to be met as indicated at the June 2014 CAQ SEC Regulations
Committee joint meeting with the SEC staff: (1) the disposal of the
discontinued operation has occurred; (2) the financial statements have been
audited, including the retrospective revision; and (3) the registrant has
consulted with the appropriate industry group.
For more information, see Section 4710 of the FRM. Also see Section 8.7 of
Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets and Discontinued
Operations.
Chapter 4 — Other Registration Statement Reporting
Chapter 4 — Other Registration Statement Reporting
4.1 Introduction
Many disclosures in addition to those in the
financial statements must be included in an IPO
registration statement. These disclosure
requirements are summarized in Appendix A. Some
of the more significant financial-related
disclosure requirements are summarized below. For
certain scaled disclosure requirements for SRCs,
see Appendix
B.
4.2 Selected Quarterly Financial Data
Under Regulation S-K, Item 302, registrants that have securities
registered under Section 12(b) or 12(g) of the Exchange Act must disclose selected
quarterly financial data for each full quarter within the two most recent fiscal
years and any subsequent interim period for which financial statements are presented
if a registrant reports a material retrospective change (or changes). In such
circumstances, a registrant must disclose (1) an explanation for the material
change(s) and (2) select financial information reflecting such change(s) for the
affected quarterly periods, including the fourth quarter. Material retrospective
changes may include, for example, a change in accounting principle in accordance
with ASC 250 or a disposition of a business that is accounted for as a discontinued
operation in accordance with ASC 205-20. The quarterly financial data table does
not need to be provided in an IPO registration statement because the
entity’s securities are not yet registered.
Although this requirement only applies to existing registrants and
only when a material retrospective change has occurred, companies undertaking an IPO
frequently include selected quarterly financial data voluntarily, often at the
request of underwriters, to illustrate the sequential quarterly growth of the
business. If presented, the quarterly financial data typically include, at a
minimum:
- Net sales.
- Gross profit (net sales less costs and expenses associated directly with or allocated to products sold or services rendered, including depreciation and amortization).
- Income (loss) from continuing operations.
- Income (loss) from continuing operations per share.
- Net income (loss).
- Net income (loss) per share.
- Net income (loss) attributable to the registrant.
The quarterly financial data may be included in an unaudited
footnote to the annual financial statements or in a separate table elsewhere in the
registration statement.
4.3 Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
The purpose of MD&A is to give readers the information they need to
understand a company’s financial condition,
changes in financial condition, liquidity and
capital resources, and results of operations
(collectively, “financial condition and operating
performance”), as well as its prospects for the
future. Since the initial adoption of the MD&A
disclosure requirements in 1980, the SEC has
issued numerous rules and interpretive guidance
intended to enhance the overall quality of
MD&A disclosures. General disclosure
requirements for domestic companies can be found
in Regulation S-K, Item 303, as interpreted in
Section 501 of the SEC’s Codification of
Financial Reporting Policies and Topic 9 of the
FRM.
Regulation S-K, Item 303(a), states that the “objective of the discussion and
analysis is to provide material information relevant to an assessment of the
financial condition and results of operations of the registrant including an
evaluation of the amounts and certainty of cash flows from operations and from
outside sources.” To that end, the discussion should:
- Focus on material events and uncertainties.
- Include discussion of the financial statements and other data that would be useful to understanding the registrant’s financial condition, cash flows, and results of operations.
- Allow investors to understand management’s perspective on the business.
An MD&A section typically includes an overview section about the
company and its business, an analysis of results of operations that addresses
period-to-period changes in income statement line items, a discussion of liquidity
and capital resources that focuses on the company’s financial position and cash
flows, and a summary of the company’s critical accounting estimates (CAEs) intended
to highlight financial statement items for which significant management estimates
and judgment are required. In addition to the discussion and analysis of historical
information, companies must disclose in MD&A any known trends, events, or
uncertainties that are reasonably likely to have a material effect on their future
liquidity, capital resources, or results of operations. As part of the discussion of
liquidity and capital resources, registrants should include an analysis of “material
cash requirements from known contractual and other obligations” and disclose
material off-balance-sheet arrangements. Registrants should consider whether this
disclosure requirement would be met by referring to the financial statement
footnotes (e.g., debt maturity table) or whether additional tabular or narrative
disclosure would be appropriate.
For each CAE, a registrant should discuss, to the extent material
and reasonably available, (1) why the CAE is subject to uncertainty; (2) how much
the CAE or assumption (or both) has changed during the relevant period; and (3) the
sensitivity of reported amounts to the methods, assumptions, and estimates
underlying the CAE’s calculation. Further, Instruction 3 to Item 303(b) states that
disclosure of CAEs should “supplement, but not duplicate, the description of
accounting policies or other disclosures in the notes to the financial
statements.”
4.4 Pro Forma Financial Information
A registrant in an IPO may have consummated, or may be contemplating, a
transaction in which presentation of pro forma financial information is required.
The objective of providing pro forma financial information is to enable investors to
understand and evaluate the continuing impact of a transaction (or a group of
transactions) by showing how the transaction might have affected the historical
financial position and results of operations of the registrant if it had been
consummated at an earlier date.
The requirements related to the presentation and preparation of pro forma
financial information are addressed in Regulation S-X, Article 11. Article 11
prohibits presentation of pro forma information in the historical financial
statements unless such disclosure is required by GAAP or IFRS® Accounting
Standards. Therefore, the pro forma presentation is often presented in a separate
section in the registration statement. Note that the requirements for pro forma
financial information under Article 11 are separate and distinct from the
requirements to present supplementary pro forma information for a business
combination under ASC 805. For more information about the pro forma information
disclosures that ASC 805 requires for a completed business combination, see
Section 5.4.
4.4.1 Circumstances in Which Presentation of Pro Forma Information Is Required
Article 11 lists several circumstances in which a registrant may need to provide
pro forma financial information. Such information is most commonly required when
a significant business combination or a disposition of a significant portion of
a business has occurred or is probable. As part of an IPO, corporate
reorganizations, changes in capitalization, and the use of proceeds are
frequently reflected in pro forma financial information; however, a registrant
needs to consider whether any other significant events or transactions have
occurred or are probable that would also be meaningful to investors on a pro
forma basis. Factors that may affect whether a registrant needs to provide pro
forma financial information in a registration statement include (1) whether the
event or transaction is significant; (2) whether it is already reflected in the
historical financial statements; (3) if the event has not yet occurred, whether
it is probable; and (4) in the case of the acquisition of a business, whether
the separate financial statements of the acquiree are included in the
registration statement (see Section 2.5
for more information).
4.4.2 Basic Presentation Requirements
Pro forma financial information, which is unaudited, typically includes an
introductory paragraph, a pro forma balance sheet, pro forma income
statement(s), and accompanying explanatory notes. The introductory paragraph
briefly describes the transaction(s), the entities involved, the periods for
which the pro forma financial information is presented, and any other
information that may help readers understand the content of the pro forma
information. The pro forma balance sheet and income statement are presented in a
columnar format with separate columns for the registrant, the acquiree (in the
case of a business combination), transaction accounting adjustments, autonomous
entity adjustments, and pro forma totals. See below for more information about
the types of pro forma adjustments. Further, each adjustment should include a
reference to an explanatory note that clearly discusses the assumptions involved
and how the adjustments are derived or calculated. In the limited cases in which
only a few adjustments are required and those adjustments are easily understood,
a registrant may include a narrative presentation of the pro forma effects of a
transaction in lieu of full pro forma financial information.
4.4.3 Pro Forma Periods Presented
A pro forma balance sheet is required as of the same date as the registrant’s most recent balance sheet
included in the IPO registration statement (i.e., one pro forma balance sheet as of the end of the fiscal year or the subsequent interim period, whichever is later). In the computation of pro forma balance sheet adjustments,
it is assumed that the transaction was consummated on the balance sheet date. A pro forma balance sheet is not required if the transaction is already reflected in the historical balance sheet.
Pro forma income statements are required for both the registrant’s most recent
fiscal year and any subsequent year-to-date interim period included in the IPO
registration statement. In the computation of pro forma income statement
adjustments, it is assumed that the transaction was consummated at the beginning
of the most recently completed fiscal year (and carried forward to the interim
period, if presented). The SEC normally does not permit registrants to prepare
pro forma information for more than one complete fiscal year. However, a
registrant must provide pro forma information for all periods presented in its
historical financial statements if the pro forma information reflects the impact
of a transaction that must be revised retrospectively in the historical
financial statements, such as a discontinued operation or a reorganization of
entities under common control. A pro forma income statement is not required if
the transaction is included in the historical financial statements for the full
period covered by the pro forma income statement.
4.4.4 Pro Forma Adjustments
There are two categories of required pro forma adjustments:
- Transaction accounting adjustments — These adjustments are limited to those that reflect the accounting for the transaction in accordance with U.S. GAAP or IFRS Accounting Standards, as applicable. For an acquisition, such adjustments may include, among other items, the recognition of goodwill and intangible assets and adjustments of assets and liabilities to fair value on the balance sheet, as well as the related impacts on the income statement, under the assumption that the balance sheet adjustments were made as of the beginning of the fiscal year presented. For dispositions, the adjustments may reflect the disposal of assets and related impacts. The SEC staff has also indicated that transaction accounting adjustments should generally be shown gross rather than net so that the reader can understand the nature and amount of each adjustment. Alternatively, a more detailed explanation of the components of the adjustments may be presented in the notes to the pro forma financial information. The transaction accounting adjustments should contain references to notes that clearly explain the assumptions involved and other relevant information for each adjustment.
-
Autonomous entity adjustments — These adjustments, which are only required if the registrant was previously part of another entity, reflect incremental expense or other changes necessary to reflect the registrant’s financial condition and results of operations as if it were a separate stand-alone entity. For example, if a public entity plans to distribute a portion of its business to shareholders as a separate public company (e.g., spin-off), the spinnee’s pro forma financial statements must include autonomous entity adjustments to reflect the incremental costs expected to be incurred as if the distributed entity were a separate stand-alone entity.At the 2021 AICPA & CIMA Conference on Current SEC and PCAOB Developments, the SEC staff addressed considerations related to distinguishing between autonomous entity adjustments and management’s adjustments (see following paragraph). The staff noted that changes to a spinnee’s cost structure that are supported by a contractual arrangement may be considered autonomous entity adjustments (e.g., a new lease agreement, a transition services agreement with the former parent). By contrast, changes in spinnee costs that are not supported by contractual arrangements generally do not represent autonomous entity adjustments. However, such changes may represent synergies or dis-synergies that may be presented as management’s adjustments if they meet the conditions in Regulation S-X, Rule 11-02(a)(7).
In addition to the required adjustments noted above, the pro forma rules give
registrants the flexibility to present, in the explanatory notes to the pro
forma financial information, management’s adjustments, which reflect synergies
and dis-synergies identified by management when evaluating whether to consummate
an acquisition. Management’s adjustments also may provide insight into the
potential effects of the acquisition and the plans that management expects to
implement after the acquisition (which may include forward-looking information).
Registrants must provide separate columns in their pro forma
financial information for (1) historical financial information, (2) transaction
accounting adjustments, and (3) autonomous entity adjustments, as well as a pro
forma total, which would include pro forma EPS. In the notes to the pro forma
financial information, a registrant must (1) clearly explain each adjustment and
(2) detail any revenues, expenses, gains and losses, and related tax effects
that will not recur in the registrant’s income statement beyond a year from the
transaction date.
Adjustments made to the pro forma income statement are not required to have a
continuing (recurring) impact. Accordingly, a pro forma income statement must
reflect both the recurring and nonrecurring effects of the transaction (e.g.,
transaction expenses, one-time compensation charges, and adjustments to
inventory). In addition, it is not appropriate to include a transaction
accounting adjustment to eliminate or omit the effects of nonrecurring items
reflected in the historical financial statements. Rather, a registrant should
separately disclose in a note to the pro forma financial statements the amounts
associated with revenues, expenses, gains and losses, and related tax effects
that will not recur in the income of the registrant more than 12 months after
the transaction.
For additional discussion of pro forma financial information requirements, see
Chapter 4 of Deloitte’s Roadmap
SEC Reporting Considerations for Business
Acquisitions.
4.4.5 Other Common IPO Considerations Related to Pro Forma Information
In addition to the information discussed above, certain pro
forma information may need to be included in specific situations, as discussed
in Section
3400 of the FRM. Such situations include distributions to
owners under SAB Topic
1.B.3, changes in capitalization at or before the closing of
an IPO, and changes in corporate structure that result in a change in tax
status. For more information about distributions to owners, changes in
capitalization, and changes in corporate structure, see Sections 5.6.1, 5.6.2, and 5.9.2, respectively.
Changing Lanes
Section 3400 of the FRM required a registrant to include
certain pro forma disclosures in or alongside the historical financial
statements in an IPO registration statement. Regulation S-X, Rule
11-02(a)(12)(i) — as amended — states that a “registrant must not
present pro forma financial information on the face of the registrant’s
historical financial statements or in the accompanying notes, except
where such presentation is required by U.S. GAAP or IFRS-IASB, as
applicable.” The guidance in FRM Section 3400 on presenting such pro
forma financial information has not yet been updated to reflect the
amendments to Article 11. However, we understand that the SEC staff
expects that disclosure giving pro forma effect to the transactions
described in Section 3400 of the FRM would be provided elsewhere (i.e.,
outside of the financial statements) in the IPO registration
statement.
4.4.5.1 Distributions to Owners
If a planned distribution to owners or promoters, regardless of whether it has
been declared or whether it will be paid from proceeds, is not reflected in
the latest balance sheet but would be significant to reported equity, pro
forma balance sheet information should be presented to reflect the
distribution accrual (without giving effect to the offering proceeds) and
the impact on equity. In addition, if a distribution to owners is to be paid
out of proceeds of the offering rather than from the current year’s
earnings, pro forma per-share data (pro forma EPS) should be presented for
the latest fiscal year and interim period only. The SEC staff considers
dividends declared in the year before the IPO to be in contemplation of the
IPO and therefore paid out of offering proceeds if they exceed earnings
during the preceding 12 months. Pro forma EPS should be calculated by
including an incremental number of shares (not to exceed the number of
shares being offered in the IPO) that, on the basis of the offering price,
would be needed to pay the portion of the dividend that exceeds earnings for
the previous year.
4.4.5.2 Conversion of Outstanding Securities
Pro forma EPS for the latest fiscal year and interim period is also required if
outstanding securities will be converted after the latest balance sheet date
and the conversion will result in a material reduction of historical EPS. A
common example of this scenario is the mandatory conversion of preferred
stock into common stock in conjunction with an IPO. In this case, pro forma
basic EPS would include the preferred stock on an as-converted basis (but
would not give effect to the offering).
4.4.5.3 Changes in Terms of Outstanding Equity
A registrant may also be required to provide pro forma balance sheet information
to give effect to a change in capitalization when (1) the terms of the
registrant’s outstanding equity securities will change after the date of the
latest historical balance sheet and the new terms result in a material
reduction of permanent equity or (2) a material amount of equity securities
will be redeemed in conjunction with the offering.
4.4.5.4 Changes in Tax Status
If the registrant is organized as a nontaxable entity (e.g., partnerships, LLCs,
S corporations) and expects to be converted to a taxable entity (e.g., a C
corporation) in conjunction with the IPO, pro forma income taxes and EPS
should be presented to reflect the impact of the conversion. This
presentation is required for the latest fiscal year and interim period, but
if the pro forma adjustments are limited to income taxes, pro forma
information for all periods presented is permitted.
4.5 Non-GAAP Financial Measures
While a company’s financial statements must be prepared in accordance with GAAP,
many companies also elect to disclose non-GAAP financial measures1 — that is, numerical measures of a company’s financial performance, financial
position, or cash flows for which the GAAP counterparts are adjusted in some
fashion. Examples of common non-GAAP financial measures include EBITDA, adjusted
EBITDA, adjusted earnings or adjusted EPS, and free cash flow.
When using non-GAAP financial measures, a registrant must be aware of certain
SEC requirements, including the rules in Regulation G and Regulation S-K, Item
10(e). In addition, the SEC staff has published a number of C&DIs (which are updated
periodically) to clarify its views on many non-GAAP presentation issues. SEC
officials have indicated in public forums that the SEC is looking for full
compliance with the C&DIs in IPO registration statements.
The key requirements for disclosure of non-GAAP information in SEC filings, including press releases, are
related to the following:
- Prominence — The most directly comparable GAAP measure should be presented with equal or greater prominence.
- Not misleading — A non-GAAP measure should not be presented in a misleading manner.
- Reconciliation — Registrants should present a quantitative reconciliation of the non-GAAP measure to the most directly comparable GAAP measure and should transparently describe all adjustments.
- Clear labeling — Registrants should clearly label and describe non-GAAP measures and adjustments but should not, for example, use titles or descriptions that are confusingly similar to those used for GAAP financial measures.
- Usefulness and purpose — Registrants should disclose why they believe the non-GAAP measure provides useful information to investors and, to the extent material, a statement disclosing how management uses the non-GAAP measure.
In addition, for additional background and guidance on the presentation and use
of non-GAAP measures, see Deloitte’s Roadmap Non-GAAP Financial Measures and
Metrics.
4.5.1 Presentation of Equal or Greater Prominence
The SEC has frequently cited its C&DI on prominence,
Question
102.10, when commenting on non-GAAP measures. Accordingly,
it may be helpful for a registrant to note the following:
- If GAAP and non-GAAP measures are presented in a particular section of a document, the GAAP measures should be presented before the non-GAAP measures. For example, if a registrant wants to use certain non-GAAP measures in its discussion of results of operations, it should consider the order of presentation and discuss the GAAP results before the non-GAAP measures.
- When a registrant reconciles a non-GAAP measure to the
most comparable GAAP measure, it should start with the GAAP measure. See
Section 3.2 of Deloitte’s
Roadmap Non-GAAP Financial Measures and
Metrics.
- The registrant should not present a non-GAAP measure in more detail, or emphasize it more, than the comparable GAAP measure.
- The disclosures related to non-GAAP purpose and use should not state or imply that the non-GAAP measures are superior to, provide better information about, or more accurately represent the results of operations than GAAP measures. See Section 3.4 of Deloitte’s Roadmap Non-GAAP Financial Measures and Metrics.
- Certain presentations that give undue prominence to non-GAAP information, such as a full non-GAAP income statement, are prohibited.
- If non-GAAP measures are presented in a chart or graphic, the chart or graphic should include the most directly comparable GAAP measures or they should be displayed in an equally prominent location.
Changing Lanes
In December 2022, the SEC updated Question 102.10 of the
C&DIs on non-GAAP financial measures. This
question provides guidance on when a non-GAAP measure is more prominent
than the corresponding GAAP measure, to add additional interpretive
guidance in three subsections:
-
C&DI Question 102.10(a), which highlights the scope of what is considered undue prominence and includes refreshed examples of situations in which non-GAAP measures would be disclosed more prominently than the comparable GAAP measures. Those include presenting (1) ratios when a non-GAAP measure is used in the numerator, denominator, or both without disclosing the equivalent GAAP ratio or (2) charts, tables, or graphs of non-GAAP measures without disclosing the comparable GAAP measures.At the 2022 AICPA & CIMA Conference on Current SEC and PCAOB Developments, Division Chief Accountant Lindsay McCord noted that footnote 27 of the SEC’s original final rule on the conditions for the use of non-GAAP financial measures (issued in 2003) already extended the non-GAAP requirements to each non-GAAP measure used in the calculation of a ratio, but the guidance in the C&DI serves as an additional reminder for registrants that the GAAP counterpart should also be presented.
-
C&DI Question 102.10(b), which provides examples of situations in which non-GAAP reconciliations may give undue prominence to a non-GAAP measure. The SEC staff has stressed that non-GAAP reconciliations should always begin with the most directly comparable GAAP measure and go down to the non-GAAP measure.
-
C&DI Question 102.10(c), which specifies that a non-GAAP income statement would include all or most of the line items and subtotals contained in a comparable GAAP income statement. Before being updated, C&DI Question 102.10 indicated that disclosing a “full income statement of non-GAAP measures” would be an example of a non-GAAP measure that is presented with undue prominence. Ms. McCord noted that issuers often had questions about the meaning of the term “full” in that context, so the guidance was updated to delete the term “full.”
4.5.2 Potentially Misleading Non-GAAP Measures
An overriding theme of the SEC’s guidance on the use of or
references to non-GAAP measures in public statements or disclosures is that they
should not be misleading. Section 100 of the C&DIs also provides examples of
potentially misleading non-GAAP measures, including those that:
- Exclude normal, recurring cash operating expenses necessary for business operations.
- Are presented inconsistently between periods, such as by adjusting an item in the current reporting period, but not a similar item in the prior period, without appropriate disclosure about the change and an explanation of the reasons for it.
- Exclude certain nonrecurring charges but do not exclude nonrecurring gains (e.g., “cherry picking” non-GAAP adjustments to achieve the most positive measure).
- Are based on individually tailored accounting principles, including certain adjusted revenue measures.
- Are mislabeled or not clearly labeled as non-GAAP measures or otherwise include adjustments that are not clearly or accurately labeled or described.
In addition to the examples discussed in the C&DIs, various
other presentations could be considered misleading depending on the facts and
circumstances.
In interactions with the SEC staff regarding non-GAAP measures viewed as
misleading, some registrants have proposed supporting continued presentation of
such measures by adding transparent disclosures related to the calculation of
the measures or about the measures’ purpose and use. However, Question 100.06 of
the C&DIs indicates that even detailed disclosures about a misleading
measure would not prevent it from being misleading.
At the 2022 AICPA & CIMA Conference on Current SEC and PCAOB Developments,
the SEC staff indicated that once a non-GAAP measure or adjustment is concluded
to be misleading or otherwise inconsistent with non-GAAP rules, the staff
expects the registrant to correct the presentation in the next filing or
publicly available SEC document by removing the measure or adjustment. If
comparable periods are presented, the non-GAAP measure or adjustment should be
removed from all periods presented.
Changing Lanes
In December 2022, the SEC staff released new and updated
C&DIs on non-GAAP financial measures. The staff has observed that
the volume of non-GAAP disclosure comments has remained high over the
past several years and that it continues to receive questions on this
topic. The new and updated C&DIs help increase the transparency of
the SEC staff’s process for evaluating certain non-GAAP measures as well
as its criteria for considering such measures misleading.
At the 2022 AICPA & CIMA Conference on Current SEC
and PCAOB Developments, Ms. McCord emphasized that the intent of the new
and updated C&DIs is to communicate interpretive feedback that the
SEC staff has provided to registrants in various speeches and the
comment letter process. In addition, she noted that the updates to the
C&DIs are not intended to change the SEC staff’s position on
non-GAAP adjustments that it has not objected to in the past (e.g.,
adjustments for restructuring costs and stock-based compensation).
However, Ms. McCord further acknowledged that conclusions about the
application of the C&DIs to non-GAAP measures and adjustments will
depend on a registrant’s individual facts and circumstances.
The following changes related to misleading non-GAAP measures were made
to the C&DIs:
- C&DI Question 100.01 was updated to add interpretive guidance on what may be considered normal or recurring. The C&DI cautions issuers that a non-GAAP measure may be considered misleading if it excludes cash operating expenses that are normal and recurring in the operation of a registrant’s business. At the 2022 AICPA & CIMA Conference on Current SEC and PCAOB Developments, Ms. McCord explained that the SEC staff evaluates whether an expense is “normal” by considering the nature and effect of the non-GAAP adjustment and how the expense is related to the registrant’s operations, revenue-generating activities, business strategy, industry, and regulatory environment. She also noted that the SEC staff evaluates whether an operating expense is considered “recurring” when it occurs repeatedly or occasionally, including at irregular intervals of reoccurrence.
- C&DI Question 100.04 was updated to clarify that adjustments that represent the application of individually tailored accounting principles extend beyond the original example of adjustments that accelerate revenue recognition. The C&DI specifies that non-GAAP adjustments that change the GAAP recognition and measurement principles would be considered individually tailored and may cause the presentation of the non-GAAP measure to be misleading. The C&DI includes new examples that illustrate the application of individually tailored accounting principles and thus may be misleading.
- C&DI Question 100.05 was added to highlight the SEC’s guidance that non-GAAP measures should be labeled as such and that adjustments should be clearly labeled and described in the disclosures. The C&DI also gives examples of misleading labels and descriptions for non-GAAP measures.
- C&DI Question 100.06 was added to emphasize that no amount of disclosure can make a measure compliant with the non-GAAP rules if it has been determined to be misleading.
During the IPO process, these concepts should be carefully
considered in the determination of which non-GAAP measures to present in the IPO
filing. Because non-GAAP measures are widely used in IPOs and are closely
scrutinized by the SEC, non-GAAP measures are one of the most frequent topics on
which the SEC comments during the IPO review process. See Deloitte’s Roadmap
SEC Comment Letter
Considerations, Including Industry Insights for the SEC
staff’s recent comments on this topic.
In addition, for additional background and guidance on the presentation and use
of non-GAAP measures, see Deloitte’s Roadmap Non-GAAP Financial Measures and Metrics.
Footnotes
1
Regulation S-K, Item 10(e)(2), defines a non-GAAP financial
measure as “a numerical measure of a registrant’s historical or future
financial performance, financial position or cash flows that: (i) Excludes
amounts, or is subject to adjustments that have the effect of excluding
amounts, that are included in the most directly comparable measure
calculated and presented in accordance with GAAP in the statement of
comprehensive income, balance sheet or statement of cash flows (or
equivalent statements) of the issuer; or (ii) Includes amounts, or is
subject to adjustments that have the effect of including amounts, that are
excluded from the most directly comparable measure so calculated and
presented.”
4.6 Metrics and Key Performance Indicators
Financial or operational metrics, sometimes called key performance indicators
(KPIs), may also be included in an IPO registration statement to illustrate the
size, profitability, and growth of the business or other relevant trends such as
customer acceptance or retention. The SEC has indicated that registrants should
consider the need to disclose KPIs or metrics that management uses in managing its
business within MD&A, because such information may be material to an investor’s
understanding of the company’s performance. Examples of metrics include items such
as number of Web page views, total customers/subscribers, customer retention rates,
average revenue per user, occupancy percentage, or same-store sales.
Metrics may be based on GAAP amounts, non-GAAP amounts, nonfinancial amounts, or
any combination thereof. When using metrics, registrants should first consider
whether an existing regulatory framework applies. For example, metrics based on
non-GAAP measures would be subject to the requirements in Regulation G and
Regulation S-K, Item 10(e) (see Section 4.5).
If metrics are not subject to an existing framework, registrants should consider
what additional information they may need to present for investors to understand the
metric presented. As clarified in interpretive
guidance issued by the SEC in January 2020, the SEC would
generally expect the following disclosures to accompany all KPIs and metrics in
MD&A:
- A clear definition of the metric and how it is calculated.
- A statement indicating the reasons why the metric provides useful information to investors.
- A statement indicating how management uses the metric in managing or monitoring the performance of the business.
- Whether there are estimates or assumptions underlying the metric or its calculation that may be important for investors to understand.
- Disclosures accompanying any changes in the calculation or presentation of KPIs and metrics from period to period.
The guidance also reminds registrants of the importance of maintaining effective
disclosure controls and procedures related to KPIs and metrics, including
maintaining consistency and accuracy of disclosures.
In addition, for additional background and guidance on the presentation and use of
metrics and KPIs, see Section 2.4 of
Deloitte’s Roadmap Non-GAAP Financial Measures and
Metrics.
Chapter 5 — Accounting Matters
Chapter 5 — Accounting Matters
5.1 Introduction
This section highlights common accounting issues addressed in preparing
financial statements for inclusion in an IPO registration statement.
While some of the guidance may be directly applicable, some of it
may be applied to IPO registration statements by analogy, may be
complex, and may require significant judgment. Understanding the
structure and substance of the transactions to effect the IPO is
critical to making sound and reasonable judgments. During its
comment process, the SEC staff will frequently ask management to
explain the basis for those judgments, alternatives considered, and
why the information provided to the user is representationally
faithful. For additional observations related to frequently issued
SEC staff comments, see Deloitte’s Roadmap SEC Comment
Letter Considerations, Including Industry
Insights.
5.2 Structure of the IPO Transaction
5.2.1 Carve-Out Considerations
“Carve-out financial statements” is a general term used to describe financial
statements derived from the financial statements of a larger
parent company. Carve-out financial statements may be
included in an initial registration statement for a
registrant and its predecessor when a portion of a larger
parent company is sold to the public in an initial equity
offering or when a public entity plans to spin off a
business or group of businesses to shareholders as a
separate public company (see the next section). When a
portion of a larger parent company is sold to the public in
an IPO, carve-out financial statements that comply with the
general financial statement requirements in Regulation S-X,
Rules 3-01 through 3-04, are generally required for a
registrant and its predecessor in an initial registration
statement (e.g., Form 10, Form S-1). In addition, carve-out
financial statements of the registrant and its
predecessor(s) for the comparative periods must be included
in Forms 10-K and 10-Q after the initial registration
statement is declared effective.
The form and content of the carve-out financial statements depend on the needs
or requirements of financial statement users and any
regulatory requirements applicable to the transaction for
which the carve-out financial statements are being prepared.
See Deloitte’s Roadmap Carve-Out
Transactions for more information
about preparing carve-out financial statements.
5.2.2 Spin-Off Transactions
ASC 505-60 defines a spin-off as “[t]he transfer of assets that constitute a
business by an entity (the spinnor) into a new legal
spun-off entity (the spinnee), followed by a distribution of
the shares of the spinnee to its shareholders, without the
surrender by the shareholders of any stock of the spinnor.”
Entities that want to streamline their operations might
enter into spin-offs as an alternative to selling those
parts of the business since a spin-off may provide certain
tax advantages that a sale does not.
ASC 845 provides guidance on accounting for a spin-off. The accounting for the
distribution of nonmonetary assets to owners in a pro rata
spin-off is based on recorded amounts (after reduction, if
appropriate, for an indicated impairment of value).
Generally, a pro rata distribution to existing shareholders
does not result in a change in control of the distributed
business; therefore, a change in accounting basis would not
be appropriate.
Often, a spin-off will be executed concurrently with an initial listing of the
shares of the spinnee. For a spinnee’s securities to be
listed on public exchanges such as Nasdaq or the NYSE, its
shares must be registered via Form 10 in a 1934 Act filing.
In addition, a spinnee may initiate a 1933 Act filing, such
as a Form S-1 or its equivalent, to register the sale of
additional securities in the future.
Preparing financial statements for the spinnee can be complex. Both Form 10 and Form S-1 (or
its equivalent) require audited historical financial statements of the spinnee; pro forma financial
information; and, depending on the timing of the filing during the fiscal year, interim financial
information.
Determining reporting requirements may be further complicated in a spin-off
transaction accounted for as a reverse spin-off. A reverse
spin-off occurs when the legal form of the transaction
differs from its substance to such a degree that the
financial statements of the spinnee will be the historical
financial statements of the legal spinnor. In a spin-off
transaction, an entity must consider the factors in ASC
505-60-25-8 when identifying the accounting spinnor and
spinnee, which may differ from the legal spinnor and
spinnee. At the 2014 AICPA Conference on Current SEC and
PCAOB Developments, the SEC staff cautioned that significant
judgment must be used in the determination of the accounting
spinnor and spinnee and the related financial statement
presentation and SEC reporting requirements for a reverse
spin-off transaction:
[W]hen the spinoff
is determined to be a reverse spin under Subtopic
505-60, some registrants have assumed that this
conclusion dictates the financial statements that
are presented in a registration statement that is
filed to effect the spinoff. Specifically, some
registrants have concluded that when a transaction
is accounted for as a reverse spin, the financial
statements of the existing registrant (i.e. — the
legal spinnor) can be used to satisfy the financial
statement requirements of the entity that will be
spun off (i.e. — the accounting spinnor/legal
spinnee). On this point, our colleagues in the
Division of Corporation Finance view this as an
assessment that is based on the unique facts and
circumstances of each transaction, and there may be
situations in which carveout financial statements
are required for the accounting spinnor/legal
spinnee in a registration statement relating to a
reverse spin. Overall, the separation of an existing
registrant into two or more registrants in a spinoff
transaction may present a number of reporting
questions, both with respect to the registration
statement as well as the subsequent Exchange Act
reports for each continuing entity. Given the
significant judgments involved in determining the
accounting spinnor as well as the appropriate
financial statement presentation, the staff
encourages registrants to continue to consult on
their accounting and reporting conclusions relating
to spinoffs, particularly when the transaction is
expected to be accounted for as a reverse
spin.
At the 2021 AICPA & CIMA Conference on
Current SEC and PCAOB Developments, the SEC staff further
emphasized that registrants should also evaluate the ongoing
reporting obligations of the spinnee and spinnor, which may
be particularly complex in a reverse spin-off. The SEC staff
reminded registrants that SAB Topic 5.Z.7 prohibits an
existing SEC reporting company from treating the spin-off
transaction as a change in the reporting entity in which the
spinnee’s operations would be removed from the spinnor’s
financial statements as if the spinnor never held the
business.
If management has concluded that a spin-off transaction is expected to be accounted for as a reverse
spin-off, or if the determination is subject to a high degree of judgment, management should consider
(1) consulting with its auditors and other professional advisers and (2) preclearing its conclusions about
the accounting and reporting requirements with the SEC staff.
5.2.3 Reorganization in Anticipation of a Transaction
In anticipation of a spin-off or IPO of a portion of a larger parent entity, a
parent entity may reorganize its business by transferring
certain assets or liabilities to a newly formed or existing
subsidiary that will be used to effect the transaction (the
“receiving entity”). Because the assets and liabilities are
under the control of the parent entity both before and after
the reorganization, the transfer is accounted for as a
common-control transaction and there is generally no change
in basis in the assets and liabilities. However, the
carrying amounts of the net assets in the transferred
entity’s financial statements can sometimes differ from
those in the parent entity’s consolidated financial
statements. Such differences may arise, for example, if the
net assets being transferred were acquired in a business
combination but the transferring entity did not apply
pushdown accounting at the time of acquisition. Under ASC
805-50-30-5, “the financial statements of the receiving
entity shall reflect the transferred assets and liabilities
at the historical cost of the parent of the entities under
common control.” As a result, the receiving entity
effectively applies pushdown accounting in its separate
financial statements.
For more information about accounting for common-control transactions, see
Deloitte’s Roadmap Business
Combinations.
5.3 Related-Party Transactions
All related-party transactions, including those that arise as a result of the
IPO process, need to be identified to ensure that
they are properly disclosed as well as to identify
those transactions that are modified or
terminated, such as (1) shareholder agreements
that provide rights of first refusal, (2) loans to
directors or executive officers that may not be
allowed under Sarbanes-Oxley, and (3) stock option
or award plans and stock purchase plans. For
example, issuers are prohibited from providing a
personal loan to or for any director or executive
officer (or equivalent). Accordingly, any such
loans must be repaid or otherwise settled before
an entity’s first public filing with the SEC.
5.3.1 Definition of a Related Party
Although both public and nonpublic entities are required to include
related-party disclosures in their financial
statements under U.S. GAAP, an SEC registrant’s
financial statements and other disclosures in an
IPO must comply with incremental SEC guidance.
Therefore, when preparing for an IPO, management
should be aware of the differences between the
U.S. GAAP definition of “related party” and the
SEC’s definition of the term to ensure that
disclosures are compliant with SEC guidance.
ASC 850 defines a related party as follows:
Related parties include:
- Affiliates of the entity
- Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
- Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
- Principal owners of the entity and members of their immediate families
- Management of the entity and members of their immediate families
- Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
- Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
With respect to the financial statements, the
definition of related party in Regulation S-X, Rule 1-02(u), is consistent with
that in U.S. GAAP. Regarding disclosures in the registration statement outside
the financial statements, the SEC’s definition of a related party is similar to
that in U.S. GAAP but the SEC has established its own definition of a “related
person” in Regulation S-K, Item 404(a). This definition includes:
- “Any director or executive officer of the registrant.”
- “Any nominee for director, when the information . . . is being presented in a proxy or information statement relating to the election of that nominee for director.”
- Any beneficial owner of more than 5 percent of any class of the company’s voting securities (see Regulation S-K, Item 403(a)).
- “Any immediate family member” of the people listed above (i.e., “any child, stepchild, parent, stepparent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law” of such people) “and any person (other than a tenant or employee) sharing the household” of such people.
The example below highlights the need to consider what constitutes a related party under both U.S.
GAAP and Regulation S-K.
Example 5-1
Under U.S. GAAP, a principal
owner is considered a related party. ASC 850
defines the term “principal owners” as “[o]wners
of record . . . of more than 10 percent of the
voting interests of the entity.” Under the SEC
definition, this amount is decreased to 5 percent
of any class of voting securities. If a
shareholder holds a 7 percent interest in an
entity both before and after an IPO, that
individual would not represent a related party for
U.S. GAAP purposes but would be considered a
related party under Regulation S-K, in which case
additional disclosures would be required.
5.3.2 Presentation and Disclosures Associated With Related-Party Transactions
The SEC considers disclosures about related-party transactions as an integral
part of the financial statements and other
disclosures in the registration statement.
Management must therefore provide detailed
disclosures about these transactions in
registration statements.
5.3.3 Related-Party Disclosures Under U.S. GAAP
ASC 850-10-50 provides the guidance below on related-party disclosures (this
guidance applies to both public and nonpublic
entities).
ASC 850-10
50-1
Financial statements shall include disclosures of
material related party transactions, other than
compensation arrangements, expense allowances, and
other similar items in the ordinary course of
business. However, disclosure of transactions that
are eliminated in the preparation of consolidated
or combined financial statements is not required
in those statements. The disclosures shall
include:
- The nature of the relationship(s) involved
- A description of the transactions, including transactions to which no amounts or nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements
- The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing the terms from that used in the preceding period
- Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement
- The information required by paragraph 740-10-50-17.[1]
50-2 Notes or
accounts receivable from officers, employees, or
affiliated entities must be shown separately and
not included under a general heading such as notes
receivable or accounts receivable.[2]
50-3 In some
cases, aggregation of similar transactions by type
of related party may be appropriate. Sometimes,
the effect of the relationship between the parties
may be so pervasive that disclosure of the
relationship alone will be sufficient. If
necessary to the understanding of the
relationship, the name of the related party shall
be disclosed.
50-4 It is
not necessary to duplicate disclosures in a set of
separate financial statements that is presented in
the financial report of another entity (the
primary reporting entity) if those separate
financial statements also are consolidated or
combined in a complete set of financial statements
and both sets of financial statements are
presented in the same financial report.
Disclosures About Arm’s-Length Bases of
Transactions
50-5
Transactions involving related parties cannot be
presumed to be carried out on an arm’s-length
basis, as the requisite conditions of competitive,
free-market dealings may not exist.
Representations about transactions with related
parties, if made, shall not imply that the related
party transactions were consummated on terms
equivalent to those that prevail in arm’s-length
transactions unless such representations can be
substantiated.
Control
Relationships
50-6 If the
reporting entity and one or more other entities
are under common ownership or management control
and the existence of that control could result in
operating results or financial position of the
reporting entity significantly different from
those that would have been obtained if the
entities were autonomous, the nature of the
control relationship shall be disclosed even
though there are no transactions between the
entities.
5.3.3.1 Related-Party Disclosures for SEC Registrants
In addition to meeting the disclosure requirements under U.S. GAAP, a registrant’s financial statements
should comply with the applicable requirements of Regulation S-X. The SEC staff frequently requests
additional related-party disclosures.
Regulation S-X prescribes the types, form, and content of the financial information that registrants must
file. Many of these requirements expand on the disclosure requirements in U.S. GAAP. Under Regulation
S-X, Rule 4-08(k):
- Registrants must state the amounts of related-party transactions on the face of the balance sheet, statement of comprehensive income, or statement of cash flows.
- When separate financial statements are presented for a registrant, certain investees, or subsidiaries, registrants must separately disclose in such statements any historical intercompany profits or losses resulting from transactions with related parties and the effects thereof.
In addition, Regulation S-X, Rule 5-02(3)(a), requires entities to state
separately, on the face of the balance sheet,
amounts receivable from (1) customers (trade); (2)
related parties; (3) underwriters, promoters, and
employees (other than related parties) that “arose
in other than the ordinary course of business”;
and (4) others.
Further, Regulation S-K, Item 404(a), requires registrants to disclose, in the
registration statement and outside the financial
statements, transactions with related parties they
participated in, or will participate in, for which
the “amount involved exceeds $120,000, and [the
related party] had or will have a direct or
indirect material interest.” This disclosure
should include information such as:
- “The name of the related person and the basis on which the person is a related person.”
- “The related person’s interest in the transaction with the registrant.”
- “The approximate dollar value of the . . . transaction.”
- Any additional information about the transaction “that is material to investors in light of the circumstances of the particular transaction.”
5.3.4 Identifying Related-Party Transactions
In identifying related-party transactions, registrants should consider
consulting with legal counsel and reviewing the
instructions to Regulation S-K, Item 404(a), to
better understand the definition of a “related
person” and the types of transactions a registrant
needs to disclose. As part of this process, a
master list of all related parties should be
maintained and communicated to directors,
officers, and employees so that they are aware of
them. Additional information about related parties
may be obtained in various ways, including an
annual questionnaire distributed to directors and
officers through which an entity obtains basic
information about transactions between directors
and officers, their family members, and the
entity. Other potential sources that may help
identify related parties include, but are not
limited to:
- Disclosures on the entity’s Web site.
- Tax filings and related correspondence.
- Invoices from professional advisers.
- Conflicts-of-interest statements from management and others.
- Shareholder registers that identify the entity’s principal shareholders.
- Life insurance policies purchased by the entity.
- Records of investments, pension funds, and other trusts established for the benefit of employees, including the names of the officers and trustees of such investments, pension plans, and other trusts.
- Contracts or other agreements (e.g., partnership agreements) with management.
- The entity’s organizational charts.
- Records from a whistleblower program.
- Expense reimbursement documents for executive management.
Connecting the Dots
PCAOB auditing standards
require the auditor to perform certain procedures to audit related-party
transactions and the related internal controls. See Section
6.7.3 for more information.
5.3.5 Focus of SEC
Types of related-party transactions that the SEC staff often comments on during
the registration process include (1) sales and
loans between related parties and (2) the entity’s
policies and procedures for reviewing, approving,
or ratifying transactions with related persons.
For additional observations related to frequently
issued SEC staff comments, see Deloitte’s Roadmap
SEC Comment Letter Considerations, Including
Industry Insights.
5.3.6 Regulation S-K, Item 404(a)(5), “Transactions With Related Persons”
Regulation S-K, Item 404(a)(5), indicates that registrants should disclose the
major terms of related-party indebtedness,
including the amounts involved, the largest
principal amount outstanding during the period and
as of the latest practicable date, principal and
interest payments made during the period, and the
interest rate or the interest-payable amount as of
the end of the period. The SEC staff often asks
registrants to expand their disclosures related to
these requirements.
5.3.7 Regulation S-K, Item 404(b), “Review, Approval or Ratification of Transactions With Related Persons”
Regulation S-K, Item 404(b), requires a registrant to develop and disclose its “policies and procedures for the review, approval, or ratification of any transaction” with related persons. These policies and procedures are essential to providing information to investors regarding how related-party transactions will be addressed. Recent SEC comment letters have indicated that although the SEC may ask for additional information regarding these policies, registrants often disclose the existence, or a general summary, of such policies and procedures but exclude material features such as the types of transactions covered, the standards to be applied to the transactions, and the persons or group of persons responsible for applying the policies and procedures.
Footnotes
[1]
ASC 740-10-50-17 states, “An
entity that is a member of a group that files a
consolidated tax return shall disclose in its
separately issued financial statements:
- The aggregate amount of current and deferred tax expense for each statement of earnings presented and the amount of any tax-related balances due to or from affiliates as of the date of each statement of financial position presented
- The principal provisions of the method by which the consolidated amount of current and deferred tax expense is allocated to members of the group and the nature and effect of any changes in that method (and in determining related balances to or from affiliates) during the years for which the above disclosures are presented.”
[2]
As discussed above, loans to
directors or executive officers may not be allowed
under Sarbanes-Oxley.
5.4 Business Combinations
In addition to the SEC pro forma financial information that must be disclosed
for a business combination or probable business combination, when a business combination is
completed, an entity must disclose pro forma financial information in the notes to the
financial statements in accordance with ASC 805.
ASC 805-10-50-2(h) requires an acquirer that meets the definition of a public entity to disclose the
following:
- “The amounts of revenue and earnings of the acquiree since the acquisition date included in the consolidated income statement for the reporting period.”
- “[T]he revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period.”
- “The nature and amount of any material, nonrecurring pro forma adjustments directly attributable to the business combination(s) included in the reported pro forma revenue and earnings.”
Entities must provide pro forma information for business combinations that occur
(1) during the reporting period or (2) after the reporting date but before the
financial statements are issued, unless the initial accounting for the business
combination is incomplete at the time the financial statements are issued or
available to be issued. In addition, if multiple immaterial business combinations
occur that are material collectively, pro forma information should be disclosed in
the aggregate for those business combinations.
The ASC 805 pro forma disclosures are required only for public entities. Therefore, an entity may not
have provided these disclosures in its financial statements before becoming a public entity. However, if
a material business combination or multiple immaterial business combinations that are material in the
aggregate have occurred in any of the reporting periods presented in the registration statement, the
entity would be required to provide these disclosures in its registration statement.
The supplemental pro forma
information required by ASC 805-10-50-2(h) (i.e., the revenue and earnings of the acquiree
for the periods before the acquisition) does not need to be audited. Auditors, however,
should perform the procedures required by PCAOB AS Section 2705.
The SEC’s rules on disclosure of pro forma financial information differ
from the guidance in U.S. GAAP on this topic. Specifically:
- ASC 805-10-50-2(h) requires disclosure of pro forma financial information in the notes to the historical financial statements for revenue and earnings only.
- SEC Regulation S-X, Article 11, requires presentation of pro forma financial information in certain SEC filings (e.g., Form 8-K, registration statements, and proxy statements) to reflect a pro forma balance sheet and income statement.
In complying with the more extensive presentation requirements of Article
11, it is insufficient for an entity to provide only the pro forma financial information
disclosures required by ASC 805. Because the FASB does not provide detailed guidance on
preparing pro forma financial information, registrants preparing disclosures required by ASC
805 may apply the same concepts described in Article 11.
For more information about presenting pro forma financial information under ASC
805, see Deloitte’s Roadmap Business Combinations.
5.5 Financial Instruments
5.5.1 Valuation of Financial Instruments
Fair value has become an integral part of financial reporting and is often cited
by investors as the most relevant measurement attribute for financial
instruments. Under U.S. GAAP, derivative financial instruments, whether
freestanding or bifurcated from host instruments, must generally be reported at
fair value in the balance sheet. Consequently, the SEC staff often comments on
how freestanding derivatives and bifurcated embedded derivatives have been
measured and reported in the balance sheet. For example, the staff has
frequently requested issuers to expand fair value disclosures to include
quantitative information about significant unobservable inputs used in fair
value measurements. Some of the SEC staff’s additional topics of focus related
to financial instrument valuation include the following:
- Significant assumptions, factors, and methods used to determine fair value.
- Changes in valuation of the instruments over time.
- Categorization of instruments in the fair value hierarchy.
- Whether an independent valuation was performed contemporaneously.
- Explanations of any discounts (e.g., marketability, liquidity).
For additional observations related to frequently issued SEC staff comments, see
Deloitte’s Roadmap SEC
Comment Letter Considerations, Including Industry
Insights.
Because of the complexity of financial instruments, simple valuation models
often are not appropriate for measuring fair value. At the Forum on Auditing in
the Small Business Environment hosted by the PCAOB in 2012, the staff in the
SEC’s Division of Corporation Finance noted that errors in valuation of
financial instruments often result from entities’ failure to carefully consider
and evaluate the accounting implications of contractual provisions.3 Prospective registrants are strongly encouraged to evaluate such
provisions, paying attention to the identification of any embedded features that
may affect an instrument’s valuation. Such features may affect the settlement
amount (and thus the fair value) of the instrument or embedded feature, and the
valuation method or methods selected should appropriately incorporate all
relevant terms.
The fair value of freestanding financial instruments (e.g., warrants) and
bifurcated derivatives (e.g., conversion options bifurcated from debt or
preferred stock) can fluctuate significantly with changes in the value of the
underlying stock or underlying assumptions used in determining the instruments’
fair value. As is generally the case for a prospective registrant, when no
active market exists for the underlying stock associated with the financial
instrument, the entity must establish appropriate valuation processes and
controls related to determining the fair value of both the stock underlying the
financial instrument and the financial instrument in its entirety.
Connecting the Dots
Issuers often need to determine the fair value of the
stock into which a financial instrument is convertible, because either
the financial instrument in its entirety must be accounted for at fair
value or an embedded conversion feature must be bifurcated and accounted
for separately at fair value.
As the complexity of financial instruments increases, an entity may be required to use significant
judgment in measuring fair value. Prospective registrants should ensure that their disclosures include
the information investors need to understand how management determined fair value. Furthermore,
depending on the complexity and terms of the instrument, an independent valuation specialist may
need to be engaged to assess the instrument’s fair value. Section 7(a) of the 1933 Act requires that a
written consent be obtained from an independent valuation firm that is “named as having prepared or
certified any part of the registration statement, or is named as having prepared or certified a report or
valuation for use in connection with the registration statement.”
Footnotes
3
For more information, see the slide presentation from the forum.
5.6 Liabilities, Equity, and Temporary Equity
The SEC historically has focused on the classification of financial instruments
as liabilities or equity in the balance sheet when those financial instruments have
redemption provisions or possess characteristics of both liabilities and equity. For
example, the classification of embedded features within convertible debt instruments
and freestanding warrants is often scrutinized since they may contain both liability
and equity components under U.S. GAAP.4
At the time they are approaching a potential IPO, prospective registrants may
have outstanding financial instruments with characteristics of both liabilities and
equity, or in connection with a potential IPO, an entity may issue new financial
instruments. Even if certain instruments are already outstanding before an IPO, when
public financial statements are initially issued, it may be appropriate for a
financial instrument to be classified as temporary equity (e.g., outside of
permanent equity) in accordance with SEC rules even if it was acceptable for the
financial instrument to be classified as permanent equity before the IPO. In
accordance with ASC 480-10-S99-3A(2), which contains interpretations of the
requirements of Regulation S-X, Rule 5-02.27(a) (as amended by ASR 268), an
equity-classified instrument is presented outside of permanent equity if it is
redeemable for cash or other assets in any of the following circumstances: at a
fixed or determinable price on a fixed or determinable date, at the option of the
holder, or upon the occurrence of an event that is not solely within the control of
the issuer. The SEC’s guidance on temporary equity applies to SEC registrants’
financial statements that are prepared in accordance with Regulation S-X. Nonpublic
entities are not required to apply this guidance but may elect to do so.
Accordingly, an entity undertaking an IPO that has not previously elected to apply
the SEC’s guidance on temporary equity would need to reassess its classification
conclusion for equity-classified instruments. For equity-classified instruments
(e.g., preferred stock) that must be treated as temporary equity, specific balance
sheet presentation and disclosure would be required. In subsequently measuring an
instrument classified in temporary equity, an entity must also assess whether (1)
the instrument is currently redeemable or (2) it is probable that the instrument
will become redeemable in the future. The SEC staff closely scrutinizes whether
registrants’ balance sheet classification of capital securities is appropriate, as
demonstrated in recent comment letters on registrants’ filings and the number of
restatements associated with inappropriate classification. Given the extent of the
SEC’s scrutiny on proper classification of capital securities as liabilities,
temporary equity, or permanent equity, entities are encouraged to consult with their
independent registered public accounting firms on the appropriate application of
GAAP.
For more information about the classification of liabilities and equity, see
Deloitte’s Roadmap Distinguishing Liabilities From Equity.
5.6.1 Distributions to Owners Under SAB Topic 1.B.3
While planning for an IPO, entities may make distributions to pre-IPO owners as compensation or as a
return of capital. The SEC provides explicit guidance on reporting planned distributions to owners at or
before the closing of an IPO.
Distributions are generally paid out of earnings. However, if the planned
distribution exceeds earnings for the previous 12-month period, the amount of
the distribution in excess of current earnings is deemed to be paid out of the
proceeds of the offering.
Regardless of the source from which the planned distributions will be made to
owners, if such planned distributions are not reflected in the latest balance
sheet and the amount is significant in relation to reported equity, an entity
should provide pro forma disclosures that reflect an accrual for the planned
distribution and its impact on reported equity without giving effect to the
offering proceeds (see paragraph 3420.1 of the FRM). Historically, this pro forma
information was presented alongside the historical balance sheet or in an
appropriate footnote disclosure. However, SEC Final Rule 33-10786, which amends
Regulation S-X, Rule 11-02(a)(12), states that a registrant must not “[p]resent
pro forma financial information on the face of the registrant’s historical
financial statements or in the accompanying notes, except where such
presentation is required by U.S. GAAP or IFRS-IASB, as applicable.” Accordingly,
registrants should determine the appropriate location of the pro forma
information, which might include summary financial information, the
capitalization table, or separate unaudited pro forma financial information.
In addition, if a planned or actual distribution to owners is deemed to be paid out of proceeds of the
offering rather than from the current year’s earnings, pro forma per-share data (pro forma EPS) should
be presented for the latest fiscal year and interim period only. Pro forma EPS should be calculated by
including an incremental number of shares, not to exceed the number of shares being offered in the
IPO that, on the basis of the offering price, would be needed to pay the portion of the distribution that
exceeds earnings for the previous 12-month period.
5.6.2 Changes in Capitalization
Changes in an entity’s capitalization or revisions to the capital structure often occur before, or
concurrently with, the effective date or closing of an IPO. Such changes are frequently associated with
the complex equity structures of many pre-IPO entities and are made to ensure that the entity has an
appropriate capital structure to go public.
Changes in capitalization take various forms, including amendments to an entity’s articles of
incorporation, stock splits, redemptions of preferred stock, and conversions of preferred stock or
debt into common stock. Some changes, such as stock splits, are reflected retrospectively in all
periods presented in the financial statements. Most other changes, if they occurred after the latest
balance sheet date, are only recorded prospectively and may not be reflected in the historical financial
statements presented in an IPO filing. However, such changes in capitalization may need to be
presented as part of pro forma information.
5.6.2.1 Stock Splits in Contemplation of the IPO
Stock splits (or reverse stock splits) may be declared during the pre-IPO
process with the intent to be effected shortly before the effective date of
the registration statement (i.e., just before the closing of the IPO). A
stock split is often executed to establish an outstanding share count that
will result in an offering price that is within a preferred range based on
the estimated post-IPO valuation. If the stock split is both declared and
effected before an amendment to the registration statement is filed, the
impact must be retrospectively reflected in the historical financial
statements. The related footnote disclosures should include:5
- A description of the change.
- The retroactive presentation.
- The date the change became effective.
When a prospective stock split has been declared but is not yet effected, it is
still typical to retrospectively reflect the stock split in the historical
financial statements. Because the stock split is not yet effective as of the
issuance of the financial statements, but those financial statements
retroactively reflect the impact of the stock split, the registration
statement must include a “to-be-issued” auditor’s report (i.e., a draft
report in the form that will be issued at a future date). Such an auditor’s
report would include a preface (or legend) signed by the auditor stating
that it expects to be in a position to issue the report in the form
presented when the stock split is legally effected. The highlights of the
June 2014 CAQ SEC Regulations Committee joint meeting with the SEC staff
discuss the following situations related to such a presentation:
In certain situations, a registrant’s financial
statements included in a registration statement may reflect a
transaction that has not yet occurred but (a) will occur just prior to
or at effectiveness and (b) will be reflected retrospectively in the
historical financial statements in accordance with US GAAP. Examples are
a stock split or a legal reorganization. In those circumstances, the
staff will commence a review of a registration statement that includes a
“to-be-issued” audit report on financial statements that have already
been revised to reflect the transaction retrospectively (see
FRM Section
4710).
Note that the registration statement cannot be declared effective until the legend is removed and the
auditor’s report is finalized. Entities are encouraged to consult with their independent registered public
accounting firms if they believe they meet the requirements described above.
5.6.2.2 Redemption or Conversion of Preferred Stock to Common Stock and Conversion of Debt
In many instances, preferred stock or convertible debt will automatically convert to common stock upon
an IPO. If the original terms of outstanding convertible preferred stock do not provide for automatic
conversion into common stock upon an IPO, an entity may, before commencing the IPO process, seek to
obtain the agreement of the preferred stockholders to convert their preferred stock into common stock
at the time of the IPO or to modify existing provisions in organizational documents to incorporate an
automatic conversion feature. As a result, a change in capitalization may occur after the date of the most
recent balance sheet presented. Similarly, changes in capitalization can result from conversion of debt
into equity after the date of the latest balance sheet presented.
Paragraph 3430.1 of the FRM points out that the historical financial statements, including EPS data,
generally “should not be revised to reflect modifications of the terms of outstanding securities that
become effective after the latest balance sheet date.” However, a registrant may need to provide pro
forma information, as discussed further below.
5.6.2.3 Presentation of Pro Forma Information Related to Changes in Capitalization
The registration statement may need to include pro forma financial information related to changes in
capitalization that occur around the same time as an IPO.
The SEC staff often asks registrants to present pro forma information when
changes in capitalization will occur after the date of the latest balance
sheet. Paragraph
3430.2 of the FRM indicates that when such changes (1) will
“result in a material reduction of permanent equity”
or (2) result from “redemption of a material amount of equity securities . .
. in conjunction with the offering,” a pro forma balance sheet should be
included in the filing (presented alongside the historical balance sheet)
that takes into account the change in capitalization but not the effects of
the offering proceeds. As discussed in Section 5.6.1, SEC Final Rule
33-10786, which amended Rule 11-02(a)(12), states that a registrant must not
“[p]resent pro forma financial information on the face of the registrant’s
historical financial statements or in the accompanying notes, except where
such presentation is required by U.S. GAAP or IFRS-IASB, as applicable.”
Accordingly, registrants should determine the appropriate location of the
pro forma information, which might include summary financial information,
the capitalization table, or separate unaudited pro forma financial
information.
The conversion of preferred stock to common stock in
conjunction with an IPO is not a reduction of
permanent equity and therefore does not need to be included in the pro forma
balance sheet (see paragraph 3430.2 of the FRM). However, many entities
choose to reflect such conversions in pro forma balance sheet information.
A prospective registrant should also present pro forma EPS when outstanding securities are or will be
converted after the latest balance sheet date and this conversion will cause a material reduction in EPS
(excluding the effects of the offering). The pro forma EPS should reflect the securities conversion but not
the effects of the offering. Such pro forma EPS should be presented for the latest fiscal year and interim
period presented in the registration statement.
5.6.3 SAB Topic 4.E, “Receivables From Sale of Stock”
ASC 505-10
45-2 An entity may receive a
note, rather than cash, as a contribution to its equity.
The transaction may be a sale of capital stock or a
contribution to paid-in capital. Reporting the note as
an asset is generally not appropriate, except in very
limited circumstances in which there is substantial
evidence of ability and intent to pay within a
reasonably short period of time, for example, as
discussed for public entities in paragraph 210-10-S99-1
(paragraphs 27 through 29), which requires a deduction
of the receivable from equity. However, such notes may
be recorded as an asset if collected in cash before the
financial statements are issued or are available to be
issued (as discussed in Section 855-10-25).
Generally, receivables that result from the issuance of shares classified as permanent or mezzanine equity should be presented as a reduction of each respective class of stock (i.e., contra-equity). That is, receivables that result from the issuance of shares classified as permanent equity generally should be presented as a reduction of permanent equity in accordance with ASC 505-10-45-2. Similarly, receivables that result from the issuance of shares classified as mezzanine equity should be presented as a reduction of mezzanine equity by analogy to the guidance in EITF Issue 89-11 (not codified), which
states, in part, that “when ASR 268 . . . requires some or all of the value of
the securities to be classified outside of permanent equity, a proportional
amount of the debit in the equity section . . . if any, should be similarly
classified.”
Under SAB Topic
4.E (codified in ASC 310-10-S99-2), outstanding receivables
from officers or other employees related to the issuance of stock to officers or
other employees must generally be presented as a deduction from stockholders’
equity rather than as an asset.
Asset classification of such receivables may be appropriate only when the receivable is fully repaid in
cash before the financial statements are issued. The date of payment must be disclosed in the notes to
the financial statements.
SAB Topic 4.E cautions, however, that the SEC staff would consider any
subsequent return of cash to the officer or employee as potentially representing
an effort “to evade the registration or reporting requirements of the securities
laws.” Although the receivable may be settled before the effective date of the
IPO, receivables of this nature must be disclosed separately, regardless of
whether they are classified as an asset or as a deduction from equity.
In addition, an entity that allows an employee to finance the purchase of shares
should consider whether recourse or nonrecourse notes have been tendered.
Nonrecourse notes are not recognized because such financing is accounted for, in
substance, as a stock option. See Section 3.11.2 of Deloitte’s Roadmap
Share-Based Payment
Awards for further guidance.
Connecting the Dots
Entities preparing to file a registration statement with
the SEC should be particularly cognizant of the potential legal
ramifications that may arise as a result of such loans and should
address any issues with their legal counsel well in advance of becoming
public. Section 402 of Sarbanes-Oxley generally precludes certain loans
with officers and directors. Before going public, prospective
registrants should consult with legal counsel regarding potential
settlement of such loans.
Footnotes
4
For more information about the classification of warrants
issued in SPAC transactions, see Deloitte’s October 2, 2020 (last updated
April 11, 2022), Financial Reporting Alert.
5
These disclosures are required by SAB Topic
4.C (codified as ASC 505-10-S99-4) as well as
for changes in capital structure that involve a stock dividend.
5.7 Accounting for Offering Costs — SAB Topic 5.A
Expenses incurred during an IPO can be divided into those that occur as a direct
result of an IPO and those that occur as part of
an entity’s ordinary operations. SAB Topic
5.A (codified in ASC 340-10-S99-1)
indicates that “[s]pecific incremental costs
directly attributable to a proposed or actual
offering of securities may properly be deferred
and charged against the gross proceeds of the
offering.” Therefore, entities undertaking an IPO
should ensure that all costs earmarked for
deferral are incremental costs directly resulting
from the IPO as opposed to costs that are part of
an entity’s ongoing operations before or after the
IPO.
Connecting the Dots
Costs incurred during an IPO
may be significant. Therefore, the appropriate
identification of costs that qualify for deferral
is particularly important given the potential
impact on reported profit or loss if such costs
are incorrectly allocated. Similarly, entities
should be cognizant of the risk of deferring costs
that do not qualify for such treatment. In certain
cases, management may need to exercise judgment to
appropriately allocate costs and should consider
consulting with professional advisers and auditors
before making a final determination.
Costs that may qualify for deferral include registration fees, filing fees,
listing fees, specific legal and accounting costs,
and transfer agent and registrar fees. However, in
accordance with SAB Topic 5.A, costs such as
management salaries or other general and
administrative expenses generally are not
considered incremental or directly attributable to
the IPO, even though they may increase as a result
of the IPO. Such costs should be accounted for
under other accounting standards.
In rare instances, an IPO could consist solely of selling shareholders, with no new shares being issued by
the entity. In such cases, offering costs should be expensed because there are no proceeds against which
to offset the costs.
For more information about
issuance costs within the scope of SAB Topic 5.A,
see Deloitte’s Roadmaps Distinguishing
Liabilities From Equity and
Issuer’s Accounting
for Debt.
5.7.1 Aborting or Postponing an Offering
An entity that aborts an IPO can no longer defer offering costs that otherwise
qualified for deferral; rather, such deferred
costs should be immediately expensed. However, as
indicated in SAB Topic 5.A, “[a] short
postponement (up to 90 days) does not represent an
aborted offering.” In practice, postponements
regularly occur in response to market fluctuations
or entity-specific circumstances (e.g., delays in
the finalization of a contract that is intended to
form the foundation of an entity’s IPO). Judgment
should be used in the determination of whether a
postponement of more than 90 days represents an
aborted offering.
When a delay or postponement occurs, the determination of whether costs should
continue to be deferred as a result of a delay or postponement depends on
whether the costs are associated with a probable, successful future offering of
securities. To the extent that a cost will be incurred a second time or will not
provide a future benefit, it should be charged to expense.
In determining the actual postponement date, an entity may be required to use significant judgment and
consider the facts and circumstances. For example, if an offering is delayed beyond 90 days because
market conditions would not yield an acceptable return, the delay would generally be considered an
aborted offering and previously deferred offering costs would be charged to expense. Conversely, a
delay of more than 90 days could be considered a short postponement, rather than an aborted offering,
in certain circumstances. Sufficient and appropriate evidence should exist to support the assertion that
the delay of an offering of securities does not constitute an aborted offering. Factors that may indicate
that an offering has not been aborted include, but are not limited to:
- The resolution of the items causing the delay (e.g., accounting, legal, or operational matters) is
necessary for the completion of the offering. Such resolution may include:
- Completing new (or revising existing) contractual arrangements with shareholders or other parties.
- Obtaining audited financial statements for other required entities (e.g., significant acquisitions under Regulation S-X, Rule 3-05; significant equity method investments under Regulation S-X, Rule 3-09).
- A plan for resolving the delay, including a revised timetable detailing the necessary steps to achieve a registration; such a plan should be approved by the board of directors or management.
- Continuing to undertake substantive activities in accordance with the plan, demonstrating an intent to proceed with the offering.
- Continuing to prepare financial information or updating the registration statement either to respond to SEC staff review comments or because information may become stale.
Management will need to use significant judgment in determining whether a delay is a short
postponement or an aborted offering and may need to consult with accounting and legal advisers.
5.8 Share-Based Compensation
An entity that is preparing for an IPO may have a share-based compensation
strategy designed to retain and attract employees and nonemployees. Share-based
compensation often is in the form of stock options, stock appreciation rights,
restricted stock, restricted stock units, or an employee stock purchase plan (ESPP).
In addition, an entity may use share-based compensation to purchase goods or
services from third-party vendors or service providers. Management should consider
the financial reporting implications associated with each of the various types of
share-based compensation arrangements that an entity may enter into with employees
and nonemployees. Additional topics that an entity undergoing an IPO often must
consider include the valuation of share-based compensation, repurchase features,
certain profit-sharing arrangements, performance conditions associated with
liquidity events, modifications, employee loans, escrowed stock arrangements, EPS,
and disclosures.
This section of the Roadmap focuses on share-based compensation granted to
grantees under ASC 718. In this section, it is assumed that an entity has adopted
ASU
2018-07, which simplifies the accounting for share-based
payments granted to nonemployees for goods and services. While ASU 2018-07 aligns
most of the guidance on nonemployee share-based payment awards with the requirements
for employee share-based payment awards, certain differences remain. Because of
these differences, it is still important for an entity to consider whether the
counterparty in an arrangement is an employee or a nonemployee when accounting for
share-based payment awards. See Chapter 9 of Deloitte’s Roadmap Share-Based Payment Awards for a
discussion of awards granted to nonemployees.
As a reminder, share-based payment awards accounted for under ASC 718 must be
either (1) settled by issuing the entity’s equity shares or other equity instruments
or (2) indexed, at least in part, to the value of the entity’s equity shares or
other equity instruments. Generally, equity-classified share-based payment awards
are measured by using a fair-value-based measure on their grant date.
Liability-classified share-based payment awards are also generally measured by using
a fair-value-based measurement; however, they are remeasured in each subsequent
reporting period until settlement. The fair-value-based measure for share-based
payment awards is recognized over the requisite service period, which often is the
vesting period.
5.8.1 Valuation
One of the most significant inputs related to measuring share-based compensation is the underlying
valuation of the entity’s shares. A pre-IPO entity should become familiar with the U.S. GAAP and SEC
valuation requirements, including differences between valuation methods for public entities and those
for nonpublic entities. The sections below summarize some of the more significant considerations
related to share-based compensation for an entity contemplating an IPO.
5.8.1.1 Pre-IPO Valuation Considerations
ASC 718-10
30-2 A share-based payment
transaction shall be measured based on the fair
value (or in certain situations specified in this
Topic, a calculated value or intrinsic value) of the
equity instruments issued.
ASC 718 identifies three ways for nonpublic entities to measure share-based
payment awards (the terms below are defined in the ASC master glossary):
- By using fair value, which is the “amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”
- By using a calculated value, which is a “measure of the value of a [stock] option or similar instrument determined by substituting the historical volatility of an appropriate industry sector index for the expected volatility of a nonpublic entity’s share price in an option-pricing model.”
- By using intrinsic value, which is the “amount by which the fair value of the underlying stock exceeds the exercise price of an option” or similar instrument.
Changing Lanes
In October 2021, the FASB issued ASU
2021-07, which allows nonpublic entities to use,
as a practical expedient, “the reasonable application of a
reasonable valuation method” to determine the current price input of
equity-classified share-based payment awards issued to both
employees and nonemployees on a measurement-date-by-measurement-date
basis. The ASU notes that a valuation performed in accordance with
specified U.S. Treasury regulations related to Section 409A of the
Internal Revenue Code (IRC) is an example of a reasonable valuation
method under the practical expedient. The ASU also explicitly refers
to other valuation approaches under IRC Section 409A that are
presumed to be reasonable. The guidance in ASU 2021-07 is effective
for nonpublic entities for fiscal years beginning on or after
December 15, 2021, and interim periods within fiscal years beginning
after December 15, 2022. Entities must apply the ASU’s provisions
prospectively and may early adopt them for interim and annual
financial statements that have not yet been issued or made available
for issuance as of October 25, 2021.
As discussed in Sections 5.8.1.1.2 and
5.8.1.1.3, under ASC 718, nonpublic entities can
apply other practical expedients related to the use of the
calculated value and intrinsic value. In SAB Topic 14.B, the SEC
provides transition guidance for entities that elect those practical
expedients and are changing their status from nonpublic entity to
public entity (see Section 5.8.1.2.2). However, there is no similar
transition guidance in ASU 2021-07 on the use of the practical
expedient. Therefore, an entity that no longer meets the criteria to
be a nonpublic entity would have to reverse the practical
expedient’s effect in its historical financial statements.
Consequently, before electing the practical expedient in ASU
2021-07, nonpublic entities that could become public entities should
carefully consider the potential future costs of having to perform
such a reversal.
5.8.1.1.1 Fair-Value-Based Measurement
Nonpublic entities should make an effort to value their equity-classified awards
by using a fair-value-based measure. A nonpublic entity may look to
recent sales of its common stock directly to investors or common-stock
transactions in secondary markets. However, observable market prices for
a nonpublic entity’s equity shares may not exist. In such an instance, a
nonpublic entity could apply many of the principles of ASC 820 to
determine the fair value of its common stock, often by using either a
market approach or an income approach (or both). A “top-down method” may
be applied, which involves first valuing the entity, then subtracting
the fair value of debt, and then using the resulting equity valuation as
a basis for allocating the equity value among the entity’s equity
securities. While not authoritative, the AICPA Accounting and Valuation
Guide on valuation of privately-held-company equity
securities issued as compensation (the “AICPA Valuation Guide”)
emphasizes the importance of using contemporaneous valuations from
independent valuation specialists to determine the fair value of equity
securities.
5.8.1.1.2 Calculated Value
When stock options or similar instruments are granted by a nonpublic entity, the entity should try to
use a fair-value-based measure to value those equity-classified awards. However, in certain instances,
a nonpublic entity may not be able to reasonably estimate the fair-value-based measure of its options
and similar instruments because it is not practicable for it to estimate the expected volatility of its share
price. In these cases, the nonpublic entity should substitute the historical volatility of an appropriate
industry sector index for the expected volatility of its own share price. In assessing whether it is practicable to estimate the expected volatility of its own share price, the entity should consider the following factors:
- Whether the entity has an internal market for its shares (e.g., investors or employees can purchase and sell shares).
- Previous issuances of equity in a private transaction or convertible debt provide indications of the historical or implied volatility of the entity’s share price.
- Whether there are similarly sized public entities (including those within an index) in the same industry whose historical or implied volatilities could be used as a substitute for the nonpublic entity’s expected volatility.
If, after considering the relevant factors, the nonpublic entity determines that estimating the expected
volatility of its own share price is not practicable, it should use the historical volatility of an appropriate
industry sector index as a substitute in estimating the fair-value-based measure of its awards.
An appropriate industry sector index would be one that is narrow enough to reflect the nonpublic
entity’s nature and size (if possible). For example, the use of the Philadelphia Exchange (PHLX)
Semiconductor Sector Index is not an appropriate industry sector index for a small nonpublic software
development entity because it represents neither the industry in which the nonpublic entity operates
nor the size of the entity. The volatility of an index of smaller software entities would be a more
appropriate substitute for the entity’s expected volatility of its own share price.
Under ASC 718-10-55-58, an entity that uses an industry sector index to determine the expected
volatility of its own share price must use the index’s historical volatility (rather than its implied volatility).
However, ASC 718-10-55-56 states that “in no circumstances shall a nonpublic entity use a broad-based
market index like the S&P 500, Russell 3000, or Dow Jones Wilshire 5000” (emphasis added).
A nonpublic entity’s conclusion that estimating the expected volatility of its
own share price is not practicable may be subject to scrutiny. We would
typically expect a nonpublic entity that can identify an appropriate
industry sector index would be able to identify similar entities from
the selected index to estimate the expected volatility of its own share
price and would therefore be required to use the fair-value-based
measurement method.
In measuring awards, a nonpublic entity should switch from using a calculated
value to using a fair-value-based measure when it (1) can subsequently
estimate the expected volatility of its own share price or (2) becomes a
public entity. ASC 718-10-55-27 states that the “valuation technique an
entity selects [should] be used consistently and [should] not be changed
unless a different valuation technique is expected to produce a better
estimate” of a fair-value-based measure (or, in this case, a change to a
fair-value-based measure). The guidance goes on to state that a change
in valuation technique should be accounted for as a change in accounting
estimate under ASC 250 and should be applied prospectively to new
awards.6 Therefore, for existing equity-classified awards (i.e., unvested
equity awards that were granted before an entity switched from the
calculated value method to a fair-value-based measure), an entity would
continue to recognize compensation cost on the basis of the calculated
value determined as of the grant date unless the award is subsequently
modified. An entity should use the fair-value-based method to measure
all awards granted after it switches from the calculated value
method.
ASC 718-20-55-76 through 55-83 provide an example of when it may be appropriate for a nonpublic
entity to use the calculated value method.
5.8.1.1.3 Intrinsic Value
Nonpublic entities can make a policy election to measure all
liability-classified awards (not including awards determined to be
consideration payable to a customer) at intrinsic value (instead of at
their fair-value-based measure or calculated value) as of the end of
each reporting period until the award is settled. However, it is
preferable for an entity to use the fair-value-based method to justify a
change in accounting principle under ASC 250. Therefore, a nonpublic
entity that has elected to measure its liability-classified awards at a
fair-value-based measure (or calculated value) would not be permitted to
subsequently change to the intrinsic-value method.
ASC 718-30-55-12 through 55-20 illustrate the application of the intrinsic value
method for liability-classified awards granted by a nonpublic
entity.
5.8.1.1.4 Cheap Stock
The SEC often focuses on “cheap stock”7 issues in connection with a nonpublic entity’s preparation for an
IPO. The SEC staff is interested in the rationale for any difference
between the fair value measurements of the underlying common stock of
share-based payment awards and the anticipated IPO price. In addition,
the SEC staff will challenge valuations that are significantly lower
than prices paid by investors to acquire similar stock. If the
differences cannot be reconciled, a nonpublic entity may be required to
record a cheap-stock charge. Since share-based payments are often a
compensation tool to attract and retain employees and nonemployees, a
cheap-stock charge could be material and, in some cases, lead to a
restatement of the financial statements.
An entity preparing for an IPO should refer to paragraph 7520.1 of the FRM, which outlines
considerations registrants should take into account when the “estimated fair value of the stock is
substantially below the IPO price.” In such situations, registrants should be able to reconcile the change
in the estimated fair value of the underlying equity between the award grant date and the IPO by taking
into account, among other things, intervening events and changes in assumptions that support the
change in fair value.
The SEC staff has frequently inquired about a
registrant’s pre-IPO valuations. Specifically, during the registration
statement process, the SEC staff may ask an entity to (1) reconcile its
recent fair values with the anticipated IPO price, (2) describe its
valuation methods, (3) justify its significant valuation assumptions,
and (4) discuss the weight it gives to stock sale transactions. We
encourage entities planning an IPO in the foreseeable future to use the
AICPA Valuation Guide and to consult with their valuation specialists.
Further, such entities should ensure that their pre-IPO valuations are
appropriate and that they are prepared to respond to questions the SEC
may have during the registration statement process. For further
discussion of disclosures related to cheap stock, see Section
5.8.4.1.
The AICPA Valuation Guide highlights differences between pre-IPO and post-IPO
valuations. One significant difference is that the valuation of
nonpublic-entity securities often includes a discount for lack of
marketability (DLOM). The DLOM can be determined by using several
valuation techniques and is significantly affected by the underlying
volatility of the stock and the period in which the stock is
illiquid.
In addition to considerations related to cheap stock, entities commonly face
issues caused by obtaining independent valuations infrequently, because
the dates of those valuations do not always coincide with the grant
dates for share-based payment awards. As a result, management will need
to assess the current fair value of the underlying shares as of the
grant date. Further, an entity could evaluate the use of an
interpolation or extrapolation framework to estimate the fair value of
the underlying shares when equity is granted (1) on dates between two
independent valuations or (2) after the date of an independent
valuation. For details on interpolation and extrapolation methods,
including examples, see Chapter 4.12.4 of Deloitte’s Roadmap Share-Based Payment Awards.
5.8.1.1.5 Internal Revenue Code Section 409A
When granting share-based payment awards, a nonpublic
entity should be mindful of the tax treatment of such awards and the
related implications. IRC Section 409A contains requirements related to
nonqualified deferred compensation plans that can affect the taxability
of holders of share-based payment awards. If a nonqualified deferred
compensation plan (e.g., one issued in the form of share-based payments)
fails to comply with certain IRC rules, the tax implications and
penalties at the federal level (and potentially the state level) can be
significant for holders.
Under U.S. tax law, stock option awards can generally be
categorized into two groups:
- Statutory options, including incentive stock options (ISOs) and ESPPs that are qualified under IRC Sections 422 and 423, respectively. The exercise of an ISO or a qualified ESPP does not result in a tax deduction for the issuing entity unless the employee or former employee makes a disqualifying disposition. While an ISO may result in favorable tax treatment for the recipient, certain eligibility conditions must be met.
- Nonstatutory options, also known as NQSOs or NSOs. The exercise of an NQSO results in a tax deduction for the issuing entity that is equal to the intrinsic value of the option when exercised.
The ISOs and ESPPs described in IRC Sections 422 and
423, respectively, are specifically exempt from the requirements of IRC
Section 409A. Other NQSOs are outside the scope of IRC Section 409A if
certain requirements are met. One significant requirement is that the
exercise price must not be below the fair market value of the underlying
stock as of the grant date. Accordingly, it is imperative to establish a
supportable fair market value of the stock to avoid unintended tax
consequences to the issuer and holder. While IRC Section 409A also
applies to public entities, the valuation of share-based payment awards
for such entities is subject to less scrutiny because the market prices
of their shares are generally observable. Among other details, entities
should understand (1) which of their compensation plans and awards are
subject to the provisions of IRC Section 409A and (2) how they can
ensure that those plans and awards remain compliant with IRC Section
409A and thereby avoid unintended tax consequences of noncompliance.
A company’s failure to comply with the requirements in IRC Section 409A
related to nonqualified deferred compensation plans may affect how the
fair value of existing and future share-based compensation is determined
and how those awards are taxed. Specifically, if the form and operation
of compensation arrangements do not comply with the requirements in IRC
Section 409A, service providers will be required to include the
compensation in their taxable income sooner than they would need to
under general tax rules (e.g., vesting as opposed to exercise of an
option) and service providers will be subject to an additional 20
percent federal income tax plus interest on the amount included in their
taxable income. Although the tax is imposed on the individuals receiving
the compensation, in certain instances, an entity may decide to pay the
additional tax liabilities on behalf of its employees. Among IRC Section
409A’s many requirements, valuation of the stock on the grant date is
critical, and grantees should establish the fair market value of their
shares to ensure compliance. Both nonqualified and statutory options are
subject to IRC Section 409A unless they otherwise meet its criteria for
treatment as exempt stock rights. It is important for an entity to
consult with tax advisers regarding the tax effects of both existing and
planned share-based compensation plans to determine whether it is
subject to the requirements in IRC Section 409A or other IRC
sections.
In addition, when recognizing compensation cost, many
nonpublic entities use IRC Section 409A assessments to value share-based
payments. Because those assessments are used for tax purposes, nonpublic
entities should carefully consider whether they are also appropriate for
measuring share-based payment awards under ASC 718.
See Chapter 10 of Deloitte’s Roadmap Income
Taxes for a discussion of the income tax effects of
share-based payments.
5.8.1.1.6 Purchase of Shares From Grantees
To provide liquidity or for other reasons, entities may
sometimes repurchase vested common stock from their share-based payment
award grantees. In some cases, the price paid for the shares exceeds
their fair value at the time of the transaction, and the excess would
generally be recognized as additional compensation cost in accordance
with ASC 718-20-35-7. In addition, an entity’s practice of repurchasing
shares, or an arrangement that permits repurchase, could affect the
classification of share-based payment awards.
On occasion, existing investors (such as private equity
or venture capital investors) intending to increase their stake in an
emerging nonpublic entity may undertake transactions with other
shareholders in connection with or separately from a recent financing
round. These transactions may include the purchase of shares of common
or preferred stock by investors from the founders of the nonpublic
entity or other individuals who are also considered employees. Because
the transactions are between grantees of the nonpublic entity and
existing shareholders and are related to the transfer of outstanding
shares, the nonpublic entity may not be directly involved in them
(though it may be indirectly involved by facilitating the exchange or
not exercising a right of first refusal). If the price paid for the
shares exceeds their fair value at the time of the transaction, it may
be difficult to demonstrate that the transaction is not compensatory,
and the nonpublic entity would most likely be required to recognize
compensation cost for the excess, even if the entity is not directly
involved in the transaction. It is important for a nonpublic entity to
recognize that such a transaction may be subject to the guidance in ASC
718 because the investors are considered holders of an economic interest
in the entity.
Although the presumption in such transactions is that
any consideration in excess of the fair value of the shares is
compensation paid to employees, under ASC 718, an entity should consider
whether the amount paid is related to an existing relationship or to an
obligation that is unrelated to the employees’ services to the entity in
assessing whether the payment is “clearly for a purpose other than
compensation for goods or services to the reporting entity.” Although it
is difficult to demonstrate that a non–fair value transaction with
employees is clearly for other purposes, AIN-APB 25 (superseded by FASB Statement 123(R)) describes situations in which doing so may be
possible, including the following:
- “[T]he relationship between the stockholder and the corporation’s employee is one which would normally result in generosity (i.e., an immediate family relationship).”
- “[T]he stockholder has an obligation to the employee which is completely unrelated to the latter’s employment (e.g., the stockholder transfers shares to the employee because of personal business relationships in the past, unrelated to the present employment situation).”
In all situations, the determination of whether a
transaction should be accounted for under ASC 718 should be based on an
entity’s specific facts and circumstances.
In addition, there may be situations in which, as part of a financing
transaction between a nonpublic entity and a new investor that is
acquiring a significant ownership interest in the nonpublic entity, the
new investor purchases common shares in the nonpublic entity from
employees of the nonpublic entity. For example, the investor may not
have participated in a prior financing arrangement and may be purchasing
convertible preferred stock from the nonpublic entity and common stock
from the nonpublic entity’s existing employees. In this scenario, the
investor pays the same price to purchase the preferred stock from the
nonpublic entity and the common stock from the employees. While it did
not hold an economic interest before entering into the transaction with
the nonpublic entity, the new investor is not unlike a party that
already holds such an interest and may be similarly motivated to
compensate employees.
As noted in ASC 718-10-15-4, a share-based payment arrangement between
the holder of an economic interest in a nonpublic entity and an employee
of the nonpublic entity should be accounted for under ASC 718 unless the
arrangement “is clearly for a purpose other than compensation for goods
or services.” If a new investor purchases common stock valued at an
amount based on the value of the preferred stock, we would generally
expect the analysis to be similar to that performed by a preexisting
investor that purchases common stock from a nonpublic entity’s
employees.
Shares purchased from grantees by a related party or an economic interest
holder may include shares that have been vested (or have been issued as
a result of the exercise of options) for less than six months (i.e., the
shares are considered immature). We do not believe that a reporting
entity would generally consider a history of investor purchases of
immature shares from grantees (regardless of whether such purchases are
at fair value or at an amount that exceeds fair value) when assessing
whether it has established a past practice of settling immature shares
that results in a substantive liability. Generally, if the reporting
entity otherwise classifies the shares as equity, purchases of such
shares by the related party or economic interest holder do not satisfy a
liability on the reporting entity’s behalf. Rather, the purchaser (often
through a tender offer to grantees that is, in part, organized by the
reporting entity) is making an investment decision to establish or
increase its ownership interest in the reporting entity and therefore is
the party making a payment as the principal in the purchase transaction
with grantees. Accordingly, a related party or an economic interest
holder that directly makes such a purchase from grantees would not
change the substantive terms of the share-based payment arrangement that
requires the reclassification of the shares from equity to a
liability.
See Sections 5.6 and 6.10 of Deloitte’s Roadmap
Share-Based
Payment Awards for additional discussion of how
an entity’s past practice affects the classification of share-based
payment awards.
5.8.1.2 Valuation Considerations for Public Entities
5.8.1.2.1 SAB Topic 14, “Share-Based Payment”
The SEC issued SAB Topic
14 (codified in ASC 718-10-S99-1) to “assist issuers
in their application of FASB ASC Topic 718 and enhance the information
received by investors and other users of financial statements.” SAB
Topic 14 contains interpretive guidance related to share-based payment
transactions (e.g., guidance on the transition from nonpublic-entity to
public-entity status and valuation methods, including assumptions such
as expected volatility and expected term).
In November 2021, the SEC staff issued Staff Accounting
Bulletin (SAB) No. 120, which provides the SEC staff’s views on the
measurement and disclosure of certain share-based payment awards granted
when entities possess material nonpublic information (i.e.,
“spring-loaded” awards). In SAB 120, the SEC staff describes a
spring-loaded award as follows:
A share-based
payment award granted when a company is in possession of material
nonpublic information to which the market is likely to react
positively when the information is announced is sometimes referred
to as being “spring-loaded.”
Under the SAB, an entity that grants a share-based
payment award while in possession of positive material nonpublic
information should consider whether adjustments to the following are
appropriate when determining the fair-value-based measure of the award:
(1) the current price of the underlying share or (2) the expected
volatility of the price of the underlying share for the expected term of
the share-based payment award.
5.8.1.2.2 Transition From Nonpublic-Entity to Public-Entity Status
The measurement alternatives available to a nonpublic entity (calculated value
and intrinsic value) are no longer appropriate once the entity is
considered a public entity.8 In addition, the practical expedient related to determining the
expected term of certain options and similar instruments is used
differently by public entities than it is by nonpublic entities. To
estimate the expected term as a midpoint between the requisite service
period and the contractual term of an award, entities will need to
comply with the requirements of the SEC’s simplified method. The
simplified method is described in further detail in Section
5.8.1.2.3.1.
In SAB Topic 14.B, the SEC discusses various transition issues associated with valuing share-based payment awards related to an entity’s becoming public (e.g., when the entity files its initial registration statement with the SEC), including the following:
- If a nonpublic entity historically measured equity-classified share-based payment awards at their calculated value, the new public entity should continue to use that approach for share-based payment awards granted before the date it becomes a public entity unless those awards are subsequently modified, repurchased, or canceled.
- If a nonpublic entity historically measured liability-classified share-based payment awards on the basis of their intrinsic value and the awards are still outstanding, the new public entity should measure those liability awards at a fair-value-based measurement upon becoming a public entity.
- Upon becoming a public entity, the entity is prohibited from retrospectively applying the fair-value-based measurement to its awards if it used calculated value or intrinsic value before the date it became a public entity.
- Upon becoming a public entity, the entity should clearly describe in its MD&A the change in accounting policy that will be required by ASC 718 in subsequent periods and any reasonably likely material future effects of the change.
The SEC’s guidance does not address how an entity should account for a change from the intrinsic
value method for measuring liability-classified awards to the fair-value-based method. In informal
discussions, the SEC staff indicated that it would be acceptable to record the effect of such a change
as compensation cost in the current period or to record it as the cumulative effect of a change in
accounting principle in accordance with ASC 250. While the preferred approach is to treat the effect of
the change as a change in accounting principle under ASC 250, with the cumulative effect of the change
recorded accordingly, recording it as compensation cost is not objectionable given the SEC’s position.
Under either approach, entities’ financial statements should include the appropriate disclosures.
ASC 250-10-45-5 states that an “entity shall report a change in accounting principle through
retrospective application of the new accounting principle to all prior periods, unless it is impracticable
to do so.” Retrospective application of the effects of a change from intrinsic value to fair value would
be impracticable because objectively determining the assumptions an entity would have used for the
prior periods would be difficult without the use of hindsight. Therefore, the change would be recorded
as a cumulative-effect adjustment to retained earnings and applied prospectively, as discussed in ASC
250-10-45-6 and 45-7. This conclusion is consistent with the guidance in SAB Topic 14.B that states
that entities changing from nonpublic to public status are not permitted to apply the fair-value-based
method retrospectively.
5.8.1.2.3 Valuation Assumptions
The sections below discuss three significant share-based compensation valuation
assumptions addressed in SAB Topic 14.D, including
those related to expected, expected volatility, and the current price of
the underlying share.
5.8.1.2.3.1 Expected Term
ASC 718-10-55-30 states, in part:
The expected term of an employee share option or similar instrument is the period of time for which the
instrument is expected to be outstanding (that is, the period of time from the service inception date to the date
of expected exercise or other expected settlement).
Although ASC 718 does not specify a method for estimating the expected term of
an award, such a method must be objectively supportable. Similarly,
historical observations should be accompanied by information about
why future observations are not expected to change, and any
adjustments to these observations should be supported by objective
data. ASC 718-10-55-31 identifies the following factors an entity
may consider in estimating the expected term of an award:
- The vesting period of the award — Options generally cannot be exercised before vesting; thus, an option’s expected term cannot be less than its vesting period.
- Historical exercise and postvesting employment termination behavior for similar grants — Historical experience should be an entity’s starting point for determining expectations of future exercise and postvesting termination behavior. Historical exercise patterns should be modified when current information suggests that future behavior will differ from past behavior. For example, rapid increases in an entity’s stock price after the release of a new product in the past could have caused more grantees to exercise their options as soon as the options vested. If a similar increase in the entity’s stock price is not expected, the entity should consider whether adjusting the historical exercise patterns is appropriate.
- Expected volatility of the underlying share price — An increase in the volatility of the underlying share price tends to result in an increase in exercise activity because more grantees take advantage of increases in an entity’s share price to realize potential gains on the exercise of the option and subsequent sale of the underlying shares. ASC 718-10-55-31(c) states, “An entity also might consider whether the evolution of the share price affects [a grantee’s] exercise behavior (for example, [a grantee] may be more likely to exercise a share option shortly after it becomes in-the-money if the option had been out-of-the-money for a long period of time).” The exercise behavior based on the evolution of an entity’s share price can be more easily incorporated into a lattice model than into a closed-form model.
- Blackout periods — A blackout period is a period during which exercise of an option is contractually or legally prohibited. Blackout periods and other arrangements that affect the exercise behavior associated with options can be included in a lattice model. Unlike a closed-form model, a lattice model can be used to calculate the expected term of an option by taking into account restrictions on exercises and other postvesting exercise behavior.
- Employees’ ages, lengths of service, and home jurisdictions — Historical exercise information could have been affected by the profile of the employee group. For example, during a bull market, some entities are more likely to have greater turnover of employees since more opportunities are available. Many such employees will exercise their options as early as possible. These historical exercise patterns should be adjusted if similar turnover rates are not expected to recur in the future.
If historical exercise and postvesting employment termination behavior are not
readily available or do not provide a reasonable basis on which to
estimate the expected term, alternative sources of information may
be used. For example, an entity may use a lattice model to estimate
the expected term (the expected term is not an input in the lattice
model but rather is inferred on the basis of the output of the
lattice model). In addition, an entity may consider using other
relevant and supportable information such as industry averages or
published academic research. When an entity takes external peer
group information into account, there should be evidence that such
information has been sourced from entities with comparable facts and
circumstances. Further, entities may use practical expedients to
estimate the expected term for certain awards. Question 6 of
SAB Topic
14.D.2 notes that if a public entity concludes
that “its historical share option exercise experience does not
provide a reasonable basis upon which to estimate expected term,”
the entity may use what the SEC staff describes as a “simplified
method” to develop the expected-term estimate. Under the simplified
method, the public entity uses an average of the vesting term and
the original contractual term of an award. The method applies only
to awards that qualify as “plain-vanilla” options.
As discussed above, an entity measures stock options
under ASC 718 by using an expected term that takes into account the
effects of grantees’ expected exercise and postvesting behavior.
However, determining an expected term for nonemployee awards could
be challenging because entities may not have sufficient historical
data related to the early exercise behavior of nonemployees,
particularly if nonemployee awards are not frequently granted. In
addition, nonemployee stock option awards may not be exercised
before the end of the contractual term if they do not contain
certain features typically found in employee stock option awards
(e.g., nontransferability, nonhedgeability, and truncation of the
contractual term because of postvesting service termination).
Accordingly, ASC 718 allows an entity to elect on an award-by-award
basis to use the contractual term as the expected term for
nonemployee awards. If an entity elects not to use the contractual
term for a particular award, the entity must estimate the expected
term. However, a nonpublic entity can make an accounting policy
election to apply a practical expedient to estimate the expected
term for awards that meet the conditions in ASC 718-10-30-20B (see
discussion in Section 9.4.2.1 of Deloitte’s Roadmap Share-Based Payment
Awards). In accordance with ASC
718-10-55-29A, if an entity does not elect to use the contractual
term as the expected term for a particular award and, for a
nonpublic entity, does not apply the practical expedient to estimate
the expected term, the entity should consider factors similar to
those in ASC 718-10-55-29 when estimating the expected term for
nonemployee awards.
As the SEC states in SAB Topic 14.D.2, the simplified method applies only to
awards that qualify as plain-vanilla options. A share-based payment
award must possess all of the following characteristics to qualify
as a plain-vanilla option:
- “The share options are granted at-the-money.”
- “Exercisability is conditional only on performing service through the vesting date” (i.e., the requisite service period equals the vesting period).
- “If an employee terminates service prior to vesting, the employee would forfeit the share options.”
- “If an employee terminates service after vesting, the employee would have a limited time to exercise the share options (typically 30–90 days).”
- “The share options are nontransferable and nonhedgeable.”
If an award has a performance or market condition, it would not be considered a
plain-vanilla option. Entities should evaluate all awards to
determine whether they qualify as plain-vanilla options.
The SEC staff believes that public entities should stop using the simplified
method for stock option grants if more detailed external information
about exercise behavior becomes available. In addition, the staff
issues comments related to the use of the simplified method and, in
certain instances, registrants have been asked to explain why they
believe that they were unable to reasonably estimate the expected
term on the basis of their historical stock option exercise
information.
In accordance with the SEC’s guidance in Question 6 of SAB Topic 14.D.2, a
registrant that uses the simplified method should disclose in the
notes to its financial statements (1) that the simplified method was
used, (2) the reason the method was used, (3) the types of stock
option grants for which the simplified method was used if it was not
used for all stock option grants, and (4) the period(s) for which
the simplified method was used if it was not used in all periods
presented.
5.8.1.2.3.2 Expected Volatility
ASC 718-10-55-36 states, in part:
Volatility is a measure of the amount by which a financial variable, such as share price, has fluctuated (historical
volatility) or is expected to fluctuate (expected volatility) during a period. Option-pricing models require
expected volatility as an assumption because an option’s value is dependent on potential share returns over
the option’s term. The higher the volatility, the more the returns on the shares can be expected to vary — up or
down.
ASC 718 does not require entities to use a single method for estimating the
expected volatility of the underlying share price; rather, ASC
718-10-55-35 states that the objective of estimating such volatility
is “to determine the assumption about expected volatility that
marketplace participants would be likely to use in determining an
exchange price for an option.” ASC 718-10-55-37 lists factors that
entities would consider in estimating the expected volatility of the
underlying share price. The method selected to perform the
estimation should be applied consistently from period to period, and
entities should adjust the factors or assign more weight to an
individual factor only on the basis of objective information that
supports such adjustments. The interpretive response to Question 1
of SAB Topic
14.D.1 notes that entities should incorporate
into the estimate any relevant new or different information that
would be useful. Further, they should “make good faith efforts to
identify and use sufficient information in determining whether
taking historical volatility, implied volatility or a combination of
both into account will result in the best estimate of expected
volatility” of the underlying share price.
- Historical volatility of the underlying
share price — Entities typically value stock options
by using the historical volatility of the underlying share
price. Under a closed-form model, such volatility is based
on the most recent volatility of the share price over the
expected term of the option; under a lattice model, it is
based on the contractual term. ASC 718-10-55-37(a) states
that an entity may disregard the volatility of the share
price for an identifiable period if the volatility resulted
from a condition (e.g., a failed takeover bid) specific to
the entity and the condition “is not expected to recur
during the expected or contractual term.” If the condition
is not specific to the entity (e.g., general market
declines), the entity generally would not be allowed to
disregard or place less weight on the volatility of its
share price during that period unless objectively verifiable
evidence supports the expectation that market volatility
will revert to a mean that will differ materially from the
volatility during the specified period. The SEC staff
believes that an entity’s decision to disregard a period of
historical volatility should be based on one or more
discrete and specific historical events that are not
expected to occur again during the term of the option. In
addition, the entity should not give recent periods more
weight than earlier periods.In certain circumstances, an entity may rely exclusively on historical volatility. However, because the objective of estimating expected volatility is to ascertain the assumptions that marketplace participants are likely to use, exclusive reliance may not be appropriate if there are future events that could reasonably affect expected volatility (e.g., a future merger that was recently announced). In addition, an entity that is valuing a spring-loaded award would consider whether it should factor material nonpublic information into its determination of historical volatility.
- Implied volatility of the underlying
share price — The implied volatility of the
underlying share price is not the same as the historical
volatility of the underlying share price because it is
derived from the market prices of an entity’s traded options
or other traded financial instruments with option-like
features and not from the entity’s own shares. Entities can
use the Black-Scholes-Merton formula to calculate implied
volatility by including the fair value of the option (i.e.,
the market price of the traded option) and other inputs
(stock price, exercise price, expected term, dividend rate,
and risk-free interest rate) in the calculation and solving
for volatility. When valuing employee or nonemployee stock
options, entities should carefully consider whether the
implied volatility of a traded option is an appropriate
basis for the expected volatility of the underlying share
price. For example, traded options usually have much shorter
terms than employee or nonemployee stock options, and the
calculated implied volatility may not take into account the
possibility of mean reversion. To compensate for mean
reversion, entities use statistical tools for calculating a
long-term implied volatility. For example, entities with
traded options whose terms range from 2 to 12 months can
plot the volatility of these options on a curve and use
statistical tools to plot a long-term implied volatility for
a traded option with an expected or a contractual term equal
to an employee or nonemployee stock option. Generally, entities that can observe sufficiently extensive trading of options and can therefore plot an accurate long-term implied volatility curve should place greater weight on implied volatility than on the historical volatility of their own share price (particularly if they do not meet the SEC’s conditions for relying exclusively on historical volatility). That is, a traded option’s volatility is more informative in the determination of expected volatility of an entity’s stock price than historical stock price volatility, since option prices take into account the option trader’s forecasts of future stock price volatility. In determining the extent of reliance on implied volatility, an entity should consider the volume of trading in its traded options and its underlying shares, the ability to synchronize the variables used to derive implied volatility (as close to the grant date of employee or nonemployee stock options as reasonably practicable), the similarity of the exercise prices of its traded options to its employee and nonemployee stock options, and the length of the terms of its traded options and employee or nonemployee stock options. In addition, an entity that is valuing a spring-loaded award would consider whether material nonpublic information affects the extent of reliance on implied volatility when estimating the expected volatility.
- Limitations on availability of
historical data — Public entities should compare the
length of time an entity’s shares have been publicly traded
with the expected or contractual term of the option. A newly
public entity may also consider the expected volatility of
the share prices of similar public entities. In determining
comparable public entities, the newly public entity would
consider factors such as industry, stage of life cycle,
size, and financial leverage.Nonpublic entities may also base the expected volatility of their share prices on the expected volatility of similar public entities’ share prices, and they may consider the same factors as those described above for a newly public entity. When a nonpublic entity is unable to reasonably estimate its entity-specific volatility or that of similar public entities, it may use a calculated value.
- Data intervals — An entity that considers the historical volatility of its share price when estimating the expected volatility of its share price should use intervals for price observations that (1) are appropriate on the basis of its facts and circumstances (e.g., given the frequency of its trades and the length of its trading history) and (2) provide a basis for a reasonable estimate of a fair-value-based measure. Daily, weekly, or monthly price observations may be sufficient; however, if an entity’s shares are thinly traded, weekly or monthly price observations may be more appropriate than daily price observations.
- Changes in corporate and capital structure — An entity’s corporate and capital structure could affect the expected volatility of its share price (e.g., share price volatility tends to be higher for highly leveraged entities). In estimating expected volatility, an entity should take into account significant changes to its corporate and capital structure, since the historical volatility of a share price for a period in which the entity was, for example, highly leveraged may not represent future periods in which the entity is not expected to be highly leveraged (or vice versa).
The SEC staff believes entities that have appropriate traded financial instruments from which they can
derive an implied volatility should generally consider this measure. Further, depending on the extent
to which these financial instruments are actively traded, more reliance or exclusive reliance on implied
volatility may be appropriate because implied volatility reflects market expectations of future volatility.
SAB Topic 14.D.1 also addresses circumstances in which it is acceptable to rely exclusively on either
historical volatility or implied volatility. To rely exclusively on historical volatility, an entity must:
- Have “no reason to believe that its future volatility over the expected or contractual term, as applicable, is likely to differ from its past.”
- Perform the computation by using a “simple average calculation method.”
- Use a “sequential period of historical data at least equal to the expected or contractual term . . . , as applicable.”
- Apply “[a] reasonably sufficient number of price observations . . . , measured at a consistent point throughout the applicable historical period.”
- Consistently apply this approach.
To rely exclusively on implied volatility, an entity must:
- Use a valuation model for employee stock options “that is based upon a constant volatility assumption.”
- Derive the implied volatility from “options that are actively traded.”
- Measure the “market prices (trades or quotes) of both the traded options and underlying shares at a similar point in time to each other and on a date reasonably close to the fair value measurement date of the share options.”
- Use traded options whose (1) exercise prices “are both . . . near-the-money and . . . close to the exercise price of the share options” and (2) “remaining maturities . . . are at least one year.”
- Ensure “material nonpublic information that would be considered in a marketplace participant’s expectation of future volatility does not exist.”
- Consistently apply this approach.
If an entity is newly public or nonpublic, it may have limited historical data and no other traded financial
instruments from which to estimate expected volatility. In such cases, as discussed in the SEC guidance
in SAB Topic 14.D.1, it may be appropriate for the entity to base its estimate of expected volatility on the
historical, expected, or implied volatility of comparable entities.
Further, when valuing spring-loaded awards, an entity needs to
determine whether a marketplace participant would consider the
material nonpublic information when estimating expected volatility.
Material nonpublic information may affect the extent of reliance on
implied volatility and may need to be factored into the
determination of implied and historical volatility.
5.8.1.2.3.3 Current Price of the Underlying Share
Under SAB 120, an entity that grants a share-based
payment award while in possession of positive material nonpublic
information should consider whether adjustments to the current price
of the underlying share are appropriate when determining the
fair-value-based measure of the award. Any adjustments required as a
result of the SAB would be related only to the determination of a
fair-value-based measure in accordance with ASC 718 and would not
extend to the determination of fair value under ASC 820.
In SAB 120, the SEC staff acknowledges that entities
should use significant judgment when determining whether an
adjustment to the observable market price is necessary. The SAB
notes that it is not uncommon for entities to possess nonpublic
information when entering into share-based payment transactions and
that an observable market price on the grant date is “generally a
reasonable and supportable estimate of the current price of the
underlying share in a share-based payment transaction, for example,
when estimating the grant-date fair value of a routine annual grant
to employees that is not designed to be spring-loaded.” However, the
SAB does not limit an entity’s consideration of grants to those that
are nonroutine. Therefore, an entity should have policies and
procedures in place so that it can identify when a grant is
spring-loaded in nature.
5.8.2 Other Pre-IPO Issues
5.8.2.1 Repurchase Features
Because a nonpublic entity’s common stock is not publicly traded, share-based
payment awards often include repurchase features related to the underlying
stock to provide grantees with liquidity and to limit the number of holders
of stock before an IPO. These features typically are in the form of a (1)
call right, in which a nonpublic entity has the right (but not the
obligation) to repurchase stock from a grantee for cash, or (2) put right,
which gives the grantee the right to require the nonpublic entity to
repurchase the stock for cash. The repurchase price associated with the call
and put options can vary (e.g., fair value, fixed amount, cost, formula
value). In addition, repurchase features often expire or are otherwise
eliminated upon an IPO (i.e., when the underlying stock is liquid). An
entity should evaluate repurchase features to determine whether they affect
the classification of share-based payment awards as either a liability or
equity award.
ASC 718-10
25-9 Topic 480 does not apply
to outstanding shares embodying a conditional
obligation to transfer assets, for example, shares
that give the grantee the right to require the
grantor to repurchase them for cash equal to their
fair value (puttable shares). A put right may be
granted to the grantee in a transaction that is
related to a share-based compensation arrangement.
If exercise of such a put right would require the
entity to repurchase shares issued under the
share-based compensation arrangement, the shares
shall be accounted for as puttable shares. A
puttable (or callable) share awarded to a grantee as
compensation shall be classified as a liability if
either of the following conditions is met:
- The repurchase feature permits the grantee to avoid bearing the risks and rewards normally associated with equity share ownership for a reasonable period of time from the date the good is delivered or the service is rendered and the share is issued. A grantee begins to bear the risks and rewards normally associated with equity share ownership when all the goods are delivered or all the service has been rendered and the share is issued. A repurchase feature that can be exercised only upon the occurrence of a contingent event that is outside the grantee’s control (such as an initial public offering) would not meet this condition until it becomes probable that the event will occur within the reasonable period of time.
- It is probable that the grantor would prevent the grantee from bearing those risks and rewards for a reasonable period of time from the date the share is issued.
For this purpose, a period of six
months or more is a reasonable period of time.
An award with a call right is classified as a liability if it is probable that
the employer would prevent the grantee from bearing the risks and rewards of
equity ownership for at least six months from the date the good is delivered
or the requisite service is rendered and the share is issued or issuable.
Similarly, an award with a put right is classified as a liability if it
permits a grantee to avoid bearing the risks and rewards of equity ownership
for at least six months from the date the good is delivered or the requisite
service is rendered and the share is issued or issuable. Unlike a call
right, the probability that a put right will be exercised is generally not
considered (i.e., exercise is generally assumed).
The classification analysis could be complex and depends on whether the
repurchase price is at fair value or another amount. If the repurchase price
is not at fair value, the six-month holding period is not relevant, and the
repurchase feature should generally be considered for as long as it is
outstanding. Additional analysis is required, but the award is generally
classified as a liability until the repurchase feature expires since it is
generally probable that a call feature allowing the entity to repurchase
stock at a price that is below fair value or potentially below fair value
will be exercised. In addition, repurchase features are often exercisable
only upon the occurrence of a specified future event (i.e., a triggering
event), such as termination of employment. While the probability of the
triggering event is analyzed in the determination of the appropriate
classification, if the triggering event is within the grantee’s control
(e.g., voluntary termination) and is related to a put right, that triggering
event is generally ignored. See Section 5.3 of Deloitte’s Roadmap
Share-Based Payment
Awards for considerations related to the impact of
repurchase features on the classification of share-based payment awards.
For put rights, an entity undergoing an IPO must consider the requirements of
ASC 480-10-S99-3A and SAB Topic 14.E. SAB Topic 14.E requires that an SEC
registrant present share-based payment awards (otherwise classified as
equity) subject to redemption features not solely within the control of the
issuer as temporary (or “mezzanine”) equity. Classification in temporary
equity is required even if the awards qualify for equity classification
under ASC 718 (e.g., an award that is contingently puttable by the grantee
at the then-current fair value more than six months after vesting or share
issuance). Puttable awards classified as temporary equity should be
recognized at their redemption value over the requisite service period or
nonemployee’s vesting period. Such awards are remeasured at the end of each
reporting period unless exercise is contingent on an event whose occurrence
is not probable.
5.8.2.2 Substantive Classes of Equity
Nonpublic entities (often limited partnerships or limited liability companies)
may grant special classes of equity, frequently referred to as “profits
interests.” In many cases, a waterfall calculation is used to determine the
payout to the different classes of shares or units. While arrangements vary,
the waterfall calculation is often performed to allocate distributions and
proceeds to the profits interests only after specified amounts (e.g.,
multiple of invested capital) or specified returns (e.g., internal rate of
return [IRR] on invested capital) are first allocated to the other classes
of equity. In addition, future profitability threshold amounts, or
“hurdles,” must be cleared before the grantee receives distributions so
that, for tax purposes on the grant date, the award has zero liquidation
value. However, for accounting purposes, the award would have a fair value
in accordance with ASC 718. In certain cases, distributions on and
realization of value from profits interests are expected only from the
proceeds from a liquidity event such as a sale or IPO of the entity,
provided that the sale or IPO exceeds a target hurdle rate.
While the legal and economic form of these awards can vary, they should be
accounted for on the basis of their substance. If an award has the
characteristics of an equity interest, it represents a substantive class of
equity and should be accounted for under ASC 718; however, an award that is,
in substance, a performance bonus or a profit-sharing arrangement would be
accounted for as such in accordance with other U.S. GAAP (e.g., typically
ASC 710 and ASC 450 for employee arrangements).
In a speech at the 2006 AICPA Conference on Current SEC and
PCAOB Developments, Joseph Ucuzoglu, then a professional accounting fellow
in the SEC’s Office of the Chief Accountant, discussed the SEC staff’s
observations related to special classes of equity and associated financial
reporting considerations. Specifically, he stated:
Public companies often create special classes of
stock to more closely align the compensation of an employee with the
operating performance of a portion of the business with which he or
she has oversight responsibility. That is, rather than granting an
equity interest in the parent company, employees are granted
instruments whose value is based predominantly on the operations of
a particular subset of the parent’s operations. The staff has
observed the use of these arrangements in diverse industries,
ranging from the grant of an interest in a group of restaurants that
an employee oversees, to the grant of an interest in a particular
investment fund that an employee manages.
Similarly, pre-IPO companies often create special
classes of stock to provide employees with an opportunity to
participate in any appreciation realized through a future initial
public offering or sale of the company, with limited opportunity for
gain if no liquidity event occurs. In order to accomplish this
objective, the special class is often subordinate in both dividend
rights and liquidation preference to the company’s main class of
stock, and may have little or no claim to the underlying net assets
of the company. In many cases, the terms of these instruments
mandate conversion into the entity’s main class of common stock upon
the completion of an IPO.
Several accounting issues arise when a special class
of stock is granted to employees. First and foremost, one must look
through the legal form of the instrument to determine whether the
instrument is in fact a substantive class of equity for accounting
purposes, or is instead similar to a performance bonus or profit
sharing arrangement. When making this determination, all relevant
features of the special class must be considered. There are no bright lines or litmus tests. When few if any assets underlie the special class, or the holder’s claim to those assets is heavily subordinated, the arrangement often has characteristics of a performance bonus or profit-sharing arrangement. Instruments that provide the holder with substantive voting rights and pari passu dividend rights are at times indicative of an equity interest. Consideration should also be given to any investment required and any put and call rights that may limit the employee’s downside risk or provide for cash settlement. Many of these factors were contained in Issues 28 and 40 of EITF Issue 00-23, which provided guidance on
the accounting under Opinion 25 for certain of these
arrangements.
When the substance of the instrument is that of a
performance bonus or profit sharing arrangement, it should be
accounted for as such. In those circumstances, any returns to the
employee should be reflected as compensation expense, not as equity
distributions or minority interest expense. Further, if the employee
remitted consideration at the outset of the arrangement in exchange
for the instrument, such consideration should generally be reflected
in the balance sheet as a deposit liability.
On the other hand, when the substance of the
arrangement is in fact that of a substantive class of equity,
questions often arise as to the appropriate valuation of the
instrument for the purpose of recording compensation expense
pursuant to FASB Statement No. 123R. These instruments, by design,
often derive all or substantially all of their value from the right
to participate in future share price appreciation or profits.
Accordingly, the staff has rejected the use of valuation
methodologies that focus predominantly on the amount that would be
realized by the holder in a current liquidation, as such an approach
fails to capture the substantial upside potential of the security.
[Footnotes omitted]
Although Issues 28 and 40 of EITF Issue 00-23 (referred to in the speech above) were superseded and nullified by FASB Statement 123(R) (codified in ASC
718), the indicators provided in them are useful in the determination of
whether profits interests represent a substantive class of equity. Those
indicators, as well as others, include the legal form of the instrument (a
profits interest can only be a substantive class of equity if it is
legal-form equity); distribution rights, particularly after vesting; claims
to the residual assets of the entity upon liquidation; substantive net
assets underlying the interest; retention of vested interests upon
termination; any investment required to purchase the shares or units;
transferability after vesting; voting rights commensurate with those of
other substantive equity holders; an entity’s intent in issuing the interest
(i.e., whether the entity is attempting to align the holder’s interests with
those of other substantive equity holders); provisions for realization of
value; and repurchase features that may affect exposure to risks and
rewards.
A key focus in the determination of whether profits interests represent a
substantive class of equity is the ability to retain residual interests upon
vesting (e.g., after termination), including the ability to realize value
that is tied to the underlying value of the entity’s net assets, through
distributions that are based on an entity’s profitability and operations as
well as on any liquidity event, even if through a lower level of waterfall
distributions. By contrast, in a profit-sharing arrangement, a grantee
typically is only able to participate in the entity’s profits while
providing goods or services to the entity, and a residual interest is not
retained upon termination. A profit-sharing arrangement may also contain
provisions (e.g., repurchase features) that limit the grantee’s risks and
rewards (e.g., a repurchase feature that, upon termination of employment, is
at cost or a nominal amount).
In addition, not all the indicators described above are given equal weight.
While voting rights and transferability may be indicative of an equity
interest, the absence of such features would not preclude the interest from
being considered a substantive class of equity. Nonpublic entities
frequently issue equity interests that lack voting rights, particularly to
noncontrolling interest holders, and have transferability restrictions.
Further, if a grantee does not make an initial investment to purchase an
equity interest, the equity interest may still be a substantive class of
equity. In that circumstance, consideration for the shares or units is in
the form of goods or services.
In determining whether a vested residual interest is retained after termination,
an entity typically focuses on what happens to the interest if the grantee
is an employee who voluntarily terminates employment without good reason9 or if the grantee is a nonemployee who ceases to provide goods or
services. For example, if an employee award is legally vested but is
substantively forfeited upon voluntary termination without good reason
(e.g., the entity can repurchase the legally vested award at the lower of
cost or fair value upon such a termination event), the award will most
likely be a profit-sharing arrangement (see Section 3.4.3 of Deloitte’s Roadmap
Share-Based Payment
Awards for a discussion of repurchase features that
function as vesting conditions). By contrast, if an employee award is
legally vested but substantively forfeited only upon termination for cause
(e.g., the entity can repurchase the legally vested award at the lower of
cost or fair value upon such a termination event), that feature would not
affect the analysis since it functions as a clawback provision (see
Section 3.9
of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of
repurchase features that function as clawback provisions).
In determining whether an award is a profit-sharing arrangement, an entity
should consider the substance of an award rather than its form. For example,
an award may legally vest immediately under an agreement; however, the
vesting may not be substantive if the award cannot be transferred or
otherwise monetized until an IPO occurs and the entity can repurchase the
award for no consideration if the grantee terminates employment or ceases to
provide goods or services before the IPO. Such an award would be likely to
have a substantive performance condition that affects vesting (i.e., an IPO
is a vesting condition) even though the award was deemed “immediately
vested” according to the agreement.
From a valuation standpoint, nonpublic entities should consider whether the
profits interests that represent a substantive class of equity have no value
on the grant date. For example, if the entity were liquidated on the grant
date, the waterfall calculation would result in no payment to the special
class. However, in a manner consistent with the SEC staff’s speech above,
the profits interests generally have a fair value because of the upside
potential of the equity.
Further, from a classification standpoint, even if a nonpublic entity concludes
that the profits interests are subject to the guidance in ASC 718, the
entity would still need to assess the conditions in ASC 718-10-25-6 through
25-19A to determine whether the award is equity- or
liability-classified.
5.8.2.3 IPO Vesting Conditions
Certain share-based payment awards may vest only upon the occurrence of an IPO,
which represents a performance condition. If the holder of the awards is no
longer providing goods or services (e.g., an employee had retired) before an
IPO, the awards are forfeited.10
ASC 718-10 — Glossary
Performance
Condition
A condition affecting the vesting,
exercisability, exercise price, or other pertinent
factors used in determining the fair value of an
award that relates to both of the following:
- Rendering service or delivering goods for a specified (either explicitly or implicitly) period of time
- Achieving a specified performance target that is defined solely by reference to the grantor’s own operations (or activities) or by reference to the grantee’s performance related to the grantor’s own operations (or activities).
Attaining a specified growth rate in
return on assets, obtaining regulatory approval to
market a specified product, selling shares in an
initial public offering or other financing event,
and a change in control are examples of performance
conditions. A performance target also may be defined
by reference to the same performance measure of
another entity or group of entities. For example,
attaining a growth rate in earnings per share (EPS)
that exceeds the average growth rate in EPS of other
entities in the same industry is a performance
condition. A performance target might pertain to the
performance of the entity as a whole or to some part
of the entity, such as a division, or to the
performance of the grantee if such performance is in
accordance with the terms of the award and solely
relates to the grantor’s own operations (or
activities).
ASC 718-10
25-20 Accruals of
compensation cost for an award with a performance
condition shall be based on the probable outcome of
that performance condition — compensation cost shall
be accrued if it is probable that the performance
condition will be achieved and shall not be accrued
if it is not probable that the performance condition
will be achieved. If an award has multiple
performance conditions (for example, if the number
of options or shares a grantee earns varies
depending on which, if any, of two or more
performance conditions is satisfied), compensation
cost shall be accrued if it is probable that a
performance condition will be satisfied. In making
that assessment, it may be necessary to take into
account the interrelationship of those performance
conditions. Example 2 (see paragraph 718-20-55-35)
provides an illustration of how to account for
awards with multiple performance conditions.
In accordance with ASC 718, compensation cost should be recorded for a share-based payment
award only if an entity determines that the achievement of the performance condition is probable.
Generally, compensation cost is not recognized for awards that vest upon certain liquidity events,
such as a change in control or an IPO, until the event takes place. That is, a change in control or an
IPO is generally not probable until it actually occurs. This position is consistent with the guidance in
ASC 805-20-55-50 and 55-51 on liabilities that are triggered upon the consummation of a business
combination. Therefore, compensation cost is not recognized for an award that only vests upon an IPO
until the IPO occurs.
ASC 718-10 — Glossary
Market
Condition
A condition affecting the exercise
price, exercisability, or other pertinent factors
used in determining the fair value of an award under
a share-based payment arrangement that relates to
the achievement of either of the following:
- A specified price of the issuer’s shares or a specified amount of intrinsic value indexed solely to the issuer’s shares
- A specified price of the issuer’s shares in terms of a similar (or index of similar) equity security (securities). The term similar as used in this definition refers to an equity security of another entity that has the same type of residual rights. For example, common stock of one entity generally would be similar to the common stock of another entity for this purpose.
An award may vest on the basis of the occurrence of both an IPO and a specified
rate of return on the entity’s stock. For example, an award vests upon an
IPO as long as the IPO price results in an IRR of a certain percentage on
certain shareholders’ initial investment in the entity. This type of award
contains both a performance condition (IPO) and a market condition
(achievement of a specified rate of return on the entity’s stock). Although
performance conditions are assessed for probability, with compensation cost
recognized on the basis of whether the performance condition is achieved,
market conditions are factored into the grant-date fair-value-based
measurement of an award and do not affect whether compensation cost is
recognized because a market condition is not a vesting condition.
ASC 718-10
25-21 If an award requires
satisfaction of one or more market, performance, or
service conditions (or any combination thereof),
compensation cost shall be recognized if the good is
delivered or the service is rendered, and no
compensation cost shall be recognized if the good is
not delivered or the service is not rendered.
Paragraphs 718-10-55-60 through 55-63 provide
guidance on applying this provision to awards with
market, performance, or service conditions (or any
combination thereof).
Therefore, in such cases, if an IPO occurs but the IRR does not exceed the
benchmark, the awards are not earned. However, as long as the holder
delivers the good or provides the required service, the grant-date
fair-value-based measurement would still be recognized as compensation cost
upon the IPO, regardless of whether the market condition is achieved,
because (1) the requisite service is rendered or the good is delivered and
the performance condition is met and (2) the risk of not attaining the
market condition was already considered in the grant-date fair-value-based
calculation.
5.8.2.4 Escrowed Share Arrangements
As part of completing an IPO or other financing, certain shareholders who are also key employees of an entity may agree to place in escrow a portion of their shares, which will be released to them upon the satisfaction of a specified condition. In many of these arrangements, the shares are released only if the employee shareholders remain employed for a certain period or the company achieves a specified performance target, and services from the employee shareholders may be explicitly stated in the arrangement or implicitly required in accordance with a performance target.
As indicated in ASC 718-10-S99-2, the SEC staff has historically expressed the view that escrowed share arrangements such as these are presumed to be compensatory and equivalent to reverse stock splits followed by the grant of restricted stock, subject to certain conditions (e.g., service, performance, or market conditions). If the release of shares is tied to continued employment, the presumption cannot be overcome. In addition, even if the entity is not directly a party to the arrangement (e.g., when the arrangement is only between shareholders and new investors), the arrangement should be reflected in the entity’s financial statements.
However, the SEC staff has stated that in certain circumstances, the presumption
that an arrangement is compensation can be overcome. ASC 718-10-S99-2 states
that to identify those circumstances, an entity should assess the substance
of the escrowed share arrangement to determine whether it was “entered into
for purposes unrelated to, and not contingent upon, continued employment.”
For example, as a result of concerns related to the entity’s value,
investors may require certain shareholders to participate in an escrowed
share arrangement before the entity can raise financing. Further, investors
may require the entity to achieve certain performance targets (e.g., an
EBITDA target over a specified period) before the shares can be released. If
the arrangement also requires continued employment, the arrangement is
considered compensatory. However, if continued employment is not required
(either explicitly or implicitly), the entity should consider all relevant
facts and circumstances to determine whether the substance of the
arrangement is unrelated to employee compensation.
5.8.3 Modifications
Share-based payment awards are frequently modified in anticipation of an IPO.
Any change in the terms or conditions of a share-based payment award represents
a modification. Modified awards are viewed as an exchange of the original award
for a new award. For an equity award measured at intrinsic value, the change in
compensation cost should be measured by comparing the intrinsic value of the
award immediately after the modification with the intrinsic value immediately
before the modification. When an equity-classified award is modified and the
original award was expected to vest on the modification date, an entity must
compare the fair-value-based measurement of the award immediately before the
modification with the fair-value-based measurement of the award immediately
after the modification. Any incremental compensation cost must be recognized
over the remaining vesting period. In addition, at a minimum, the original
grant-date fair-value-based measure must be recognized. Therefore, total
recognized compensation cost attributable to an award that has been modified is
(1) the grant-date fair-value-based measure of the original award for which the
required service has been provided (i.e., the number of awards that have been
earned) or is expected to be provided and (2) any incremental compensation cost
conveyed to the holder of the award as a result of the modification. In
contrast, if the original award was not expected to vest on the modification
date, the original grant-date fair-value-based measure is ignored and
compensation cost is recognized on the basis of the fair-value-based measure of
the new award on the modification date.
Modification accounting is not applied if the fair-value-based measure, vesting
conditions, and classification of an award are the same immediately before and
after the modification.
ASC 718-20
35-3 Except as described in
paragraph 718-20-35-2A, a modification of the terms or
conditions of an equity award shall be treated as an
exchange of the original award for a new award. In
substance, the entity repurchases the original
instrument by issuing a new instrument of equal or
greater value, incurring additional compensation cost
for any incremental value. The effects of a modification
shall be measured as follows:
- Incremental compensation cost shall be measured as the excess, if any, of the fair value of the modified award determined in accordance with the provisions of this Topic over the fair value of the original award immediately before its terms are modified, measured based on the share price and other pertinent factors at that date. As indicated in paragraph 718-10-30-20, references to fair value throughout this Topic shall be read also to encompass calculated value. The effect of the modification on the number of instruments expected to vest also shall be reflected in determining incremental compensation cost. The estimate at the modification date of the portion of the award expected to vest shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121).
- Total recognized compensation
cost for an equity award shall at least equal the
fair value of the award at the grant date unless
at the date of the modification the performance or
service conditions of the original award are not
expected to be satisfied. Thus, the total
compensation cost measured at the date of a
modification shall be the sum of the following:
- The portion of the grant-date fair value of the original award for which the promised good is expected to be delivered (or has already been delivered) or the service is expected to be rendered (or has already been rendered) at that date
- The incremental cost resulting from the modification.
Compensation cost shall be subsequently adjusted, if necessary, in accordance with paragraph 718-10-35-1D or 718-10-35-3 and other guidance in Examples 14 through 15 (see paragraphs 718-20-55-107 through 55-121). - A change in compensation cost for an equity award measured at intrinsic value in accordance with paragraph 718-20-35-1 shall be measured by comparing the intrinsic value of the modified award, if any, with the intrinsic value of the original award, if any, immediately before the modification.
Many modifications are made before an IPO occurs but are not effective unless
the IPO occurs. While the date on which the contingent modification is made is
generally the modification date in the measurement of compensation cost, the
accounting consequence may not be recognized until the IPO’s effective date if
the modification depends on the occurrence of the IPO. For example, an award
could be modified to increase the quantity of shares underlying the award upon a
successful IPO. In this circumstance, any additional compensation cost (as
determined on the modification date) would not be recognized until the IPO is
effective since IPOs are generally not considered probable until they occur.
In addition, there could be circumstances in which changes associated with an award that are not modifications result in accounting consequences. For example, an entity could grant an award with a repurchase feature that causes the award to be liability-classified. If the original terms contain a provision that the repurchase feature will expire upon an IPO, however, the award would be reclassified from liability to equity upon the IPO.
5.8.4 Disclosures
ASC 718-10
50-1 An entity with one or more
share-based payment arrangements shall disclose
information that enables users of the financial
statements to understand all of the following:
- The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders
- The effect of compensation cost arising from share-based payment arrangements on the income statement
- The method of estimating the fair value of the equity instruments granted (or offered to grant), during the period
- The cash flow effects resulting from share-based payment arrangements.
This disclosure is not required for
interim reporting. For interim reporting see Topic 270.
See Example 9 (paragraphs 718-10-55-134 through 55-137)
for an illustration of this guidance.
ASC 718-10-50-1 highlights disclosure objectives related to share-based
compensation arrangements, and ASC 718-10-50-2 lists the minimum information
needed to achieve these objectives. The SEC staff frequently comments on the
disclosures associated with share-based compensation, including the minimum
disclosure requirements and significant valuation assumptions. For additional
observations related to frequently issued SEC staff comments, see Deloitte’s
Roadmap SEC Comment Letter
Considerations, Including Industry Insights.
5.8.4.1 Cheap Stock Disclosures
Typically, a registrant undergoing an IPO identifies share-based compensation as
a CAE because the lack of a public market for the pre-IPO shares makes the
estimation process complex and subjective. For more information about cheap
stock, see Section
5.8.1.1.4.
Further, paragraph 7520.1 of the FRM outlines considerations related to the “estimated fair value of
[stock that] is substantially below the IPO price” (often referred to as “cheap stock”). Registrants should
be able to reconcile the change in the estimated fair value of the underlying equity between the award
grant date and the IPO by taking into account, among other things, intervening events and changes in
assumptions that support the change in fair value.
The SEC staff had historically asked registrants to expand the disclosures in
their CAEs to add information about the valuation methods and assumptions
used for share-based compensation in an IPO. In 2014, however, the staff
updated Section
9520 of the FRM to indicate that registrants should
significantly reduce, in the CAEs section of MD&A, their disclosures
about share-based compensation and the valuation of pre-IPO common stock.
Nevertheless, paragraph
9520.2 of the FRM notes that the SEC staff may continue to
request that entities “explain the reasons for valuations that appear
unusual (e.g., unusually steep increases in the fair value of the underlying
shares leading up to the IPO).” Such requests are meant to ensure that a
registrant’s analysis and assessment support its accounting for share-based
compensation; they do not necessarily indicate that the registrant’s
disclosures need to be enhanced.
At the Practising Law Institute’s “SEC Speaks in 2014” Conference, the SEC staff discussed the types of
detailed disclosures it had observed in IPO registration statements that had prompted the updates to
Section 9520 of the FRM. The staff noted that registrants have historically included:
- A table of equity instruments issued during the past 12 months.
- A description of the methods used to value the registrant’s pre-IPO common stock (i.e., income approach or market approach).
- Detailed disclosures about certain select assumptions used in the valuation.
- Discussion of changes in the fair value of the entity’s pre-IPO common stock (i.e., registrants have historically included each grant leading up to the IPO, resulting in repetitive disclosures).
The staff indicated that despite the volume of share-based compensation
information included in IPO filings, disclosures of such information were
typically incomplete because registrants did not discuss all assumptions
related to their common-stock valuations. Further, disclosures about
registrants’ pre-IPO common-stock valuations were not relevant after an IPO
and were generally removed from their periodic filings after the IPO. The
SEC staff expressed the view that in addition to reducing the volume of
information, streamlined share-based compensation disclosures make reporting
more meaningful. The staff also indicated that by eliminating unnecessary
information, registrants could reduce many of their prior disclosures “down
to one paragraph.”
At the conference, the SEC staff also provided insights into how registrants would be expected to apply
the guidance in paragraph 9520.1 of the FRM and thereby reduce the share-based compensation
disclosures in their IPO registration statements:
- The staff does not expect much detail about the valuation method registrants
used to determine the fair value of their pre-IPO shares. A
registrant need only state that it used the income approach,
the market approach, or a combination of both.Further, while registrants are expected to discuss the nature of the material assumptions they used, they would not be required to quantify such assumptions. For example, if a registrant used an income approach involving a discounted cash flow method, it would only need to provide a statement indicating that a discounted cash flow method was used and involved cash flow projections that were discounted at an appropriate rate. No additional details would be needed.
- Registrants would have to include a statement indicating that the estimates in their share-based compensation valuations are highly complex and subjective but would not need to provide additional details about the estimates. Registrants would also need to include a statement disclosing that such valuations and estimates will no longer be necessary once the entity goes public because it will then rely on the market price to determine the fair value of its common stock.
The staff emphasized that its ultimate concern is whether registrants correctly
accounted for pre-IPO share-based compensation. Accordingly, the staff will
continue to ask them for supplemental information to support their
valuations and accounting conclusions — especially when the fair value of an
entity’s pre-IPO common stock is significantly less than the expected IPO
price.11
Footnotes
6
A nonpublic entity’s use of calculated value
does not represent an accounting policy election, since a
nonpublic entity must use calculated value to measure its awards
if it is not practicable for it to estimate the expected
volatility of its share price. Thus, once an entity is able to
estimate the expected volatility of its own share price or it
becomes a public entity, the entity should switch from using a
calculated value to using a fair-value-based measure and should
account for the change as a change in accounting estimate under
ASC 250.
7
Cheap stock refers to the issuance of equity
securities before an IPO in which the value of the shares is
below the IPO price.
8
The definition of “public entity” in ASC 718
encompasses entities that make “a filing with a regulatory
agency in preparation for the sale of any class of equity
securities in a public market.” The definition therefore
includes entities that have filed an initial registration
statement with the SEC before the effective date of an IPO.
9
A significant demotion, a significant reduction in
compensation, or a significant relocation are commonly considered
“good reasons” for termination.
10
ASC 718-10-30-28 specifies that a share-based
payment award with established performance targets that affect
vesting and that could be achieved after a grantee completes the
requisite service or a nonemployee’s vesting period (i.e., the
grantee would be eligible to vest in the award regardless of whether
the grantee is delivering goods or rendering service on the date the
performance target could be achieved) should be treated as a
performance condition that is a vesting condition. For example, the
terms of an award to an employee may allow the award to vest upon
completion of an IPO (i.e., the performance target) even if the IPO
occurs after the employee has completed the requisite service
period.
11
At the conference, the SEC staff noted that
valuations that appear unusual may be attributable to the peer
companies selected when a market approach is used. Specifically, the
staff indicated that there are often inconsistencies between the
peer companies used by registrants and those used by the
underwriters, which result in differences in the valuations.
Accordingly, the staff encouraged registrants to talk to the
underwriters “early and often” to avoid such inconsistencies.
5.9 Income Taxes
An IPO typically increases the complexity of accounting for income taxes. For
example, in an IPO involving a carved-out portion of a larger entity, the tax
provision may be prepared for the first time for multiple periods, in which case an
entity may be required to use significant judgment in assessing the accounting and
presentation of income taxes. Irrespective of whether the registrant is a carve-out
or an existing business, however, changes in tax status, predecessor/successor
issues, and other transactions with shareholders in connection with an IPO result in
complexities in the calculation and presentation of the income tax provision for the
pre- and post-IPO periods. In addition, for interim reporting, possible limitations
on future deductions may need to be assessed as well as additional disclosure
requirements.
The income tax accounting and reporting requirements can be complex
for entities that are preparing an initial registration statement. For more detailed
considerations related to accounting for income taxes, see Deloitte’s Roadmap
Income
Taxes.
In addition to the accounting and reporting issues addressed in these sections,
management should consider working with tax advisers to determine the income tax
implications of an IPO. Tax advisers often add value to the IPO process by
identifying income tax or transaction tax matters that may be material to the
IPO.
5.9.1 Separate or Carve-Out Financial Statements
One of the major activities associated with an IPO is
preparation of the financial statements that will be included in the
registration statement. Financial statements often need to include assets and
operations of some subcomponent of a larger consolidated reporting entity. Such
financial statements are commonly referred to as “separate” or “carve-out”
financial statements.
When used broadly, “separate” and “carve-out” describe financial statements that
are derived from the financial statements of a larger parent company. In this
context, the words are often used interchangeably. A narrower use of the term
“carve-out financial statements” refers specifically to financial statements
that are not the separate financial statements of a legal-entity subsidiary but
rather of certain operations (e.g., unincorporated divisions, branches,
disregarded entities, or lesser components of the parent reporting entity) that
have been “carved out” of the parent entity or one or more legal-entity
subsidiaries. Even though carve-out financial statements are not those of a
legal entity (i.e., they are composed of portions of a legal entity or entities
that have been “carved out”), they are commonly referred to as the financial
statements of the carve-out “entity.”
Current and deferred income taxes must be allocated to separate and carve-out
financial statements prepared in contemplation of an IPO. The allocation of
income taxes in carve-out financial statements included in an SEC filing is
required regardless of whether the carved-out operations will be subsumed into a
taxable or nontaxable entity upon consummation of the transaction for which the
carve-out financial statements are being prepared. Only in limited circumstances
has the SEC allowed the omission of a tax provision (e.g., if the carve-out
entity prepares abbreviated financial statements in accordance with Rule
3-05).
Deloitte’s Roadmap Carve-Out Transactions discusses general accounting
issues that often arise in connection with the preparation of separate or
carve-out financial statements, and Chapter 8 of Deloitte’s Roadmap Income Taxes
discusses the methods used in practice to allocate income taxes into separate or
carve-out financial statements and common issues that occur.
5.9.2 Change in Tax Status
5.9.2.1 General
For general income tax accounting guidance on accounting for
the effects of a change in tax status of a reporting entity, see Section 3.5.2 of Deloitte’s Roadmap
Income
Taxes. Also see Section 5.9.6.3 of this Roadmap for
more information regarding pro forma reporting disclosures that may be
triggered by a change in status.
5.9.2.2 Nontaxable to Taxable
In connection with an IPO, it is common for a preexisting entity to be converted
from a nontaxable entity (e.g., a partnership) to a taxable entity (e.g., a
taxable C corporation). While this conversion may seem straightforward, the
change in status is often effected through a series of complex transactions.
One mechanism for doing this conversion is referred to informally as an
“Up-C” transaction. In Up-C transactions, the historical partners in a
partnership (the “founders”) establish a C corporation (the “Up-C”) to serve
as the IPO vehicle. The Up-C is the entity that will ultimately issue its
shares to the public and become the SEC registrant. In addition, the Up-C
often uses the IPO proceeds to acquire an incremental ownership interest in
the partnership from current owners.
Depending on the nature of the predecessor and successor entities and the
resulting structure, it is common under U.S. tax law for a step-up in tax
basis to occur, in which case an entity would be required to recognize DTAs
and deferred tax liabilities (DTLs) that net to an amount equivalent to the
tax effect of a gain recognized by the former partners.
Sections 3.5.2.3,
6.2.7.2,
and 11.7.4.1 of
Deloitte’s Roadmap Income Taxes provide detailed guidance on a
successor entity’s accounting for the recognition of income taxes when the
predecessor entity is nontaxable.
5.9.2.2.1 Tax Receivable Agreements
In connection with an IPO, many Up-Cs enter into tax
receivable agreements (TRAs) related to certain tax attributes (e.g., a
net operating loss carryforward) or certain tax effects of the IPO
transaction (e.g., a step-up in tax basis of the assets and liabilities
of the IPO company). TRAs are often entered into between the Up-C and
its previous owners to compensate the previous owners for these
attributes and tax effects. Such tax attributes and tax effects may be
realized by the public company after the IPO, resulting in a required
payment under the TRA. Entities that encounter TRAs or similar
agreements should consult with their tax and accounting advisers to
determine the appropriate accounting treatment.
5.9.2.3 Taxable to Nontaxable
In connection with an IPO, a parent may plan to contribute
“unincorporated” assets, liabilities, and operations of a division or
disregarded entity to a new company (i.e., a “newco”) at or around the time
of the transaction. The newco is typically established to serve as the IPO
vehicle (i.e., it is the entity that will ultimately issue its shares to the
public) and, therefore, ultimately becomes an SEC registrant. In some
instances, income taxes will be allocated in the financial statements of the
predecessor division or disregarded entity in periods before the IPO but the
successor newco will be a nontaxable entity after the IPO. In that case, the
successor newco will not include deferred taxes in its financial statements
after the IPO. For detailed guidance on the accounting for the elimination
of income taxes allocated to a predecessor entity when the successor entity
is nontaxable, see Sections 3.5.2.4 and 11.7.4.2 of Deloitte’s Roadmap
Income
Taxes.
5.9.3 Tax Consequences of Transactions Among or With Shareholders
Certain transactions between an entity and its shareholders that occur during an
IPO may affect an entity’s tax attributes and may also change the tax bases of
its assets and liabilities. For example, an IPO may significantly change the
composition of shareholders, which can trigger tax consequences for the entity
undertaking the IPO.
For detailed guidance on the accounting for tax consequences of
transactions among or with shareholders, see Section 6.2.6 of Deloitte’s Roadmap
Income
Taxes.
5.9.4 Interim Reporting
Before an IPO, an entity may not have been subject to interim reporting
requirements and therefore may be unfamiliar with the guidance in ASC 740-270.
The core principle of ASC 740-270 is that the interim period is integral to the
entire financial reporting year. Thus, annual income tax expense must be
allocated to an entity’s interim financial statements. A major part of the
allocation process is estimating the annual effective tax rate (AETR), which
will need to be updated in each interim reporting period.
The AETR is based on estimates of income by jurisdiction, the impact of operating
losses, changes in valuation allowances, and utilization of tax credits. These
estimates are further complicated when a change in tax law or income tax rates
occurs in an interim period. Taxable transactions that are accounted for outside
of ordinary income must also be considered when an entity estimates discrete tax
consequences or benefits. Such transactions must be recognized in the interim
period in which they occur and be presented in appropriate components of the
financial statements.
For detailed guidance on interim reporting requirements, see Chapter 7 of Deloitte’s Roadmap Income Taxes.
5.9.5 Tax Effects of Executive and Employee Compensation
5.9.5.1 Limitations on Future Compensation Deductions
IRC Section 162(m) limits the deductibility of cash and share-based payment
awards issued by an entity that is a “publicly held corporation” for Section
162(m) purposes. The definition of a publicly held corporation includes
entities subject to registration of securities under Section 12 or entities
required to file reports under Section 15(d) of the Exchange Act. The
statute specifically limits the deductibility of compensation paid to a
company’s CEO and CFO as well as its three other highest paid officers
(referred to collectively as the “covered employees”). Under IRC Section
162(m), only the first $1 million in compensation (whether cash or
share-based remuneration) paid to a covered employee is deductible for tax
purposes in any given year. Once an individual becomes a covered employee,
the individual remains a covered employee each year during the period of
employment and thereafter, including after termination and death. Before the
enactment of the Tax Cuts and Jobs Act of 2017 (the “Tax Act”),
performance-based compensation was generally not subject to this limitation.
For detailed guidance on determining the deductibility of share-based payment
awards under IRC Section 162(m), see Section
10.2.3 of Deloitte’s Roadmap Income Taxes.
5.9.5.2 Share-Based Compensation
Private companies looking to go public often use share-based compensation
arrangements to attract and retain key employees, and the tax treatment of
those arrangements can have substantial tax effects on an entity and its
employees. Therefore, stakeholders should be aware of certain SEC focus
areas with respect to IPOs, including “cheap stock” issues resulting from
the issuance of equity instruments preceding an IPO, as well as a company’s
compliance with the requirements in IRC Section 409A. In some cases, issuing
cheap stock may result in unintended tax consequences for the grantor and
grantee of the share-based payment award. Therefore, it is important for an
entity to consult with tax advisers regarding the tax effects of both
existing and planned share-based compensation plans to determine whether the
requirements in IRC Section 409A or other IRC sections may apply.
See Sections 4.12.1
and 4.12.2 of
Deloitte’s Roadmap Share-Based Payment Awards for additional
discussion of cheap stock and IRC Section 409A, respectively.
5.9.6 Additional Disclosure Requirements
5.9.6.1 Disclosures in the Financial Statements
An entity that becomes a public registrant may be required to provide additional
disclosures about its income taxes that were not required in prior financial
statements. In addition to providing the disclosures described below, public
entities must present, under Regulation S-X, Rule 12-09, a “[l]ist, by major
classes, [of] all valuation and qualifying accounts and reserves not
included in specific schedules,” including valuation allowances related to
DTAs. This list may be included as a supplemental schedule in an entity’s
annual filings or may be included in the financial statement footnotes, and
the schedule must contain a rollforward of such accounts, showing additions
and deductions throughout the year.
Other possible income-tax-related disclosure requirements for public entities
include the following:12
- Change in status.
- Unrecognized tax benefits.
- Deferred taxes.
- Rate reconciliation.
- Income tax expense.
See Chapter 14 and
Appendix E of Deloitte’s Roadmap
Income
Taxes for further discussion of the financial reporting
matters listed above, including sample disclosures provided in accordance
with the accounting and disclosure requirements of Regulation S-K and
Regulation S-X.
Changing Lanes
In March 2023, the FASB issued a proposed ASU that would modify
or eliminate certain requirements related to income tax disclosures
as well as establish new disclosure requirements. The proposed ASU
is intended to improve the usefulness of information provided to
financial statement users about an entity’s income taxes and
addresses investors’ requests for greater transparency by enhancing
the disclosure requirements related to the rate reconciliation and
income taxes paid. The amendments also retain certain changes
proposed in the FASB’s 2019 exposure draft. Comments on the proposal
are were due by May 30, 2023. Some of the proposed disclosure
requirements already exist in Regulation S-X, while others would be
new requirements that the FASB staff believes would improve the
effectiveness of financial reporting. Many of the proposed
disclosure requirements apply only to PBEs. Accordingly, preparers
anticipating an IPO in the near future should monitor the status of
this project as well as its impact on the disclosure requirements
for PBEs. For more information about the status of this project, see
the project page on the FASB’s Web site.
5.9.6.2 Disclosures Outside the Financial Statements — MD&A
As described in more detail in Section 4.3, public entities are also
required to include MD&A in their public filings. Discussion and
analysis of income taxes is an important part of an entity’s MD&A since
income taxes can be a significant factor in the entity’s operating results.
Such discussion should address the following (if material):
- CAEs — The determination of income tax expense, DTAs and DTLs, and unrecognized tax benefits inherently involves several CAEs of current and future taxes to be paid. Management should provide information about the nature of these estimates in MD&A.
- Liquidity and capital resources — The SEC staff expects registrants to disclose (1) the amount of cash and short-term investments held by foreign subsidiaries that would not be available to fund domestic operations unless the funds were repatriated and (2) whether additional tax expense would need to be recognized if the funds are repatriated. Although we expect this issue to be less prevalent than it was historically, an entity may still be subject to income tax on its foreign investments (e.g., foreign exchange gains or losses on distributions and withholding taxes).
A tabular disclosure of contractual obligations and
disclosures about off-balance-sheet arrangements are no longer required.
Regulation S-K, Item 303(b), does require a registrant to include an
analysis of “material cash requirements from known contractual and other
obligations” in the discussion of liquidity and capital resources. This
discussion should take into account the entity’s unrecognized tax
benefits.
In addition to discussion concerning the current-year operations, Regulation
S-K, Item 303(a), requires entities to provide certain forward-looking
information related to “material events and uncertainties known to
management that are reasonably likely to cause reported financial
information not to be necessarily indicative of future operations.”
Many tax-related events and uncertainties may need to be
clarified in MD&A. For instance, before the enactment of tax law
proposals or changes to existing tax rules, an SEC registrant should
consider whether the potential changes represent an uncertainty that
management reasonably expects could have a material effect on the
registrant’s results of operations, financial position, liquidity, or
capital resources. If so, the registrant should consider disclosing
information about the scope and nature of any potential material effects of
the changes.
After the enactment of a new tax law, registrants should
consider disclosing, when material, the anticipated current and future
impact of the law on their results of operations, financial position,
liquidity, and capital resources. In addition, registrants should consider
providing disclosures in the CAEs section of MD&A to the extent that the
changes could materially affect existing assumptions used in estimating
tax-related balances.
The SEC staff also expects registrants to provide
early-warning disclosures to help users understand various risks and how
these risks potentially affect the financial statements. Examples of such
risks include situations in which (1) the registrant may have to repatriate
foreign earnings to meet current liquidity demands, resulting in a tax
payment (e.g., withholding taxes) that may not be accrued for; (2) the
historical effective tax rate is not sustainable and may change materially;
(3) the valuation allowance on net DTAs may change materially; and (4) tax
positions taken during the preparation of returns may ultimately not be
sustained. Early-warning disclosures give investors insight into
management’s underlying assumptions as well as the conditions and risks an
entity faces before a material change or decline in performance is
reported.
Appendix
E of Deloitte’s Roadmap Income Taxes contains sample
disclosures provided in accordance with the accounting and disclosure
requirements of Regulation S-K and Regulation S-X.
5.9.6.3 Pro Forma Disclosures
In connection with an IPO, certain income-tax-related events or transactions
may occur for which disclosure of pro forma financial information would be
required in the registrant’s filing under Regulation S-X, Article 11. Such
events or transactions may include termination or revision of tax or other
cost-sharing agreements or a change in a registrant’s tax status (e.g., an
issuer was formerly a partnership or similar pass-through entity for tax
purposes). A registrant may be required to provide pro forma financial
information in such circumstances if the transaction is material to the
registrant’s financial statements. See Section
4.4 for additional discussion of pro forma financial
information.
5.9.7 Resource Considerations
An IPO can cause substantial changes to an entity’s income taxes. To
appropriately address the income tax accounting implications of going public, it
is critical for an entity to obtain sufficient resources and establish
appropriate accounting processes and internal controls well in advance of the
IPO.
Specifically, entities should consider the resources they need to address the following:
- Tax department participation in preparation of initial and ongoing SEC filings.
- Availability, accuracy, and timeliness of income-tax-related information used for financial reporting.
- Accumulation of income-tax-related information for required historical audited financial statements.
- Income-tax-related disclosure requirements that specifically apply to public companies.
- Augmenting or revisiting current internal controls and preparation for certification in connection with the effectiveness of income-tax-related internal controls. See Sections 6.11 and 7.5 for considerations and requirements related to ICFR.
- An entity undergoing an IPO will also encounter many tax issues beyond accounting for income taxes (e.g., issues associated with tax planning and the IRS requirements for public companies).
Footnotes
12
Note that other tax-related disclosure requirements
may apply to particular transactions.
5.10 Earnings per Share
Public entities must comply with ASC 260, which provides guidance on calculating
and presenting EPS for common stock. For each period presented,
entities are required to present basic EPS (i.e., income available
to common stockholders divided by the weighted average number of
common shares outstanding) and diluted EPS, which includes the total
weighted-average number of common shares of the entity’s potential
common stock that would dilute basic EPS if actually issued.
An IPO commonly involves changes in capital structure (see Section 5.6.2), including both
simple reclassifications and other, more complex changes that may
even occur for the same equity security. Section 8.6.2 of Deloitte’s Roadmap Earnings per Share
provides examples illustrating changes in capital structure and the
related impact on reported amounts of EPS, as well as an overview of
the FRM guidance on the EPS accounting for changes in capital
structure at or before closing an IPO. (ASC 260 does not contain
such guidance.) While this guidance specifically applies to changes
in capital structure that occur in conjunction with an IPO, it would
also be relevant to other changes in capital structure.
Presentation and disclosure of EPS can be affected by
the structure and substance of the transactions to effect an IPO
(see Section
5.2). Section 8.6.3 of
Deloitte’s Roadmap Earnings per Share provides an
overview of EPS accounting considerations related to IPOs of
entities that were previously part of a larger entity, including
spin-offs and other dispositions. This guidance applies to such IPOs
even if those share offerings are not spin-offs from a legal
perspective.
ASC 260 also provides additional guidance specific to
share-based compensation. An entity should carefully analyze
share-based compensation arrangements to determine the EPS impact on
the basis of the substance of the arrangements. For example, shares
may be legally outstanding; however, for EPS purposes, unvested
shares are not treated as being issued but are instead viewed as
potentially dilutive and incorporated into the calculation of
diluted EPS. For more information about the impact of share-based
payment awards on EPS, see Section 12.4 of
Deloitte’s Roadmap Share-Based Payment Awards.
For more information about the presentation and disclosure of EPS, see
Deloitte’s Roadmap Earnings per Share, especially
Section
8.6.2.1, which provides an overview of common
ways in which ASC 260 is misapplied in an IPO.
5.11 Segments
Public entities are required to disclose certain financial information for
reportable segments under ASC 280. The segment determinations made by a public
entity that files with the SEC are the basis for certain other disclosures within
SEC filings, including the business section and MD&A. Accordingly, it is
important for an entity that is going public to thoroughly consider the
identification of its operating and reportable segments.
As stated in ASC 280-10-05-3, in identifying operating segments, an entity is
required to use the management approach, which is “based on the way that management
organizes the segments within the public entity for making operating decisions and
assessing performance.” An operating segment possesses the following
characteristics: engagement in business activities from which it may recognize
revenues and incur expenses, operating results that are regularly reviewed by the
chief operating decision maker (CODM) to allocate resources and assess performance,
and availability of discrete financial information. An entity may be required to use
judgment in evaluating whether a component has all the characteristics of an
operating segment. Various information sources may help an entity identify operating
segments, including the entity’s organizational structure (which shows who reports
directly to the CODM), the CODM’s periodic reporting package, the level at which
budgets are reviewed and approved by the CODM, and an understanding of the incentive
compensation structure.
To determine which subset of those operating segments to report in the financial
statements (i.e., its reportable segments), an
entity uses a modified management approach based
on aggregation criteria and quantitative
requirements. An entity must use reasonable
judgment when aggregating two or more operating
segments into a single operating segment, and all
the aggregation criteria need to be met, including
the requirement that aggregation be consistent
with the objectives and principles of ASC 280. If
a single or aggregated operating segment
represents 10 percent or more of revenue,
profitability, or total assets, that operating
segment represents a reportable segment and
separate disclosure is required. An entity may
need to disclose additional segments separately to
ensure that reportable segments constitute at
least 75 percent of reported revenue. An entity
may separately report information on material
segments, irrespective of whether the segment
meets the quantitative requirements for separate
disclosure. An entity’s identified reportable
segments should “facilitate consistent
descriptions” of the entity in its annual report
and other published information, such as its
earnings release, investor presentations, and the
financial information on its Web site.
ASC 280 also requires certain entity-wide disclosures, which are intended to ensure some level of
comparability among entities. Accordingly, an entity should carefully consider the objectives and
principles of ASC 280 when evaluating the disclosure requirements.
Changing Lanes
In October 2022, the FASB issued a proposed
ASU that would enhance disclosures about significant
segment expenses. The proposed guidance is intended to increase the
information disclosed by public entities by requiring disclosure of (1) the
significant segment expenses that are regularly provided to the CODM and (2)
other segment items. Public entities would also need to provide all required
annual segment disclosures on an interim basis. Comments on the proposed ASU
were due by December 20, 2022. For more information, see the project page on the FASB’s Web site.
For more information on segment reporting, see Deloitte’s Roadmap Segment Reporting. In
addition, see Deloitte’s Roadmap SEC Comment Letter Considerations, Including Industry
Insights for the SEC staff’s recent comments on this topic.
5.12 Subsequent Events
When evaluating potential disclosures in the financial statements for inclusion in a company’s initial
registration statement, management should consider subsequent events through the date on which
the financial statements are issued or are available to be issued. Such an evaluation should include
consideration of whether events are recognized (i.e., “Type 1”) or nonrecognized (i.e., “Type 2”)
subsequent events, as described in ASC 855.
An initial registration statement may be amended several times before ultimately becoming
effective. Each time the registration statement is amended, financial statements included in the
registration statement are reissued. Questions often arise regarding the date through which
subsequent events should be evaluated when financial statements are revised or reissued as a result of
a registration statement amendment.
If new events are identified after the original registration statement has been
filed, but before the subsequent amendment of a registration statement, financial
statements included in the amendment may need to include disclosure of additional
subsequent events but would not contain recognition of the impact of such events
(unless a material error was identified). This approach is based on a reissuance
framework — the premise that financial statements included in the amendment
represent a reissuance of financial statements for subsequent-event purposes. The
reissuance guidance in ASC 855-10-25-4 states:
An entity may
need to reissue financial statements, for example, in reports filed with the SEC
or other regulatory agencies. After the original issuance of the financial
statements, events or transactions may have occurred that require disclosure in
the reissued financial statements to keep them from being misleading. An entity
shall not recognize events occurring between the time the financial statements
were issued or were available to be issued and the time the financial statements
were reissued unless the adjustment is required by GAAP or regulatory
requirements. Similarly, an entity shall not recognize events or transactions
occurring after the financial statements were issued or were available to be
issued in financial statements that are later reissued in comparative form along
with financial statements of subsequent periods unless the adjustment meets the
criteria stated in this paragraph.
To the extent that new information is discovered after the financial statements were originally available
to be issued, management should determine whether such currently available information represents
(1) information that management was aware of and misapplied or (2) information that management
should have been aware of. Errors identified during the preparation of a registration statement
amendment that meet the criteria for the correction of an error or for a prior-period adjustment should
be evaluated and accounted for in accordance with ASC 250. Management should use judgment in
performing such an evaluation.
For Type 2 subsequent events, unless a material subsequent event was accounted
for or disclosed in a subsequent interim period presented in the registration
statement, the annual financial statements would generally need to be updated to
disclose such an event. This disclosure may be provided in a separate note to the
annual financial statements captioned as “Subsequent Event (Unaudited).” In certain
circumstances, the annual financial statements may be retrospectively revised (e.g.,
discontinued operations, change in segments, stock split). In such cases, the
evaluation of subsequent events must be updated to reflect the retrospective
change.
In addition, the entity’s financial statements included in the IPO
registration statement must include disclosure of the date through which subsequent
events were evaluated. When financial statements are revised, ASC 855 requires an
entity to disclose the dates through which subsequent events have been evaluated in
both the originally issued financial statements and the retrospectively revised
financial statements.
Chapter 6 — Audit Considerations
Chapter 6 — Audit Considerations
Chapter 6 — Audit Considerations
6.1 Introduction
After the financial statement requirements have been identified for a
registration statement, the next step for the registrant’s audit committee1 is to engage auditors to complete the necessary audits and reviews of the
financial statements, as applicable (see Section 2.4). The SEC indicates on its
Web
site that the 1933 Act, which governs registration
statements, has two fundamental goals: (1) to “require that investors receive
financial and other significant information concerning securities being offered
for public sale” and (2) to “prohibit deceit, misrepresentations, and other
fraud in the sale of securities.” In accordance with these objectives, the
Securities Act requires that an independent registered public accounting firm
audit annual financial statements and read certain other financial information
included in the registration statement. In addition, interim financial
statements included in the registration statement may be subject to a review
under PCAOB standards. In some instances, stub-period financial statements may
also need to be audited.
Audited financial statements to be included in the IPO registration statement
often will be subject to additional audit procedures because the standards
governing audits of public companies are different from those for private
companies. Specifically, the financial statement audits performed for a private
company and its independent auditor are subject to the auditing standards issued
by the AICPA’s Auditing Standards Board; however, audits of financial statements
included in a registration statement filed with the SEC need to be performed in
accordance with PCAOB standards. Although the auditor may have previously
expressed an opinion on the annual financial statements in accordance with AICPA
auditing standards (i.e., auditing standards generally accepted in the United
States of America, or “U.S. GAAS”), the auditor will need to issue an auditor’s
report on the required annual financial statements in accordance with PCAOB
standards for inclusion in the registration statement, or in accordance with
both U.S. GAAS and PCAOB standards when the company is submitting its draft
registration statement confidentially. Auditors would also issue a report under
two sets of standards (i.e., perform an audit in accordance with both U.S. GAAS
and PCAOB standards, commonly referred to as a dual-standard report) in other
scenarios, such as when a Form 10 is being filed (e.g., when currently
outstanding equity securities are registered) or when a private-company
predecessor’s financial statements are included in a registration statement. To
issue such an auditor’s report, the auditor must be registered with the PCAOB
and comply with all relevant PCAOB requirements.
Footnotes
1
If the entity has not yet formed an audit committee,
other governing bodies the entity has charged with governance, such as a
board of directors or owners, may fulfill this role before the entity
becomes a public company.
6.2 Independence Considerations
Because the SEC’s and PCAOB’s independence rules are generally more restrictive
than the AICPA’s, both the auditor and management, with oversight from the audit committee,
need to determine (1) whether there is possible noncompliance with the SEC’s and PCAOB’s
independence rules, (2) whether there are conflicts of interest before the entity undertakes
an IPO or a transaction involving a SPAC, or (3) both. For example, because certain
nonattest services that the auditor is permitted to provide under the AICPA’s rules may be
prohibited under the SEC’s independence rules, the auditor and management need to evaluate
whether the nonattest services provided during the financial statement periods included in
the registration statement (or services approved by the audit committee but not yet
provided), are permitted under the SEC’s and PCAOB’s independence rules.2 In addition, the auditor may need to be independent of other entities, individuals, or
both, that meet the definition of an affiliate of the entity under audit3 in accordance with the SEC’s independence rules but would not be considered an
affiliate under the AICPA’s independence rules. For instance, while controlling entities are
within the scope of both the SEC’s and AICPA’s definitions of an affiliate, the SEC’s
definition does not allow for materiality considerations related to the determination of
whether an upstream controlling entity is an affiliate while the AICPA’s definition does.
Therefore, an entity not previously considered an affiliate under the AICPA’s independence
rules may meet the definition of an affiliate under the SEC’s independence rules. In
addition, the SEC’s general standard of independence requires the auditor to consider
relationships with, or services provided to, a nonaffiliate entity that is under common
control with the entity under audit (i.e., one or both entities are not material to the
controlling entity).
Connecting the Dots
Both the auditor and management should compile a list of all of the
auditor’s services and the corresponding fee arrangements that (1) are currently being
provided to the entity and its affiliates (as defined by the SEC’s rules), (2) were
previously provided during the financial statement periods to be included in the
registration statement, and (3) have been approved but not yet provided.
While some ongoing or future services may be permissible, other services or fee
arrangements may need to be modified or terminated before the auditor is engaged or begins
audit procedures in accordance with PCAOB standards. If prohibited nonattest services,
including prohibited fee arrangements, were provided during the financial periods to be
included in the registration statement, the auditor may not be independent and thus may not
be able to issue (or reissue) auditor reports covering those periods. Therefore, the
conflict and independence review should begin as early as possible (i.e., as soon as the IPO
or SPAC transaction is initially considered) so that there is sufficient time to gather,
understand, and appropriately address any services or relationships (e.g., financial,
employment, business) for which there are potential conflicts of interest or independence
implications before the IPO or SPAC transaction.
In addition, before auditors are
engaged to perform audit services and before they commence work, audit committee preapproval
is required for all services to be provided to the entity and its subsidiaries. For existing
permissible nonaudit services that will continue to be provided after the auditor is engaged
to perform a PCAOB audit, audit committee approval is required before the service can be
continued. This approval is required under Regulation S-X, Rule 2-01, and must be obtained
before the auditor is engaged to conduct the audit in accordance with PCAOB standards. In
connection with seeking such audit committee approval, the requirements of PCAOB Rules 3524
and 3525 also apply to permissible tax services and permissible nonaudit services related to
ICFR, as applicable, including required written communications and discussions with the
audit committee. Audit committee approval is not required for services that have been
completed before the auditor is engaged to perform a PCAOB audit.
Section 600 of the code of the International Ethics Standards Board for
Accountants (IESBA) requires the entity’s audit committee to concur that any nonaudit
services provided to upstream controlling entities or downstream controlled, nonconsolidated
entities do not affect the auditor’s independence from the entity under audit before the
engagement begins or work commences. This requirement is an expansion of the aforementioned
approval requirement under Regulation S-X, Rule 2-01. Section 410 of the IESBA code requires
that additional information regarding fees paid or owed to the auditor be communicated to
the entity’s audit committee as well. Both of these IESBA requirements should be addressed
through the initial PCAOB Rule 3526 communication.
Independence concerns may also arise as a result of business relationships (both
indirect and direct) between the auditor, including covered persons at the auditor, and the
entity commencing the IPO or SPAC transaction process, its affiliates, or persons (including
entities) in a decision-making capacity at the entity under audit, such as officers,
directors, or beneficial owners with significant influence. Therefore, these relationships
should be reviewed for compliance with the SEC’s independence rules. Audit committee
preapproval is not required for business relationships; however, such relationships may
reasonably be thought to bear on the auditor’s independence and generally should be
communicated by the auditor in the initial PCAOB Rule 3526 communication. See Table 6-2 for a list of potentially
independence-impairing business relationships.
The auditor typically will evaluate whether previous or present relationships
(e.g., financial, employment, business) with any of the following could potentially impair
its independence or otherwise pose professional, legal, or business conflicts:
- The entity itself.
- Any of the entity’s affiliates under SEC affiliate rules.
- Individuals serving in an accounting role or financial reporting oversight role, including officers and directors.
- Persons (including entities) in a decision-making capacity at the entity under audit, such as officers, directors, or beneficial owners with significant influence.
- Any entities that are under common control with the entity under audit but are not affiliates under SEC affiliate rules (i.e., one entity or both entities are not material to the controlling entity).
Further, the auditor, with the client’s assistance, should determine whether any
individuals or entities with significant influence over the entity under audit (e.g.,
officers, directors, or beneficial owners, including individuals and entities that are not
otherwise affiliates) have a lending relationship with the auditor, any covered person at
the auditor, or an immediate family member of any covered person.
Connecting the Dots
A complete corporate entity tree is critical to performing a thorough
review of independence and potential conflicts. This tree should include a detailed
organizational structure consisting of all legal corporate entities considered to be (1)
affiliates, including entities, individuals of the entity (as defined by the SEC), or
both, and (2) entities that are under common control with the entity under audit but are
not affiliates of the entity as defined by the SEC (i.e., one entity or both entities
are not material to the controlling entity). At a minimum, the corporate entity tree
should also include individuals or entities with significant influence over the entity
under audit that are not otherwise affiliates (i.e., officers, directors, or beneficial
owners with significant influence). However, for monitoring purposes, inclusion of
additional beneficial owners that do not meet the significant influence criteria is
preferred. In gathering corporate tree information, the entity should also evaluate any
independence or conflict-related considerations by compiling a list of services provided
by the auditor to the entities or individuals within the tree, as well as any business
relationships between the auditor and such entities or individuals. It is advisable for
management to work closely with the entity’s auditor to ensure that the requisite
information is available to complete this process in a timely fashion.
Below are examples of services (Table 6-1) and business relationships (Table 6-2) for entities to consider
when evaluating the auditor’s independence. As previously mentioned, there are certain
differences between the SEC’s or PCAOB’s independence rules and the AICPA’s independence
rules. Such differences may be particularly relevant to nonattest services currently being
performed at the entity or its affiliates since an entity deemed an affiliate under the
SEC’s rules may not have previously been deemed an affiliate under the AICPA’s rules. This
may also be the case for certain individuals under the PCAOB’s rules (i.e., financial
reporting oversight roles).
Table 6-1
Examples of Prohibited and Potentially Independence-Impairing Services for the
Audit Client and Its Controlled and Significantly Influenced and Material
Affiliates |
---|
|
Table 6-2
Examples of Prohibited and Potentially Independence-Impairing Business
Relationships With the Audit Client and Its Controlled and Significantly
Influenced and Material Affiliates and With Persons (Including Entities) in a
Decision-Making Capacity at the Entity Under Audit, Such as Officers, Directors,
or Beneficial Owners With Significant Influence |
---|
|
In accordance with PCAOB Rule 3526, before accepting an initial engagement to
audit an entity under PCAOB standards, the auditor must (1) communicate, in writing, to the
audit committee all relationships between the auditor and the audit client and its
affiliates (or persons in financial reporting oversight roles at the audit client) that, as
of the date of the communication, may reasonably be thought to bear on the auditor’s
independence; (2) discuss, with those charged with governance (i.e., the audit committee),
the potential effects of such relationships on the auditor’s independence; and (3) document
the substance of the discussion with the audit committee regarding the potential effects of
the relationships described in the initial written communication on the auditor’s
independence. The matters covered during the initial written communication may include
issues that occurred beyond the audit period or professional engagement period. Acceptance
of the audit engagement occurs after the auditor completes its engagement acceptance
activities and before it obtains the executed engagement letter establishing the terms of
the new engagement to perform PCAOB audits in connection with the IPO (referred to as the
“IPO engagement letter”). Rule 3526 also includes the auditor’s responsibilities with
respect to annual communications to the audit committee.
Footnotes
2
For first-time filers and when a target entity is included in a SPAC’s
filing, PCAOB and SEC independence is required for the most recent full fiscal year’s
financial statements included in the initial filing and any other subsequent unaudited
interim periods. Any earlier periods included in the filing must comply with AICPA
independence rules and the SEC general standard of independence. Accordingly, all
periods of the filing need to be considered and evaluated under SEC and PCAOB
independence rules.
3
Entity whose financial statements or other information is being
audited.
6.3 Rotation of Audit Partners
The SEC’s independence rules require that the audit partner and the engagement
quality control reviewer (generally another partner in the independent registered
public accounting firm) serve in those roles for a maximum of five consecutive
years. Certain other partners4 on the audit engagement or those in equivalent roles are limited to seven
consecutive years of service. Before a registration statement is filed and the
auditor’s report under PCAOB standards is issued, the audit engagement team needs to
reassess the time that partners have served on the audit engagement before being
engaged to perform the PCAOB audit. Certain periods during which partners subject to
rotation served on AICPA audits may be factored into the determination of compliance
with the rotation requirements under SEC rules.
Under SEC rules, the audit partner rotation measurement period generally begins
with the earliest audit period included in the initial registration statement or a
JOBS Act confidential filing. If a partner on the audit engagement was involved in
the prior-year AICPA audits and is continuing in that role for the reissuance of
those auditor reports for inclusion in the registration statement, each financial
statement period included in the initial and amended registration statements counts
as one separate year of service toward the SEC rotation period. Any years of service
by those individuals before the financial statement periods included in the
registration statement do not count toward the SEC rotation period. Potential delays
in the effectiveness of the registration statement and performing first-time
financial statement audits of multiple periods as the successor auditor at the same
time could affect the measurement period of required audit partner rotation.
Example 6-1
The partner who served as the audit
engagement partner for AICPA audits of 20X0, 20X1, 20X2, and
20X3 financial statements will continue serving in that role
for the reissuance of the auditor’s report on the 20X1,
20X2, and 20X3 financial statements to be included in the
initial registration statement (public or confidential
filing).
After many amendments to the registration
statement, the SEC declared the company’s registration
statement effective in March 20X5 (the registration
statement declared effective included the audited financial
statements for the years ended December 31, 20X2, 20X3, and
20X4).
For SEC partner rotation purposes, the
partner (1) would be viewed as having served as the audit
engagement partner for four years (20X1, 20X2, 20X3, and
20X4), counting all the years included in the registration
statements filed with the SEC, and (2) has one year (20X5)
remaining before starting a five-year time-out period from
the audit client and its affiliates.
Example 6-1A
XYZ Company hired an independent registered
accounting firm in 20X3 to perform a multiple-period audit
concurrently as part of the registration process, and the
auditor had not previously been involved in providing any
attest services to this entity or its affiliates.
In this example, Partner A is serving as the
audit engagement partner on XYZ Company’s multiple-period
audit for the years ended December 31, 20X0, 20X1, and 20X2.
The first audit opinion issued in accordance with PCAOB
standards is included in XYZ’s registration statement filed
in 20X3 and contained the audited financial statements for
the years ended December 31, 20X0, 20X1, and 20X2. After
some amendments to the registration statement, the SEC
declared XYZ Company’s registration statement effective in
June 20X3. (The registration statement declared effective
included the audited financial statements for the years
ended December 20X0, 20X1, and 20X2.)
For SEC partner rotation purposes, Partner A
would be viewed as having served only one year for SEC
purposes since the three years were audited at the same
time. Partner A may serve in the role of audit engagement
partner for XYZ Company for four more years before starting
a five-year time-out period from the audit client and its
affiliates.
Footnotes
4
In this Roadmap, the term “partner” refers to a partner,
principal, or managing director, as applicable to the particular
circumstances of the role being served and the audit engagement.
6.4 Restriction on Company’s Employment of Former Audit Personnel
The SEC’s independence rules also mandate a “cooling-off” period before a member or former member
of the audit engagement team can begin working for the registrant in an accounting or financial
reporting oversight role. Accordingly, management and the audit committee need to consider
these requirements when determining whether to offer employment to a current or former partner,
principal, shareholder, or employee of the entity’s auditors.
6.5 Legal Protective Clauses in Engagement Letters
Generally, legal protective clauses to mitigate the auditor’s potential
liability are permitted in AICPA audit engagement letters. The most common legal
protective clause that is included in such letters is a release and indemnification
for management misrepresentations. In certain circumstances, such as some financial
statement audits performed in connection with a transfer of ownership interests,
other legal protective clauses (e.g., a limitation of liability) may also be
included in AICPA audit engagement letters.
However, the SEC’s independence rules do not permit inclusion of legal protective clauses in audit
engagement letters. When an entity is an issuer or the auditor is engaged to perform an audit
in accordance with PCAOB standards, auditors are subject to, and must comply with, the SEC’s
independence rules; accordingly, auditors do not include such legal protective clauses in PCAOB audit
engagement letters.
6.6 Changes in Auditors
When planning for an IPO, an entity often considers whether its independent auditors have the
requisite qualifications and experience to assist the entity with the IPO process. In addition to seeking
an independent registered public accounting firm that has extensive experience with IPOs and public
companies, an entity that has (or is interested in developing) international operations often wishes to
engage an independent registered public accounting firm with a network of affiliated international firms
around the globe.
In certain cases, the entity may be required to change its independent auditor to move forward with its
IPO process because the prior auditor may be unable to be associated with the IPO. This could be the
case because, for example, the audit firm is not registered with the PCAOB or is not in compliance with
the SEC’s independence rules for its audits of the years for which financial statements will be included
in the registration statement. A successor auditor will need to gain an understanding of the business,
perform audits of one or more years, and coordinate with the predecessor auditor.
Connecting the Dots
If an entity changes to a new audit firm shortly before it
commences an IPO process, the previous audit firm would be required to
consent to the use of its previously issued auditor’s report(s) on
prior-year financial statements that are included in the SEC filing. If the
prior auditor is not able to or willing to consent to the use of its
auditor’s report(s), the new auditor may need to reaudit previously issued
financial statements.
An entity that changes auditors during the two most recent fiscal years or
any subsequent interim period must provide certain disclosures under
Regulation S-K, Item
304. For an existing public company, these disclosures are
typically provided on a Form 8-K; however, the required disclosures for an
IPO must be provided in the IPO registration statement.
6.6.1 Considerations Related to Dividing Responsibility for an Audit
Both AICPA and PCAOB standards allow an audit firm to divide
responsibility for an audit with another auditor, although it is not common for
audit firms to do so. Under SEC rules, if an independent public accounting firm
divides responsibility with another audit firm because another independent
auditor audits a component of the entity (e.g., a discrete business), the other
auditor’s report must be filed with the SEC and this report must refer to PCAOB
standards. The other independent auditor would also need to consent to the use
of its auditor’s report in the registration statement. (See Section 6.8 for more
information about consents.)
Even if an auditor previously divided responsibility with
another auditor in its AICPA auditor’s report, it may not be appropriate to
divide responsibility in the PCAOB auditor’s report if the other auditor is not
in a position to reissue its auditor’s report on the component it audited and
refer to PCAOB standards. In addition, paragraph 4140.1 of the FRM states that
“[g]enerally, the principal auditor is expected to have audited or assumed
responsibility for reporting on at least 50% of the assets and revenues of the
consolidated entity.” As a result, if an auditor previously divided
responsibility with another auditor in a prior AICPA audit, the auditor would be
required to reevaluate the appropriateness of that conclusion given the SEC’s
position on this matter.
6.7 Completing Audits and Reviews
There are currently many differences between AICPA and PCAOB standards, the vast
majority of which are nuanced and minor. However, some of the differences are more
significant, as a result of which the auditor will be required to perform more
procedures under PCAOB standards than under AICPA standards.5
Connecting the Dots
Management should evaluate whether it has sufficient
resources to respond to additional auditor information requests.
These differences between the two sets of auditing standards can broadly affect
the audit beyond just the testing procedures performed by the audit engagement
personnel. For example, because auditors that issue a report in accordance with
PCAOB standards must be registered with the PCAOB, it is necessary to understand
whether the auditor is qualified to issue an auditor’s report in accordance with
PCAOB standards. In addition, auditors in foreign jurisdictions that participate as
a component auditor may also need to be registered with the PCAOB. The need for a
component auditor to also be registered is based on the size of the component to the
consolidated entity. Under PCAOB Rule 2100, if a component auditor plays a
substantial role, defined as performing audit procedures with respect to a
subsidiary or component that constitutes 20 percent or more of the consolidated
assets or revenue, that firm must also be registered with the PCAOB. For example,
the U.S. audit firm may be appropriately registered with the PCAOB, but one of its
component audit firms in another jurisdiction that plays a substantial role may not.
Also, it may be necessary for the audit firm to change or augment the personnel
assigned to the PCAOB audit to achieve the right blend of experience and knowledge
for the audit.
Connecting the Dots
An audit performed in accordance with PCAOB standards versus
a previous audit performed in accordance with AICPA standards will be a “new
audit” and typically results in a new report date. In addition to auditing
any required incremental public-company GAAP disclosures or disclosures
required by Regulation S-X, the auditor will need to inquire about and
evaluate subsequent events through the new report date.
An IPO often takes many months or years to complete. In an effort to accelerate
that process, some entities request that their auditor perform incremental
procedures in accordance with PCAOB standards before they launch the IPO. In making
such a request, an entity needs to consider the cost of performing such procedures
versus the benefit of accelerating the IPO process.
Connecting the Dots
If the entity’s current owners believe that an IPO may be
possible in the foreseeable future, management should discuss such plans and
the timing with the auditor as well as the costs and benefits of requesting
the auditor to perform accelerated, incremental PCAOB audit procedures.
6.7.1 Audit Readiness and Completion
Once management has identified the appropriate reporting entity or entities for
which financial statements are required, as well as the periods covered by those
financial statements (see Chapter 2), management must determine, for each set of financial
statements to be included in the registration statement, whether audits need to
be performed in accordance with AICPA standards (i.e., auditing standards
generally accepted in the United States, or “U.S. GAAS”), PCAOB standards, or
both.
In some cases, the audit required for the IPO will be the first time those financial statements have been audited. While the registrant’s financial statements and those of any predecessors must generally be audited in accordance with PCAOB standards, certain other audited financial statements that must be included in a registration statement (e.g., financial statements of a significant acquisition required by Rule 3-05) may need to be audited in accordance with AICPA standards.
Changing Lanes
The “Compliance With Standards Rule” of the AICPA
Code of Professional Conduct indicates that the PCAOB is
responsible for establishing standards related to preparing and issuing
auditor’s reports for issuers, brokers, and dealers. In contrast,
the Auditing Standards Board is responsible for establishing standards
related to preparing and issuing auditor’s reports for
nonissuers.
The SEC considers entities filing public
registration statements to be issuers and requires entities to include
with the registration statement an auditor’s report that refers to
performance of audit procedures in accordance with PCAOB standards. This
requirement applies to periods during which the registration statement
is not yet effective.
Entities submitting nonpublic draft registration
statements, typically EGCs or other entities electing the accommodations
provided under the JOBS Act, are not technically considered issuers;
nonetheless, the SEC requires that auditors perform audits of nonpublic
filers, or of those submitting draft registration statements, in
accordance with PCAOB standards.
To clarify this nuance, the AICPA amended its auditing
standards6 to explain that auditors must still conduct audits in accordance
with GAAS for audits of nonissuers even when a regulator (e.g.,
the SEC) requires that such audits be conducted in accordance with PCAOB
standards. In this instance, audits for such entities should be
performed in accordance with both U.S. GAAS and PCAOB standards and the
related auditor’s report must refer to both sets of standards.
Connecting the Dots
Early in the process, management should identify all the
financial statements to be included in the registration statement and
discuss with the auditor whether an audit under AICPA standards, PCAOB
standards, or both is required. It may be prudent to consult with
outside advisers and, if complex issues are identified, to consider
preclearance with the SEC.
6.7.2 Audit Planning and Risk Assessment Process
6.7.2.1 Audit Materiality and Scope
In all audits, the auditor establishes a materiality level for the planning and
execution of the audit, which affects many of the auditor’s decisions about
the audit strategy and scope, including determining which accounts will be
tested at which locations as well as the extent of testing to be performed.
Materiality is based on quantitative as well as qualitative factors,
including the needs of the expected users of the financial statements. The
determination of audit materiality is not a mathematical exercise, and the
auditor will need to use judgment and consider the entity’s specific facts
and circumstances in making this determination. Because users of the
financial statements to be included in a registration statement differ from
users of a private company’s financial statements (e.g., lenders, limited
partners, suppliers), auditors’ materiality determinations in a PCAOB audit
may also differ from those in an AICPA audit.
Accordingly, the auditor would need to revisit its judgments about materiality in prior AICPA audits and determine whether those judgments are significantly different with respect to the needs of the expected users of the financial statements to be included in the registration statement. If so, the auditor may need to revise the scope of its prior audits on the basis of the revised materiality, which could result in the need to perform additional audit procedures for the prior years.
Connecting the Dots
Management and those charged with governance should
perform a similar exercise in assessing materiality to potential new
financial statement users. In determining financial statement
materiality, an entity should consider SAB Topic
1.M (SAB 99).
As discussed in other sections of this Roadmap as well as in Deloitte’s Roadmap
Carve-Out
Transactions, the financial statements included in
the registration statement vary and may involve carved-out portions (see
Section
2.3.1) or put-together pieces of other entities (see
Section
2.3.2). When the reporting entity or its composition changes,
the auditor will be conducting a “new” audit of a different entity. While
the auditor typically will attempt to leverage audit work performed in prior
audits of parts of the new reporting entity, the scope of the previous audit
work performed must be reconsidered with respect to the components of the
new reporting entity to determine, in the auditor’s judgment, whether that
audit scope and the related procedures performed are sufficient to issue an
auditor’s report on the financial statements of the new reporting entity,
particularly if certain components have not been previously audited.
Connecting the Dots
As soon as preparations for the IPO transaction
begin, management should consider informing the auditor of its
intention to take the entity public. An auditor that has advance
notice will be able to take the potential public filing into account
in establishing the scope of audit procedures to be performed for
the current AICPA audits; accordingly, the auditor may be able to
avoid the need to perform expanded audit procedures when the IPO
filing is imminent.
6.7.2.2 Auditor Inquiries
Both PCAOB and AICPA standards require auditors to make certain inquiries on various topics as part of
their risk assessment and planning process. Because PCAOB standards prescribe certain inquiries not
required by AICPA standards, auditors may need to conduct additional inquiries regarding prior AICPA
audits. In making these incremental inquiries, auditors may be required to conduct further discussions
with the following:
The above inquiries are related to the risk assessment process; since the auditor’s risk assessment is an
ongoing activity, management should be prepared to respond to the inquiries throughout the audit.
6.7.3 Related-Party Transactions
PCAOB AS 2410 establishes requirements related to the auditor’s evaluation of a
company’s identification of, accounting for (see Section 5.3), and disclosure of relationships and transactions
between the company and related parties.
PCAOB AS 2410 states that the auditor is required to do the following when
assessing related parties:
- [P]erform [specific] procedures to obtain an understanding of the company’s relationships and transactions with its related parties[, including] obtaining an understanding of the nature of the relationships . . . and of the terms and business purposes (or the lack thereof) of the transactions involving related parties. . . .
- [E]valuate whether the company has properly identified its related parties and relationships and transactions with related parties. . . . This evaluation requires the auditor to perform procedures to test the accuracy and completeness [of management’s identification], taking into account the information gathered during the audit. . . . If the auditor identifies information that indicates that related parties or relationships or transactions with related parties previously undisclosed to the auditor might exist, the auditor should perform the procedures necessary to determine whether previously undisclosed relationships or transactions with related parties, in fact, exist. . . .
- [Perform specific procedures if] the auditor determines that a related party or relationship or transaction with a related party previously undisclosed to the auditor exists. . . .
- Perform [specific] procedures [regarding] each related party transaction . . . that is required to be disclosed in the financial statements or determined to be a significant risk.
- [C]ommunicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties[, and] other significant matters arising from the audit.
Further, PCAOB AS 2110 indicates that the auditor is required to “perform procedures to obtain an understanding of the company’s financial relationships and
transactions with its executive officers.” However, the auditor is not required to make any determination
regarding the reasonableness of compensation arrangements or recommendations regarding
compensation arrangements.
Connecting the Dots
If it has not done so previously, management should
design a process for (1) identifying related parties and transactions,
(2) authorizing and approving transactions with related parties, and (3)
accounting for and disclosing relationships and transactions with
related parties in financial statements. Entities should be prepared to
respond to additional inquiries from auditors and should ensure that
executive management and those charged with governance are available for
such inquiries.
6.7.4 Audit Confirmations
Auditors may consider whether confirmations should be requested from additional external parties,
including new legal counsel. While such confirmations are not necessarily related to incremental
requirements of a PCAOB audit, they may ultimately be necessary as a response to new risks in an IPO.
Confirmations from third parties generally yield reliable audit evidence and can result in higher-quality
evidence than relying on inquiries with management alone.
6.7.5 Concluding Procedures
6.7.5.1 Subsequent Events
Although management is required to evaluate subsequent events through the date
of the registration statement, for previously issued financial statements,
management would generally not update its financial statement disclosure of
subsequent events unless the financial statements included in the
registration statement have been revised (e.g., the entity must make a
retrospective adjustment to effect a stock split), or disclosure would be
required to prevent the reissued financial statements from being misleading.
See Section
5.12 for additional considerations related to
subsequent-event disclosures.
6.7.5.2 Evaluating Uncorrected Misstatements
In both AICPA and PCAOB audits, the entity and the auditor need to accumulate
uncorrected misstatements identified during the audit and determine whether
those misstatements are material individually or in the aggregate to the
financial statements as a whole. In AICPA audits, this accumulation is based
on either the iron-curtain method or the rollover method, depending
on the entity’s policy. For PCAOB audits, however, entities and auditors
need to use both the iron-curtain method and the rollover methods to
accumulate uncorrected misstatements as of and for each period under audit.
Further, the evaluation of the materiality of such errors must principally
consider the method that yields the greater value of uncorrected
misstatements. The two methods can be described as follows:
- Iron-curtain method — Under this approach, the entity and the auditor focus on misstatements existing in the balance sheet at the end of the current period, regardless of the period(s) in which the misstatement originated. This approach does not take into account the income statement effects of the reversal of the carryover of a prior-period misstatement to be evaluated as an error.
- Rollover method — Under this approach, misstatements are quantified on the basis of the amount of error originating in the current-period income statement. Therefore, this approach could allow misstatements in the balance sheet to increase each period by immaterial amounts until the cumulative amount becomes material, which could then result in a material misstatement under the iron-curtain method.
Example 6-2
Assume that in 20X2, Company A
begins over-accruing a liability each year by $20.
Therefore, at the end of 20X6, liabilities are
overstated by $100. The $20 annual over-accrual is
not considered material to any of the individual
prior-period financial statements. At issue is
whether A should evaluate the uncorrected
misstatement as a $100 overstatement of liabilities
(iron-curtain method) or a $20 overstatement of
expenses (rollover method).
The following table shows
adjustments that A would make under each method to
correct the 20X6 financial statements:
Under SAB Topic
1.N (SAB 108), registrants are
required to use both approaches when evaluating the
uncorrected misstatement and to adjust the financial
statements if either
approach results in quantification of a material
misstatement. While typically this materiality
analysis would be performed by public entities,
management of an entity undergoing an IPO must also
consider its application while preparing the
entity’s financial statements for the IPO
registration statement.
Assume that the $100 uncorrected
misstatement under the iron-curtain approach is
material to 20X6 and that the financial statements
need to be adjusted, as a result of which expenses
are understated by $80 and the 20X6 income statement
is therefore misstated. The $80 understatement
should be evaluated for materiality with respect to
the 20X6 financial statements; if this
understatement is considered material, the
prior-period financial statements should be
corrected. In this example, the $20 accrual each
year should be reversed as follows:
Auditors will need to reevaluate whether uncorrected misstatements identified in
the prior audits are material to the prior-period financial statements on
the basis of (1) the greater of the amount determined under the iron-curtain
approach or that under the rollover approach and (2) their judgment about
materiality for the PCAOB audit. Further, as a result of this reevaluation,
if an auditor determines that the total amount of accumulated uncorrected
misstatements approaches materiality, the auditor may either (1) request
that management adjust the financial statements or (2) perform additional
audit procedures to reduce the risk that the combination of possible
undetected misstatements and misstatements identified during the audit
reaches materiality.
Connecting the Dots
Management should consider quantitative and
qualitative measures of materiality when reviewing uncorrected
misstatements and should determine whether the financial statements
need to be revised as a result of prior-year uncorrected
misstatements. Management should share its analysis with its auditor
and be prepared to support its judgments.
6.7.6 Communications With Management and Audit Committees
6.7.6.1 Requirements of PCAOB Standards
6.7.6.1.1 Communications With Audit Committees
PCAOB standards encourage auditors and the audit committee to effectively
communicate throughout the audit, since such communication can lead to a
better understanding of audit-related matters. In preparing to file an
initial registration statement, an entity typically will change its
governance structure, including the formation and composition of an
audit committee, to meet the governance requirements the entity will be
subject to after it becomes public. As a result, the individuals
auditors communicate with when reissuing auditor’s reports on prior
years are often different from the individuals auditors communicated
with in prior AICPA audits. In such cases, auditors may consider
recommunicating matters related to prior audits for the benefit of new
audit committee members.
6.7.6.2 Management Representation Letters
In connection with each amendment to a registration statement, auditors obtain
updates to the management representation letter obtained upon the initial
submission or filing of the registration statement, generally on the dates
on which each amendment is filed and on the effective date (or as close
thereto as is practicable in the circumstances).
6.7.6.3 Form of Auditor’s Report
The form and content of the auditor’s reports for PCAOB audits differ from those for AICPA audits as a result
of differences in the auditing standards. These differences include:
- The applicable auditing standards — PCAOB auditor’s reports include a statement that the audits were performed in accordance with PCAOB standards, while AICPA auditor’s reports include a statement that the audit was performed in accordance with U.S. GAAS. As noted in Section 6.7.1, it is also possible for the auditor’s report to refer to both sets of standards, if applicable.
-
Independence — PCAOB auditor’s reports must include a statement that the auditor is a public accounting firm registered with the PCAOB and must be independent with respect to the company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the SEC and PCAOB.
- Audit firm tenure — PCAOB auditor’s reports include a statement containing the year the auditor began serving consecutively as the company’s auditor.
- CAMs — PCAOB auditor’s reports include communication of CAMs related to the audit of the current-period financial statements or state that the auditor determined that there are no CAMs. A CAM is any matter arising from the audit of the financial statements that was communicated, or was required to be communicated, to the audit committee and that (1) is related to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment. It is expected that, in most audits, the auditor would determine that at least one matter involved especially challenging, subjective, or complex auditor judgment.As noted in Section 1.6.2, communication of CAMs does not need to be included in the auditor’s report of an EGC, since EGCs are among the companies9 exempt from this PCAOB requirement.
AICPA auditor’s reports also contain statements related to the responsibilities
of management and the auditor that are not required to be included in PCAOB
auditor’s reports.
6.7.7 Interim Reviews
Entities are often required to include interim financial information in the
registration statement (see Section 2.4.2). Because the auditor is associated with such
information, review procedures are often performed in accordance with PCAOB
standards. Specifically, paragraph 7 of PCAOB AS 4105 states, in part:
The objective of a review of interim financial
information . . . is to provide the [auditor] with a basis for
communicating whether he or she is aware of any material modifications
that should be made to the interim financial information for it to
conform with generally accepted accounting principles. The objective of
a review of interim financial information differs significantly from
that of an audit conducted in accordance with the standards of the
PCAOB. A review of interim financial information does not provide a
basis for expressing an opinion about whether the financial statements
are presented fairly, in all material respects, in conformity with
generally accepted accounting principles. A review consists principally
of performing analytical procedures and making inquiries of persons
responsible for financial and accounting matters, and does not
contemplate (a) tests of accounting records through inspection,
observation, or confirmation; (b) tests of controls to evaluate
their effectiveness; (c) obtaining corroborating evidence in
response to inquiries; or (d) performing certain other procedures
ordinarily performed in an audit. A review may bring to the [auditor’s]
attention significant matters affecting the interim financial
information, but it does not provide assurance that the [auditor] will
become aware of all significant matters that would be identified in an
audit.
Further, paragraph 16 of PCAOB AS 4105 indicates that the auditor “should apply analytical procedures
to the interim financial information to identify and provide a basis for inquiry about the relationships and
individual items that appear to be unusual and that may indicate a material misstatement.” The analytical
procedures that the auditor performs generally include:
- “Comparing the quarterly interim financial information with comparable information for the immediately preceding interim period and the quarterly and year-to-date interim financial information with the corresponding period(s) in the previous year, giving consideration to knowledge about changes in the entity’s business and specific transactions.”
- “Considering plausible relationships among both financial and, where relevant, nonfinancial information.” The auditor also may consider “information developed and used by the entity, for example, information in a director’s information package or in a senior committee’s briefing materials.”
- “Comparing recorded amounts, or ratios developed from recorded amounts, to expectations developed by the [auditor]. The [auditor] develops such expectations by identifying and using plausible relationships that are reasonably expected to exist based on the [auditor’s] understanding of the entity and the industry in which the entity operates.”
- “Comparing disaggregated revenue data, for example, comparing revenue reported by month and by product line or operating segment during the current interim period with that of comparable prior periods.”
Connecting the Dots
Management may perform the same review procedures that
auditors do and may use such procedures both as a risk assessment tool
and to be responsive to auditor inquiries. Providing the auditor with a
description of these procedures and documentation regarding
period-to-period fluctuations in account balances (or the absence of
expected fluctuations) is likely to reduce the time the auditor spends
in completing its review.
Footnotes
5
For example, under PCAOB standards, the auditor is always
required to perform a test of details in response to a significant risk. In
contrast, under AICPA standards, the auditor is not required to perform such
a test provided that its response addresses both substantive analytical
procedures and tests of controls.
6
SAS 131 (codified in AICPA AU-C Section
700).
7
Paragraph 11 of AICPA AU-C Section 600
defines a component auditor as “[a]n auditor who performs
work on the financial information of a component that will
be used as audit evidence for the group audit. A component
auditor may be part of the group engagement partner’s firm,
a network firm of the group engagement partner’s firm, or
another firm.”
8
A service auditor is an auditor that reports
on the effectiveness of controls at an outside service
provider (e.g., a transaction processor or investment
custodian).
9
Communication of CAMs is not required
for audits of (1) brokers and dealers reporting under
Rule 17a-5 of the Exchange Act; (2) investment companies
registered under the Investment Company Act of 1940,
other than business development companies; (3) employee
stock purchase, savings, and similar plans; and (4)
EGCs, as defined in Section 3(a)(80) of the Exchange
Act.
6.8 Consents
As noted in Chapter
1, the registration statement may be amended a number of times before
it is declared effective. In some cases, the financial statements may be revised
during this process. Auditors will most likely need to issue a written consent
agreeing to the inclusion of their auditor’s report in each filed registration
statement amendment.
When providing its consent, an auditor must extend its subsequent-event procedures and inquiries
(e.g., management inquiries, legal counsel inquiries). Further, management must provide updated
representation letters to the auditor through the date of the auditor’s consent. Updated legal
representations may also be needed.
The written consent provided by the auditor will be filed as an exhibit to the
registration statement and will include the auditor’s signature and a statement
indicating that it consents to have its auditor’s report on the financial statements
included in the filing.
Connecting the Dots
Issuers that submit draft registration statements to the SEC
staff for nonpublic or confidential review under the accommodations
identified in Section
1.4.2 will not need to include a written consent by the
auditor in the registration statement amendment; however, requirements to
update the financial statements (as necessary), perform additional
subsequent-event procedures, and obtain an updated management representation
letter still apply.
Prospectus supplements or draft registration statements may
also include an “experts” statement that refers to the auditor as a named
expert. However, the auditor does not issue a consent to this reference.
6.9 Other Financial and Nonfinancial Information
Section 4.4
discusses the preparation of pro forma financial
information in accordance with Regulation S-X,
Article 11. While auditors do not report on pro
forma financial information, this information, as
well as other information such as MD&A, is
included in the registration statement along with
the audited financial statements and the auditor’s
report. The auditor is required to read MD&A,
pro forma financial information, and other
information for material consistency with the
audited financial statements.
6.10 Comfort Letters
In conjunction with an IPO, underwriters will request a “comfort letter” from the company’s auditor. The purpose of such a letter is to assist underwriters in performing a reasonable investigation of financial and accounting information in the prospectus that is not covered by the auditor’s report.
The comfort letter lists procedures performed by the auditor on the basis of (1) PCAOB standards and
(2) specific requests by underwriters. These procedures typically include:
- Assertion of the auditor’s independence.
- Affirmation of the annual periods audited under PCAOB standards and compliance of the financial statements with the accounting requirements of the 1933 Act.
- Affirmation of the interim periods reviewed under PCAOB standards.
- A description of procedures performed with respect to periods after the latest balance sheet included in the prospectus; the purpose of such procedures is to determine whether there have been any significant financial changes, such as a decline in sales or income since the last balance sheet date, that are not adequately disclosed in the document.
- “Circle-up” or “tickmark” comfort, in which the auditor compares financial data in the prospectus with accounting records or financial statements or proves the arithmetical accuracy of such data.
Under PCAOB standards, the auditor may only provide comfort with respect to information that (1) is
expressed in dollars (or percentages derived from such dollar amounts) and that has been obtained
from accounting records that are subject to the entity’s controls over financial reporting or (2) has
been derived directly from such accounting records by analysis or computation. The auditor may
also comment on quantitative information that has been obtained from an accounting record if the
information is subject to the same controls over financial reporting as the dollar amounts. It is important
for the company to be involved in the procedures requested by the underwriters early in the process,
since management may need to provide support for amounts in the registration statement.
Two comfort letters are generally issued — one on the effective date of the registration statement and one on the closing date, the latter of which is often referred to as the “bring-down” letter. However, a draft of the comfort letter may be requested as of each filing date so that the underwriters may decide whether the procedures described in the letter are consistent with what they requested.
If more than one auditor is involved in the IPO, either as a predecessor auditor to the registrant or as the auditor of other financial statements included in the IPO document, the other auditors may also be requested to provide a comfort letter related to financial information with which they are associated.
Connecting the Dots
Providing supporting documentation for amounts included in
MD&A, pro forma financial information, and elsewhere in the registration
statement is critical to expediting the procedures auditors perform upon the
request of underwriters. Including both management and the auditor in
discussions with the underwriter regarding comfort letter timelines and the
expected nature of the auditor’s “comfort” procedures may prevent
surprises.
6.11 Internal Control Over Financial Reporting
6.11.1 Management and Auditor Attestations
While a newly public entity does not need to provide management’s report on ICFR
in a registration statement or in the entity’s first Form 10-K after the
registration statement is declared effective, the entity should nonetheless be
prepared to evaluate its ICFR on a quarterly basis, and key executives should be
comfortable with certifying that disclosure controls and procedures are
effective, in accordance with Section 302 of Sarbanes-Oxley. Auditors are not
required to issue an auditor’s report on the effectiveness of ICFR in connection
with the entity’s registration statement or its first Form 10-K but may be
required to do so in the entity’s second Form 10-K.
Connecting the Dots
Under the JOBS Act, an entity that qualifies as an EGC
is exempt from the requirement to obtain an attestation report on the
entity’s ICFR from its registered public accounting firm. However, as
noted in Section
1.6.2, an EGC only qualifies as such during the period in
which it meets certain quantitative requirements or up to five years
after its initial registration statement. In contrast, EGCs are not
exempt from the requirement to perform management’s assessment of ICFR
(Section 404(a) of Sarbanes-Oxley and the disclosure requirement in
Regulation S-K, Item 308(a)).
In addition to establishing and evaluating the effectiveness of its disclosure controls and procedures as
an entity prepares to go public, management will need to assess whether any changes or improvements
have been made to its ICFR.
For additional considerations related to control-related public-company disclosure requirements, see
Chapter 7.
6.11.2 Auditors’ Testing of Controls in a PCAOB Audit
In both AICPA and PCAOB audits, auditors are required to obtain a sufficient understanding of the
entity’s internal controls to plan the financial statement audit. However, the auditor’s evaluation of the
design effectiveness of relevant controls and the related documentation may be more extensive in a
PCAOB audit than in an AICPA audit.
Connecting the Dots
Management should inform the auditor early of its plans
to go public. Because of the increased focus on internal controls for
public companies, auditors will often increase their audit procedures
related to the entity’s internal controls as they perform AICPA audits
of an entity that plans to go public in the near future. Auditors can
often make helpful suggestions on how management can strengthen internal
controls and related documentation in preparing to meet the SEC’s
requirements.
To this end, management should consider developing plans
for implementing any needed internal control enhancements when preparing
for an IPO. A leading practice is to perform a formalized risk
assessment and identify risks of material misstatement associated with
each process. Once the risks of material misstatement have been
identified, identifying the controls needed to address those risks is
more straightforward. Furthermore, auditors will request such
documentation from management or the entity’s internal auditors.
In addition to the communication matters described in Section 6.7.6, there are incremental
requirements for PCAOB audits related to communicating control-related matters
to those charged with governance and management, which include the following:
- If auditors become aware that the oversight of the entity’s external financial reporting and ICFR by the entity’s audit committee is ineffective, auditors communicate that information in writing to the board of directors.
- The auditor needs to communicate in writing information about significant deficiencies and material weaknesses before the auditor’s report release date, instead of just on a timely basis as required by AICPA standards. For more detail on evaluating control deficiencies, see Section 3.7.4.
If members of management or those charged with governance have changed since the
previous AICPA audits, auditors may decide to include the matters communicated
in previous audits in the current communication. All matters must be
communicated before the release of the auditor’s report to be included in the
registration statement.
Chapter 7 — What to Expect After the Registration Statement Is Declared Effective
Chapter 7 — What to Expect After the Registration Statement Is Declared Effective
7.1 Introduction
When preparing for an IPO, it would be prudent for management to plan for the
SEC compliance and reporting requirements that will affect the company after the
registration statement is declared effective. Management should analyze — and should
consider engaging specialists to evaluate — whether the processes and controls the
company has established to meet these requirements are appropriately designed and
implemented. The company may need to develop new processes and controls to ensure
that it complies with ongoing regulations fully and in a timely fashion (e.g.,
periodic reporting requirements, current reporting requirements, and SEC Regulation
Fair Disclosure [FD]).
7.2 Periodic Reporting Requirements and SRC Status
After a registration statement is declared effective, a company is required to file quarterly reports on
Form 10-Q and annual reports on Form 10-K. The first Form 10-Q, for the quarter after the most recent
period included in the registration statement, is due the later of 45 days after the effective date or the
date the Form 10-Q would otherwise be due if the company had been a public filer. For example, if a
registrant with a December 31 year-end has a Form S-1 that is declared effective on July 15 and for
which March 31 interim information is included in the registration statement, the registrant’s first Form
10-Q would be for the second quarter ending on June 30 and would be due on August 29, 45 days after
July 15. The third-quarter Form 10-Q would be due 45 days after September 30, the end of the third
quarter.
A registrant’s first annual report on Form 10-K would generally be due 90 days
after its fiscal year-end. If the effective date of the initial registration
statement was within 45 days after the fiscal year-end but the registration
statement did not include the audited statements for the recently completed year,
the registrant would still need to file its annual report on Form 10-K within the
normal deadline (i.e., the post-IPO accommodation for Form 10-Q discussed above is
generally not available for Form 10-K). However, if the registrant is subject to the
Exchange Act reporting requirements only by virtue of Section 15(d), a Special
Report on Form 10-K containing audited statements for that year may be filed within
90 days of effectiveness and a complete annual report on Form 10-K would not be
required until the following fiscal year. See paragraph 1330.5 of the FRM for further
details.
The filing deadlines that apply to quarterly and annual reports after the first
Form 10-K are summarized in the table below. These due dates vary depending on
whether the company’s filing status1 is large accelerated, accelerated, or nonaccelerated. A company’s filing
status is determined, in part, on the basis of its public float, which is the AWMV
of the company’s voting and nonvoting common equity held by nonaffiliates. To be
considered a large accelerated or accelerated filer, the registrant must have filed
at least one annual report and must have been subject to the requirements of
Sections 13(a) and 15(d) of the 1934 Act for at least 12 months. Accordingly, the
registrant generally cannot be considered a large accelerated or accelerated filer
for its first Form 10-K filing as a public company. However, companies that become
public through a reverse merger with a public company may be required to take on the
filing status of the legal acquirer and should consider carefully evaluating their
filing status with their SEC counsel.
Filer
| Public
Float2 and Revenue |
SEC Form 10-K
|
SEC Form 10-Q
|
---|---|---|---|
Large accelerated filer
| Public float ≥ $700 million and any amount of revenue |
60 days after end of fiscal year
|
40 days after end of fiscal quarter
|
Accelerated filer
|
Public float ≥ $75 million but < $ 700
million and revenue ≥ $100 million
|
75 days after end of fiscal year
|
40 days after end of fiscal quarter
|
Nonaccelerated filer
|
Public float < $75 million and any amount
of revenue or revenue < $100
million and public float < $700 million
|
90 days after end of fiscal year
|
45 days after end of fiscal quarter
|
A nonaccelerated filer will qualify as an SRC and, in some instances, so will an
accelerated filer. See Section 1.5 and
Appendix B for more information about SRCs
and related accommodations that apply to such entities.
Footnotes
1
As defined in Section 240.12b-2 of Title 17, Code of
Federal Regulations. See Section 1340 of the FRM for a summary
of the accelerated filer rule.
2
Paragraph 1340.2
of the FRM defines public float as “[t]he aggregate
worldwide market value of its voting and non-voting
common equity held by non-affiliates.” Therefore,
debt-only registrants are nonaccelerated filers.
7.3 Current Reporting Requirements
As a public company, a registrant is also required to file a current report on Form 8-K that discloses
various material events that occur between its periodic reports, including, but not limited to:
- A public announcement or press release containing material nonpublic information about a registrant’s results of operations or financial condition for a completed quarterly or annual period.
- Entering into or terminating a material agreement not in the ordinary course of business.
- Completion of an acquisition or disposition of assets.
- Creation of a direct financial obligation or obligation under an off-balance-sheet arrangement.
- Exit or disposal activities.
- Material impairment charges under U.S. GAAP.
- Securities and trading information such as a notice of delisting, unregistered sales of equity securities, and material modifications to the rights of security holders.
- A change in its independent registered public accounting firm.
- Corporate governance matters, such as a change in control of the registrant, the appointment or departure of a principal officer, compensation agreements of certain officers, an amendment to the code of ethics, and a submission of matters for a vote by security holders.
Unless otherwise specified in the Form 8-K instructions, such events must generally be disclosed within
four business days after they occur. (For additional information about many of the required Form 8-K
disclosures, see the SEC’s Investor Bulletin, “How to Read an 8-K.”) Management should consider
the controls and procedures in place to identify these events and report them in a timely manner. It is
recommended that an entity consult with SEC counsel regarding the Form 8-K reporting requirements.
7.4 SEC Regulation FD
SEC Regulation FD requires that material nonpublic information be fully and
fairly disclosed to all investors. For example, if a registrant selectively
discloses material information to persons or entities such as securities analysts,
money managers, activist investors, or other investors, the company must also
disclose the information publicly. If the company intentionally discloses the
material nonpublic information, it should make such information public at the same
time as it provides the selective disclosure. If the company unintentionally
discloses the information, it should provide such disclosure as soon as reasonably
possible (i.e., within 24 hours or the start of the next day’s trading on a stock
exchange such as the New York Stock Exchange, whichever comes later). Such
disclosures should be provided broadly to the public (e.g., in a Form 8-K or, in
certain circumstances, on the registrant’s Web site3). To foster compliance with Regulation FD and to prevent unintentional
disclosures of material nonpublic information, registrants should consider educating
management on Regulation FD and should establish strong investor relations and
social media policies.
Footnotes
7.5 Internal Controls and Procedures
There are two types of controls and procedures that a public company will need to address in its filings
with the SEC. ICFR refers to procedures within a company that are designed to reasonably ensure
compliance with the company’s policies related to the preparation of financial statements that are
compliant with U.S. GAAP and Regulation S-X. Disclosure controls and procedures are a broader set of
controls that largely encompass ICFR and are designed to provide assurance that information that the
registrant must disclose in the reports that it files or submits under the 1934 Act is recorded, processed,
summarized, and reported within the periods specified.
When preparing their annual and quarterly reports, registrants need to consider
the requirements related to ICFR. Management must annually file a report containing
its assessment of the effectiveness of ICFR. Moreover, an auditor’s attestation
report on the effectiveness of ICFR must be included in annual reports of non-EGC4 accelerated and large accelerated filers. However, all newly public companies
can take advantage of a phase-in exception in Regulation S-K, Item 308, under which
management’s report and the auditor’s attestation are generally not required before
the second annual report (i.e., until a registrant had been required to file or had
filed a Form 10-K for the prior fiscal year).
Also, on a quarterly basis, the company must:
- Disclose any change in its ICFR that occurred during that quarter and that materially affected, or is reasonably likely to materially affect, its ICFR.
- Evaluate and reach a conclusion about the effectiveness of the company’s disclosure controls and procedures as of the end of the quarter.
In addition to the requirements described above, as part of a company’s quarterly and annual reports,
the registrant’s principal executive and principal financial officer (typically the CEO and CFO) must file
certifications prescribed by Sections 302 and 906 of Sarbanes-Oxley.
The Section 302 certifications signify that the CEO and CFO (1) have reviewed
the respective quarterly or annual report; (2) do not know of any material facts
that were omitted from, or untrue or misleading statements that were included in,
the report; (3) believe that the financial information in the report presents
fairly, in all material respects, the company’s financial conditions, results of
operations, and cash flows; (4) are responsible for establishing and maintaining
disclosure controls and procedures and ICFR;5 and (5) have communicated all detected significant deficiencies and material
weaknesses, as well as any fraud involving the company’s management, to the audit
committee and the external auditors.
In the Section 906 certifications, the CEO and CFO must certify that (1) the
company’s quarterly or annual report complies fully with the requirements of Rule
13a or 15d of the 1934 Act and (2) information contained in this report presents
fairly, in all material respects, the company’s financial condition and results of
operations.
The corporate governance at many registrants includes an internal subcertification process in which
other members of management help the CEO and CFO assess disclosure controls and procedures.
These subcertifications cover matters consistent with those discussed in the paragraph above and are
provided to the CEO and CFO before each periodic report is issued. A company may wish to consider
who will be part of the subcertification process during its IPO readiness procedures.
The following table summarizes the
control-related reporting requirements for various types of filers:
Description | Applicable
Regulation | Annual Reporting
Requirement? | Interim Reporting
Requirement? | |
---|---|---|---|---|
Management’s
assertion on the
effectiveness of
disclosure controls and
procedures | Rule 13a-15 or 15d-15 of
the 1934 Act | Yes | Yes | |
Management’s
assertion on the
effectiveness of ICFR | Section 404(a) of
Sarbanes-Oxley Regulation S-K, Item 308(a) | Newly public company
filing first Form 10-K | No | No |
Second Form 10-K and
thereafter | Yes | |||
Auditor’s report on the
effectiveness of ICFR | Section 404(b) of
Sarbanes-Oxley Regulation S-K, Item 308(b) | Newly public company
filing first Form 10-K | No | No |
EGCs6 | No | |||
Nonaccelerated filers | No | |||
Non-EGC accelerated filer | Yes | |||
Large accelerated filer | Yes | |||
Disclosure of material
changes in ICFR | Regulation S-K, Item 308(c) | Yes | Yes | |
CEO and CFO
certifications | Sections 302 and 906 of
Sarbanes-Oxley | Yes | Yes |
Footnotes
4
For special relief provisions available to EGCs, see
Section
1.6.
5
Before the initial requirement to file management’s
assertion on the effectiveness of ICFR, the certifications may omit the
specific references to ICFR.
6
For additional information about
EGCs, see Section 1.6.
7.6 Other Post-IPO Considerations
In addition to current and periodic filing responsibilities, a company needs to
carefully consider other topics as it moves forward as a public registrant. The
company will need to establish controls and procedures to support areas such as
investor relations, XBRL requirements, cybersecurity, proxy statements, compliance
with the Foreign Corrupt Practices Act, tender offers, stock repurchase programs,
beneficial ownership reporting, trading activities by insiders, compliance with safe
harbor provision requirements related to the disclosure of forward-looking
information (e.g., the Private Securities Litigation Reform Act of 1995), and
disposition of restricted securities and securities held by affiliates. Companies
will also need to follow the regulatory process, such as SEC and FASB activity, for
new and amended requirements. Because these responsibilities and requirements are
far-reaching and will take time to implement, it will be important for a company to
prepare to comply with them during the planning stages of its IPO. See Deloitte’s
Strategies for Going Public for more
information about these requirements.
XBRL is an eXtensible Markup Language (XML) standard for tagging
financial reports. With XBRL, a uniform taxonomy or format is used to facilitate the
transparency and comparability of information. For example, the U.S. GAAP financial
reporting taxonomy consists of a list of computer-readable tags in XBRL that allows
companies to label financial data presented in financial statements and footnote
disclosures. Inline XBRL allows filers to embed XBRL data directly into an HTML
document and is required for all filers. After an IPO, use of inline XBRL is
required starting with the first Form 10-Q for domestic filers and for the first
Form 20-F for FPIs.
Changing Lanes
SEC Final Rule Released in
2022
Executive Compensation Disclosures
In August 2022, the SEC issued a final rule that requires certain
registrants to provide disclosures about executive pay and company
performance within any proxy statement or information statement for which
executive compensation disclosures are required. The disclosure requirements
were effective for registrants beginning with fiscal years ending on or
after December 16, 2022, and apply to all registrants other than EGCs,
registered investment companies, and FPIs. SRCs are exempt from certain of
the requirements.
While the final rule’s requirements do not apply to EGCs,
they include transition provisions for newly public companies that are not
EGCs. Because the disclosures are not required in registration statements,
they do not have to be provided during the IPO process. In addition, the
requirements apply only for years in which a registrant was subject to
reporting requirements under the 1934 Act (i.e., a public company). For
example, if a non-EGC registrant completes its IPO in 2023, the proxy
statement for fiscal year 2023 would provide such disclosure only for fiscal
year 2023. The registrant would add subsequent years to each annual proxy
filing until it includes five years (i.e., in the proxy filing for fiscal
year 2027, which would be the year that includes the fourth anniversary of
its IPO).
SEC Final Rule Released in
2023
Cybersecurity-Related Disclosures
In July 2023, the SEC issued a final
rule that requires registrants to provide enhanced
disclosures about “cybersecurity incidents and cybersecurity risk
management, strategy, and governance.”
The final rule addresses concerns over investor access to
timely and consistent information related to cybersecurity as a result of
the widespread use of digital technologies and artificial intelligence, the
shift to hybrid work environments, the rise in the use of cryptoassets, and
the increase in illicit profits associated with ransomware and stolen data,
all of which continue to escalate cybersecurity risk and its related costs
to registrants and investors. The final rule establishes new requirements
related to:
- Material cybersecurity incidents, which would need to be disclosed on Form 8-K within four business days of their being deemed material. A registrant may delay filing the Form 8-K if the U.S. Attorney General “determines immediate disclosure would pose a substantial risk to national security or public safety.”
- Annual disclosures in Form 10-K pertaining to (1) cybersecurity risk management and strategy, (2) “management’s role in assessing and managing material risks from cybersecurity threats,” and (3) “the board of directors’ oversight of cybersecurity risks.”
- The presentation of disclosures in Inline XBRL.
All SEC registrants would be subject to the new rule. For
more information about the final rule, see Deloitte’s July 30, 2023,
Heads
Up.
SEC Proposed Rule Released in
2022
Enhancements to Climate-Related Disclosure
Requirements
EGCs and other companies should be aware of the SEC’s
proposal that would require public companies to enhance and standardize
their climate disclosures. For more information about this proposal, see the
Changing Lanes in Section
1.7.
Connecting the Dots
As previously stated above regarding the SEC's final rule on
executive compensation disclosures, registrants that initially qualify as an
EGC are exempt from providing disclosures about executive pay and company
performance. However, a registrant that loses its EGC status is required to
comply with the rule. For example, a calendar-year EGC registrant that
initially completed its IPO in March 2020 but lost its EGC status as of
December 31, 2023, would be required to provide disclosures about executive
pay and company performance for three years (two years for an SRC) in its
early 2024 proxy statement (i.e., for 2021, 2022, and 2023). This
requirement is consistent with the transition provisions in the final rule
that allow registrants to provide three years of disclosures in their first
filing. See Deloitte’s September 2, 2022, Heads Up for more
information.
7.7 Registration Statements After the IPO
After its initial registration, a domestic registrant may need to register
additional securities. The SEC offers various forms to facilitate
registration; the form used will depend on the type of offering
undertaken by the registrant. The sections below briefly summarize
the most commonly used forms. When registering securities,
registrants should consider consulting their legal counsel to
determine the appropriate form to file.
While the accommodation for EGCs to use two years of financial statements
rather than three generally only applies to their IPO registration
statement, the SEC will accept two years of financial statements in
a registration statement filed after the IPO, but before the first
Form 10-K, as long as the registrant remains an EGC. However, if a
registrant loses EGC status either during or after its IPO, it must
provide three years of financial statements for any future
registration statement, even if the third year predates the
information provided in the IPO registration statement.
7.7.1 Form S-1
The Form S-1 registration statement is used (1) when no other form is prescribed by SEC rules and (2) by all issuers that have not previously filed under either the Securities Act or the Exchange Act or that have been in the Exchange Act reporting system for less than 12 months. A newly public company may use Form S-1 for a follow-on offering in which the company offers additional registered shares to the public or registers privately held shares of the company’s founders, board of directors, or other large shareholders so that those shares may be sold in the public market.
Connecting the Dots
An issuer may voluntarily submit for nonpublic review a
draft registration statement within one year of the effective date of
either its initial Securities Act registration statement or its Exchange
Act Section 12(b) registration statement. This accommodation is
available only for the initial submission. A registrant that files a
draft registration statement in these circumstances must subsequently
respond to Division staff comments on the draft registration statement
by means of a public filing rather than a revised draft registration
statement. At the time of the public filing, the previously submitted
draft registration statement should also be filed. The public filing
must be available on EDGAR for at least 48 hours before the issuer’s
requested effective date for the registration statement.
7.7.2 Form S-3
Form S-3 is a more simplified form of registration statement than a Form S-1. Eligible public companies can use Form S-3 to sell securities provided that they satisfy certain reporting status requirements. For example, a registrant:
- Must be organized under the laws of, and have its principal business operations in, the United States.
- Must be currently reporting under the 1934 Act and have filed, in a timely manner, all the information required by the 1934 Act for at least 12 calendar months immediately preceding the filing of the form.
- Must not have defaulted on any preferred stock dividend or sinking fund payment, installment on indebtedness for borrowed money, or rental under any long-term lease since the date of the last annual financial statements (unless the effects of such defaults, in the aggregate, were not material to the registrant’s consolidated financial position).
There may also be restrictions on the types or amounts of securities and offerings that may be registered by using Form S-3. A registrant should consult with legal counsel to determine a desired offering of securities that may be S-3 eligible. If a company is not eligible to use Form S-3, the offering may be made by using another appropriate securities offering form, often Form S-1. A Form S-3 can be used as a “shelf offering” in which the company does not intend to immediately sell all the securities being registered but is able to sell the registered shares in future transactions, often referred to as “takedowns” from the shelf.
7.7.3 Form S-4
Form S-4 is used for registration of securities to be issued in specified types of mergers, acquisitions, and exchange offers. For example, if a registrant’s shares are being registered and exchanged as consideration in a proposed acquisition or merger, they may be registered on Form S-4. Form S-4 may also be used to register private debt securities, previously issued under Securities Act Rule 144A, which contained registration rights requiring a future exchange of such debt for debt that is registered.
7.7.4 Form S-8
Form S-8 is used to register securities to be offered to employees as part of certain employee benefit plans. Because many newly public companies have stock compensation plans, it is common for the related shares to be registered by using Form S-8, shortly after the completion of a company’s public offering.
7.7.5 Form S-11
Form S-11 is used to register securities to be issued by REITs or “other issuers
whose business is primarily that of acquiring and holding for investment real
estate or interests in real estate or interests in other issuers whose business
is primarily that of acquiring and holding real estate or interest in real
estate for investment.”
7.7.6 Other
Various other forms may also be used to register securities, including forms
that may be used by FPIs. A more complete list of these
forms is available on the SEC’s Forms
List Web page. The individual forms
and related instructions should be consulted for specific
eligibility and content requirements.
Appendix A — Common Disclosures in an IPO Registration Statement
Appendix A — Common Disclosures in an IPO Registration Statement
Typical Sections in an IPO Registration Statement
The table below summarizes the information entities either are required to provide or often include in
an IPO registration statement.
Section | Section Overview |
---|---|
Prospectus summary (often
referred to as the “box”) | Highlights in one consolidated location the key information related to the IPO,
such as a summary of the company and its business, the nature of the securities
being offered, primary risk factors, and summarized financial information. |
Risk factors | Highlights the company’s most significant risk factors. Risk factors should be
specific to the company. |
Use of proceeds | Describes the primary intended use of the net proceeds. Examples of typical
uses may include acquisitions, capital expenditures, debt reduction, and general
corporate purposes. |
Dividend policy | Discusses current dividend policy and any anticipated changes to the policy. |
Capitalization | A table presenting the capital structure of the company before and after the
offering is often presented. |
Dilution | Disclosure, often in a tabular format, of any material difference between the IPO
price of the securities and the net tangible book value per share. |
MD&A | Discusses the company’s financial condition and results of operations for the
periods presented, including forward-looking information. |
Business | Contains extensive disclosure and discussion about a company’s business,
including, but not limited to, its industry, customers, products and services,
properties, operating segments, and significant litigation and contingencies. |
Executive officers, directors,
and principal and selling
stockholders | A company’s executive officers and directors must be identified. A brief summary
of the relevant business experience for each must also be disclosed. In addition,
a company must disclose the name and beneficial stock ownership of each
director/selling stockholder, executive officer, all directors and executive officers
as a group, and each known 5 percent stockholder. |
Executive compensation | Highlights the key provisions of the compensation arrangements of executive
officers and directors. |
Description of capital stock | Summarizes the terms of capital stock outstanding after the IPO, including the
number of stockholders and shares, rights to acquire capital stock, and any anti-takeover
provisions. |
Underwriting/plan of
distribution | Discloses the price of the securities being offered, the names of the managing
underwriters and other members of the underwriting syndicate, and
underwriting discounts and any other compensation arrangements with the
underwriters. |
Experts | Identifies any parties or persons who have prepared or certified any part of the
prospectus (e.g., an independent registered public accounting firm that audits
the financial statements included therein). |
Financial statements | Any required annual or interim financial statements of the registrant or other
entities. (See Chapter 2 for further details.) |
Other disclosures | Certain relationships and related-party transactions, material income tax
consequences, and legal matters. |
Appendix B — Summary of Scaled Disclosure Requirements Available to SRCs
Appendix B — Summary of Scaled Disclosure Requirements Available to SRCs
The tables below compare certain requirements under Regulations S-K and S-X for
SEC registrants and the related SRC scaled disclosures.
Disclosure Requirements Under Regulation S-K
Regulation S-K Item | Summary of Disclosure | SRC Scaled Disclosure | Registrants Other Than SRCs1 |
---|---|---|---|
Item 101, “Description of
Business” | Description of business
developments, including
principal products and
services rendered | SRCs may elect to provide the alternative business disclosure (which may be less
detailed) under Item 101(h) | Required |
Item 201, “Market Price
of and Dividends on the
Registrant’s Common
Equity and Related
Stockholder Matters” | A graph depicting share
performance over the
past five years against
market indexes | Not required | Required |
Item 302, “Supplementary
Financial Information” | Under Item 302(a), if a registrant reports a material retrospective change (or
changes) for any of the quarters within the two most recent fiscal years, the
registrant must disclose (1) an explanation for the material change(s) and (2)
select financial information reflecting such change(s) for the affected
quarterly periods, including the fourth quarter. | Not required | Required |
Item 303, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations”
| Discussion of results of
operations | Discuss prior two years | Discuss prior three years, but may refer to discussion of earliest period in
prior filing. |
Item 305, “Quantitative
and Qualitative
Disclosures About Market
Risk” | Disclosure of information about market-sensitive instruments and related
exposure, including sensitivity analysis | Not required | Required |
Item 402, “Executive
Compensation” | Number of named
executive officers | Three | Five |
Scope of summary
compensation table | Two years | Three years | |
Compensation discussion
and analysis, grants
of plan-based awards
table, option exercises
and stock vested
table, pension benefits
table, nonqualified
deferred compensation
table, disclosure of
compensation policies
and practices related to
risk management, pay
ratio disclosure | Not required | Required | |
Item 404, “Transactions
With Related Persons,
Promoters and Certain
Control Persons” | Description of policies/procedures for the review, approval, or ratification of
related-party transactions | Not required | Required |
Item 407, “Corporate Governance”
| Disclosure of audit
committee financial
expert | Not required in first
annual report | Required |
Disclosure of
compensation committee
interlocks and insider
participation | Not required | Required | |
Compensation committee
report | Not required | Required | |
Item 503, “Prospectus Summary”
| Discussion of the most
significant risk factors
facing the company | Not required in Exchange Act filings (e.g., annual or interim reports); required
in a registration statement | Required |
Financial Statement Requirements Under Regulation S-X
Financial Statement Requirements2 | Summary of Disclosure | SRC Scaled Disclosure | Registrants Other Than
SRCs |
---|---|---|---|
Annual financial
statements | Annual audited financial
statements | Two years balance sheet,
income statement, cash
flow, and shareholders’
equity | Three years income
statement, cash flow, and
shareholders’ equity, two
years balance sheet |
Footnote and other disclosures
| Compliance with presentation and disclosure requirements of Regulation S-X, including, but not limited to, separate disclosure of revenue and costs from products and services and separate presentation of related-party transactions | Generally not required | Required |
Disclosure of accounting
policy related to certain
derivative instruments
(Rule 4-08(n)) | Required | Required | |
Adoption date for new or revised accounting standards3
|
Use “Bucket 1” adoption dates (unless the registrant is an
EGC that has elected to defer adoption dates for new standards)
| ||
Disclosure of certain
information related
to guaranteed or
collateralized securities
(Rule 3-10 and Rule 3-16) | Required | Required | |
Compliance with
auditor independence
requirements (Article 2) | Required | Required | |
Supplemental financial statement schedules | Not required | Required | |
Financial information of EMIs | Summarized financial
data of the EMI disclosed
in the registrant’s financial
statements | Required if the EMI
exceeds 20 percent
significance in both
interim and annual
periods | Required if the EMI exceeds 20 percent significance at interim periods or 10
percent significance for the annual period6 |
Audited historical financial
statements of the EMI | Only required if EMI financial statements would be “material to investors”7 | Required if the EMI exceeds 20 percent significance8 |
Footnotes
1
The disclosures identified in the “Registrants Other
Than SRCs” column do not contemplate certain scaled disclosure
accommodations that may be available to EGCs.
2
SRCs apply the requirements in
Regulation S-X, Article 8, when preparing their
financial statements. SRCs typically are not
required to apply the disclosure provisions of
Regulation S-X in their entirety unless Article 8
indicates otherwise. Registrants other than SRCs
should apply Regulation S-X in its entirety, as
applicable.
3
As a result of ASU 2019-10, SRCs can adopt ASU 2016-13
(as amended) and ASU 2017-04 in a manner consistent with private-company
adoption dates. In addition, the FASB intends to use the two-bucket
framework to stagger effective dates for future major accounting
standards.
4
See Section 2.5.2 for additional
information.
5
See footnote 4.
6
Regulation S-X, Rule 4-08(g) and Rule 10-01(b)(1),
prescribe the annual requirements for summarized financial information and
the interim requirements for summarized income statement information,
respectively.
7
See paragraph 5330.2 of the FRM.
8
Regulation S-X, Rule 3-09, prescribes the annual
requirements for financial statements of an EMI. See Deloitte’s Roadmap
SEC Reporting
Considerations for Equity Method Investees for further
guidance on evaluating the significance of EMIs.
Appendix C — Key Benefits Available to EGCs and Non-EGCs
Appendix C — Key Benefits Available to EGCs and Non-EGCs
The table below compares certain benefits available to EGCs and non-EGCs.
Description of Benefit | Non-EGCs3 | |
---|---|---|
Submit draft registration statements for: | ||
Securities Act IPOs and initial registration statements | X | X |
Exchange Act Section 12(b) registration statement (e.g., Form 10) | X | X |
Securities Act offerings within one year of an IPO or Exchange Act Section 12(b)
registration statement | X | X |
Omit financial information4 from a draft registration statement if the company
reasonably believes that it will not be required: | ||
At the time of the offering5 | X6 | |
At the time of the public filing | X | X |
Include only two years of audited annual financial statements in: | ||
An IPO of common equity securities | X | |
An IPO of debt securities or Exchange Act registration statements (e.g., Form 10) | ||
May elect to defer the adoption of new or revised accounting standards until
they become effective for private companies (i.e.,
nonissuers)8 | X | |
Eligible for reduced executive compensation disclosures | X | |
May omit management’s assessment of ICFR under Section 404(a) of Sarbanes-Oxley
in the first Form 10-K after an
IPO | X | X |
May omit the auditor’s assessment under Section 404(b) of Sarbanes-Oxley: | ||
In the first Form 10-K after an IPO | X | X |
In the next four annual periods if the registrant continues to qualify as an EGC | X |
The table above is not intended to be all-inclusive. We recommend that an issuer refer to SEC
regulations, read the guidance in the FRM, and consult with its external auditors and SEC counsel on
the application of SEC reporting requirements before submitting any registration statement or current
report on Form 10-K.
Footnotes
1
See Topic 10 of the
FRM for additional information about the eligibility
requirements for, and accommodations available to,
EGCs.
2
See Topic 5 of the
FRM for information about the eligibility
requirements for, and additional relief available
to, SRCs.
3
See footnote 2.
4
We believe this may also include
financial information of entities other than the
registrant (i.e., under Regulation S-X, Rule 3-05 or
3-09).
5
The general instructions to
Form S-1 and Form F-1 indicate that before the
registrant distributes a preliminary prospectus to
investors, the registration statement must be
amended to include all financial information
required under Regulation S-X.
6
This applies only to IPOs of debt or
equity securities on Form S-1 or Form F-1. For
example, it would not apply to draft registration
statements on Form S-11 or Form 10.
(7)
An EGC would generally be required
to present three years of financial statements for
an IPO of debt securities or a registration
statement on Form 10. See paragraph
10220.1 of the FRM for more
information.
8
EGCs should refer to Section
10230 of the FRM for more
information.
Appendix D — Titles of Standards and Other Literature
Appendix D — Titles of Standards and Other Literature
AICPA Literature
Accounting and Valuation Guide
Valuation of Privately-Held-Company
Equity Securities Issued as Compensation
Professional Standards
AU-C Section 600, “Special
Considerations — Audits of Group Financial
Statements (Including the Work of Component
Auditors)”
AU-C Section 700, “Forming an Opinion and Reporting on
Financial Statements”
Statements on Auditing Standards
No. 131, Amendment to
Statement on Auditing Standards No. 122 Section
700, Forming an Opinion and Reporting on Financial
Statements
No. 134, Auditor Reporting and
Amendments, Including Amendments Addressing
Disclosures in the Audit of Financial
Statements
FASB Literature
ASC Topics
ASC 205, Presentation of Financial
Statements
ASC 250, Accounting Changes
and Error Corrections
ASC 260, Earnings per
Share
ASC 270, Interim
Reporting
ASC 280, Segment
Reporting
ASC 310, Receivables
ASC 326, Financial Instruments — Credit
Losses
ASC 340, Other Assets and Deferred
Costs
ASC 450, Contingencies
ASC 480, Distinguishing
Liabilities From Equity
ASC 505, Equity
ASC 606, Revenue From
Contracts With Customers
ASC 710, Compensation —
General
ASC 718, Compensation — Stock
Compensation
ASC 740, Income Taxes
ASC 805, Business
Combinations
ASC 815, Derivatives and Hedging
ASC 820, Fair Value
Measurement
ASC 825, Financial
Instruments
ASC 842, Leases
ASC 845, Nonmonetary
Transactions
ASC 850, Related Party
Disclosures
ASC 855, Subsequent
Events
ASUs
ASU 2013-12, Definition of a Public
Business Entity: An Addition to the Master Glossary
ASU 2016-13, Financial Instruments — Credit Losses
(Topic 326): Measurement of Credit Losses on Financial Instruments
ASU 2017-04, Intangibles — Goodwill and Other (Topic
350): Simplifying the Test for Goodwill Impairment
ASU 2018-07, Compensation — Stock
Compensation (Topic 718): Improvements to Nonemployee Share-Based Payment
Accounting
ASU 2019-10, Financial Instruments
— Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic
842): Effective Dates
ASU 2020-06, Debt — Debt with
Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging — Contracts
in Entity's Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and
Contracts in an Entity's Own Equity
ASU 2021-07, Compensation — Stock Compensation
(Topic 718): Determining the Current Price of an Underlying Share for
Equity-Classified Share-Based Awards — a consensus of the Private Company
Council
Proposed ASUs
No. 2019-500, Income Taxes (Topic
740): Disclosure Framework — Changes to the Disclosure Requirements for Income
Taxes (Revision of Exposure Draft Issued July 26, 2016)
No. 2022-ED100, Segment Reporting (Topic 280):
Improvements to Reportable Segment Disclosures
IESBA
Section 410, Independence for Audit and Review
Engagements: Fees
Section 600, Independence for Audit and Review
Engagements: Provision of Non-Assurance Services to an Audit Client
IFRS Literature
IFRS 8, Operating Segments
IRC
Section 162, “Trade or Business
Expenses”
Section 409A, “Inclusion in Gross
Income of Deferred Compensation Under Nonqualified
Deferred Compensation Plans”
Section 422, “Incentive Stock
Options”
Section 423, “Employee Stock
Purchase Plans”
PCAOB Literature
Auditing Standard 2110, Identifying
and Assessing Risks of Material Misstatement
Auditing Standard 2201, An Audit of
Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial
Statements
Auditing Standard 2410, Related
Parties
Auditing Standard 2705, Required Supplementary
Information
Auditing Standard 4105, Reviews of
Interim Financial Information
AU Section 558, Required Supplementary
Information
Rule 2100, “Registration Requirements
for Public Accounting Firms”
Rule 3524, “Audit Committee Pre-Approval
of Certain Tax Services”
Rule 3525, “Audit Committee Pre-Approval
of Non-Audit Services Related to Internal Control Over Financial Reporting”
Rule 3526, “Communication With Audit
Committees Concerning Independence”
SEC Literature
Accounting Series Release (ASR)
No. 268, Presentation in
Financial Statements of “Redeemable Preferred
Stocks” (Rule 5-02.28 of SEC Regulation
S-X)
Final Rule Releases
No. 33-10786, Amendments to Financial Disclosures
About Acquired and Disposed Businesses
No. 33-11126, Listing Standards for Recovery of
Erroneously Awarded Compensation
No. 33-11216, Cybersecurity Risk Management, Strategy,
Governance, and Incident Disclosure
No. 34-95607, Pay Versus
Performance
FRM
Topic 1, “Registrant’s Financial Statements”
Topic 2, “Other Financial Statements Required”
Topic 3, “Pro Forma Financial Information”
Topic 4, “Independent Accountants’ Involvement”
Topic 5, “Smaller Reporting Companies”
Topic 6, “Foreign Private Issuers
& Foreign Businesses”
Topic 7, “Related Party Matters”
Topic 9, “Management’s Discussion and Analysis of Financial Position
and Results of Operations (MD&A)”
Topic 10, “Emerging Growth Companies”
Topic 12, “Reverse Acquisitions and Reverse Recapitalizations”
Industry Guide
Industry Guide 5, “Preparation of
Registration Statements Relating to Interests in
Real Estate Limited Partnerships”
Interpretive Releases
No. 33-10751, Commission Guidance
on Management’s Discussion and Analysis of Financial Condition and Results of
Operations
No. 34-58288, Commission Guidance
on the Use of Company Web Sites
Proposed Rule Releases
No. 33-11028, Cybersecurity Risk Management for
Investment Advisers, Registered Investment Companies, and Business Development
Companies
No. 33-11042, The Enhancement and Standardization of
Climate-Related Disclosures for Investors
No. 33-11048, Special Purpose Acquisition Companies,
Shell Companies, and Projections
No. 33-11061, The Enhancement and
Standardization of Climate-Related Disclosures for Investors (extension of comment
period)
Regulation S-K
Item 10(e), “Use of Non-GAAP
Financial Measures in Commission Filings”
Item 101, “Description of
Business”
Item 201, “Market Price of and
Dividends on the Registrant’s Common Equity and
Related Stockholder Matters”
Item 302, “Supplementary
Financial Information”
Item 303, “Management’s
Discussion and Analysis of Financial Condition and
Results of Operations”
- Item 303(a), “Objective”
Item 305, “Quantitative and
Qualitative Disclosures About Market Risk”
Item 308, “Internal Control Over Financial Reporting”
- Item 308(a), “Management’s Annual Report on Internal Control Over Financial Reporting”
- Item 308(b), “Attestation Report of the Registered Public Accounting Firm”
- Item 308(c), “Changes in Internal Control Over Financial Reporting”
Item 402, “Executive Compensation”
Item 403(a), “Security Ownership of
Certain Beneficial Owners”
Item 404, “Transactions With
Related Persons, Promoters and Certain Control
Persons”
- Item 404(a), “Transactions With Related Persons”
- Item 404(b), “Review, Approval or Ratification of Transactions With Related Persons”
Item 407, “Corporate
Governance”
Item 503, “Prospectus
Summary”
Item 601, “Exhibits”
Item 901(c), “Definitions”
(roll-up transaction)
Regulation S-X
Rule 1-02, “Definitions of Terms Used in Regulation S-X
(17 CFR Part 210)”
-
Rule 1-02(u), “Related Parties”
-
Rule 1-02(w), “Significant Subsidiary”
-
Rule 1-02(bb), “Summarized Financial Information”
Article 2, “Qualifications and Reports of Accountants”
-
Rule 2-01, “Qualifications of Accountants”
Article 3, “General Instructions as to
Financial Statements”
-
Rule 3-01, “Consolidated Balance Sheets”
-
Rule 3-04, “Changes in Stockholders’ Equity and Noncontrolling Interests“
-
Rule 3-05, “Financial Statements of Businesses Acquired or to Be Acquired“
- Rule 3-05(a), “Financial Statements Required”
-
Rule 3-06, “Financial Statements Covering a Period of Nine to Twelve Months”
-
Rule 3-09, “Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons“
-
Rule 3-10, “Financial Statements of Guarantors and Issuers of Guaranteed Securities Registered or Being Registered“
-
Rule 3-12, “Age of Financial Statements at Effective Date of Registration Statement or at Mailing Date of Proxy Statement”
-
Rule 3-13, “Filing of Other Financial Statements in Certain Cases”
-
Rule 3-14, “Special Instructions for Financial Statements of Real Estate Operations Acquired or to Be Acquired”
-
Rule 3-16, “Financial Statements of Affiliates Whose Securities Collateralize an Issue Registered or Being Registered”
Article 4, “Rules of General
Application”
- Rule 4-08(g), “Summarized Financial Information of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons”
- Rule 4-08(k), “Related Party Transactions That Affect the Financial Statements”
- Rule 4-08(n), “Accounting Policies for Certain Derivative Instruments”
Article 5, “Commercial and
Industrial Companies”
- Rule 5-02, “Balance Sheets“
- Rule 5-03, “Statements of Comprehensive Income”
Article 6, “Registered Investment
Companies and Business Development Companies”
Article 7, “Insurance
Companies”
Article 8, “Financial Statements of Smaller Reporting
Companies”
Article 9, “Bank Holding Companies”
Article 10, “Interim Financial Statements”
-
Rule 10-01, “Interim Financial Statements”
- Rule 10-01(b), “Other Instructions as to Content”
Article 11, “Pro Forma Financial
Information”
- Rule 11-01, “Presentation Requirements”
- Rule 11-02, “Preparation Requirements”
- Rule 11-02(a), “Form and Content”
Article 12, “Form and Content of Schedules”
-
Rule 12-09, “Valuation and Qualifying Accounts”
Rule 13-01, “Guarantors and Issuers of
Guaranteed Securities Registered or Being Registered”
Rule 13-02, “Affiliates Whose Securities
Collateralize Securities Registered or Being Registered”
SAB Topics
No. 1, “Financial Statements”
-
No. 1.B, “Allocation of Expenses and Related Disclosure in Financial Statements of Subsidiaries, Divisions or Lesser Business Components of Another Entity“
- No. 1.B.3, “Other Matters”
-
No. 1.M, “Materiality“ (SAB 99)
-
No. 1.N, “Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements“ (SAB 108)
No. 4, “Equity Accounts”
-
No. 4.C, “Change in Capital Structure”
-
No. 4.E, “Receivables From Sale of Stock”
No. 5, “Miscellaneous Accounting”
-
No. 5.A, “Expenses of Offering”
-
No. 5.Z.7, “Accounting for the Spin-off of a Subsidiary”
-
No. 5.BB, “Inventory Valuation Allowances”
No. 11.M, “Disclosure of the Impact That Recently Issued
Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted
in a Future Period”
No. 14, “Share-Based Payment”
- No. 14.B, “Transition From Nonpublic to Public Entity Status”
- No. 14.D, “Certain
Assumptions Used in Valuation Methods“
- No. 14.D.1, “Expected Volatility”
- No. 14.D.2, “Expected Term”
- No. 14.E, “FASB ASC Topic 718, Compensation — Stock Compensation, and Certain Redeemable Financial Instruments”
Securities Act of 1933
Section 7, “Information Required
in Registration Statement”
Rule 144A, “Private Resales of
Securities to Institutions”
Securities Exchange Act of 1934
Rule 10b-5, “Employment of Manipulative and Deceptive
Practices”
Rule 13a-15, “Controls and
Procedures“
Rule 15d-15, “Controls and Procedures“
Rule 17a-5, “Reports to Be Made by
Certain Brokers and Dealers”
Section 3, “Definitions and
Application of Title”
Section 12, “Registration
Requirements for Securities”
Section 15(d), “Registration and
Regulation of Brokers and Dealers; Supplementary
and Periodic Information”
Superseded Literature
Accounting Principles Board (APB) Opinion
No. 25, Accounting for Stock Issued to
Employees
AICPA Accounting Interpretation
AIN-APB 25, Accounting for Stock Issued to Employees: Accounting
Interpretations of APB Opinion No. 25
EITF Abstracts
Issue No. 89-11, “Sponsor’s Balance Sheet Classification of Capital
Stock With a Put Option Held by an Employee Stock Ownership Plan”
Issue No. 00-23, “Issues Related to the Accounting for Stock Compensation Under APB Opinion No. 25 and FASB Interpretation No. 44”
FASB Statement
No. 123(R), Share-Based
Payment
Appendix E — Abbreviations
Appendix E — Abbreviations
Abbreviation
|
Description
|
---|---|
AETR
|
annual effective tax rate
|
AICPA
|
American Institute of Certified Public
Accountants
|
APB
|
Accounting Principles Board
|
ASC
|
FASB Accounting Standards Codification
|
ASR
|
SEC Accounting Series Release
|
ASU
|
FASB Accounting Standards Update
|
AWMV
|
aggregate worldwide market value
|
CAE
|
critical accounting estimate
|
CAM
|
critical audit matter
|
CAQ
|
Center for Audit Quality
|
CEO
|
chief executive officer
|
CFO
|
chief financial officer
|
CIMA
|
Chartered Institute of Management Accountants
|
CODM
|
chief operating decision maker
|
C&DI
|
SEC Compliance and Disclosure
Interpretation
|
DLOM
|
discount for lack of marketability
|
Dodd-Frank Act or Dodd-Frank
|
Dodd-Frank Wall Street Reform and Consumer Protection Act
|
DTA
|
deferred tax asset
|
DTL
|
deferred tax liability
|
EBITDA
|
earnings before interest, taxes,
depreciation, and amortization
|
EDGAR
|
SEC’s Electronic Data Gathering, Analysis,
and Retrieval system
|
EGC
|
emerging growth company
|
EITF
|
Emerging Issues Task Force
|
EMI
|
equity method investee
|
EPS
|
earnings per share
|
ESPP
|
employee stock purchase plan
|
Exchange Act or 1934 Act
|
Securities Exchange Act of 1934
|
FAQ
|
frequently asked question
|
FASB
|
Financial Accounting Standards Board
|
FAST Act
|
Fixing America’s Surface Transportation Act
|
FRM
|
SEC Division of Corporation Finance’s
Financial Reporting Manual
|
GAAP
|
generally accepted accounting principles
|
GAAS
|
generally accepted auditing standards
|
HTML
|
HyperText Markup Language
|
ICFR
|
internal control over financial
reporting
|
IESBA
|
International Ethics Standards Board for Accountants
|
IFRS
|
International Financial Reporting Standard
|
IPO
|
initial public offering
|
IRC
|
Internal Revenue Code
|
IRR
|
internal rate of return
|
IRS
|
Internal Revenue Service
|
ISO
|
incentive stock option
|
JOBS Act
|
Jumpstart Our Business Startups Act
|
KPI
|
key performance indicator
|
LLC
|
limited liability company
|
MD&A
|
Management’s Discussion and Analysis
|
Nasdaq
|
National Association of Securities Dealers
Automated Quotations
|
NQSO or NSO
|
nonqualified stock option
|
NYSE
|
New York Stock Exchange
|
PBE
|
public business entity
|
PCAOB
|
Public Company Accounting Oversight
Board
|
PCC
|
Private Company Council
|
REIT
|
real estate investment trust
|
SAB
|
SEC Staff Accounting Bulletin
|
Sarbanes-Oxley Act or Sarbanes-Oxley
|
Sarbanes-Oxley Act of 2002
|
SAS
|
AICPA Statement on Auditing Standard
|
S&P
|
Standard & Poor’s
|
SEC
|
U.S. Securities and Exchange Commission
|
Securities Act or 1933 Act
|
Securities Act of 1933
|
SPAC
|
special-purpose acquisition company
|
SRC
|
smaller reporting company
|
Tax Act
|
Tax Cuts and Jobs Act of 2017
|
TRA
|
tax receivable agreement
|
XBRL
|
eXtensible Business Reporting Language
|
XML
|
eXtensible Markup Language
|
Appendix F — Roadmap Updates for 2023
Appendix F — Roadmap Updates for 2023
The table below summarizes the
substantive changes made in the 2023 edition of this Roadmap.
Section
|
Title
|
Description
|
---|---|---|
The IPO Registration Statement
|
Added timeline of the IPO process from
inception to closing for a typical 1933 Act registration
statement.
| |
Special-Purpose Acquisition Companies
|
Added Changing Lanes related to the SEC’s
proposed rule that would require companies completing an IPO
and operating companies merging with a registrant (including
a SPAC) to enhance and standardize their climate-related
disclosures. Further, added language to clarify interpretive
guidance on disclosing cybersecurity risks and
incidents.
| |
Interim Financial Statements
|
Clarified that, although SEC regulations do
not require that interim financial statements in an IPO
registration statement be subject to a review under PCAOB
standards, underwriters will often require that such a
review be performed.
| |
Age of Financial Statements
|
Updated the table that provides the dates on
which financial statements become “stale” for a
calendar-year-end company undertaking an IPO.
| |
Omission of Certain Financial Information
From Draft Registration Statements
|
Added an example demonstrating the
application of the guidance in Question 101.04 of the
Securities Act C&DIs. Renumbered subsequent
examples.
| |
Periods of Preacquisition Financial
Statements Required
|
Clarified in Example 2-5 that if a company
completes its IPO during the grace period, the required
financial statements and pro forma financial information
must be filed on Form 8-K within 75 days of the close of the
acquisition.
| |
Form of Financial Statements
|
Clarified that certain PBEs, when preparing
financial statements of a non-PBE acquiree, may use non-PBE
effective dates for the FASB’s leasing standard. Once the
standard is adopted, the financial statements must reflect
the disclosures for PBEs.
Further, added clarification to reflect
discussion from the October 2020 CAQ SEC Regulations
Committee joint meeting with the SEC staff regarding the
adoption of ASC 842’s risk-free-rate practical expedient by
an acquired or to be acquired business.
| |
Abbreviated Financial Statements
|
Added discussion of the presentation and
disclosure requirements set forth in Regulation S-X, Rule
3-05(e)(2), for abbreviated financial statements.
| |
Financial Statements of Real Estate
Operations Acquired or to Be Acquired (Rule 3-14)
|
Added discussion related to financial
statements and other related information required for a REIT
spin or REIT conversion.
| |
Evaluating Accounting Errors
|
Added a summary of Paul Munter’s March 9,
2022, speech on the importance of objectivity in the
assessment of the materiality of errors.
| |
Additional IPO Considerations
|
Added Changing Lanes discussing the SEC’s
final rule implementing the Dodd-Frank Section 954 mandate
for executive “excess compensation.” Under the final rule,
an issuer must “claw back” excess compensation for the three
fiscal years before the determination of a restatement and
must disclose its recovery policy.
| |
Pro Forma Adjustments
|
Removed an example related to “autonomous
entity adjustments” since it is no longer applicable.
| |
4.4.4A
|
Disclosure of Management’s Adjustments
|
Deleted discussion on management adjustments
and provided a reference to Chapter 4 of
Deloitte’s Roadmap SEC Reporting Considerations
for Business Acquisitions for further
details.
|
Presentation of Equal or Greater
Prominence
|
Added Changing Lanes discussing the updated
C&DI Question 102.10, which provides guidance on when a
non-GAAP measure is more prominent than the corresponding
GAAP measure.
| |
Potentially Misleading Non-GAAP Measures
|
Expanded discussion of non-GAAP measures on
the basis of SEC staff comments at the 2022 AICPA & CIMA
Conference on Current SEC and PCAOB Developments.
Added Changing Lanes discussing new and
updated C&DIs, which provide guidance on potentially
misleading non-GAAP measures (C&DI Questions 100.01,
100.04, 100.05, and 100.06).
| |
Business Combinations
|
Updated reference from PCAOB AU Section 558
to PCAOB AS Section 2705.
| |
Valuation of Financial Instruments
|
Removed language in Connecting the Dots
related to the evaluation of beneficial conversion features
since ASU 2020-06 is now effective for all entities.
| |
Liabilities, Equity, and Temporary
Equity
|
Added guidance on the presentation of
equity-classified instruments in accordance with ASC
480-10-S99, which includes interpretations of SEC Regulation
S-X, Rule 5-02.27.
Removed language on hybrid instruments and
beneficial conversion features since ASU 2020-06 is now
effective for all entities.
| |
Internal Revenue Code Section 409A
|
Added clarification related to a company’s
failure to comply with the requirements in IRC Section 409A
related to nonqualified deferred compensation plans.
| |
Purchase of Shares From Grantees
|
Added discussion of a reporting entity’s
consideration of share purchases from grantees by a related
party or economic interest holder in the assessment of
whether a past practice of settling immature shares has been
established.
| |
Disclosures in the Financial Statements
|
Updated Changing Lanes to cover FASB’s
proposed ASU related to income tax disclosures.
| |
Earnings per Share
|
Added discussion of changes in capital
structure at or before closing and the impact on an entity’s
EPS.
| |
Segments
|
Added Changing Lanes on FASB’s
proposed ASU related to segment
reporting disclosures.
| |
Independence Considerations
|
Added a discussion of the requirements in
Sections 600 and 410 of the IESBA code, which must be
addressed through the initial PCAOB Rule 3526
communications.
| |
Changes in Auditors
|
Added a discussion of required disclosures
under Regulation S-K, Item 304, in connection with a change
in auditor during the two most recent fiscal years or any
subsequent interim period. Disclosures can be provided in a
Form 8-K for existing registrants; however, for an IPO, they
must be provided in the IPO registration statement.
| |
Other Post-IPO Considerations
|
Added two Changing Lanes on the SEC’s final
rules on disclosures about (1) executive pay and company
performance within certain proxy statements or information
statements and (2) cybersecurity. Moreover, added Changing
Lanes on the SEC’s proposed rule on disclosures about
climate change.
|