The explosion in special purpose acquisition company (SPAC) mergers with private companies to form public companies during 2020 and 2021 highlighted a variety of concerns with this new form of ownership, including when to reclassify equity warrants to liabilities, whether error corrections due to reclassifications should be treated as revisions or restatements of financial statements, how to comply with SEC and PCAOB regulations, and how to judge the impact on audit quality control deficiencies. Marcum LLP is the dominant player in this market, with one-fifth of its total audit fees of $184 million attributable to revenue from auditing SPACs. Among the 11 audit quality control deficiencies cited in the SEC’s legal settlement with Marcum include the acceptance and continuance of clients and engagement, engagement performance, and quality controls. The SEC is working on proposals that would enhance disclosures to better protect investor interests.
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New forms of entity ownership that have emerged in recent years raise questions about whether audit quality controls are operating effectively and meeting SEC and PCAOB requirements. One such form is the special purpose acquisition company (SPAC). SPACs have changed the landscape for some audit firms that have taken on hundreds of such clients. An overriding concern is whether auditors have the requisite knowledge and experience auditing SPACs to adhere to all relevant professional standards.
A variety of issues need to be addressed if auditors are to meet their professional obligations. These include accounting for SPAC acquisitions; evaluating restatements of financial statements; ensuring compliance with SEC and PCAOB regulations; adhering to PCAOB audit quality control standards; addressing audit independence issues; and considering the implications for corporate governance, including the audit committee.
SPACs are shell companies formed with the sole purpose of raising funds so they can buy an existing business. SPACs are often referred to as blank check companies, because they are formed without a specific acquisition target in mind. Investors do not know which company the SPAC intends to acquire, so they must feel comfortable being in the dark. When a SPAC and a private company agree to a merger, the private company receives the funds. The SPAC then goes through a short regulatory and legal process to go public. The merger of the SPAC and the target company (de-SPAC) and related transactions may provide the target company with capital that it might otherwise need to raise in a traditional IPO. After the merger, SPAC shareholders and target shareholders own the public company. One of the advantages of using a SPAC to go public is that traditional IPOs take more time and cost more money to go through the SEC’s IPO process. According to Audit Analytics, as of May 14, 2023, there were 707 SPACs and shell companies registered with the SEC (“Who Audits Public Companies,” June 8, 2023, http://tinyurl.com/39bb6cnc).
Once the process is complete, the original SPAC is then dissolved and delisted from trading and the private company is now a public company. SPAC shareholders can decide if they want to be a part of the deal or drop out and get their money back. This provides a level of flexibility that makes a SPAC appealing.
According to Statista, there were 248 SPAC IPOs in 2020, 613 in 2021, and then a decline to 86 in 2022 [Statista, “Number of special purpose acquisition company (SPAC) IPOs in the United States from 2003 to August 2023,” http://tinyurl.com/3dkbtp9h]. The decline from 2021 to 2022 is likely due to the increased regulatory scrutiny of these arrangements by the PCAOB and SEC.
Two firms—Marcum LLP and WithumSmith+Brown PC (Withum)—dominate the market auditing SPACs. According to data provided by Audit Analytics, the portion of Withum’s revenue from auditing SPACs was half of its $70 million total fees during 2020 and 2021. The portion of Marcum’s revenue from auditing SPACs was one-fifth of its $184 million total audit fees (“Audit Market Following SPAC Mergers,” Jan. 25, 2022, http://tinyurl.com/2m2rfya2).
Many SPACs that changed their audit firm prior to a merger of the two entities involved in the SPAC transaction were Marcum clients. According to the Audit Analytics data, a majority of Marcum’s clients that changed auditors did so during August 2021, just prior to issuing restated financial statements to address the accounting of certain shares as derivative liabilities.
According to the SEC’s legal action against Marcum in 2023, over 860 SPACs completed IPOs in the United States in 2020 and 2021. More than 400 of these SPAC IPOs were audited by Marcum. In 2019, Marcum had served as the auditor for only 185 public company issuers; by 2022, Marcum was responsible for auditing more than three times that number—a total of 575 issuers, the majority of which were SPACs. This vaulted Marcum to the fifth largest public company auditing firm, as measured by number of clients (SEC, In the Matter of Marcum LLP Respondent, Accounting and Auditing Enforcement Release No. 4423, June 21, 2023, http://tinyurl.com/3tkx5dhe).
Accounting for Warrants
A SPAC transaction generally starts with an acquisition by investors who are awarded shares and warrants upon the SPAC going public. The proceeds are held in trust to be used for the acquisition of a target, typically for less than 24 months. If the acquisition is not completed by then, investors’ shares are redeemed (plus interest) from the funds in the trust. Investors can sell their shares and warrants on the secondary market at any time. They can retain their warrants even if the shares are redeemed. But sponsors are typically required to retain their shares and warrants.
Recent SEC scrutiny of warrant accounting has resulted in financial statement restatements by many SPACs; this is because it is not unusual for SPACs to account for warrants as equity. In a joint statement issued by John Coates, acting director of the SEC Division of Corporation Finance, and Paul Munter, SEC chief accountant, the SEC pointed to the complex requirements for the investment to be accounted as equity and said—more often than not—it should be treated as a liability. The reasoning is that, if the SPAC fails to control the ability to settle with shares and the failure is based on the provision that SPAC warrant agreements allow holders to elect to receive cash if a tender or exchange of the underlying shares are made in the context of a change of control, then liability treatment would be required [Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (SPACs), April 12, 2021, http://tinyurl.com/ep2cpk8c].
SPACs that do not meet the requirements to be accounted for as equity have been required to restate their financial statements and classify the warrants as derivatives in the liability section of the balance sheet. If SPACs conclude that an error in prior recording had occurred, it might trigger the need to restate their financial statements and to revise prior disclosures about the effectiveness of internal controls over financial reporting (ICFR) (http://tinyurl.com/ep2cpk8c).
Restatement of Financial Statements
If a company and its auditors determine that, in light of the SEC’s joint statement on SPACs, there was an error regarding the classification of warrants in previously filed financials, the company has to consider the materiality of the error in assessing whether it needs to restate its financials—which could involve amending one or more periodic reports and filing a Form 8-K. In addition, the company needs to consider whether it should upgrade its ICFR and disclosure controls and procedures, and amend its prior disclosures on the evaluation of ICFR and disclosure controls.
Cornerstone Research examined SPAC restatements for warrants issued during the period from April 13, 2021, through June 22, 2021, shortly after the SEC statement, and found that, of the 497 SPACs that reclassified warrants as liabilities, the majority corrected previously issued financial statements to reflect a restatement, whereas some implemented a revision whereby the correction was applied only to current and future financial restatements. Nearly all SPACs that have restated their financial statements also determined that material weaknesses existed in their internal controls. Specifically, researchers found that, out of the 497 restatements, more than 90% identified a material weakness in the SEC filing in which the restatement was reported (Accounting Class Action Filings and Settlements 2021 Review and Analysis, http://tinyurl.com/4x922zsk).
Corporate restatements reached a 15-year high in 2021, as the SEC told hundreds of SPACs to fix pervasive accounting errors. Corrections to financial statements totaled 1,470 in 2021, soaring 289% over 2020, according to Audit Analytics. SPACs accounted for 77% of the corrections reported to the SEC. Restatements would have dropped 10% absent SPACs, according to the report. Some restatements had so many corrections that the companies had to refile an entirely new set of financial statements; those types of restatement were up 62% in 2021 (Audit Analytics, “2021 Financial Restatements: A Twenty-One-Year Review,” May 2022, http://tinyurl.com/k3j43yce).
In correcting for past errors in accounting for warrants as equity rather than liabilities, most audit firms have considered the adjustment small enough to be treated as a revision of the financial statements (i.e., a “Little r” restatement), therefore, prior years’ financials would not need be restated. A material error in the prior period financial statements (a “Big R” restatement) requires revision and restatements of the financials. Most companies prefer not to restate the financials, because it would mean that they would have to inform the users of the financial statements that they can no longer be relied upon, and the audit opinion would have to be revised.
SEC and PCAOB Regulatory Actions Against Marcum
On June 21, 2023, the SEC fined Marcum LLP $10 million for standards violations and systemic quality control failures in its audit work for hundreds of SPACs. The PCAOB also fined the firm $3 million. During the period that Marcum saw a nearly sixfold increase in clients, the SEC found violations in 25–50% of audits reviewed. In hundreds of audit clients, Marcum failed to comply with audit standards related to audit documentation, engagement quality reviews, risk assessments, audit committee communications, engagement partner supervision and review, and due professional care. The SEC’s order against Marcum charged that the firm failed to design, implement, and monitor an adequate system of quality control in connection with certain audit standards, as well as with respect to other key quality control components, including client acceptance and technical consultations. The SEC also charged that the firm engaged in improper professional conduct within the meaning of Rule 102(e) of the SEC’s Rules of Practice, violated multiple audit standards across numerous engagements, and violated Rule 2-02(b)(1) of Regulation S-X (SEC, In the Matter of Marcum LLP, Accounting and Auditing Enforcement Release No. 4423, June 21, 2023, http://tinyurl.com/3tkx5dhe).
In addition to the fines it levied, the SEC, working in tandem with the PCAOB, announced a settled disciplinary order that requires Marcum to create a new position (chief quality officer) and a new committee to oversee its audit practice (audit oversight committee). This is the first time the PCAOB has required a registered firm to make functional changes to its quality control supervisory structure (Order Instituting Disciplinary Proceedings, Making Findings, and Imposing Sanctions In the Matter of Marcum LLP, June 21, 2023, http://tinyurl.com/yc7mrxa4).
Audit Quality Control Deficiencies
The SEC order identifies violations of PCAOB audit and quality control standards during Marcum’s audits of SPACs. These run the gamut from failing to provide the firm with reasonable assurance that its personnel comply with applicable professional standards and the firm’s standards of quality to failing to communicate quality control policies and procedures to firm personnel, in a manner that provides reasonable assurance that those policies and procedures are understood and followed.
According to the SEC order, Marcum violated PCAOB Auditing Standard (AS) 1215, Audit Documentation, in a variety of ways. In most cases, the violations are attributable to a lack of audit quality controls. The violations included the following:
- ▪ Lacked sufficient policies, procedures, and monitoring related to work paper sign-offs, including the timing and dating thereof, as well as timely assembly and retention of audit documentation.
- ▪ Failed to comply with the requirement that the assembly and release of audit documentation be completed within 45 days after the audit report release date.
- ▪ Lacked sufficient policies, procedures, and monitoring to provide reasonable assurance that the work performed by firm personnel with respect to the documentation of warrant accounting procedures met the requirements of AS 1215. (http://tinyurl.com/zhjpfv6z)
Other PCAOB audit standards violated include AS 1015, Due Care in the Performance of Work, AS 1201, Supervision of the Audit Engagement, and AS 1301, Communications with Audit Committees. The latter violation occurred because Marcum failed to communicate significant matters to those changed with governance, including the audit committee, as well as due to the firm’s approach to internal control relevant to the audit, including, when applicable, whether the auditor will express an opinion on the effectiveness of ICFR.
Mike Shaub addressed the failures at Marcum and observed that the “real problem unearthed by the SEC and PCAOB investigations was the lack of quality control.” Shaub pointed out that “Marcum underestimated the inherent nature of the clients themselves, as well as in the impact on their audit staff of managing that level of rapid growth.” As he pointed out, a growth orientation such as the one at Marcum was likely to make a firm understate the risks of an audit. Shaub also suggested that “several tendencies undermine the firm’s objectivity and professional skepticism with SPACs” (Michael K. Shaub, “Expanding Audit Practices Too Quickly Opens the Door to Danger,” September 29, 2023, http://tinyurl.com/2p8u3cy9).
Engagement quality reviews (EQR) have an important role to play as an independent voice to evaluate significant judgments and conclusions made by the audit team. A “well-performed EQR serves as an important safeguard against erroneous or insufficiently supported audit opinions and as a meaningful check on the work performed by engagement teams,” according to a PCAOB staff report (“Spotlight: Inspection Observations Related to Engagement Quality Reviews,” October 2023, http://tinyurl.com/5n8jv7pr).
The 11 violations of quality control standards cited in the SEC’s action against Marcum are described in the Exhibit. The SEC charged Marcum with failing to properly adhere to EQR standards, specifically AS 1220, Engagement Quality Review. In particular, the firm failed to adequately document EQRs. The SEC found that approximately 33% of the EQR sign-offs were either signed post-issuance or were missing. Moreover, in some cases, the sign-offs occurred prior to the relevant engagement partner sign-offs.
Quality Control Deficiencies in SPAC Audits
SEC Regulatory Actions against Crowe U.K. LLP
Marcum is not the only accounting firm that was sanctioned by the SEC for deficiencies in handling SPAC transactions. Crowe U.K. LLP, a PCAOB-registered public accounting firm headquartered in London, was sanctioned on August 14, 2023, for its handling of a merger between Akazoo Limited (Old Akazoo) and a SPAC with respect to Crowe’s 2018 audit of the financial statements encompassing Old Akazoo’s business combination with a SPAC. The transition process conducted by Akazoo began after the formal merger was announced.
The SPAC transaction included Crowe’s June 7, 2019, audit report containing an unqualified opinion in its joint proxy and registration statement filed for the business combination of the SPAC with Old Akazoo (de-SPAC transaction). The information included in the filing falsely stated that Old Akazoo earned more than $120 million in revenue and had over four million paying subscribers to its music streaming business in 2018. In reality, Old Akazoo had only negligible amounts of revenue and subscribers.
The SEC ruled that Crowe U.K. violated applicable PCAOB standards in its audit by not exercising the requisite due care and professional skepticism. It also failed to conduct a meaningful EQR and had deficient controls. The facts of the case were complex, but the following is a description of one deficiency described in the SEC order.
Crowe U.K. did not conduct a sufficient EQR in accordance with PCAOB standards, giving rise to a number of deficiencies during the audit. Rather than conducting his review independently, the Engagement Quality Reviewer felt pressured by the engagement team to complete his review quickly in order to meet a deadline set by Old Akazoo related to the de-SPAC transaction. Consequently, the Engagement Quality Reviewer deviated from his standard practice of independently accessing and reviewing work papers in the audit file and instead relied on the engagement team’s answers to his questions. He also relied on a handful of documents selected by the engagement team, including a draft version of the audit findings report that contained false statements, such as the engagement team’s representation that they reviewed cash payments from the aggregators [payment processors] as part of their audit procedures (In the Matter of Crowe U.K. LLP, Nigel D. Bostock, FCA, and Matthew C. Stallabrass, FCA, August 14, 2023, http://tinyurl.com/2py53kkf).
Audit Independence Issues
A staff statement by the SEC’s Division of Corporation Finance advises that a private company target must have an audit that satisfies PCAOB standards to merge with a SPAC and that the SEC will not review the registration for a SPAC merger unless it includes the opinion of a PCAOB-registered auditor. One potential problem is that historical audits may not have satisfied both SEC and PCAOB auditor independence requirements. Private company targets will need to analyze audit-related requirements in a timely manner in the transaction process to determine whether they will need to retain a new auditor and perform additional audit procedures on prior financial statements (SEC, “Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies,” March 31, 2021, http://tinyurl.com/yausfjsn).
Auditors should consider whether the appropriate acceptance and continuance procedures have occurred when a formerly private audit client prepares to go public through a SPAC merger. To ensure independence, this may require adjustments to the engagement team to ensure that it has the appropriate level of expertise and experience with SEC and PCAOB requirements.
Audit independence issues arise if the same audit firm of the private company remains the auditor of the public company after the SPAC merger. One reason is that the firm might wind up auditing its own work in violation of independence standards. However, according to the data from Audit Analytics cited earlier, although SPACs are not likely to change their audit firm before the completion of a merger, SPACs are very likely to change their audit firm after a merger. Using data as of December 31, 2021, of the 300 SPACs that completed a merger, 88% engaged a new audit firm (http://tinyurl.com/2m2rfya2). The change in auditor enables the resulting public company to start fresh with a new auditor and avoid some of the problems that otherwise might occur.
The SEC and PCAOB need to exert pressure on audit firms to err on the side of caution when evaluating whether threats to independence exist. Any such threats might negatively influence the ability of auditors to conduct an audit with due care. Certain questions should be considered in assessing whether independence exists in SPAC arrangements:
- ▪ Who will audit the resulting public company?
- ▪ Does the audit firm have adequate procedures in place to evaluate client acceptance?
- ▪ Is the audit engagement team experienced enough to manage SPACs?
- ▪ Is the audit firm independent of the SPAC and the resulting public company?
- ▪ Are there potential conflicts of interest that might impair audit independence?
- ▪ Does the audit firm have in place audit quality controls to ensure that policies and procedures are in place to provide reasonable assurance that the work performed by engagement personnel complies with professional standards and the firm’s own standards of quality?
Corporate Governance and Audit Committees
Most SPACs will be listed on the New York Stock Exchange or Nasdaq, and the combined company after a merger will be subject to exchange listing standards, including corporate governance requirements. These include a majority-independent board of directors; an independent audit committee consisting of directors with specialized experience with audit and financial reporting matters; and codes of conduct and policies applicable to directors, officers, and employees. Accordingly, the private company target will need to consider changes required to comply with corporate governance requirements, such as identifying potential new directors. By having an effective audit committee in place, the post-merger company will have access to a valuable advisory mechanism to review accounting and auditing issues that may arise during audits (such as those addressed in this article), especially audit quality controls.
SEC Chief Accountant Paul Munter issued a statement on March 31, 2021 (“Financial Reporting and Auditing Considerations of Companies Merging with SPACs,” http://tinyurl.com/yjnawvvv), in which he addressed the corporate governance and audit committee considerations related to SPACs. Munter pointed to the important role of the audit committee in auditor selection, compliance with auditor independence rules, oversight of financial reporting, ICFR, and the external audit process. He noted that corporate board oversight is essential prior to, during, and after de-SPAC mergers; This includes board members having a clear understanding of their roles, responsibilities, and fiduciary duties, as well as management having a clear understanding of its responsibilities for communicating and interacting with the board. According to Munter, important responsibilities of the audit committee include:
- ▪ Clear and candid communications between the audit committee, auditor, and management are important for setting expectations and proactively engaging as reporting, control, or audit issues arise during and after the merger process.
- ▪ Effective communication should exist that contributes to the appropriate “tone at the top” within the combined public company.
- ▪ Creating an environment that supports the integrity of the financial reporting process and the independence and quality of the audit strengthens the role and responsibilities of the audit committee. (“Financial Reporting and Auditing Considerations of Companies Merging with SPACs,” http://tinyurl.com/yjnawvvv)
Audit committee members have an important role to play in the merger of a private company and SPAC. It starts with whether the audit firm of the resulting entity is independent. The internal controls should be operating as intended and audit quality controls must be effective to ensure that the resulting post-merger audit adheres to all relevant standards, including those of the SEC and PCAOB.
Where Do We Go from Here?
The PCAOB is considering whether to issue a proposal on “Firm and Engagement Performance Metrics” in 2024. The original proposal dates to 2015, when it was intended to enhance key “audit quality indicators” (AQI). The proposal was revived in the fall of 2022, with the focus on the goal of developing a set of measurements to assess the quality of an auditor’s work. If a final standard is adopted, it may have significant effects on the audit quality control deficiencies in SPAC arrangements discussed in this article, or at least on how they are measured.
On March 30, 2022, the SEC proposed new rules and amendments that would impact SPAC IPOs and the subsequent merger between a SPAC and private operating company (the de-SPAC). The new rules would require additional disclosures in SPAC IPOs. One in particular may affect the future of SPAC transactions by requiring the disclosure of “conflicts of interest that might arise between the SPAC sponsor, or its officers/directors or promoters, and purchasers in the offering, including those that may arise in determining whether to proceed with a de-SPAC transaction” (SEC Chair Gary Gensler, “Statement on Special Purpose Acquisition Companies (SPACs), Shell Companies, and Projections,” March 30, 2022, http://tinyurl.com/yutsak8e).
The SEC seeks to strengthen the oversight of SPACs to protect investor interests. SEC Chair Gary Gensler has communicated that he wants SPACs to be scrutinized more like traditional IPOs. The proposed new rules cover disclosures by sponsors, liabilities of financial advisors and underwriters, financial projections and restatements, and other disclosures. The proposed changes would mandate additional information be provided to SPAC shareholders before they make voting, investment, or redemption decisions in connection with a proposed SPAC target IPO transaction.
The SEC has been reviewing letters in response to the proposal. For example, the American Bar Association stated: “If the proposed rules are adopted in substantially the form in which these have been currently proposed, SPACs and Targets would need to undertake additional measures, which would entail significant, new, and additional costs, in order for market participants to be prepared to move forward” (“Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association Takes Aim at SEC Proposed SPAC Rules,” http://tinyurl.com/yc56vmub).
Comments such as these have pushed forward the date at which the SEC will provide more certainty to issuers and investors by providing a clearer framework and guidelines.