PwC recently released research on trends in material weakness disclosures among IPOs. The research looked at domestic and foreign issuer IPOs listed on the NYSE and NASDAQ stock exchanges between January 1, 2016, and June 30, 2021. PwC did choose to exclude certain IPOs including those with proceeds that are less than $25 million, best efforts offerings, oil and gas royalty trusts, business development companies, pricing on OTC Bulletin Board, and OTC Pink Sheets, and special purpose acquisition companies (SPACs).
Phaik Sin Tay who sits in the Accounting and Financial Reporting Advisory Services Group at PwC recently joined Aptitude’s Mark Aubin on a webinar and spoke about the research and how to conduct an IPO readiness assessment. We’ve included some of the highlights from the PwC report and the webinar below.
What is a material weakness?
A material weakness, as defined by the SEC, is a deficiency, or a combination of deficiencies, in ICFR such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. (source)
Said more succinctly, it’s an admission by an organization that the internal controls around their financial reporting may not prevent a misstatement.
In their report, PwC found that more companies are disclosing material weaknesses (MWs) than in the past. In the first half of 2021, 50% of companies going public disclosed an MW, up from 39% in 2016.
“The wave of (material weakness) disclosures suggests that the market increasingly expects public companies to have a strong understanding of their internal controls and processes well before the IPO.”
-Phaik Sin Tay, Accounting & Financial Reporting Advisory Services, PwC
Impact of deal value size
Historically, the lower the IPO deal value and revenues, the more likely an organization was to report material weaknesses. This is no longer the case. Beginning in 2016, the PwC report found no correlation between deal size and the rate of MW disclosure. Large companies, with more sophisticated financial technology and process controls, were reporting MWs at the same rate (41%) as smaller companies with a lower IPO deal value.
Foreign vs domestic issuers
The analysis also showed that foreign private issuers have a significantly higher rate of material weakness disclosure as compared with domestic issuers. In 2020, a staggering 90% of foreign private issuers declared a material weakness compared with 35% of domestic issuers. According to Phaik Sin Tay, this is likely due to the differences in local rules and regulations, the enhanced scrutiny of the US reporting environment, and insufficient training of personnel operating in the US regulatory environment for the first time.
Commonly cited Material Weaknesses
The most common MWs reported relate to insufficient accounting personnel (26%), lack of financial reporting oversight and review processes (21%), and lack of appropriate procedures (19%). Tay observes, “considering that pre-IPO companies typically have fewer resources and leaner organizations, it’s common to see MWs related to inadequate personnel oversights and lack of reviews. It’s critical that companies put proper financial reporting processes in place to ensure they can collect the right data and generate accurate statements.”
What does this mean for pre-IPO companies?
There is absolutely an increased demand by investors for transparency in IPO filings. Disclosing a material weakness along with a remediation plan prior to an IPO can show the market that the organization understands potential issues and has a plan in place to address them. However, to try and limit these types of disclosures as much as possible, Sin recommends conducting an overall readiness assessment to determine issues with controls and processes. “In our experience, companies that operate under SOX compliance for 6-12 months prior to going public have less risk of identifying internal control issues once they become public.”
Thank you to Phaik Sin Tay and to co-presenter, Mark Aubin! Access the webinar and learn more about the PwC research and the role of revenue management in driving growth through an IPO or M&A.