Currently, there is tremendous interest by companies in a variety of industries to access the capital markets either via a traditional initial public offering of securities (IPO) or via a merger with a special purpose acquisition company (SPAC). The popularity of SPACs in 2020 and the first quarter of 2021 has now resulted in the Securities and Exchange Commission (SEC) placing a new layer of scrutiny on SPACs to go along with the common accounting considerations for these vehicles.
A SPAC is a public company that has been formed specifically with the intent of investing in a private operating company. The proceeds raised in the SPAC’s IPO are placed in a trust account. Once a target operating company is identified, the proceeds of that trust are then used to purchase the target. The merger between the SPAC and the target operating company is typically referred to as a “de-SPAC” transaction.
SPACs In the News
On April 12, 2021, John Coates, Acting Director, Division of Corporate Finance, and Paul Munter, Acting Chief of Accountant of the SEC issued a Staff Statement on Accounting and Reporting Considerations for Warrants Issued by SPACs, stating in part:
We recently evaluated fact patterns relating to the accounting for warrants issued in connection with a SPAC’s formation and initial registered offering. While the specific terms of such warrants can vary, we understand that certain features of warrants issued in SPAC transactions may be common across many entities. We are issuing this statement to highlight the potential accounting implications of certain terms that may be common in warrants included in SPAC transactions and to discuss the financial reporting considerations that apply if a registrant and its auditors determine there is an error in any previously-filed financial statements.
You can read the full article here.
Based on this Staff Statement and two examples provided, many public entities are now re-evaluating the classification of warrants accounted for as equity in filings with the SEC. Many have decided to restate previously issued financial statements to present the warrants as liabilities. Many more restatements are expected.
However, the Staff Statement over warrants is not the only accounting issue associated with SPACs that one should bear in mind. Use this overview for insights regarding other, more significant accounting considerations for SPAC transactions.
Determination of the Accounting Acquirer
In most de-SPAC acquisitions, the target company/legal acquiree is determined to be the accounting acquirer. However, this should not just be assumed. Several steps must first be considered and documented. This begins by determining whether the target company is a variable interest entity (VIE). If the target company qualifies as a VIE, then the primary beneficiary of the VIE becomes the acquirer in the de-SPAC transaction.
However, if the voting interest model applies, the combined company must consider the guidance in Accounting Standards Codification (ASC) 805, Business Combinations specifically ASC 805-10-55-11 through ASC 805-10-55-15 and any factors that may indicate which party is deemed the accounting acquirer rather than just looking at the legal structure of the transaction. These factors may include:
- Relative voting rights in the combined reporting entity
- Existence and size of a single minority voting interest in the combined reporting entity
- Composition of the governing body of the combined reporting entity
- Composition of senior management of the combined reporting entity
- Terms of the exchange of equity interests (an entity that pays a premium)
- The relative size of the combining entities
A robust and thorough performance of this analysis is key.
If the target company is determined to be the accounting acquirer, then the transaction is considered a reverse acquisition and business combination accounting is not applied. In other words, the assets and liabilities of the target operating company continue to be carried at their historical values and there is no goodwill resulting from the transaction. However, the equity of the combined company is a blend of the SPAC and operating company equity accounts. The SPAC’s legal form of equity interests continues to exist and is presented, while the historical retained earnings (deficit) and other accumulated comprehensive income of the target operating company are carried over. Of course, any changes to the equity structure resulting from the de-SPAC transaction are reflected in the combined entity’s financial statements.
Earn-Out and Contingent Payments
Many transactions between a SPAC and a target operating company include provisions where the combined company will issue financial instruments to key stakeholders (usually sponsors of the SPAC or former founders of the target operating company) if the newly public company meets certain operating or financial metrics. On the assumption that the transaction is considered a reverse acquisition by the target company, these contingent equity issuances should be evaluated as to whether they should be classified as either equity or a liability on the combined company’s financial statements.
Most contingent issuances in a typical de-SPAC transaction will meet the definition of a derivative. With that criteria, these transactions should be recognized as a stand-alone financial instrument at fair value, with changes in fair value recorded through the company’s earnings. With the complexity of these financial instruments, the company must prepare a welldocumented and detailed analysis of the instruments’ features analyzed in the context of ASC 815, Derivatives and Hedging.
Typically, prior to the merger between a SPAC and a target operating company, and often on the merger date, each entity will issue certain freestanding equity-linked instruments. Warrants and earnouts are discussed above and are intended to provide value to the original SPAC investors, as well as to the founders of the target company. Frequently, there also will be share-based payment awards in the form of options or restricted stock awards granted to management and key employees. There are a host of complex accounting standards applicable to these instruments to be considered, including ASC 815, ASC 480, Distinguishing Liabilities from Equity, and ASC 718, Compensation – Stock Compensation.
As stated, in light of the SEC Staff Statement, many public entities are re-evaluating warrants and adapting strategies for moving forward.
Earnings Per Share
Most of the target operating companies acquired in a de-SPAC transaction are private entities, such as private-equity-backed companies or founder-owned companies. These entities are not required to report on earnings per share while private. However, once the de-SPAC transaction is complete, the newly combined entity must calculate and present basic and diluted earnings per share. While this is routine for public entities with mature financial reporting models, the earnings per share calculations can be complex and challenging for a team unfamiliar with the calculations.
It is also important to note that the new public entity must consider challenging earnings per share issues resulting from the share-based compensation as well as complex warrants and other equity-linked instruments discussed above when calculating diluted earnings per share.
While segment reporting is not required for private entities, the identification of reporting segments is one of the most common issues that a new public entity must face. ASC 280-10-10-1 states:
The objective of segment reporting is to provide information about the different types of business activities in which a public entity engages and the different economic environments in which it operates to help users of financial statements do all the following:
- Better understand the public entity’s performance
- Better assess its prospects for future net cash flows
- Make more informed judgments about the public entity as a whole.
The method for determining what information to report is the management approach. It is based on how management organizes segments within the public entity for making operating decisions and assessing performance. The underlying key concept in the management approach is the determination of the Chief Operating Decision Maker (CODM), and how the CODM evaluates the performance of the entity and makes resource allocation decisions.
Many small operating companies contend that they only have one reporting segment. However, the internal management reporting often contains a level of detail that may appear to contradict management’s assertion. If internal management reporting presents financial information or key metrics for multiple business units and the CODM uses those reports to allocate capital and other resources, then there is a rebuttable presumption that each business unit presented is a reportable segment. To overcome that presumption, company management must provide evidence that the CODM does, indeed, make decisions for the business as a whole and that the detailed information is informative, but not used operationally.
How DHG Can Help
These are just some examples of accounting issues associated with SPAC targets. To help you navigate them and provide the information you need to create ongoing strategies, we stand ready to answer questions regarding your specific accounting issues.
For further insight regarding accounting topics for SPACs and how our technical knowledge, industry intelligence and our future focused approach can work for you, please connect with us at email@example.com.