After several years of increasing numbers of U.S. companies making initial public stock offerings, starting in late summer 2011, some companies postponed going public as economic and market conditions grew turbulent and uncertain. But even a holding pattern might have some advantages if companies use that time to better prepare for the numerous demands that accompany going public, such as audit and tax assistance in preparation of financial statements. In doing so, companies will be looking to their tax department and advisers for guidance in navigating the labyrinth of complexities associated with managing the tax accounting component of the IPO process.
Earlier this year, evidence indicated IPOs had been rising for several years after previous doldrums (see Exhibit 1). The U.S. was again the No. 1 market for IPOs (“Take that China! U.S. is Number One (in IPOs),” The Wall Street Journal, June 16, 2011).
Current economic volatility may delay IPOs, but it is not expected to curtail their eventual advancement. According to an article in the Chicago Tribune (“IPO pipeline stopped up by market volatility,” Aug. 10, 2011), “Analysts say they don’t believe IPO activity will dry up in the same way it did during the global financial crisis in 2008.” Volatility drives the “stressed” capital to the sidelines, the article said, quoting California IPO adviser Lise Buyer. “The buyers who are left are the dream team buyers of long-standing, big mutual fund companies who tend to have a longer-term horizon,” Buyer said. “So while the price might come down, the quality of the investor goes up.”
Perhaps the most important advice that a company should follow in preparing its tax function for an IPO is to “act public before going public.” From perfecting the tax team and refining internal controls to establishing a quarterly close process and preparing interim tax provisions, it is important that the pre-IPO company operate as if it is public with respect to all key facets of its tax function. Only then will the pre-IPO company experience a smooth and successful transition to public status.
Following is a step-by-step guide instructing private companies on how to “act public” with respect to their tax function before starting the IPO process.
1. ESTABLISH AN INDEPENDENT, PROFICIENT TAX TEAM
The level of complexity will increase when the company becomes public. Many advisers who can offer basic, cost-effective services to a private company may no longer be adequate for a public company. Therefore, a private company must review internal resources and external advisers to ensure they employ the necessary technical and public company expertise before initiating the IPO process. Most companies will experience some level of increased costs associated with their tax accounting and should prepare for that outlay.
Private companies may find it efficient to rely on their external audit firm to provide many tax services for the company, including the tax provision preparation. However, additional caution must be taken as a company prepares itself for an IPO to ensure continued auditor independence.
Independence requirements tend to be more lenient for auditors of a private company, held primarily to AICPA independence standards, than those of a public company, subject to more restrictive PCAOB/SEC independence requirements. What is considered a permissible nonmanagerial service under the AICPA independence rules may be considered an impermissible managerial service under PCAOB/SEC requirements. This is especially true with respect to tax provision preparation under FASB Accounting Standards Codification (ASC) Topic 740, Income Taxes (including assistance with all component parts of the tax provision, such as ASC Subtopic 740-10, formerly FIN 48, Accounting for Uncertainty in Income Taxes). It is also true with respect to assistance with developing and maintaining internal controls. Pre-IPO companies and their advisers should review the company’s tax services to ensure that, where tax assistance is provided by an external audit firm, independence will be maintained under both AICPA independence rules as well as the more restrictive PCAOB/SEC requirements for all years incorporated in SEC filings.
For tax services that are considered permissible, nonmanagerial services (services other than tax accounting) under both AICPA and PCAOB/SEC independence rules, the company may continue to choose the audit firm to perform the work. However, such tax services, though permissible, will require audit committee approval. Proper measures should be taken to ensure work is approved well before the services are rendered.
2. DEVELOP AND REFINE TAX INTERNAL CONTROLS
Although the Sarbanes-Oxley Act of 2002 (SOX) is not expressly applied to private companies, many private companies have adopted its best practices in some form. However, an IPO will trigger required compliance with SOX rules. Therefore, we recommend developing and refining tax internal controls more than 12 months prior to the IPO to facilitate the transition from private to public status.
Although tax internal controls should be tailored expressly to a company’s specific tax function, Exhibit 2 provides a basic example of what tax internal controls may include.
3. IMPLEMENT AND PRACTICE A QUARTERLY CLOSE PROCESS
Private companies generally are required to file financial statements annually without a compressed turnaround time, which makes one of the most difficult aspects of preparing for an IPO the adjustment required to file interim financial statements within the typical 40- to 45-day allotment. Under a standard public company closing schedule, the tax department or advisers may have only one to three days to complete the analysis upon receipt of the final quarterly financial data. Such challenges naturally permeate into the tax provision process.
The best way to begin introducing an interim tax provision cycle is to begin each quarterly tax provision process with a kickoff meeting between the company and its advisers. These meetings are useful to identify potential issues for the period and establish a specific timeline for the tax provision preparation and review. The meetings also are useful planning tools to assign responsibility for information gathering and to determine the most efficient means of acquiring necessary data (especially in the case of multiple foreign jurisdictions).
Another excellent means for private companies to expedite their interim tax provision turnaround time is to front-load as much of the tax provision process as possible prior to quarter close. Various estimates used in the interim tax provision may be “rolled forward” from one quarter to another without any material changes (for example, state apportionment and credit calculations). Similarly, some data may be available prior to quarter-end, allowing that portion of the tax provision to be completed prior to quarter close (for example, projected financial data, filed tax returns for provision-to-return true-up purposes, and stock-based compensation). At times the quarterly tax provision may be completed using projections and other estimates before quarter close, thereby requiring only minor changes to the quarterly tax provision once the official trial balance and other final data are available.
Part of expediting the tax provision process includes immediate communication of new key issues to the auditors as they arise. This provides the external audit firm with adequate time to research and obtain technical guidance. Failure to communicate new key issues to the audit team can slow down the quarterly tax provision process immensely, as audit reviews must be reperformed, tax provisions revised and draft financial statements updated. Such adjustments also may have the deleterious effect of creating many different tax provision versions that can further complicate and slow the quarterly tax provision process.
Once the tax provision has been completed, a “close meeting” is recommended to ensure company internal controls have been met. At the close meeting, the adviser should review provision conclusions with management, confirm key business/accounting matters have been appropriately addressed and ensure management understands key technical issues to facilitate internal control signoff. A similar technical meeting with the external audit team also can greatly facilitate the timeliness of its review.
4. PERFECT THE CORE TAX PROVISION MODEL
It is difficult to establish an efficient quarterly tax provision process without an exceptional tax provision model. Whether this is achieved using third-party software or an internally developed spreadsheet, the supporting workpapers should incorporate all elements necessary to facilitate company and auditor review, thereby decreasing review time and fostering a smooth audit.
At a minimum, the tax provision workpapers should include the key features in Exhibit 3.
All workpaper support must be pertinent to the reviewers, as well as clear and understandable without requiring oral explanations. Critical to achieving this is a detailed and comprehensive memorandum prepared at the end of each financial reporting period. The memorandum should meet internal control requirements as well as provide detailed analyses of critical aspects of the tax provision, general analysis of the current-period tax provision, effective tax rate, deferred inventory, ASC Subtopic 740-10 accounting for uncertainties, stock-based compensation and movement in tax accounts.
Constant communication is critical throughout the process. Communication between key financial personnel and the external audit team should continue throughout the financial reporting period, from the initial kickoff meeting to collaboration during the tax provision preparation process and final review of the reporting package and internal control signoff.
5. ADDRESS IPO-SPECIFIC TAX ISSUES
For many private companies, going public triggers tax issues that could significantly affect the company. Such issues should be evaluated prior to beginning the IPO process to allow sufficient time to fully understand and account for them.
Some common IPO-specific tax issues include those in Exhibit 4.
6. IMPLEMENT CASH SAVINGS AND ETR REDUCTION STRATEGIES
Private companies tend to be most concerned with cash savings opportunities. However, once a company goes public, effective tax rate (ETR) reduction strategies as well as cash savings opportunities become important, since SEC filings require ETR reconciliation disclosures, making them open to public scrutiny.
Private companies should consider implementing ETR reduction strategies well before going public, as such strategies may result in short-term tax rate volatility, with the beneficial ETR impacts enjoyed over a longer term. For example, optimizing a company’s global structure via transfers of intellectual property can reduce a company’s ETR, but these benefits may not be experienced for several years. A private company that implements such a structure pre-IPO will be better positioned to enjoy a reduced (and more stable publicly disclosed) ETR once it goes public.
7. ALIGN FOOTNOTE DISCLOSURE WITH PUBLIC COMPANY REQUIREMENTS
In connection with their interim tax provision preparation, private companies anticipating an IPO should align their footnote disclosures with those required by public companies. Although private company year-end footnote disclosures are similar to those of public companies, there are some specific differences. For example, ASC Subtopic 740-10 disclosures are broader for public companies, requiring a quarterly tabular reconciliation of unrecognized tax benefits, as well as disclosure of whether those unrecognized tax benefits, if recognized, would impact the company’s ETR.
Public companies are required to disclose in their footnotes an ETR reconciliation, which private companies are not required to disclose. Such additional disclosures should be incorporated into a private company’s footnotes quarterly prior to seeking an IPO.
LAYING THE GROUNDWORK
Once market conditions allow a resumption of IPO activity, more private companies will likely seek public status. And as they do, the temptation to move quickly toward this result may overshadow the necessary pre-IPO management of tax accounting. Due to the complexities, time constraints and significantly heightened public and regulatory scrutiny that a public company faces, it is important that a private company begin acting public with respect to its tax accounting management well in advance of an IPO.
EXECUTIVE SUMMARY
Private companies considering making an initial public stock offering must start adapting their tax function well in advance of going public. Tax accounting and its management can take at least seven steps:
(1)
Make sure auditor independence is established and maintained
under
PCAOB/SEC rules as well as those applicable to auditors of private companies.
(2)
Develop and refine tax internal controls
consistent
with Sarbanes-Oxley requirements.
(3)
The closing schedule for quarterly financial statements
by
public companies typically compresses the time available for tax
analysis. Greater communication and performing as much of the work
in advance as possible can help.
(4)
More comprehensive and complete tax provision workpapers
accompanied
by a detailed memorandum can also help make the tax provision model
more nimble.
(5)
Potential tax-specific issues of an IPO
can
include a change in tax attribute limitations, adjusting deferred
tax assets, IRC § 409A issues with respect to stock options, and
public company limits on deductible executive compensation.
(6) Because an effective tax rate reconciliation
will
be part of the public company’s SEC filings, companies should
undertake reduction strategies before an IPO.
(7) Certain tax-related financial statement footnote disclosures
should
be aligned with those required for public companies.
Douglas M. Sayuk (doug@cliftondouglas.com) and Matthew H. Fricke (matt@cliftondouglas.com) are partners, and Shamen R. Dugger (shamen@cliftondouglas.com) is a director, all with Clifton Douglas LLP of San Jose, Calif.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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