Accounting Challenges of an IPO Exercise

Companies which are going for IPO may raise pre-IPO funds by issuing shares to early investors to fund their business expansion or pay for IPO expenses. In addition, it is common for these companies to provide incentives to employees in the form of share options as part of the IPO exercise. Such issuance of shares may fall within the ambit of share-based payment under MFRS 2.

The example below illustrates the effects to the shareholders of a company going for listing with such an arrangement.

In this example the company issued 2 million shares at RM1 each to its employees, advisors and business associates as part of an IPO exercise. Although the IPO shares are issued to the public at RM2.50 per share, the company is offering a RM1.50 discount to the employees, advisors and business associates. MFRS 2 requires this RM1.50 discount to be expensed to the profit and loss account as share-based payment expenses. The additional cost to the company is RM3 million, calculated at 2 million shares multiplied by RM1.50 each.

This accounting treatment reduces the profit of the company by RM3mil and will have an adverse effect on the company’s valuation. For example, if the company is going for the IPO at a valuation of 15 times Price Earnings Multiple, the impact on the valuation of the company is RM45 mil - a significant impact indeed on the shareholders of the Company.

Revenue from Contracts with Customers is also commonly referred to as revenue accounting and affects companies with a large number of customers’ contracts with different terms and services. Each service may require a different method to recognise revenue. In a nutshell, where a company offers a combination of services that are bundled together, this standard requires each of the service to be separately identified. Thereafter the revenue from each of the service is recognised based on the nature of that service.

Malaysian Financial Reporting Standards 15 – Revenue From Contracts with Customers (“MFRS15”) provides guidance on how each of this revenue should be recognised.

An automobile company sells a car for RM200,000 which includes 4 years of free maintenance. In the past, the company would recognise the RM200,000 as revenue without accounting for the free maintenance in the financial statements. However, under MFRS 15, the company is required to value the “free maintenance” and reflect this as a separate revenue stream in the financial statements. 

In this example, assuming that the free maintenance is valued at RM10,000 a year, then the sale of the car needs to be unbundled into two different performance obligations / revenue streams. The revenue streams are the sale of car and the maintenance revenue. Since the maintenance is valued at RM40,000, the actual revenue from the sale of car is only RM160,000, which is recognized in Year 1. The revenue from maintenance will be recognized over the 4 years maintenance period. 

Therefore, the effects of MFRS 15 can be significant as it may reduce a company’s revenue significantly or delay the timing of revenue recognition. It can also result in the restatement of revenue in previous years especially in companies with large contracts with customers which cover a few services or products with different terms.

This situation is less common and will only apply to a group which intends to list one of its subsidiaries. In this situation, it is important to understand the effects of the subsidiary’s IPO on the financial position and results of the group as it can be material. It is important especially if the holding company itself is listed or if the group has loan or other covenants.

There are two common scenarios when a group lists its subsidiary.

In this scenario, the dilution of the group’s interest in the subsidiary will result in a dilution gain (it can result in a dilution loss but this is very unlikely). This dilution gain will be taken up directly in equity and does not affect the Group’s results. 

The remaining investment in the 51% subsidiary will continue to be accounted for in the Group’s financial statements based on existing policy.

In this scenario, the effect of the dilution is treated very differently from the first scenario. The dilution gain will be reflected in the profit and loss account of the group. 

Hence, if the dilution is significant, which is normally the case, the Group will show a significant increase in its profit in the year the IPO takes place. 

In addition, the remaining 15% investment in the former subsidiary will be classified as investments in quoted shares and are required to be marked to market. The changes in the market value are taken to the profit or loss account or other comprehensive income depending on the Group’s accounting policies. This can cause volatility in the results of the group.