More Issuers Revealing Pre-IPO Weaknesses
The percentage of IPOs revealing material weaknesses in their internal controls before they go public has been rising steadily
|Friday, October 30, 2015|
By David M. Katz, CFO.com
As most market watchers know, the number of initial public offerings has soared in recent years. Much less obviously, and maybe a bit counterintuitively, another capital-markets trend has emerged: The percentage of IPOs revealing material weaknesses in their internal controls before they go public has been rising steadily.
That’s a major finding of a research report issued recently by PWC’s deals practice. From 2011 through 2014, the total annual number of IPOs listed on the New York Stock Exchange and Nasdaq has more than doubled, from 128 to 293, according to the study. Excluding a drop to 18% in 2012, the percentage of IPOs reporting material weaknesses (MWs) in internal controls over financial reporting rose from 23% to 27% during those years, with the Big Four firm projecting a whopping 31% for 2015.
Under the Sarbanes-Oxley Act of 2002, of course, senior managers of public companies must report on internal controls of financial reporting, and the CFO and chief executive officer are required to certify the accuracy of corporate 10-Qs and 10-Ks. SOX also requires independent auditors of public companies to assess and report on ICFR.
Nevertheless, CFOs have a lot on their plates prior to a public offering. “I’ve got to get my bankers ready, worry about getting my financial statements ready. I’m probably having to worry about projections, tax restructuring, putting the [registration] document together, appointing lawyers,” says Mike Gould, the public offerings leader of PwC’s Deals Practice.
“Historically, worrying about internal controls fell down lower on the priority list. Ten years ago, it was fairly common for companies to worry about internal controls and SOX after they become a public company, and do all the documentation and testing then,” he adds.
Now, however, doing all the testing necessary to actually unearth material weaknesses before the offering — and thus have to report them then – has become more of a priority for issuers, according to Gould, whose unit benefits from such a trend. “I think now we’re getting to a point where all of that is getting done much earlier in the cycle, where prior to filing that first S-1, they have a very good idea if they have any material weaknesses,” he says.
Why the change? PwC suggests that the Jumpstart Our Business Startups Act of 2012 may have had a lot to do with it. Among other things, the JOBS Act created a number of special accommodations intended to make it easier for emerging growth companies (EGCs) to go public. (The breaks include allowing EGCs to submit confidential filings and deferral of the auditor’s attestation of internal controls of financial reporting.)
This may have led, in part, to a situation in which the preponderance of IPOs consists of small companies. From 2011 through September of 2015, about 88% of companies that reported MWs had less than $500 million in revenue in the year prior to their IPO, according to the PwC study.
“This could indicate that smaller companies are more susceptible to MWs. Smaller companies are often limited in their accounting and financial reporting capabilities, given their stage of growth, small staff, and amount of resources they are able to invest in the business,” according to the report.
“These limitations may result in a less-defined and more poorly developed internal control environment, which often leads to MWs,” the authors wrote. “To avoid surprising the markets with reports of these material weaknesses after going public, more such firms are assessing their internal controls beforehand,” according to PwC.