Nine accounting complexities facing high-growth start-ups

Start-ups looking to grow have a range of options but carefully considering accounting standards is one way to reduce complexity, write Wuraola Raheem and Paddy McGhee

For many Irish high-growth start-ups, the early years are consumed by the cash burn of developing a new product, followed by the cost of growing the market. The nuances of accounting standards are often a secondary consideration. 

However, not being aware of some of the accounting standards considerations can have a negative impact on investor confidence and regulatory compliance.

Here are nine areas of complexity that often arise for high-growth companies at the start of their journey.

IFRS or FRS 102?

If an organisation has an international shareholder base and international customers and suppliers, should it use IFRS? 

While IFRS is a complete standard recognised globally, its measurement and valuation criteria, together with its disclosure requirements, are burdensome for a small company. 
FRS 102 was written with small companies in mind, and in most cases, for a growing company, it will work as well as IFRS. 

The decision to move to IFRS will be better taken when the company matures. For example, if a firm acquires other businesses along the way, the requirements for assessing the purchase price allocation are more onerous under IFRS than FRS 102. 
Similarly, disclosure requirements are more onerous under IFRS.

Revenue recognition

There are very few modern businesses for which revenue recognition arises when the invoice is issued. Many companies provide multiple services and warranties, give a right of return or provide a service over a period of time or – increasingly in the tech sector – based on consumption. 

This will give rise to the possibility of accrued revenue in which the service is provided in advance of billing or deferred revenue if billing has occurred, but the service or good has not been fully delivered.

IFRS, US GAAP and FRS 102 are mainly consistent in their treatment of when revenue is recognised.

Many growing companies enter into tailored contracts in order to make those first few sales often giving rise to additional free services or warranties that may lead to revenue deferrals. 

Many other firms enter into agreements with large platform companies to sell their products or services, and the lines between marketing and delivery costs and net revenue can become blurred.

Accounting for venture capital
As companies begin to raise equity, the type of financing used is often not ordinary shares. Common forms of investing include:

• convertible loan notes;
• preferential loan notes;
• preference shares; and
• shares with a liquidation preference.

Today, few investments are in the form of a loan or equity as investors look to protect their investment by having some form of preference. There is often a level of negotiation in these, so funding instruments will almost always have some individual nuances.

The impact is that some convertible instruments include a hybrid instrument that needs to be assessed or, in other instances, while something may be called a ‘share’, if it has a fixed return, it may be accounted for as debt.

Many companies also overlook the fact that the direct costs of raising equity are recognised in equity, or direct costs relating to debt are capitalised and amortised using an effective interest rate method. It’s not to say that many costs leading up to a finance raise are expensed, such as due diligence fees.

Share-based payments

There has been much valid criticism in Ireland that share-based remuneration has not received more tax concessions. For a young company, a popular route to attract staff is to offer share options, reducing the cash outlay. 

In theory, share options are provided in lieu of a cash salary. Because of this, accounting standards require the intrinsic value of share options at the date they are issued to be recognised as an expense over the service period. Depending on the perceived volatility of the shares and the rights attached to them, this can result in a sizeable non-cash charge to the income statement and one that often does not appear in management accounts.

Investing in cloud infrastructure

The treatment of expenditure linking a business to cloud-based software has recently been a hot topic for large companies. 

The reason for this is that IFRS accounting standard setters recently reminded companies that where they invest in linkages to a cloud-based infrastructure, the related costs should be expensed rather than capitalised on the basis that the firms do not own or control the cloud-based software. This meant that several multi-million Euro enterprise resource planning (ERP) implementation projects were expensed rather than capitalised. 

It is easy to see the frustration that some reporters faced as they will receive the benefit of those costs over several years.

With many companies reliant on cloud-based infrastructure, it can be a shock to learn that not all the related costs meet the criteria for capitalisation.

Capitalised development expenditure

“Our enterprise value is €XX million so how come we cannot recognise that value on our balance sheet?” is a common question, followed by: “Given we have spent €XX million on product development, can we capitalise that?”

Accounting standards are very detailed on what can be capitalised and what is expensed. Generally, costs relating to internally generated brands, start-up costs, training activities, research, advertising and internally generated goodwill are expensed.
The one area in which companies may capitalise costs is where such costs relate to the development of a product or process that can be shown to bring future economic benefit. 

There are, however, concise rules on what may be capitalised. While costs can be, it does not mean such costs meet the criteria for claiming research and development (R&D) tax credits. 

While the costs can be closely aligned, they are not mutually inclusive.

International expansion

Given the size of Ireland’s indigenous market, most companies look to international expansion early on.

Initially, companies need to assess how they will expand:

• Do they use foreign subsidiaries to make sales?
• Is a foreign subsidiary used for providing services to the parent company in sales and marketing, local maintenance or R&D?

Regardless of the role played by the foreign subsidiary, from a tax perspective, the share of the taxable profit each country will get will need to be determined. This is where the concept of transfer pricing comes in, and companies need to determine where the profit would reside if the various companies were unrelated.

Increasingly with foreign expansion, companies have to deal with employee taxes for foreign employees or employees who move to a new market to help set up a presence.

Consolidation requirement

As companies grow, they reach a stage where there is a requirement to prepare consolidated statutory financial statements.

At a basic level, if a company is defined as a small company under Irish law, it is not required to prepare consolidated accounts. The requirement for consolidated accounts kicks in when a company exceeds two of the following criteria two years in a row:

• Third-party turnover of €20 million;
• Gross assets of €10 million; and/or
• 250 employees.

Given the relatively high-level criteria for employee numbers, companies generally meet the requirement when they reach the turnover limit.

Other regulatory requirements

Irish company law and accounting requirements are generally well legislated for, ensuring that small companies are not overly regulated. 

Having reached the consolidation requirement at €20 million turnover, a private company’s next legislative bar is the requirement to have a directors’ compliance statement if it reaches €25 million turnover. Having reached a consolidated turnover of €50 million, a company is required to put an audit committee in place or explain why one is not required.