Startups often have unique business models which can raise difficult questions about the most appropriate accounting treatment. Implementing well considered startup accounting policies can help declutter your financials.
Startups often have unique business models which raise questions about the most appropriate accounting treatment (such as crypto asset dual-sided marketplaces).
There are often several recurring areas which can cause difficulties with startup accounting policies.
1) Revenue Recognition
When and how much should you recognise as revenue? – it seems a straightforward question but can be complex to address.
From 1 January 2018, a revised International Accounting Standard IFRS15 “Revenue from Contracts with Customers” took effect which dramatically affected the way revenue is recognised and measured, particularly regarding complex arrangements such as bundled goods and services, goods or services delivered over time, sales with guarantees or warranties and so on.
- IFRS 15 uses a 5-step model which is applied to determine when, and how much revenue is recognised;
- whether a contract exists
- the explicit and implicit promises in the contract to deliver goods and/or services to a customer
- the transaction price payable by the customer
- how to allocate the transaction price to the goods and services, and
- when to recognise revenue based on when ‘control’ over the good or service transfers to a customer
The practical implication is that each type of sales transaction needs to be analysed to determine what is provided, at what time and for what amount.
While this is straightforward for say the sale of a product, it is much more complex for a software development contract which involves many steps and various performance obligations over a period of time.
An implication which arises also is the potential disconnect between performance reporting and reporting for accounts purposes. Understandably most startups are concerned mainly with “raw” revenue, rather than the complexities of IAS15.
Care will need to be taken to ensure investor shareholders are aware of the differences, and the potential gap between performance revenue (which often forms the basis of incentives like share awards and bonuses) and revenue for accounting purposes.
2) Share Based payments
Many startups use shares or options to pay for various goods and services as a strategy to reduce cash burn – common examples include employee remuneration or to provide investor incentives as part of debt funding. More novel examples include providing shares in part payment of legal expenses or for the use of incubator spaces.
A common misconception is that share based payments come without a cost however that is not the case in accounting terms.
The Accounting Standard IFRS 2 “Share-based payment” requires that “payments” in shares be recognised as an expense, measured at fair value, at the time the goods or services are received.
- This has a number of implications;
- The accounts will recognise an expense for the share-based payment(s)
- The value of the share-based payment(s) need to be measured at fair value – this can be complex where the share price has not been determined recently or is moving quickly
- it is likely that a difference will exist between the accounts and management reporting (which typically will not recognise the cost)
As above investors need to be fully informed to ensure they understand and accept these implications.
3) Financial Instruments
As startups grow in scale, funding transactions tend to become more complex, and may introduce financial structures such as embedded options or convertible instruments.
Such instruments are referred to as financial instruments and their accounting treatment is governed by IFRS 9 “Financial Instruments”.
IFRS 9 requires that financial assets be classified and measured at fair value, with changes in fair value recognized in profit and loss as they arise, unless certain prescriptive criteria are met for classifying and measuring the asset at either Amortized Cost or Fair Value.
- The implications for startups who hold financial instruments include;
- Financial instruments need to be separately identified and fair valued – which can be complex
- Profit and Loss must include movements arising from fair value changes, which can result in significant volatility in bottom line results
- Provisions for credit losses arising from receivables (ie customer sales) need to be established and appropriately valued
- Complex disclosure requirements associated with financial instruments must be met
While accounting policies may seem a dry topic, there have been several recent high-profile examples where inappropriate or overly ambitious startup accounting policies have led to substantial brand and reputation damage. Additionally, inappropriate revenue recognition may lead to investor scepticism, and can negatively affect the valuation of the business.
In novel accounting environments such as two-sided marketplaces or cryptocurrency-based businesses this is even more important.
If your business’ accounting policies require more expertise at the helm, reach out to the seasoned team at Fullstack who can help with outsourced CFO services.