Financial restatements surge among SPAC startups

The number of companies that have restated their financial results or disclosed accounting problems has increased significantly in recent years, and many of the problems have been occurring at special purpose acquisition companies.

SPACs, also known as blank check companies, are basically shell companies that are used as a vehicle for taking a company public. 

Glass Lewis, a proxy advisory services company, reported last month that after several years of companies going public through IPOs or SPAC mergers, it observed a more than 2.5-fold increase in companies with concerning material weaknesses or restatements, partly because many of the companies are only in the early stages of developing strong internal controls.

The Institute of Management Accountants has been seeing similar trends. 

"It's been widely reported about the number of restatements over the past few years, a lot involving SPACs and companies that have recently gone public," said Rich Brady, global chair of the IMA and CEO of the American Society of Military Comptrollers. "There are a number of reasons for that. A lot of times it comes down to the people, the process, the technology not really keeping pace with the requirements, particularly with startups in the fast pace that startups operate. But the internal control piece really affects all companies, not just startups."

However, startups and SPACs can be especially vulnerable. "That's because they're still refining their own internal controls," said Brady. "They're trying to put new controls in place. They're establishing all their accounting procedures, and they're implementing new technologies on top of it. What this all leads to is the increased risk of control deficiency, which ultimately leads to the restatements that we're seeing in the news."

The trend was noticeable last year as well, according to a 2022 report from Audit Analytics (see story). The Securities and Exchange Commission has been clamping down on SPACs with guidance in recent years on warrants and disclosures, leading to a decline in companies going public via SPACs (see story).

"You saw a significant increase in the number of SPACs from about 2000 to 2022," said Brady. "That's when, in the spring of 2022, the SEC really stepped in to increase some of the disclosure requirements around the SPACs and put some controls in place. The SPACs and their ability to move to market faster has somewhat diminished. That's why you actually saw a significant reduction in the number of SPACs after 2022."

He pointed to other reasons as well, including market volatility and the steep rise in interest rates, in addition to the extra SEC scrutiny.

Accountants should advise companies, including startups and SPACs, to use internal control frameworks such as the one from the Committee of Sponsoring Organizations of the Treadway Commission, or COSO for short. The COSO internal control framework is widely used.

"We as accounting professionals would recommend you use these pre-existing models, like the COSO model, that have already proven effective, and many CFOs lead their organizations and their teams using these models," said Brady. "The COSO framework really starts right there at the top with a control environment."

He noted that SPACs and startups typically have flat hierarchies and like to take risks with the expectation of higher reward. "When you put in internal controls, that control environment is a bit more lax or riskier, depending on which way you want to look at it, than you would have in a traditional or established company," said Brady. "But that's not to say that a traditional or established company can't have internal control challenges as well that start at the top with that internal control environment. But just by their very nature, startups and SPACs have a higher risk within their control environment, and there are some red flags that you can look at that give you a pretty good assessment of the control environment. That's why the models, like the COSO model, are important because it really emphasizes that tone at the top."

Accounting firms and departments need to recruit and train accountants to look out for such risks and implement the proper controls at startup companies. Young accountants need to gain experience with the existing accounting standards to make sure startups are following the rules. 

"If you look at the common themes that are behind a lot of these restatements, they fall into a number of areas like revenue recognition, deferred tax, assets and liabilities, things like that — common accounting policies that we're familiar with," said Brady. "But many of the accounting standards that these startup companies are trying to implement are complex and require a fair amount of judgment and more estimates. You get that as you gain that judgment and experience with estimates through more experience in the profession. A lot of these companies are navigating these complex standards, with many manual processes and spreadsheets that are prone to error and are not properly controlled. Having the accounting staff with the required knowledge, skills and experiences is necessary. One way you can approach it is looking at it from the perspective of sustainable business management. Any organization, whether you're a startup or an established company, if you want to be a sustainable business, you want to be a going concern, which means that you have to have foundational internal controls and accounting policies and processes established upfront. Even though it may slow down some of your development opportunities as a startup, it's important to have that in place to be sustainable."

Last week, the IMA issued a formal statement on the challenges of the accounting and finance pipeline, focusing on the need for rigorous and holistic accounting education across areas like advanced technologies, sustainability, data science, cybersecurity, risk management and leadership. The statement also focuses on the need to promote diversity within the profession, and highlights the IMA's efforts on this front. 

In addition, the IMA announced a collaborative agreement last week with Fordham University in New York on sustainability reporting education. The IMA and Fordham University's Gabelli School of Business signed a memorandum of understanding to deliver workshops that educate accounting and finance professionals on what they need to know to succeed in today's business environment. The first workshop,  "Bridging COSO and Sustainable Business Practices," will be produced by the IMA and will take place Nov. 20-Dec. 1, 2023. It will discuss COSO's recent publication on achieving effective internal controls over sustainability reporting through COSO's internal control framework. 

"If you think about many startups, it's a risky time just for the business," said Brady. "They're managing cash. They're managing development of some product or service. That's really where their priorities lie. And they're trying to get very flat hierarchies, with not a lot of overhead. When you start talking about things like needing to establish internal controls and compliance structures, that's an overhead that competes with product development and trying to grow the business quickly. But it really comes down to balance for the organization and understanding that, as they grow, they need to grow responsibly. Otherwise, it results in what we're seeing now: with restatements at best, and at worst, the collapse of a company because of some decisions they've made."