Scores of the blank-check companies that set the IPO market ablaze in 2020 are once again stumbling over accounting errors.
More than 160 SPACs have issued warnings in the last week that their past financial reports can’t be relied on, and that they have to redo, or restate, their financial statements, securities filings show.
It’s the second time this year that many of the special purpose acquisition companies have had to officially flag problems with their accounting and go through the time, expense, and negative publicity of a restatement. An SEC warning in April about accounting for warrants—investor incentives ubiquitous in SPAC deals—previously prompted hundreds of SPACs to restate.
Mass restatements in a single industry for a specific accounting problem are unusual. Twice in one year is unprecedented. Prior to 2021, restatements were on a downward trend, with fewer than 100 per year across all industries in 2019 and 2020.
The latest mass accounting problems reflect the uniform nature and sheer volume of the SPAC deals, as well as heavy regulator scrutiny of the hot market.
Surge Rare, Not Alarming
Restatements are typically red flags in financial reporting, but the latest wave of errors hasn’t halted the market. Five SPACs went public on Nov. 19, one deal closed on Monday, and 10 SPACs in the past week have announced they are in the pre-initial public offering stage, according to SPAC Research.
“Restatements across an entire industry and hundreds and hundreds of issuers is clearly something that’s a really uncommon occurrence. That’s why it’s so noteworthy,” said Paul Tropp, co-head of Ropes & Gray LLP’s capital markets group. “But it’s not something that investors are concerned about, and it’s not something that’s qualitatively material whatsoever.”
The errors are errors, nonetheless, and require fixing. SPACs—shell companies that raise money, go public, and seek promising private businesses to acquire—typically issue two types of shares to investors: founder shares and Class A shares. Class A shares are redeemable, meaning that investors can ask for their money back if they don’t like the company the SPAC targets to take public.
Under accounting rules outlined in ASC 480, if shares are potentially redeemable and the cash-out feature is outside the control of the company, those shares can’t be considered permanent equity.
SPACs for years labeled the redeemable shares as part of their permanent equity, in part because most SPAC governing documents say the shares can be cashed out unless redemption would force the tangible net worth of the business below a certain threshold. The accounting treatment went unquestioned for years.
SEC Scrutiny Builds
The Securities and Exchange Commission started raising questions as far back as July, according to comment letters the SEC made public this month. The regulator’s conclusion: The accounting was wrong, and the shares had to be counted as temporary, or mezzanine, equity.
How a company fixes a financial reporting problem is usually the result of a judgment call by the company and its auditor on how material, or significant, an error is. SPACs and auditors generally considered the corrections small enough to warrant only a revision, a minor correction that gets disclosed in the next period’s financial statement. But the SEC told audit firms and advisers that such a correction wasn’t enough, accountants said, and companies had to issue so-called “Big R” restatements—the serious kind that involves a special securities filing calling attention to past mistakes.
The SEC shared with audit firm Withum Smith + Brown PC an example of a SPAC that fit a fact pattern similar to that of most of the firm’s clients. The regulator said the reclassification from “permanent” to “temporary” equity was too big of a number not to be material, said Marc Silverman, SEC compliance and reporting lead at Withum, the firm that performed the second-largest number of SPAC initial public offering audits in 2021, according to SPAC Research.
“Right off the bat, they mentioned that the reclass impact of the historical equity number was too material not to be a restatement,” Silverman said.
That took many auditors and advisers by surprise. At least two SPACs that had previously disclosed “small R” revisions in recent days filed 8-Ks saying they had to do the more serious correction, filings show.
“They believe the quickest fix for them is to do an amendment,” Silverman said, rather than attempting to go “on a case-by-case basis to discuss with the SEC.”
For many SPACs, the amount of money that had to be reclassified from “permanent” to “temporary” was indeed quantitatively material and affected some key balance-sheet ratios, said Angela Veal, managing director at Eisner Advisory Group LLC.
But the SEC warning—communicated via word of mouth and comment letters—still caught SPACs off guard, especially those that went through the time, fanfare, and expense of restating their financials in the spring.
Tough Stance or ‘Waste of Time’?
“People are caught by surprise, but also not really that surprised, because they had the warrant issue and they know the SEC is scrutinizing SPACs,” Veal said. “They were surprised by the issue because historically everyone had been classifying the shares as permanent equity.”
“It’s a reclassification—moving from the permanent equity section to the mezzanine section,” Stallings said. “From an investing standpoint, it doesn’t change the economics of the deal at all. What it is, is the SEC is putting another obstacle to kind of slow down the SPAC market.”
The first round of accounting restatements cost the industry millions in accounting, auditing, legal, and consulting fees, and while the market temporarily paused, the accounting errors didn’t tank stock prices or scuttle deals, he said.
“Let’s assume this accounting change is appropriate,” Ellenoff said. “Is the way we’re being asked to do it appropriate and necessary? The industry got it wrong for 25 years, that’s why we’re doing it, but did anyone care? Does it matter?”