PwC recently released a study on the effect of disclosing material weaknesses (MWs) during an issuer's initial public offering. Disclosing material weaknesses, which are defined by the SEC as "a deficiency, or a combination of deficiencies in Internal Control over Financial Reporting (ICFR) such that there is a reasonable possibility that a material misstatement of the registrant's annual or interim financial statements will not be prevented or detected on a timely basis," has often had negative consequences for new companies whose performance is not yet well known. PwC's study found, however, that many companies that disclose MWs in conjunction with their IPOs do not experience the same unfavorable consequences during their first few years as a public company.
The study notes that the percentage of companies disclosing material weaknesses in US IPOs has risen from 18% in 2012 to 31% in 2015, to date. 88% of all companies reporting material weaknesses had less than $500 million in revenue, which PwC attributes to the fact that smaller companies are more vulnerable to MWs than larger companies with better accounting and reporting resources. Of the companies that disclosedMWs during their IPOs, PwC's research showed 33% of these companies were tech companies and 31% were healthcare companies. The industry representation may not be meaningful since the majority of IPOs have been undertaken by companies in these two industry sectors.
The most common MW disclosed was the "lack or shortage of accounting personnel", which accounted for 24% of all MWs, followed by "inappropriate reconciliation of complex or non-routine transactions," which accounted for 19%.
Although the effects of disclosing MWs for pre-IPO companies might be minimal for the first few years oflife as a public company, investors are interested in remediation steps. PwC found that 92% of companies disclosing MWs were including remediation language in their registration statements. Of the remediation solutions, the most popular solutions were to hire additional personnel, used by 65% of companies in PwC's research, and 61% would hire a Chief Financial Officer.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Morrison & Foerster LLP. All rights reserved
