How to Conduct Financial Due Diligence on a SPAC Target Company

The US SPAC market has entered a distinct phase in 2025-2026, shifting from the speculative frenzy of 2020-2021 to a more disciplined, regulatory-intensive environment. Following the SEC’s adoption of expanded proposed rules in January 2024—which reclassified SPACs as investment companies under the Investment Company Act of 1940 if they fail to complete a de-SPAC transaction within a prescribed timeline—financial due diligence on target companies is no longer a procedural checkbox but a survival imperative. The SEC’s heightened scrutiny of forward-looking revenue projections, combined with the Public Company Accounting Oversight Board’s (PCAOB) continued inability to inspect audit workpapers for China-based issuers under the Holding Foreign Companies Accountable Act (HFCAA), has created a bifurcated risk landscape. For Hong Kong-based sponsors, family offices, and cross-border investors evaluating de-SPAC candidates, the margin for error has collapsed. A single material misstatement in target financials can trigger shareholder lawsuits, SEC enforcement actions, and the unwinding of the business combination itself. This article dissects the financial due diligence framework required to navigate this environment, focusing on the specific mechanics of revenue recognition, earnout structures, and sponsor compensation—areas where the SEC and PCAOB have concentrated their enforcement priorities.

The Regulatory Architecture Governing SPAC Financial Due Diligence

The financial due diligence process for a SPAC target company must be anchored in the specific regulatory obligations that distinguish de-SPAC transactions from traditional IPOs. Unlike a conventional IPO, where the issuer has a long track record of public reporting, a SPAC target often emerges from the private markets with limited audited financial history and aggressive growth projections baked into the merger agreement.

SEC Rule 15d-21 and the Investment Company Act Exposure

The SEC’s January 2024 final rule, codified in Release No. 33-11265, directly impacts how sponsors must evaluate target financials. Under the new framework, a SPAC that has not completed a de-SPAC transaction within 18 months from its IPO is presumptively classified as an investment company. This classification triggers mandatory registration under the Investment Company Act of 1940, which imposes strict asset coverage ratios and leverage limits. For financial due diligence, this means the target company’s cash flow projections must demonstrate the ability to sustain the combined entity’s operations without reliance on the SPAC trust proceeds beyond the 18-month window. If the target’s business model depends on a cash-intensive ramp-up period exceeding 18 months, the sponsor must either negotiate an extended timeline with the SEC or structure the deal with sufficient committed equity financing.

PCAOB Auditing Standard AS 3101 and the China Inspection Gap

For targets with material operations in the People’s Republic of China (PRC), the PCAOB’s inability to inspect audit workpapers remains the single greatest due diligence risk. As of March 2025, the PCAOB has completed its initial inspections of Chinese audit firms under the 2022 HFCAA agreement, but the window for full compliance remains open. The SEC’s Division of Corporation Finance has issued a series of staff accounting bulletins (SAB 121 and SAB 122) requiring that any de-SPAC target with a PRC-based auditor must provide an attestation from the auditor confirming PCAOB access. In practice, Hong Kong-based sponsors must independently verify that the target’s auditor—typically one of the Big Four in China—has not been flagged for any PCAOB deficiency report. A single adverse finding can result in the SEC refusing to declare the registration statement effective.

Revenue Recognition: The First Line of Defense

The most common source of restatements and shareholder litigation in de-SPAC transactions is improper revenue recognition. Targets in high-growth sectors—particularly SaaS, biotech, and clean energy—frequently employ aggressive revenue recognition policies that do not align with ASC 606 (Revenue from Contracts with Customers).

ASC 606 Compliance and the Five-Step Model

The due diligence team must map the target’s revenue streams against the five-step model under ASC 606: (1) identify the contract, (2) identify performance obligations, (3) determine the transaction price, (4) allocate the transaction price, and (5) recognize revenue when (or as) performance obligations are satisfied. A common red flag is the use of “bill-and-hold” arrangements, where revenue is recognized before delivery to the customer. In a 2024 SEC enforcement action against a de-SPAC target in the electric vehicle sector, the SEC found that the company had recognized USD 45 million in revenue for vehicles that were still in production, citing violations of ASC 606-10-55-81 through 55-84. The sponsor’s due diligence had failed to request the underlying shipping documents and customer acceptance certificates.

Deferred Revenue and Contract Liabilities

Another critical area is the classification of deferred revenue versus contract liabilities. Under ASC 606-10-45-1, a contract liability is recognized when a customer prepays consideration before the entity satisfies the performance obligation. Many SPAC targets, particularly in the subscription software space, artificially inflate current assets by classifying long-term prepayments as deferred revenue rather than contract liabilities. The due diligence team should request a schedule of all contracts with prepayment terms exceeding 12 months and verify that the corresponding liability is classified as non-current. In a 2023 SEC filing for a de-SPAC transaction involving a Hong Kong-based fintech company, the target had misclassified HKD 120 million in prepaid subscriptions as deferred revenue, resulting in a 14% overstatement of current assets.

Earnout provisions are a standard feature of de-SPAC transactions, designed to bridge valuation gaps between the sponsor and target shareholders. However, these structures create complex financial reporting obligations that require granular due diligence.

Earnout Liability Measurement Under ASC 815

Under ASC 815-40-15 (Contracts in Entity’s Own Equity), earnout shares must be classified as liabilities if they are not indexed to the entity’s own stock or if they contain settlement provisions that could require cash settlement. The SEC’s Staff Accounting Bulletin No. 121 (SAB 121) explicitly states that earnout shares in a de-SPAC transaction are presumed to be liabilities unless the sponsor can demonstrate that the shares meet the “fixed-for-fixed” equity classification criteria. In practice, most earnout structures fail this test because they include performance conditions tied to stock price thresholds (e.g., “if the stock trades above USD 12.00 for 20 consecutive trading days”). The due diligence team must model the fair value of the earnout liability at each reporting period using a Monte Carlo simulation, incorporating the target’s historical volatility and the SPAC’s redemption rate. A 2024 study by the CFA Institute found that 68% of de-SPAC transactions with earnout provisions resulted in material liability reclassifications within the first two post-merger quarters.

The sponsor’s promote—typically 20% of the SPAC’s outstanding shares—represents a significant dilution event that must be factored into the target’s pro forma financial statements. Under SEC Regulation S-X Rule 11-01, the target must present pro forma earnings per share (EPS) assuming the full conversion of all sponsor shares, including those subject to vesting conditions. The due diligence team should request the sponsor’s subscription agreement and verify that the promote shares are not subject to any undisclosed side letters or preferential redemption rights. In a 2022 SEC cease-and-desist order against a SPAC sponsor, the SEC found that the sponsor had entered into undisclosed consulting agreements with target shareholders, effectively transferring the promote value without proper disclosure. The sponsor was fined USD 1.5 million and required to disgorge USD 8 million in profits.

Cross-Border Considerations: Hong Kong and PRC Entities

For targets with operations in Hong Kong or the PRC, the due diligence framework must extend beyond US GAAP to include the Hong Kong Financial Reporting Standards (HKFRS) and the PRC Accounting Standards for Business Enterprises (ASBE). The reconciliation between these frameworks and US GAAP is a frequent source of material misstatements.

VIE Structure and Consolidation Risks

Many PRC-based targets operate through Variable Interest Entity (VIE) structures to comply with PRC foreign ownership restrictions. Under ASC 810-10-25 (Consolidation), the VIE must be consolidated if the reporting entity has a controlling financial interest. However, the PRC government’s 2023 “Measures for the Administration of Overseas Securities Offerings and Listings by Domestic Companies” (CSRC Decree No. 43) requires that any VIE structure be pre-approved by the China Securities Regulatory Commission (CSRC). If the target has not obtained this approval, the VIE may be deemed unenforceable, and the SPAC’s consolidated financial statements would be misleading. The due diligence team must obtain a legal opinion from a PRC-qualified law firm confirming the validity of the VIE agreements and the target’s compliance with CSRC Decree No. 43. As of January 2025, the CSRC has rejected 12 VIE-based overseas listing applications, citing insufficient disclosure of the control arrangements.

HKFRS 15 vs. ASC 606: The Revenue Recognition Divergence

While HKFRS 15 and ASC 606 are converged in principle, there are practical differences in application. Under HKFRS 15, the “portfolio approach” is permitted for contracts with similar characteristics, whereas ASC 606 requires a contract-by-contract assessment unless the portfolio approach does not materially differ. For targets with thousands of small-value contracts—common in the Chinese consumer internet sector—the use of the portfolio approach under HKFRS 15 can result in revenue recognition timing differences of 5% to 10% compared to ASC 606. The due diligence team must prepare a reconciliation schedule showing the impact of switching from HKFRS 15 to ASC 606 for the three most recent fiscal years. If the difference exceeds 5% of total revenue, the SEC will require a full ASC 606 audit.

The Sponsor’s Burden of Proof: Documentation and Disclosure

The SEC’s 2024 rule package places the burden of financial due diligence squarely on the SPAC sponsor, not the target. The sponsor is now required to sign the registration statement as a “co-registrant” under Section 6(a) of the Securities Act of 1933, exposing the sponsor to direct liability for any material misstatements.

The 10-K/10-Q Reconciliation Requirement

Under the new rules, the de-SPAC transaction must include audited financial statements for the target for the two most recent fiscal years, prepared in accordance with US GAAP (or IFRS as issued by the IASB, with a reconciliation to US GAAP). The sponsor must also provide a reconciliation of the target’s historical financial statements to the SPAC’s pro forma financials, including the impact of the PIPE financing, the sponsor promote, and any earnout liabilities. The due diligence team should request the target’s audited financial statements for the past three years, not just two, to identify any trends in revenue growth, gross margins, or cash flow that may not be apparent in the two-year window. A 2024 SEC review of 50 de-SPAC transactions found that 34% contained material errors in the pro forma adjustments, with the most common error being the failure to account for the sponsor promote in the EPS calculation.

Materiality Thresholds and the “Outcome-Oriented” Test

The SEC has adopted a “outcome-oriented” test for materiality in de-SPAC transactions, meaning that even a small quantitative error can be material if it affects the overall narrative of the target’s growth story. For example, a 2% overstatement of revenue in a single quarter may not be material under traditional quantitative thresholds (5% of net income), but if that quarter is presented as the “inflection point” in the target’s marketing materials, the SEC will deem it material. The due diligence team must review all investor presentations, roadshow decks, and press releases issued by the target in the 12 months preceding the de-SPAC announcement. Any discrepancy between the financial data in these materials and the audited financial statements must be disclosed in the registration statement under Item 105 of Regulation S-K.

Actionable Takeaways

Verify PCAOB auditor access for any target with PRC operations by obtaining a written attestation from the auditor confirming full inspection rights and cross-referencing it against the PCAOB’s public registry of compliant firms.
Model earnout liabilities under ASC 815 using a Monte Carlo simulation with at least 10,000 iterations, incorporating the target’s historical volatility and the SPAC’s trust redemption rate, and disclose the assumptions in the registration statement.
Prepare a full ASC 606-to-HKFRS/ASBE reconciliation for all material revenue streams, with a sensitivity analysis showing the impact of a 5% timing difference on net income and working capital.
Obtain a PRC legal opinion confirming the validity of any VIE structure and the target’s compliance with CSRC Decree No. 43, and file the opinion as an exhibit to the registration statement.
Conduct a 12-month backward review of all target investor materials and reconcile any financial data presented in those materials against the audited financials, flagging any discrepancy exceeding 1% of total revenue for SEC disclosure.