SPACs: Understanding financial reporting considerations

Sneha: Today we are joined by Siddharth Talwar, an experienced Chartered Accountant who advises companies on matters related to financial reporting under international GAAP like US-GAAP and IFRS.

Siddharth: Thanks Sneha for inviting me to this podcast. There are quite a few regulations in the US governing financial reporting matters when a ‘de-SPAC’ transaction is planned. In a sharp contrast to the tax and regulatory requirements which are primarily driven by Indian income tax law or RBI’s exchange control regulations, financial reporting requirements while de-SPACing are driven by the SEC and PCAOB, the auditing regulator in the US.

So a word of caution here. While I’ll try to answer your questions in a simplified manner and taking a line from one of my favourite online shows, I will try to “cut the clutter” for your audience, I would strongly advise that companies consult a US legal counsel on a timely basis. With that, am happy to take on your questions now.

Question: Siddharth, it will be good to start with an overview of financial reporting requirements at the de-SPAC stage. Can you take us through the big picture here?

Siddharth: The first and foremost thing to understand is that the financial reporting requirements in a de-SPAC transaction are pretty much the same as those in a traditional IPO. As has been explained by Sridhar in Episode # 2, de-SPACing is the acquisition of the operating target company by a listed shell company i.e. SPAC.

Now, imagine there is a listed company that has lots of cash or is arranging fresh equity through a private placement, which is called PIPE in the US i.e. Private Investment in Public Equity. It identifies a target, say in India, and expresses its intent through a LOI followed by a business combination or a merger agreement. Of course, I have over-simplified these steps to focus on the financial reporting bit, but there is diligence involved here, and of course the tax structuring bit that Sridhar talked about in previous episode.

Coming back, what is the most common step before any company consummates a business combination or a merger – it’s the vote of the shareholders on the business combination agreement, commonly referred to in the US as soliciting proxies. And, in order to solicit those proxies, the SPAC needs to send a proxy statement to its shareholders, and that proxy statement should include financial information about the target, and some additional financial information. The proxy statement needs to be approved by the SEC before it goes to the shareholders. Usually, there is a gap of 40-45 days between the business combination agreement and the filing of the proxy statement with the SEC. So, that’s your first financial reporting requirement – the financial information that goes in the proxy-cum-registration statement on Form S-4 or F-4.

The SEC comment process may take 2-3 months after which the S-4 or F-4 is declared effective and the business combination is put up for vote. Once the SPAC’s shareholders vote and approve the business combination i.e. the de-SPACing, the transaction moves towards closing and is consummated – this may take another 30-40 days.

The post-combination registrant is then required to file Form 8-K or Form 20-F, also called the “Super 8-K’ or “Super 20-F” and that filing has to be done within 4 days of the consummation of the business combination. Super 8-K or 20-F pretty much contains the same information that goes into any initial registration statement like a Form 10. It may incorporate financial statements by reference to the S-4 or F-4, but there are certain age requirements to be complied with. So, that’s your second milestone in terms of financial reporting – the Super 8-K or the Super 20-F.

Just to recap – first, the S-4 or F-4 i.e. the proxy-cum-registration statement and second, the Super 8-K or Super 20-F. If you add all of this up, we are talking about 5-6 months end-to-end from the date the business combination agreement is signed.

Question: Sid, you mentioned quite a few forms there. Can you tell us briefly how does a company decide which form to use?

Siddharth: Sneha, this is a matter of legal determination, but the underlying determining factor is your registrant status. A US domestic registrant will use S-4 for proxies and 8-K for announcing the business combination. A Foreign Private Issuer or FPI will instead use F-4 for proxies and 20-F for business combination announcement.

Question: That’s a good bird’s eye view of the financial reporting process, Siddharth. Let’s dive deeper into this and begin with talking about the financial information that goes into these SEC forms you talked about. How many years of financial data of the target needs to be kept ready for the de-SPAC process?

Siddharth: Sneha, for Form S-4 or F-4, as the case may be, the general rule is audited P&L and cash flows for latest 3 fiscal years and audited balance sheet as at the end of latest 2 fiscal years. Unaudited interim financial statements may also be required, depending on the timing of the filing and effectiveness of the proxy-cum-registration statement. I will take this up in a moment.

But there are two exceptions to this general rule. First, if the target company is non-reporting, which is likely to be the case for most targets, and meets the requirements to be a smaller reporting company or a SRC, if it were an issuer itself, then only 2 years of audited financial statements are required. To be a SRC, the target should have revenues of less than 100 million US Dollars as per its latest annual financial statements.

The second exception to the general rule of 3 years is for emerging growth companies or EGCs as we call them. I will explain EGC shortly. Let me first talk about the qualification criteria for this exception. To qualify for this exception, there are 3 conditions – firstly, the SPAC shouldn’t have filed its first Form 10-K or the filing deadline for 10-K shouldn’t have come so far; secondly, the SPAC itself should be an EGC; and lastly, the target would be an EGC if it were conducting its own IPO.

So, what is an EGC? In the US, the JOBS Act i.e. the Jumpstart Our Business Startups Act of 2012 created a new category of companies called Emerging Growth Companies. From the perspective of financial reporting and auditing, EGCs have several relaxations. There are three conditions to be an EGC – one, revenue should be less than USD 1.07 billion in most recent fiscal year; second, it has not issued more than a billion US dollars of non-convertible debt in past 3 years and third, public float of the SPAC should be less than 700 million US Dollars.

So, to summarise, general rule is - 3 years of audited annual financial statements of the target are required and in the two exceptions we talked about – SRCs and EGCs, 2 years of audited annual financial statements of the target are to be presented.

Let me briefly touch upon the interim financial statements also. Depending on the age requirements, unaudited interims may need to be included. Interims will include a balance sheet as at the end of the most recent interim period and year-to-date P&L and cash flows for the interim period, together with corresponding interim period of previous fiscal year.

So, these are the financial data of the target that goes on the forms I mentioned.

Question: Thanks Sid. You mentioned a couple of times about the age requirements related to the financial statements of the target. What are those age requirements exactly?

Siddharth: Basically Sneha, the audited financial statements are only valid for inclusion in the relevant forms for a specific period.

The rule is that upto 45 days from the end of the latest fiscal year-end, the audited financial statements for the previous fiscal year are valid. To illustrate this, say the target has a 31 March year-end, then, upto 15th May 2021, which is when the 45 days from 31st March lapse, audited financial statements for year ended 31 March 2020 are valid. But, in that case, the SPAC will have to include interim financials of the target upto Q3 of year ended 31 March 2021 i.e. for the 9 months ended 31 December 2020.

Post 15 May 2021, audited financials for year ended 31 March 2020 will be considered aged or stale and hence need to be updated for year ended 31 March 2021.

Continuing with this example, if the filing or effectiveness of the relevant form were to happen after 134 days from fiscal year-end, then, target’s interim financial statements, which are no older than 134 days from the filing or effectiveness date are required. For example, if the filing or effectiveness date is likely to be 31 December 2021, interim financial statements at least upto 19 August 2021 shall be required, which is within 134 days of 31 December 2021 counted backwards. Though for simplicity sake, interims upto 30 September 2021 are generally considered.

Sneha, I must point out here that if the post de-SPAC registrant is a foreign private issuer or a FPI, the financial statements go “stale” even slowly. This applies for the Super 20-F filing. In summary, the 45-day rule for domestic registrants is replaced by 90-day rule for FPIs, and instead of the Q3 rule that I mentioned, an FPI’s interims included in the Super 20-F can be as old as 9 months.

Question: That’s quite useful Sid and clears some air about the “staleness rules”. Let me shift gears now and seek your thoughts on what accounting principles are applicable for the target operating companies? I understand that most Indian companies of certain size follow Indian Accounting Standards or Ind-A.S. Similarly, am aware of several global reporting standards aligned with IFRS. Can targets use their home country financial statements or IFRS financial statements?

Siddharth: That’s a million-dollar question Sneha. Its not a straightforward answer and I will have to adopt a “If this, then that” kind of an approach to respond to this one. But let me first mention what is this fuss all about. See, Indian companies generally follow Ind-AS which is almost identical to IFRS and hence as a thumb rule, it can shorten the runway to proxy statement filing to almost one-third, as compared to a USGAAP reporting requirement. Its an important consideration and must be carefully evaluated upfront.

The accounting principles or the GAAP to be followed really depends on the post de-SPACing status of the registrant. By status, I mean whether the de-SPACed entity will be a US domestic registrant or a Foreign Private Issuer i.e. a FPI. At the outset, let me stick my neck out and state the general rule – domestic registrants have to follow USGAAP and FPIs are permitted to follow IFRS. I will specify more around this in a moment.

But before I do that, I would like to take the audience back to Episode # 2, wherein Sridhar talked about several possible structures within the constraints of Indian income tax laws and exchange control laws. The externalization of the operating target company achieved through those possible structures has an impact on the post de-SPACing status of registrant which, in turn, determines the applicable accounting rules and the age requirements, as I had touched upon earlier.

At this juncture, I think its important to understand who is a FPI? The determination of FPI is done at the end of the most recently completed second fiscal quarter. To be a FPI, the issuer i.e. the post de-SPACing registrant should meet 2 conditions – (1) more than 50% of its voting securities should be held by persons who are not residents of the US and (2) more than 50% of (a) directors or executive officers or (b) assets or (c) business should be outside the US.

In general, if the SPAC is domiciled in the US, it will be a US domestic registrant and hence follow USGAAP. But at the stage of shareholder approval i.e. S-4 filing, since the business combination has not yet happened, theoretically speaking, the Indian target company’s financial statements may be prepared as per IFRS. Now that’s what it exactly is - a theoretical possibility. I would strongly advise that the post de-SPAC status is assessed before going ahead with IFRS accounts at proxy statement stage. Because, if the conclusion is that the registrant will not be a FPI after de-SPAC, it will have to nevertheless prepare USGAAP financial statements for its super 8-K filing. So, why spend the effort twice?

Now, if the listed SPAC is domiciled outside the US, like Cayman Islands and BVI are some of the favourite jurisdictions in my experience, then there is a possibility that the post de-SPAC registrant is a FPI, in which case a super 20-F can be filed with IFRS financial statements. As mentioned by Sridhar, there are quite a few regulatory challenges like round-tripping which are to be kept in mind while structuring this. Sridhar also talked about an inverted foreign owned group structure. Those structuring options interact quite a bit with the applicable GAAP and hence the two discussions need to go hand in hand.

Question: That’s an important takeaway it seems – deciding tax structuring strategy in tandem with financial reporting implications. As they say, speed is the USP of SPAC route and if one accounting framework works quicker than the other, it is certainly an issue on the table for discussion. I have a couple of more questions before we wrap this up. To my first question, you made a subtle reference to “other financial information”. How significant is that requirement?

Siddharth: You are definitely paying attention to what I am saying, Sneha. Am glad. Besides the audited annual financials and unaudited interim financials, there are two major requirements – first, the proxy-cum-registration statement should include pro forma financial information that reflects the consummation of the business combination. This means a proforma condensed balance sheet as of the date for which last balance sheet is included in S-4 or F-4 and proforma P&L for both the last fiscal year and interim period included in the proxy-cum-registration statement.

One critical aspect to consider here is “who is the accounting acquirer”. If the target is the accounting acquirer, usually SPAC will not end up meeting the definition of business under ASC 805 or IFRS 3 and hence the transaction is in effect an exchange of equity interests of the target for net assets of the SPAC i.e. the funds lying in trust account and/or cash. If the SPAC ends up being the accounting acquirer, net assets of target operating company will need to be fair valued as per ASC 805 or IFRS 3, which is a long-drawn process. Not only this, there may be a need to present multiple proforma financials since it is not yet known whether and how many shareholders will approve of the business combination and hence may force redemption of their units.

The second consideration is that if the target operating company has consummated a business combination in the most recent fiscal year or thereafter, separate financial statements of the acquire entity may need to be included, depending on the significance tests prescribed in Regulation S-X. This will again add a lot of burden on preparers.

So, in nutshell, proformas and financials of business acquired/to be acquired is what I meant by “other financial information”.

Question: I can certainly see there is a lot of work ahead for companies aspiring to list via SPAC route. One last question – how different is the auditing framework and are there any relaxations for the FPIs that you could summarise for our audience?

Siddharth: Indian companies are audited under the Standards on Auditing which are formulated by the Institute of Chartered Accountants of India, and those standards are in line with the International Standards on Auditing, barring a few exceptions, like in case of group audits. However, for the purpose of financial statements to be included in S-4 or F-4 or 8-K or 20-F, the relevant auditing standards are the ones prescribed by the PCAOB, the Public Company Accounting Oversight Board. The auditors will need to be registered with the PCAOB and will have to perform a few additional procedures to ensure compliance of their audit opinion with the applicable PCAOB norms. Besides this, the auditor’s independence requirements under Regulation S-X, Rule 2-01 are more stringent than the Code of Ethics and Corporate Law in India and hence is an area that should be cleared upfront with the auditors.

Also, the auditor’s report may include a reference to Critical Audit Matters, unless the SPAC and the target both are EGCs individually and post the de-SPAC process.

As far as the relaxations to FPIs are concerned, there quite a few actually. Again, that’s an incentive to an extent for Indian companies exploring this route for listing in the US markets. We talked of the most significant one i.e. the ability to choose to report under IFRS, which is similar to Ind-AS. We also talked about the “staleness rule” for FPIs – their financials go stale slower than the domestic registrants. Those are at the time of de-SPACing.

On an ongoing basis, there are a few more relaxations – FPIs don’t need to file quarterly financial statements on Form 10-Q and current reports on Form 8-K. Also, the annual reporting on Form 20-F can be done upto 4 months from the end of the fiscal year-end as compared to 60, 75 and 90 days requirement for large accelerated, accelerated and non-accelerated domestic filers respectively. Last, but not the least, non-accelerated FPI filers only require a management’s assessment of internal control under SOX 404, as compared to others which also require auditor’s attestation thereon.

Hence, the compliance track for FPIs is way different from domestic registrants, and thus is a critical consideration.