Going Public: Gears in a Clockwork

Do you know that the world's first initial public offering (IPO) was conducted by The Dutch East India Company, notorious for the tulip bulb craze or otherwise known as 'Tulipmania' - a prima facie finding of financial bubbles? With a 1200% soar in its share price from its IPO price followed by a 300% slump, this highlights the dictator’s concerns behind the volatility of the stock price movement (Beattie, 2019).

Let us start by addressing two fundamental questions:

1. What are the key considerations for a private company to go public?

2. What is required for a company to go public?

The underlying objective behind the decision to conduct an IPO varies from company to company - be it funding, exit strategy, acquisition, diversification or other strategic considerations. Going public is a rigorous process that requires many key considerations, primarily the filing process, incremental costs, and the ongoing costs necessary to operate as a public company.

Figure 1: EY’s IPO destination compass: considerations when deciding where to list

Source: EY

Despite the growth opportunity that lies ahead, it is not a bed of roses without some thorns. It is only through inviting new shareholders that increased cash and capital could be obtained. Consequently, the company would be subjected to public scrutiny and inevitably, loss of privacy due to various disclosures warranted and increased transparency of sensitive areas not limited to extensive financial information, compensation and corporate practices (Saada, Ethridge, Jones, & Klausner, 2017). The public’s prying eyes intensify the pressure of upholding an accurate and fair depiction of relevant information that would be available to the public: open to competitors, customers, and employees. It is worth noting that once a company decided to conduct an IPO instead of other alternatives, it is most likely that it has a strong stance that the short-term shrinkage of time and resources sowed would eventually reap long term growth.

Figure 2: IPO Readiness Framework

Source: PwC

Figure 2 illustrates the IPO readiness framework used by PwC to evaluate a company's level of preparedness spread across various functions. Underwriting, preparing financial statements, filing registration statements and tax restructuring are just several out of the many functions considered during the pre-IPO process, which are historically prioritized over internal controls (Katz, 2015).

Today, internal controls and SOX compliance have increasingly become a point of concern over the years as material weaknesses found to exist even before the offering are only revealed in the test conducted after a company's IPO. The JOBS Act introduced in 2012 possibly contributed to the rising concern of material weaknesses as it provides easier accessibility for emerging growth companies (EGCs) to go public. This was supported by a PwC study conducted throughout 2011 - 2015 which found that 88% companies that reported MWs had less than $500m in revenue in the year prior to their IPO (Cahill, 2015).

According to PCAOB, "A material weakness is a deficiency, or 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. (PCAOB, 2007)"

In response to the financial scandals happening in early 2000s, the Sarbanes-Oxley Act (SOX) was passed on 30 July 2002 to protect investors from fraudulent practices through improving corporate governance and accountability. Under SOX, management is required to establish an integrated audit of both Internal Control over Financial Reporting (ICFR) and external auditor's assessment of the effectiveness of the company's ICFR (Codreanu, 2020).

Figure 3: Effectiveness of ICFR and relevant trends

Source: Audit Analytics

Looking at the 2020 IPO material weakness study conducted by KPMG, 41 of the 125 U.S. IPOs disclosed material weakness in their registration statement (S-1s/S-1As filings) in which only seven went on to remediate before filing (Poplawski & Greer, 2020).

Figure 4: Issues contributing to material weaknesses

Source: KPMG

Figure 5: Process areas with highest concentration of material weaknesses

Source: KPMG

This study’s takeaways proposed that the two main issues contributing to MWs are lack of accounting resources and expertise followed by inadequate control design. Moreover, the two process areas with the highest concentration of MWs include financial reporting and complex transactions (Poplawski & Greer, 2020). Like gears in a clockwork, internal control is highly integrated with the outcome of publicly available company filings. SEC previous Chief Accountant Wesley Bricker once said, "Adequate internal controls are the first line of defence in detecting and preventing material errors or fraud in financial reporting... When internal control deficiencies are left unaddressed, financial reporting quality can suffer. (SEC Charges Four Public Companies With Longstanding ICFR Failures, 2019)" Underestimating SOX compliance is equivalent to undermining the significant process changes that have to be made. Without these changes, it increases the probability of filing for an incomplete and inaccurate registration statement and subsequent company filings.

There are three key provisions in SOX to take note of: Section 302 and Section 906 which are effective from the public company's first quarterly or annual report onwards and Section 404 which is required starting from a company's second annual report onwards (Codreanu, 2020). These are established to ensure the adequacy of ICFR through depicting a fair representation of a company's financial condition relating to its internal controls and compliance with the Exchange Act.

Going back to Tulipmania and the existence of financial bubbles, society's expectation is a key aspect of going public. The voice of a public company is spoken through its financial statements, and if they were to be represented unfairly, this could potentially mislead investors' assessment of the company's performance. Without effective internal controls in place, this gives rise to the question of what exactly is an investor's confidence based upon.

Bibliography

Beattie, A. (2019, October 23). What Was the First Company to Issue Stock? Retrieved from Investopedia: https://www.investopedia.com/ask/answers/08/first-company-issuestock-dutch-east-india.asp Cahill, E. (2015). Material weaknesses: Why disclosing them before your IPO may make sense. PwC. Codreanu, S. (2020). Market Overview Material weakness disclosures in an IPO. PwC. Hallas, N. (2020, September 17). Internal Control Weaknesses Following an IPO. Retrieved from https://blog.auditanalytics.com/internal-control-weaknesses-following-an-ipo/. Hannich, M., Main, L., Husain, A., & Marwah, K. (2015). So you want to take the IPO road? KPMG. Katz, D. (2015, October 26). More Issuers Revealing Pre-IPO Weaknesses. Retrieved from CFO: https://www.cfo.com/accounting/2015/10/issuers-revealing-pre-ipoweaknesses/ PCAOB. (2007, November 15). Auditing Standard No. 5. Retrieved from Auditing Standards (AS 2201, paragraph A7): https://pcaobus.org/oversight/standards/archivedstandards/details/Auditing_Standard_5_Appendix_A#:~:text=A%20material%20weak ness%20is%20a,detected%20on%20a%20timely%20basis. Poplawski, C., & Greer, R. (2020). 2020 IPO material weakness study. KPMG. Saada, B., Ethridge, D., Jones, A., & Klausner, D. (2017). Roadmap for an IPO A guide to going public. PwC. SEC Charges Four Public Companies With Longstanding ICFR Failures. (2019). Retrieved from SEC: https://www.sec.gov/news/press-release/2019- 6#:~:text=%E2%80%9CAdequate%20internal%20controls%20are%20the,financial% 20reporting%20quality%20can%20suffer.%E2%80%9D Starysh, S., & Austin, P. (2019). Flash Report Corporate Governance. BDO. Steinbach, D. M., Kelley, J., Choi, R., & Suzuki, S. (2018). Guide to going public Strategic considerations before, during and post-IPO. EY.