Why Have Financial Restatements Surged?

Audit Analytics, an independent accounting research firm, reports that restatements surged in 2021 — and more than three-quarters of these restatements were filed by special purpose acquisition companies (SPACs). Here is an overview of what SPACs are used for, why they can be risky ventures and what measures the Securities and Exchange Commission (SEC) has proposed to help rein them in.

Restating financial results

Financial restatements help gauge financial reporting quality. A financial restatement occurs when a company discovers an error or misstatement in previously issued financial statements, and the company corrects it by adjusting previous periods, using one of three methods:

  1. Reissuance restatements,
  2. Revision restatements, or
  3. Out-of-period adjustments.

The appropriate accounting method is a matter of materiality. That is, material errors or misstatements may cause a company to reissue its financial statements. But an immaterial error or misstatement may simply require a footnote about the revision or an out-of-period adjustment. An error or misstatement is considered “material” if it would influence a reasonable investor.

Evaluating the surge in restatements

In May 2022, Audit Analytics published “2021 Financial Restatements: A Twenty-One-Year Review.” The study found that the number of financial restatements filed in 2021 increased significantly, due to SPAC restatements. The majority of these restatements (62%) were reissuance restatements, which are reserved only for material errors and misstatements.

Specifically, guidance issued by the SEC on accounting for 1) redeemable shares and 2) warrant liabilities resulted in significant increases in restatements for SPACs and companies acquired by SPACs in 2021. As a result, debt and equity accounting led the list of correction types in 2021, replacing revenue recognition as the top reason for restatements. Excluding SPAC restatements, the number of restatements actually decreased from 2020 to 2021.

Understanding SPACs

Essentially, SPACs are shell corporations that are listed on a stock exchange with the purpose of acquiring a private company, thereby making it public without going through the traditional initial public offering (IPO) process. A SPAC doesn’t produce any products, sell any goods or offer any services. Typically, a SPAC’s only assets are the funds contributed by investors.

The SEC has approved SPACs, though they must meet the usual disclosure requirements and satisfy other legal formalities. It’s much easier to register for an IPO with a shell company that only holds cash than it is for an operating company that owns various operating assets and liabilities.

Reining in SPACs

With an unprecedented increase in SPACs in recent years, the SEC has been worried about risks posed to investors. So, in March 2022, the SEC voted 3 to 1 to propose a sweeping set of reforms that would apply to SPACs. The proposal would require additional disclosures about:

  • Sponsors,
  • Conflicts of interest,
  • Sources of dilution, and
  • Business combination transactions, including information related to the fairness of the transactions.

It would also address projections made by SPACs and their target companies, including the Private Securities Litigation Reform Act safe harbor for forward-looking statements.

“If adopted, the proposed rules would more closely align the required financial statements of private operating companies in transactions involving shell companies with those required in registration statements for an initial public offering,” said the SEC.

Gatekeepers — such as auditors, lawyers and underwriters — would be responsible for basic aspects of this work because they play an essential role in ensuring the accuracy of disclosures. Thus, the proposal would subject a target company and its signing persons to liability for a SPAC target IPO registration statement. It would also require that any business combination of a public shell company with a nonshell company be deemed a sale to the shell company’s shareholders subject to the Securities Act of 1933.

Evaluating investment company status

 Additionally, the proposal addresses the status of SPACs under the Investment Company Act of 1940. Some securities law experts believe that SPACs and their sponsors are violating the law because they’re investment companies, not operating companies.

Under the proposed rule, a SPAC that satisfies certain conditions limiting its duration, asset composition, business purpose and activities wouldn’t be considered an investment company under the 1940 Act. To meet the proposed conditions, a SPAC must:

  • Maintain assets comprising only cash items, government securities and certain money market funds,
  • Seek to complete a de-SPAC transaction after which the surviving entity will be primarily engaged in the business of the target company, and
  • Enter into an agreement with a target company to engage in a de-SPAC transaction within 18 months after its IPO and complete its de-SPAC transaction within 24 months of such offering.

Stay tuned

The sweeping proposal to change the reporting guidance for SPACs isn’t a sure win. SEC Commissioner Hester Peirce, who voted against the proposal, said she would have supported sensible disclosures around SPACs and de-SPACs to tackle a number of legitimate disclosure concerns. The proposal instead “seems designed to stop SPACs in their tracks.”

“Today’s proposal does more than mandate disclosures that would enhance investor understanding. It imposes a set of substantive burdens that seems designed to damn, diminish, and discourage SPACs because we do not like them, rather than elucidate them so that investors can decide whether they like them. The typical SPAC would not meet the proposal’s parameters without significant changes to its operations, economics, and timeline,” warned Peirce.

However, SEC Chair Gary Gensler is a strong proponent of the proposed changes. He said the SEC has a duty to address information asymmetries, misleading information and conflicts of interest when companies raise money from the public.

The SEC is currently reviewing comments on the proposed changes to the SPAC guidance. If approved, the changes could cause more financial restatements for 2022. However, the number of restatements for 2022 probably won’t be as high as it was for 2021, because fewer companies are using this strategy to raise capital today amid increased SEC scrutiny.


Sidebar: Spotlight on SPACs

The market for special purpose acquisition companies (SPACs) boomed in 2020 and 2021. Now it’s cooling off — in part due to increased scrutiny and regulation from the Securities and Exchange Commission (SEC). Before embarking on or investing in a SPAC, it’s important to understand how these entities work.

SPACs have been around for decades. They were traditionally seen as a last resort by companies that expected to run into fundraising problems. During the uncertain markets of the pandemic, SPACs provided an alternate method for businesses to access the public markets without the hassles associated with a traditional IPO.

A SPAC may help a growing company generate fast cash in just a couple of months, as opposed to the lengthy and more stressful IPO process. Furthermore, with a SPAC merger, the target company can negotiate its own fixed valuation with the SPAC sponsors.

A SPAC registers redeemable securities for cash, sells them to investors and puts the proceeds in a trust for a future acquisition of a private operating company. Upon finding a target private company, it merges with it, completing the deal. This is called a de-SPAC.

But there are some potential downsides to consider: SPAC investors usually don’t know what the eventual target company (or companies) will be. So, investing in a SPAC is similar to writing a blank check for an unseen product. For this reason, SPACs are sometimes called “blank check companies.”

Although a sponsor’s profile might disclose an industry specialty, SPAC investors buy shares without knowing what the acquisition target(s) will be or how the acquired company (or companies) will perform. In addition, the due diligence for SPACs may not be perceived to be as comprehensive as the procedures used to size up regular IPOs.