IPOs certainly vary across industries, but a company-wide, United States Generally Accepted Accounting Principles compliant audit (“GAAP audit” or “SEC compliant audit”) is a necessary part of every IPO preparation process. Engaging this full-scale audit is a sign that you are ready to play in the big leagues. Although you likely already know that an audit is necessary before your company can file its initial prospectus (“Form S-1” or “S-1”), you may not fully appreciate the difficulties, complexities, and bottlenecks that may arise. This article will provide a high-level overview of some of the common issues you should be aware of when preparing for your first SEC compliant audit, with references to other IPOhub articles for further explanations.
During the earlier stages of your company’s life, official policies and procedures may not be formally recorded, because the organization is small enough to rely on the collective knowledge of the existing personnel. However, for public companies, many policies must be established in writing to formally explain company protocol. Consequently, as part of a GAAP audit, your auditor will review your internal memo/policy documents, which should include the following:
- Major accounting policies (e.g., revenue recognition, functional currency designations, inventory costing methods or other significant accounting positions)
- Valuations (see our article on 409A Valuations)
- Segment/geographic reporting disclosures
If these documents are not fully drafted when the auditor arrives, which is often the case when companies undergo their first GAAP audit, your audit process will be delayed until the necessary documents are completed.
In addition to the internal policy documentation, auditors will want access to all of your official documents, such as:
- Complex financing arrangement agreements (e.g., lease arrangements)
- Debt/preferred stock agreements
- Business combination agreements
- Bank statements
- Sales contracts
- Insurance policies
- Legal bills
- Board meeting minutes
- Year-end payroll and sales tax reports
Finally, the auditor will require access to all of your account reconciliations (e.g., cash accounts, accounts receivable, accounts payable, deferred revenue, etc.) and supporting documentation. This list is not meant to be exhaustive, but it does provide examples of common documents that you will need to have ready. The audit will run more smoothly and quickly if you have already gathered together these types of documents before the auditor arrives.
The auditor is looking to gain reasonable assurance that the information presented on your financial statements is not materially misstated—in the most recent year and the two to three years prior (depending on the size of your company). Every number needs to be substantiated. The documentation you provide must serve as support for your financial statements, helping your auditor to gain a sufficient level of assurance.
When your Form S-1 is first made publicly available, your company will immediately be subject to a dramatic increase in financial scrutiny from a variety of parties, such as, the SEC, current shareholders, and potential investors. This heightened exposure demands greater consistency in financial reporting, which necessitates more clearly defined internal controls over financial reporting. Although a formal audit of internal controls—mandated for public companies by Sarbanes-Oxley section 404 (“SOX 404”)—is not required on a company’s first annual report, having controls in place with documentation will make your first GAAP audit more efficient. Therefore, if you are preparing to go public, it is best practice to start documenting your controls now. Not only will this save time in the future, but it will also increase the confidence you have in your financial information.
A crucial element of your accounting controls is the software that you use. If you want to go public, you will need software that is more robust than Excel and QuickBooks, as these tools are not normally scalable, secure, or dynamic enough to meet the financial reporting demands of a public company. Many Enterprise Resource Planning (“ERP”) software options are available for purchase—such as NetSuite, Workday, and Acumatica—that help to automate, streamline, and reconcile financial records. You should select a software that meets your specific accounting needs.
Good ERP software will enable easier financial report generation and strict user access controls that facilitate the appropriate segregation of duties concerning the creating, updating/approving, and deleting of accounting entries. Your auditor will check to verify that invoices and orders were approved by the proper personnel when they are auditing your financial records, so these processes need to be well established and understood by your management and accounting teams. Documenting these procedures early will prepare you for the rigorous demands of the SOX 404 audit in the future.
Additionally, auditors will expect to see that you are performing internal reconciliations of major accounts, such as cash, accounts receivable, and accounts payable, at the end of every period. Your internal reconciliations will be tested as part of the auditor’s procedures.
As part of the GAAP audit, your auditor will expect to see a “hard close” to your company’s accounting periods—meaning that after a certain date, the books are closed, and mistakes or changes must be recognized as adjusting entries in later periods, rather than directly fixing the original entry. This is different than the “soft close” seen in many nonpublic companies, where adjustments and error-corrections can easily be entered into the books in the weeks, months, or even years after the financial period is “closed.” To prepare for an SEC compliant audit, your company needs to establish a formal closing procedure with firm deadlines at the end of every reporting period.
When your company goes public, the market will demand quarterly and annual financial information very soon after the period closes—click here to see a chart with the SEC filing deadlines for different categories of companies—as well as financial projections looking into the future. Consequently, the closing procedures of public companies are often, of necessity, more efficient than their nonpublic counterparts. It takes significant planning and coordination to make closing procedures run smoothly, so it is best to start preparing long before you engage a GAAP audit.
One common challenge for pre-IPO companies related to closing procedures is the “quarterization” of financial statements. When your company is public, you will need to have current and historical financial records with clean quarter cutoffs, but few private companies have these quarterized records. For example, if a private company has a depreciation expense, it would normally show up as an annual entry in the December expenses for a calendar year company; but, to have an accurate quarterly financial history, this expense would need to be appropriately spread across all four quarters. The process of going back to properly carve out the quarterly financial statements is time consuming and can be very costly.
Some nonpublic companies have already engaged in various types of business combination activity, such as acquiring a smaller company for access to proprietary technology. These acquisitions, even if relatively small, can introduce a great deal of complexity to the parent company’s accounting when seeking compliance with GAAP standards.
GAAP does not allow a simple roll-up of the acquiree’s financials into the acquirer after the date of acquisition, but this is often what nonpublic companies do because of a lack of statutory requirement to record otherwise and the difficulties of calculating goodwill and related impairments. To prepare for your GAAP audit, you will need to go back to the original acquisition details to assess if any goodwill needs to be recorded, valuations performed, or accounting entries made—your auditor will verify that your assessments are correct. Post-event record creation can be very time consuming and expensive to perform. It is best to seek professional accounting guidance before, during, and after an acquisition, regardless of the stage in which your company is operating.
Additionally, the SEC may require that your company provide one to three years of separate financial statements for businesses already acquired or soon to be acquired, depending on whether certain criteria are met.
The timeliness of audited financials in the IPO preparation process is crucial. The SEC requires financial statements to be current, and the most recent financial statements provided in a Form S-1 should not be dated more than 134 days before the day of filing or else they are considered “stale1” (unless they are the third-quarter financials, which are considered timely through the 45th day after the most recent fiscal year end). Figure below provides a general example of stale dates for a calendar year company IPO (click here for access to an Excel workbook that will calculate the appropriate stale dates relative to your specific period end):
If the financial statement age requirements are not met, the SEC will not accept your S-1 filing; therefore, be sure to schedule your audit with enough lead time. See our S-1 filing article for a more in-depth explanation of the necessary elements of an S-1.
The amount of time that it takes auditors to complete an audit varies dramatically, depending on the type of business, quality of company internal controls, and degree of preparation. However, you should anticipate a three-month process at minimum for your first GAAP audit.
Now that we have addressed some of the common issues that pre-IPO companies face when preparing for a full-scale GAAP audit, we will now discuss some additional information about the audit and SEC compliance in general.
Required Financial Information
The following accrual basis statements are required to be SEC compliant:
- Balance sheets
- Statement of Operations
- Comprehensive Income Statement
- Cash Flow Statement
- Statement of Equity
- Notes to the financial statements
- Audit report from an Independent Registered Public Accounting Firm
The number of periods the SEC requires for IPO filing companies to show on their financial statements generally depends on the size of that company. If the company meets the qualifications to be classified as an emerging growth company (“EGC”) under the 2012 “Jumpstart Our Business Startups Act” (“JOBS Act”), only two years of audited financial statements and two years of selected financial data are required for the audit report. If the EGC qualifications are not met, three years of audited financial statements and five years of selected financial data are required.
Generally, to qualify as an EGC, a company must meet the following criteria:
- Total annual gross revenues of less than $1.07 billion in the most recently completed fiscal year
- Has not issued more than $1.0 billion in nonconvertible debt securities over a rolling 36-month period
The designation as an EGC can have a significant impact on your IPO preparation process. For more information, see our JOBS Act article.
In addition to the annual financial statements, your company will need to include interim financial statements if the previously audited information is stale, as discussed above. These statements can be combined with audited financial statements, or presented as a separate set of financials. Auditors will generally perform a review of these interim statements, per AU section 722 or SAS 100, but are not required to issue an official review report of their findings.
Further, although your company is not required to provide quarterly data in the Management Discussion and Analysis (“MD&A”) in Form S-1, companies will almost always include quarterly information for the two most recent years and stub periods2. Because of the significant reliance that investment bankers and others place on this information, auditors will often devote significant time and effort to verify the accuracy of the quarterly financials.
In addition to the numerical financial results in the MD&A section of the S-1, management must provide a flux analysis—comments to explain the fluctuations in the quarterly financial results. This analysis can be very difficult to create, as the public demands clear explanations for why financial results vary from period to period. For example, a normal flux analysis might explain financial fluctuations by discussing changes in the number of customers, employee headcount, product mix, geographic distribution of sales, or accounting standards.
Some private companies do not have adequate, or accessible, records to provide the data behind management’s explanations. For example, they may not have clear employee attrition reports or time specific records for the number of customers over time, yet this information is necessary to provide an appropriate level of detail. Going back to look at receipts, employee records, etc. to document the past can be very difficult, time consuming, and inaccurate. Your auditor and investment banker will demand very detailed explanations for all major fluctuations, so it is best to start preparing early and maintaining detailed and organized records now.
Cost of the Audit
Auditor fees can vary greatly, depending on the company and the complexity of the accounting, but they will generally fall between $0.5 and $1.2 million. According to the March 2017 “IPO Accounting and Legal Fees: 2016 Update” issued by Audit Analytics, the average overall accounting fee for IPO companies in 2016 was $0.95 million. However, auditor and other accounting fees are only a small part of the cost of going public. See our Costs of Going Public article for more detailed information about the total costs of an IPO.
Type of Auditor
When selecting your auditor, it is important to consider their qualifications and experience. Generally, national firms are better prepared to help your company navigate the complexities of IPO preparation, as they will likely have access to professionals with experience relevant to the issues that may arise. You may also need to engage a specialized accounting firm to deal with especially complicated accounting matters.
No matter the size of the firm(s) you choose to employ, your auditor must be registered with the Public Company Accounting Oversight Board (“PCAOB”) to satisfy SEC requirements.
Preparing for an IPO can be complex and demanding, and the GAAP audit is a common cause for delay in the process. This article has highlighted some of the common pitfalls that companies experience when they go through their first public company audit, and has provided some general information on the audit process. With this information, your company can avoid these pitfalls and anticipate changes that you need to make now to get ready. The GAAP audit is an inevitable part of being a public company, but if you prepare early, the transition to the big leagues will be a little smoother.
- Audit Analytics, “IPO Accounting and Legal Fees: 2016 Update.” March 2017.
- Ernst & Young, SEC Financial Reporting Series: “Pro forma financial information.” September 2015.
- Jumpstart Our Business Startups (JOBS) Act, Section II.
- PwC, “Roadmap for an IPO.” 2016.
- SEC Regulation S-X Rule 3-05
- Financials are considered stale when they are so old that the issuer has to include the next period of financial statements to comply with SEC requirements
- Also known as an interim period. This is the portion of the current fiscal year that has occurred or is reportable so far. For example, if a company is filing a Form 10-Q for its second fiscal quarter ended June 30, the stub period would be six months or the first half of the company’s fiscal year. (Definition from Westlaw.com)