As a Certified Public Accountant who regularly works with early-stage technology companies, I have come to accept that accounting usually is not a favorite topic among entrepreneurs. In fact, given all the other things an entrepreneur has to think about, conforming to generally accepted accounting principles and practices can end up fairly far down on the priority list.
I am a big believer that you don’t let accounting and tax rules tell you how to run your business. I also believe that a fuller understanding of the accounting considerations for equity and revenue recognition can help investors, entrepreneurs, and board members ask the right questions and know when to seek outside expertise to avoid unpleasant surprises, unanticipated adverse affects on the P&L, delays in due diligence, or renegotiated valuations.
I. Accounting for Equity
In today’s world, accounting for equity is more complex than ever before. Depending on the choices a company makes with equity awards, there are both financial reporting and tax issues. These issues are not always the same.
Entrepreneurs and their boards need to understand both the profit and loss impact and the tax ramifications of granting equity before any granting occurs. Whether the business is a Limited Liability Company (LLC), C-Corporation, or S-Corporation, the issues are generally the same.
Determining Fair Market Value is at the Core
When a company issues an equity security or option as compensation, both the Financial Accounting Standards Board (FAS 123R) and the Internal Revenue Service (IRC Sec. 409A) require the company to establish a fair market value for those securities as of the date the stock is issued or the options are granted.
The intent of FAS 123R is to make sure that the company’s financial statements accurately reflect current fair market value expenses of the grant. The IRS wants to make sure that any stock or options granted as compensation are not valued too cheaply.
The IRS and FASB requirements for setting the fair market value are similar, but not exactly the same. The consequences of being out of compliance include additional tax, interest, and penalties from the IRS’s standpoint and potential restatement of financial statements as the result of an audit, due diligence, or Initial Public Offering (IPO) filing to satisfy FASB requirements.
The following is a review of the accounting and to a lesser extent tax considerations of the various forms of equity that an early stage company is likely to use as compensation.
Stock Options
Prior to 2006 and FAS 123R, generally accepted accounting principles (GAAP) did not require privately held companies to report stock options as an expense as long they were granted at market value following the intrinsic value methodology. The intrinsic method was a theory that did not require the company to expense compensation as long as the options were issued at the fair market value. Since FASB 123R, all stock options must be recorded at their fair market value as expenses when they are granted, even if issued at the fair market value price of the stock.
To calculate the fair market value of the options (and therefore the expense), companies are required to use an option pricing model which satisfies minimum FAS 123R requirements (e.g., Black Scholes-Merton or binomial-lattice).
While a detailed discussion of these option models is well beyond the scope of this article, it is important to know that each requires the company to make assumptions about volatility, interest rates, and the dividend rate and life of the options.
The models also call for the company to establish a fair market value of the underlying stock, and this is where things can get very complicated.
It is one thing to be able to go to The Wall Street Journal or the Internet to get a price for a stock, or to establish the underlying value as a result of an investment round where the valuation of the company has been agreed. It is another thing entirely to come up with the underlying stock price when a company is just starting out and there is no valuation or current street price to base the stock price on.
A company cannot simply assign a price for the stock that seems reasonable. It is possible to establish a fair market value internally for tax purposes under IRC Sec. 409A as long the person setting the value is qualified and knowledgeable about valuation and has significant experience.
However, the calculations and considerations in a comprehensive report are so complex that many companies obtain an independent valuation report from a reputable outside appraiser to set an independent value to the common stock. These external assessments are usually a more effective way to meet the requirements that can make an accountant or auditor comfortable that the fair market value is credible.
An independent appraisal costs between $5,000 to $15,000. Very early stage companies that are pre-revenue may delay having an independent valuation to avoid these costs, but once a company has employees, transactions, revenue, and a board of directors, most accountants and CPAs—especially if they are auditing the company—will require an outside appraisal.
The fair market value of the underlying stock and the other assumptions (i.e., volatility, interest and dividend rates, life of the stock) are fed into the chosen algorithm (Black Scholes-Merton or binomial-lattice). From that calculation, the fair market value of the option is determined. This expense is then generally recognized over the vesting or earning period of the recipient of the option(s). As long as the grant of the option is issued at least at the fair market value, there will be no federal tax implication at the grant date to the company or the option recipients.
Options have a value that is set as of the date of the grant under FAS 123R. As those options vest, a corresponding expense must be charged against the profit of the company. The amount of this expense correlates to the value set at the date of the grant, no matter how the fair market value for the options may change. Even if the options are underwater, the company cannot subsequently adjust the expense downward.
Common and Preferred Stock Grants
Granting stock is an effective way to attract key employees early in the company’s life cycle. When a company grants actual stock (not options) to employees as a form of compensation or as payment for outside services, the fair market value of the stock must be recorded on the company’s books as an expense and reported to the IRS as taxable income to the person who receives the stock.
When granting shares of stock, a company’s first concern is satisfying the fair market value requirements of IRC Sec. 409A. The IRS will allow an independent appraisal, a nonlapse repurchase formula, or an illiquid startup valuation.
Management will want to seek the advice of someone with financial acumen who understands the IRS guidelines for the “reasonableness” of the valuation method used.
By following these valuation methodologies with sign-off from the board of directors, the company will at least be able to demonstrate that it followed the mechanics of IRC Section 409A if the IRS raises an issue with the resulting stock valuation.
If the company is seeking a fair market value that will stand the tests of both IRC 409A and FASB 123R, it is best to engage a Certified Public Accountant (CPA) well versed in equity accounting to verify that the methodology used for IRS purposes meets the minimum requirements of FAS 123R.
Stock appreciation rights are also subject to the IRC 409A rules. Keep in mind that board members or officers may find themselves on the hook for potential payroll taxes that are considered trustee taxes if issues with the IRS occur. In these situations, seek legal counsel.
With the economic downturn, many companies are finding their current option plan holders “under water” as the stock price is below the option price. Modifications to existing plans or changes in exercise prices most likely will have an accounting consequence to the company’s books so before making modifications a company should seek professional advice.
Restricted Stock Grants
Assuming that retention as well as attraction is also a goal of any stock compensation plan, granting restricted stock early in the company’s life cycle can be a superior strategy.
Under a restricted stock plan as compensation, management may put restrictions on the shares themselves or the grants of shares that permit the stock to vest over time. Examples of restrictions could be calendar events (a portion of the stock vests annually as long as the employee remains with the company) or milestone accomplishments (e.g., profitability, product releases, or sales goals).
For accounting purposes, if the restrictions create a “substantial risk of forfeiture to the recipient,” the company may not need to book the fair market value of the stock as expense, but rather may disclose it in the notes of their financial statements. When the event becomes probable, the company records the expense.
As the restrictions on the stock lapse and the stock vests, the employee pays federal tax on the vested stock at ordinary income rates based on the fair market value of the stock on the day it vests and the company recognizes the expense.
However, under a special IRS provision (IRC, SEC 83B), an employee can elect to pay the tax on restricted stock immediately by sending a letter to the IRS within thirty days of the grant stating their election to pay the tax today on the current fair market value of the stock. The employee will be taxed at ordinary income rates. As with all stock grants as compensation, the company reports the difference between the fair market value of the stock and any price the recipient pays as an expense.
This provision makes restricted stock a powerful tool for founders and early key employees. At the beginning of the company, the fair market value of the stock will typically be low. Under current IRS provisions, as long as the stock is held for a year and a day, any appreciation will be treated as long-term capital gain.
Warrants and Convertible Debt
A warrant is similar to an option except that it is usually issued with debt. A warrant provides the right (but not the obligation) to buy shares of stock at a certain price. Warrants, like options, must be valued at fair market value and are usually expensed over the life of the associated debt.
Convertible debt is a note that typically converts to equity at the option of the note-holder (lender) or when certain events, such as a subsequent investment round, occur. New accounting rules now require issuers to account separately for the liability and equity components of the convertible debt if the settlement can be settled at least partially or wholly in cash.
Market Capitalization Table: Keep it Simple, Accurate, and Up-To-Date
If a company ever expects to go through due diligence, whether as a candidate for private equity or in advance of an IPO, acquisition, or merger, the way they have valued their options and stock and the complexity and the currency of their market capitalization table become very important.
Keep the capital structure current, straightforward and clean. Limit the number of initial shareholders and the types of rights. We strongly advise our clients against giving different rights to different shareholders. Record each group of shareholders and option holders separately; list their names and document the terms and expectations of each category as the option or shares are granted.
The cap table is one of the most important items of due diligence. I have seen small companies with as many as 75 or 100 shareholders, with different terms and valuation, and a cap table that hasn’t been updated in months. Those conditions become a nightmare and derail the process, if not the deal, when it is time to raise angel or venture capital.
II. Revenue Recognition
In the early years of most companies, cash is the primary concern. It is likely and understandable that very aggressive deals and discounts will be offered to close sales and build a base of early adopters for the new company’s products and services.
Often these deals are structured as one-offs and are frequently a necessary part of moving the business forward. With sales people making creative proposals to customers to capture early contracts, companies must be aware that the way these proposals are structured can significantly impact the amount and timing of revenue that can be recognized.
Principles and Criteria for Revenue Recognition
The two basic principles of revenue recognition are:
- Revenue must be earned.
- Revenue must be realized.
Four criteria are generally required in order to meet the two principles of revenue recognition:
- Persuasive evidence of an arrangement exists (i.e., a contract)
- The arrangement is fixed and determinable (i.e., stated prices and rights of return are firm)
- Delivery or performance has occurred (no more services or obligations are due)
- Collectability is reasonable assured (the purchaser is deemed a good credit risk)
For most products—equipment, devices, hardware, or consumer goods—revenue recognition is reasonably straightforward as long as a company satisfies these criteria. With software, it is a different story.
In fact, the most difficult area of revenue recognition may well be in software, which generally falls under the American Institute of Certified Public Accountants rules entitled, SOP 97-2 “Software Revenue Recognition.” The guidance in this statute outlines a rule-based approach to complicated accounting issues. These provisions were instituted in 1997 as a result of companies trying to manipulate their earnings.
Since software companies and businesses that produce high technology products of which software is a significant component make up such a significant portion of angel investors’ portfolios, understanding some of the challenges of software revenue recognition will be useful.
Software Revenue Recognition
Companies follow several models when selling software. The software may be licensed as a stand-alone canned product, bundled with hardware, other software, or with post-contract support (PCS), or may be sold as a service (SaaS). Software may be plug-and-play or may require hours of contracted consulting to make it appropriately usable in the customer’s environment.
SOP 97-2 rules apply to companies selling software under any of these models and potentially to firms selling products of which software is one of multiple components. If embedded software is “more than incidental” to a system, hardware component, or other type of box, these accounting rules may apply.
Not every product that operates with software falls into this category, however. For example, there is a lot of software in a car or truck, but the automakers don’t have to use software recognition rules to account for their vehicles. On the other hand, a telecommunications company that sells a mobile device with cutting edge software may need to go under those rules.
Contracts
As salespeople make different deals, a company can find that they have millions of dollars in deferred revenue. That is why we recommend that new companies establish standard contractual terms that anticipate revenue recognition issues.
We also recommend that a process be established that requires the accountant in charge of revenue or the company’s chief financial officer to review the terms of every deal before the proposals are submitted to the customer, so that the salesperson and the company both understand how the revenue will be booked and give the parameters and discounts of the deal. Tying the salesperson’s commission to revenue recognition is another tool to help the company manage these issues.
Stated Prices and Rights of Return
When software, post-contract support (PCS), or other services, such as help-line support or feature upgrades, are bundled together, the individual components of the bundled software contracts must have readily definable fair-market values that have vendor-specific objective evidence (VSOE) for the revenue generated by each component to be recognized.
Generally VSOE means a history of transactions with customers that demonstrates the fair market value of the various components and a pattern of customer acceptance. If the bundled components have been sold separately, the standalone price is the best evidence of VSOE.
Many products don’t have a separate sales history, especially in a young company. In these cases, VSOE can be set by “management having relevant authority.” In setting VSOE, some of the factors are type of customer, geography and distribution channels.
If a company cannot convince its auditors that it is conforming to the strict guidelines of VSOE, some portion of the revenue for bundled software transactions will most likely be deferred until VSOE is satisfactorily established.
A new company may need to have separate transactions paid for in the second year of the contract before it can establish a fair market value for non-software components of the original bundle.
Consider this example: An early stage company with a fiscal year that ends December 31 sells a piece of software for $100,000 in September and charges the customer an additional $10,000 for the first twelve months of software support. The company sends the customer an invoice for $110,000, and the customer promptly pays it.
Assuming the company has not previously established VSOE for its support at $10,000, the company will only be able to recognize $27,500 (3/12 of $110,000 fee for the software) by December 31 as the entire amount must be prorated over the twelve months specified for software support.
In year two, if the company has obtained VSOE and has sold another software package with the same pricing and terms, the $100,000 for the software license can be recognized in the month it is sold and accepted. However, the $10,000 for the software support will be recognized 1/12 per month for a year.
The amount of recognizable revenue cannot be based solely on list prices or the prices on a customer invoice. After a couple of years of selling the same components, a company that keeps good records will collect enough data to support the VSOE of each of the software components, but until that is the case, a good practice is to express all discounts as a consistent percentage of the license fee, the post contract support, and any other elements that are bundled together.
If a term license includes post-contract support, revenue recognition for the portion of the fee appropriately allocated to the support will be prorated over the term of the license.
The accounting treatment of bundled software sales must be handled properly and consistently, otherwise companies may find that they have corrupted their VSOE and this could result in deferred revenue and reduced profits.
Delivery and Acceptance
It used to be that when a client sold a piece of software, proof of delivery was easily determined by looking at the Federal Express or UPS paperwork. Today most software is delivered via automatic downloads over the Internet, subscription services or shared licenses activated by keys. Proof of the delivery is impossible unless the company retains electronic records or paperwork that verifies delivery.
We recommend that each of our clients establish a clearly written, company-wide revenue recognition policy that requires customer verification (paper or electronic) that the software was received, accepted, and it has been activated before revenue can be recognized.
It is also good practice to specify in the contract an end-date for any approval, installation or service period, otherwise the contract is so open-ended that recognizing the revenue will be deferred, potentially indefinitely. In one situation we saw recently, a 24/7 support arrangement had no expiration date on use. As a result, our client found it difficult to recognize any revenue at all on this element since contractually a customer could use it indefinitely. As a basis for revenue recognition in this situation, the company would need to prove that over time a percentage of their customers no longer used the 24/7 support, even though it was available indefinitely.
Sometimes the customer can’t use the software to their specifications until significant implementation efforts occur. Months and months of consulting may be required. Depending on the way the contract is written, revenue may be recognized on a percentage of completion basis or may have to be deferred on all elements until the customer indicates acceptance of the software.
For companies that follow a typical SaaS model, revenue recognition requires clear documentation of when the customer’s subscription begins. There are too many situations where the only way the accountants could determine that a user had subscribed to the service was when transactions actually started happening. Assuming there is documentation, it is easy to recognize revenue on a monthly basis for the most simple SaaS models.
If the company grants the client the ability to buy the software product today and commits to provide the next version for free, the company cannot book the revenue because they haven’t delivered the product that the customer is buying. This treatment can apply to products other than software, but most commonly comes up with software upgrades and new product releases.
Other Terms and Nuances Can Affect Revenue Recognition
There are specific accounting regulations for extended payment terms whether for a product or service, especially when a contract contains terms that are outside the company’s typical credit policy or different from other contracts in force.
Delivering a product and allowing the customer to pay over two or three years raises questions about collection and likely will delay the full revenue recognition of the contract. The auditor’s decision often comes down to whether or not the company can demonstrate a history of payment in general and from specific customers. Usually early stage companies cannot.
Granting customers specific rights of return or acceptance periods outside of the normal practice for the company can also delay revenue recognition. Issuing significant volume discounts to customers can also pollute recognition of revenue if not handled properly.
Conclusion
Entrepreneurs and their boards should not become so focused on accounting considerations that they let the accounting rules dictate how the business is run. By establishing a process that includes reasonable record keeping and review and by anticipating the basic rules and principles of equity accounting and revenue recognition, company management and boards of directors can avoid surprises. They will understand the implications of the operating decisions they need to make to cause the business to gain traction and grow and will hopefully avoid having to make major accounting adjustments when the auditors or due diligence teams come in.
Proposed Regulations on Global Intangible Low-Taxed Income (GILTI) Inclusions
Federal Tax Law Updates, International Tax, StartupWhat is GILTI?
U.S. shareholders of Controlled Foreign Corporations (CFC’s) are required to include in income their Global Intangible Low-Taxed Income (GILTI), as a result of the addition of IRC §951A by the Tax Cuts and Jobs Act. The rules apply to tax years of foreign corporations beginning after December 31, 2017, and to tax years of the U.S. shareholders in which or with which such tax years of foreign corporations end.
How is it calculated?:
Intangible income is determined according to a formulaic approach that assigns a 10-percent return to tangible assets (Qualified Business Asset Investment (QBAI)) and each dollar above the return is treated as an intangible asset.
What are the Proposed GILTI Regulations?:
Proposed regulations have been issued that provide the best guidance on the computation of the GILTI inclusion. The proposed regulations provide some new rules, including rules for consolidated groups, domestic partnerships, and partners, and required basis adjustments. The proposed regulations also contain a number of anti-abuse rules to be aware of and impose new reporting requirements.
How do I handle GILTI compliance?:
The rules for GILTI are complex and the guidance issued to provide additional rules for computing the correct GILTI inclusion. To ensure that the inclusion is correctly computed, it is recommended to work with international tax experts like the team at Origins Group. Contact us to find out more information and if GILTI or FDII implications affect you and your business.
New Regulations for Section 199A Pass-Through Deduction
Corporate Income Tax, Entrepreneur, Federal Tax Law Updates, Individual Income Tax, Partnership Income Tax, S-Corporation, Small Business, StartupThe IRS has finally released regulations for the IRC §199A deduction for qualified business income, also known as “pass-through deduction.”
What is Section 199A and Who Does it Apply To?
Section 199A allows business owners to deduct up to 20% of their Qualified Business Income (QBI) from sole proprietorships, partnerships, trusts and S corporations. Individuals, estates and trusts can also deduct 20% of their qualified REIT dividends and Qualified Income from a Publicly Traded Partnership (PTP). The deduction was one of the most high-profile pieces of the Tax Cuts and Jobs Act.
What’s included?
The Good:
The Bad:
Mixed:
Neutral:
These changes and clarifications open up great opportunities for tax planning. Please contact us to discuss these new regulations will apply to your specific situation. Our team can review your current tax structure to ensure that you are receiving the maximum benefit of these new rules.
Automatic Accounting Method Change Opportunities Created by the TCJA
Corporate Income Tax, Federal Tax Law Updates, Partnership Income Tax, Small Business, Startup, Tax PlanningSummary:
Businesses can enhance their cash flow by optimizing their tax accounting methods. This is especially important in times of tight money and inadequate revenues. More and more companies are putting their taxes under a microscope and taking a hard look at whether they can improve their cash flow by changing the accounting methods that they have elected either on past returns or during the current year. A taxpayer who is not on the optimal accounting method is effectively prepaying taxes, an undesirable and unnecessary result.
Every business must adopt a method of accounting to determine when it recognizes items of income and deduction. An accounting method determines timing (when an item is taken into account for taxes), not whether the item is taken into account. The choice of an appropriate method (or methods) is crucial because it determines the timing of overall income or loss.
The two most common overall accounting methods are the cash method, in which income and deductions are taken into account when payments are received or made, and the accrual method, in which income and deductions are taken into account when amounts are earned and expenses are incurred. Other accounting methods can apply to specific “material” items, such as the valuation of inventory or the treatment of an installment sale. For many businesses, there are scores of these “other accounting methods” to consider.
The Tax Cuts and Jobs Act expanded the number of small business taxpayers including startups eligible to use the cash method of accounting by raising the cap on gross receipts to $25 million averaged over the prior three years. Taxpayers who meet this revenue test are also eligible to use several simplified methods of accounting that exempt them from the requirements to capitalize costs in many situations, including the cash method of accounting and certain exceptions that may apply to accounting for capitalized costs, inventory, and long-term contracts. The IRS recently announced that it would automatically consent to these changes for taxpayers who meet specific eligibility requirements.
A change in accounting method can benefit any company—of any size, in any industry. Before changing an accounting method, the IRS requires that a taxpayer obtain the IRS’s consent. For some changes, the taxpayer must apply to the IRS for advance consent and pay a user fee. The application procedures are spelled out in IRS Revenue Procedure 2015-13. For these changes, the taxpayer cannot switch methods until the IRS agrees.
For other methods, the IRS has streamlined the process and will approve changes automatically. For these changes, the taxpayer can switch to another method by merely filing the proper information with the IRS, without having to wait for the IRS to grant its consent. “Automatic consent” significantly lowers the compliance costs needs to switch to a more advantageous method, enabling many more businesses to realize net savings by identifying yet unclaimed opportunities.
If you would like to know whether a change of accounting method can benefit your business and increase your cash flow, please contact us. If you have already filed a request to make one of these changes using non-automatic consent procedures, you may be able to have the user fee for that request returned if you act quickly.
Origins Group is named Best Full-Service Tax & Accountancy Firm – California by US Business News’ 2018 North American Excellence Awards
NewsOrigins Group is named Best Full-Service Tax & Accountancy Firm – California by US Business News’ 2018 North American Excellence Awards.
Over recent years, North American companies have been one of the leading lights of the business domain. Despite the challenges and uncertainty that the industry faces, both organisations and individuals in this diverse region steadfastly refuse to let anything cease them from achieving true excellence in their respective sectors.
To reward the ingenuity and sheer hard work of these firms and the individuals driving them, the 2018 North American Excellence Awards covers a wide spectrum of sectors from finance to real estate, manufacturing to retail. Business size, age or market are not considerations- in this awards programme we focus only on true excellence.
Each of our award winners is chosen through a combination of votes gathered from our network of respected industry partners and our own rigorous in-house research. These awards aim to honor both companies and individual entrepreneurs within the corporate landscape whose hard work and consistency has been the driving force to their achievements
Every one of our winners can truly rest assured that their recognition was deserved, as we carefully scrutinise everything from a nominee’s region to their performance over the past 12 months, their commitment to innovation, their methods and even their competition to ensure that only the most deserving names walk away with one of our prestigious trophies.
2017 Tax Reform: Last-minute year-end moves in light of Tax Cuts and Jobs Act
C-Corporation, Corporate Income Tax, Federal Tax Law Updates, Individual Income Tax, Tax PlanningCongress is enacting the biggest tax reform law in thirty years, one that will make fundamental changes in the way you, your family and your business calculate your federal income tax bill, and the amount of federal tax you will pay. Since most of the changes will go into effect next year, there’s still a narrow window of time before year-end to soften or avoid the impact of crackdowns and to best position yourself for the tax breaks that may be heading your way. Here’s a quick rundown of last-minute moves you should think about making.
Lower tax rates coming. The Tax Cuts and Jobs Act will reduce tax rates for many taxpayers, effective for the 2018 tax year. Additionally, many businesses, including those operated as passthroughs, such as partnerships, may see their tax bills cut.
The general plan of action to take advantage of lower tax rates next year is to defer income into next year. Some possibilities follow:
Disappearing or reduced deductions, larger standard deduction. Beginning next year, the Tax Cuts and Jobs Act suspends or reduces many popular tax deductions in exchange for a larger standard deduction. Here’s what you can do about this right now:
Other year-end strategies. Here are some other last minute moves that can save tax dollars in view of the new tax law:
Please keep in mind that I’ve described only some of the year-end moves that should be considered in light of the new tax law. If you would like more details about any aspect of how the new law may affect you, please do not hesitate to call us at (310) 691-5040.
The Importance of Financial Statements for Your Small Business
Accounting, Small Business, Startup, Tax PlanningYour small business seems to be doing fine. You have plenty of customers and your employees are working hard, yet your bank account is empty and you’re having problems paying the bills. On the outside it looks like everything should be terrific, but somehow it isn’t. So, what’s wrong? How do you figure out where all your money is going when it seems you have plenty coming in? The answer may be in your financial statements. It may be time to analyze the financial side of your business, and that’s exactly where financial statements can help you.
Financial statements are more than a simple listing of business income and expenses. Appropriately prepared financial statements can show you the cash flow of your business, any outstanding debts, and the value of your assets. Basically, once you do this, you’ll see that the total in your checkbook is not necessarily the income you have earned. There is far more to income than actual deposits in the bank.
To really comprehend where your business stands, it is critical to look at certain financial statements. Financial statements are generated by first organizing and then analyzing numbers from your accounting activities. You’ll want to start with the two primary financial statements, which are your Profit and Loss Statement, also called an Income Statement, and your Balance Sheet. After which, you may want to delve deeper, and look at your Cash Flow Statement, as that will show you exactly where your cash is coming from and then where it is going.
So, what you want to have is:
Depending on your specific business there are other financial statements that you may find helpful, but the above three will give you detailed information in which to begin. When you look at these financial statements, a lot of the mystery surrounding the finances of your business will disappear. In black and white, you will be able to see every penny that has come into your business and every penny that has gone back out.
Financial statements are only as good as the information that is backing them up. If you do not have complete accounting records, your financial statements will not be reliable. It is extremely important to keep accurate financial records when you run a business. This is important not only for the IRS, but for your own peace of mind, as well.
You will find that financial statements, when backed up with complete accounting records, will help you plan better. For today, for tomorrow, and for the years to come.
Seven Topics You Should Discuss with Your Accountant Every Year
Accounting, Entrepreneur, Small Business, Startup, Tax PlanningSmall business owners often use the new year as a time to plan annual budgets and focus on sales growth and new business opportunities. It’s also a great time to make resolutions to review accounting practices and financial controls on the business.
To make the most of your annual accounting review, here are the seven steps you should take to prepare:
Accounting Considerations for Equity and Revenue Recognition
Accounting, Entrepreneur, Partnership Income Tax, S-Corporation, StartupAs a Certified Public Accountant who regularly works with early-stage technology companies, I have come to accept that accounting usually is not a favorite topic among entrepreneurs. In fact, given all the other things an entrepreneur has to think about, conforming to generally accepted accounting principles and practices can end up fairly far down on the priority list.
I am a big believer that you don’t let accounting and tax rules tell you how to run your business. I also believe that a fuller understanding of the accounting considerations for equity and revenue recognition can help investors, entrepreneurs, and board members ask the right questions and know when to seek outside expertise to avoid unpleasant surprises, unanticipated adverse affects on the P&L, delays in due diligence, or renegotiated valuations.
I. Accounting for Equity
In today’s world, accounting for equity is more complex than ever before. Depending on the choices a company makes with equity awards, there are both financial reporting and tax issues. These issues are not always the same.
Entrepreneurs and their boards need to understand both the profit and loss impact and the tax ramifications of granting equity before any granting occurs. Whether the business is a Limited Liability Company (LLC), C-Corporation, or S-Corporation, the issues are generally the same.
Determining Fair Market Value is at the Core
When a company issues an equity security or option as compensation, both the Financial Accounting Standards Board (FAS 123R) and the Internal Revenue Service (IRC Sec. 409A) require the company to establish a fair market value for those securities as of the date the stock is issued or the options are granted.
The intent of FAS 123R is to make sure that the company’s financial statements accurately reflect current fair market value expenses of the grant. The IRS wants to make sure that any stock or options granted as compensation are not valued too cheaply.
The IRS and FASB requirements for setting the fair market value are similar, but not exactly the same. The consequences of being out of compliance include additional tax, interest, and penalties from the IRS’s standpoint and potential restatement of financial statements as the result of an audit, due diligence, or Initial Public Offering (IPO) filing to satisfy FASB requirements.
The following is a review of the accounting and to a lesser extent tax considerations of the various forms of equity that an early stage company is likely to use as compensation.
Stock Options
Prior to 2006 and FAS 123R, generally accepted accounting principles (GAAP) did not require privately held companies to report stock options as an expense as long they were granted at market value following the intrinsic value methodology. The intrinsic method was a theory that did not require the company to expense compensation as long as the options were issued at the fair market value. Since FASB 123R, all stock options must be recorded at their fair market value as expenses when they are granted, even if issued at the fair market value price of the stock.
To calculate the fair market value of the options (and therefore the expense), companies are required to use an option pricing model which satisfies minimum FAS 123R requirements (e.g., Black Scholes-Merton or binomial-lattice).
While a detailed discussion of these option models is well beyond the scope of this article, it is important to know that each requires the company to make assumptions about volatility, interest rates, and the dividend rate and life of the options.
The models also call for the company to establish a fair market value of the underlying stock, and this is where things can get very complicated.
It is one thing to be able to go to The Wall Street Journal or the Internet to get a price for a stock, or to establish the underlying value as a result of an investment round where the valuation of the company has been agreed. It is another thing entirely to come up with the underlying stock price when a company is just starting out and there is no valuation or current street price to base the stock price on.
A company cannot simply assign a price for the stock that seems reasonable. It is possible to establish a fair market value internally for tax purposes under IRC Sec. 409A as long the person setting the value is qualified and knowledgeable about valuation and has significant experience.
However, the calculations and considerations in a comprehensive report are so complex that many companies obtain an independent valuation report from a reputable outside appraiser to set an independent value to the common stock. These external assessments are usually a more effective way to meet the requirements that can make an accountant or auditor comfortable that the fair market value is credible.
An independent appraisal costs between $5,000 to $15,000. Very early stage companies that are pre-revenue may delay having an independent valuation to avoid these costs, but once a company has employees, transactions, revenue, and a board of directors, most accountants and CPAs—especially if they are auditing the company—will require an outside appraisal.
The fair market value of the underlying stock and the other assumptions (i.e., volatility, interest and dividend rates, life of the stock) are fed into the chosen algorithm (Black Scholes-Merton or binomial-lattice). From that calculation, the fair market value of the option is determined. This expense is then generally recognized over the vesting or earning period of the recipient of the option(s). As long as the grant of the option is issued at least at the fair market value, there will be no federal tax implication at the grant date to the company or the option recipients.
Options have a value that is set as of the date of the grant under FAS 123R. As those options vest, a corresponding expense must be charged against the profit of the company. The amount of this expense correlates to the value set at the date of the grant, no matter how the fair market value for the options may change. Even if the options are underwater, the company cannot subsequently adjust the expense downward.
Common and Preferred Stock Grants
Granting stock is an effective way to attract key employees early in the company’s life cycle. When a company grants actual stock (not options) to employees as a form of compensation or as payment for outside services, the fair market value of the stock must be recorded on the company’s books as an expense and reported to the IRS as taxable income to the person who receives the stock.
When granting shares of stock, a company’s first concern is satisfying the fair market value requirements of IRC Sec. 409A. The IRS will allow an independent appraisal, a nonlapse repurchase formula, or an illiquid startup valuation.
Management will want to seek the advice of someone with financial acumen who understands the IRS guidelines for the “reasonableness” of the valuation method used.
By following these valuation methodologies with sign-off from the board of directors, the company will at least be able to demonstrate that it followed the mechanics of IRC Section 409A if the IRS raises an issue with the resulting stock valuation.
If the company is seeking a fair market value that will stand the tests of both IRC 409A and FASB 123R, it is best to engage a Certified Public Accountant (CPA) well versed in equity accounting to verify that the methodology used for IRS purposes meets the minimum requirements of FAS 123R.
Stock appreciation rights are also subject to the IRC 409A rules. Keep in mind that board members or officers may find themselves on the hook for potential payroll taxes that are considered trustee taxes if issues with the IRS occur. In these situations, seek legal counsel.
With the economic downturn, many companies are finding their current option plan holders “under water” as the stock price is below the option price. Modifications to existing plans or changes in exercise prices most likely will have an accounting consequence to the company’s books so before making modifications a company should seek professional advice.
Restricted Stock Grants
Assuming that retention as well as attraction is also a goal of any stock compensation plan, granting restricted stock early in the company’s life cycle can be a superior strategy.
Under a restricted stock plan as compensation, management may put restrictions on the shares themselves or the grants of shares that permit the stock to vest over time. Examples of restrictions could be calendar events (a portion of the stock vests annually as long as the employee remains with the company) or milestone accomplishments (e.g., profitability, product releases, or sales goals).
For accounting purposes, if the restrictions create a “substantial risk of forfeiture to the recipient,” the company may not need to book the fair market value of the stock as expense, but rather may disclose it in the notes of their financial statements. When the event becomes probable, the company records the expense.
As the restrictions on the stock lapse and the stock vests, the employee pays federal tax on the vested stock at ordinary income rates based on the fair market value of the stock on the day it vests and the company recognizes the expense.
However, under a special IRS provision (IRC, SEC 83B), an employee can elect to pay the tax on restricted stock immediately by sending a letter to the IRS within thirty days of the grant stating their election to pay the tax today on the current fair market value of the stock. The employee will be taxed at ordinary income rates. As with all stock grants as compensation, the company reports the difference between the fair market value of the stock and any price the recipient pays as an expense.
This provision makes restricted stock a powerful tool for founders and early key employees. At the beginning of the company, the fair market value of the stock will typically be low. Under current IRS provisions, as long as the stock is held for a year and a day, any appreciation will be treated as long-term capital gain.
Warrants and Convertible Debt
A warrant is similar to an option except that it is usually issued with debt. A warrant provides the right (but not the obligation) to buy shares of stock at a certain price. Warrants, like options, must be valued at fair market value and are usually expensed over the life of the associated debt.
Convertible debt is a note that typically converts to equity at the option of the note-holder (lender) or when certain events, such as a subsequent investment round, occur. New accounting rules now require issuers to account separately for the liability and equity components of the convertible debt if the settlement can be settled at least partially or wholly in cash.
Market Capitalization Table: Keep it Simple, Accurate, and Up-To-Date
If a company ever expects to go through due diligence, whether as a candidate for private equity or in advance of an IPO, acquisition, or merger, the way they have valued their options and stock and the complexity and the currency of their market capitalization table become very important.
Keep the capital structure current, straightforward and clean. Limit the number of initial shareholders and the types of rights. We strongly advise our clients against giving different rights to different shareholders. Record each group of shareholders and option holders separately; list their names and document the terms and expectations of each category as the option or shares are granted.
The cap table is one of the most important items of due diligence. I have seen small companies with as many as 75 or 100 shareholders, with different terms and valuation, and a cap table that hasn’t been updated in months. Those conditions become a nightmare and derail the process, if not the deal, when it is time to raise angel or venture capital.
II. Revenue Recognition
In the early years of most companies, cash is the primary concern. It is likely and understandable that very aggressive deals and discounts will be offered to close sales and build a base of early adopters for the new company’s products and services.
Often these deals are structured as one-offs and are frequently a necessary part of moving the business forward. With sales people making creative proposals to customers to capture early contracts, companies must be aware that the way these proposals are structured can significantly impact the amount and timing of revenue that can be recognized.
Principles and Criteria for Revenue Recognition
The two basic principles of revenue recognition are:
Four criteria are generally required in order to meet the two principles of revenue recognition:
For most products—equipment, devices, hardware, or consumer goods—revenue recognition is reasonably straightforward as long as a company satisfies these criteria. With software, it is a different story.
In fact, the most difficult area of revenue recognition may well be in software, which generally falls under the American Institute of Certified Public Accountants rules entitled, SOP 97-2 “Software Revenue Recognition.” The guidance in this statute outlines a rule-based approach to complicated accounting issues. These provisions were instituted in 1997 as a result of companies trying to manipulate their earnings.
Since software companies and businesses that produce high technology products of which software is a significant component make up such a significant portion of angel investors’ portfolios, understanding some of the challenges of software revenue recognition will be useful.
Software Revenue Recognition
Companies follow several models when selling software. The software may be licensed as a stand-alone canned product, bundled with hardware, other software, or with post-contract support (PCS), or may be sold as a service (SaaS). Software may be plug-and-play or may require hours of contracted consulting to make it appropriately usable in the customer’s environment.
SOP 97-2 rules apply to companies selling software under any of these models and potentially to firms selling products of which software is one of multiple components. If embedded software is “more than incidental” to a system, hardware component, or other type of box, these accounting rules may apply.
Not every product that operates with software falls into this category, however. For example, there is a lot of software in a car or truck, but the automakers don’t have to use software recognition rules to account for their vehicles. On the other hand, a telecommunications company that sells a mobile device with cutting edge software may need to go under those rules.
Contracts
As salespeople make different deals, a company can find that they have millions of dollars in deferred revenue. That is why we recommend that new companies establish standard contractual terms that anticipate revenue recognition issues.
We also recommend that a process be established that requires the accountant in charge of revenue or the company’s chief financial officer to review the terms of every deal before the proposals are submitted to the customer, so that the salesperson and the company both understand how the revenue will be booked and give the parameters and discounts of the deal. Tying the salesperson’s commission to revenue recognition is another tool to help the company manage these issues.
Stated Prices and Rights of Return
When software, post-contract support (PCS), or other services, such as help-line support or feature upgrades, are bundled together, the individual components of the bundled software contracts must have readily definable fair-market values that have vendor-specific objective evidence (VSOE) for the revenue generated by each component to be recognized.
Generally VSOE means a history of transactions with customers that demonstrates the fair market value of the various components and a pattern of customer acceptance. If the bundled components have been sold separately, the standalone price is the best evidence of VSOE.
Many products don’t have a separate sales history, especially in a young company. In these cases, VSOE can be set by “management having relevant authority.” In setting VSOE, some of the factors are type of customer, geography and distribution channels.
If a company cannot convince its auditors that it is conforming to the strict guidelines of VSOE, some portion of the revenue for bundled software transactions will most likely be deferred until VSOE is satisfactorily established.
A new company may need to have separate transactions paid for in the second year of the contract before it can establish a fair market value for non-software components of the original bundle.
Consider this example: An early stage company with a fiscal year that ends December 31 sells a piece of software for $100,000 in September and charges the customer an additional $10,000 for the first twelve months of software support. The company sends the customer an invoice for $110,000, and the customer promptly pays it.
Assuming the company has not previously established VSOE for its support at $10,000, the company will only be able to recognize $27,500 (3/12 of $110,000 fee for the software) by December 31 as the entire amount must be prorated over the twelve months specified for software support.
In year two, if the company has obtained VSOE and has sold another software package with the same pricing and terms, the $100,000 for the software license can be recognized in the month it is sold and accepted. However, the $10,000 for the software support will be recognized 1/12 per month for a year.
The amount of recognizable revenue cannot be based solely on list prices or the prices on a customer invoice. After a couple of years of selling the same components, a company that keeps good records will collect enough data to support the VSOE of each of the software components, but until that is the case, a good practice is to express all discounts as a consistent percentage of the license fee, the post contract support, and any other elements that are bundled together.
If a term license includes post-contract support, revenue recognition for the portion of the fee appropriately allocated to the support will be prorated over the term of the license.
The accounting treatment of bundled software sales must be handled properly and consistently, otherwise companies may find that they have corrupted their VSOE and this could result in deferred revenue and reduced profits.
Delivery and Acceptance
It used to be that when a client sold a piece of software, proof of delivery was easily determined by looking at the Federal Express or UPS paperwork. Today most software is delivered via automatic downloads over the Internet, subscription services or shared licenses activated by keys. Proof of the delivery is impossible unless the company retains electronic records or paperwork that verifies delivery.
We recommend that each of our clients establish a clearly written, company-wide revenue recognition policy that requires customer verification (paper or electronic) that the software was received, accepted, and it has been activated before revenue can be recognized.
It is also good practice to specify in the contract an end-date for any approval, installation or service period, otherwise the contract is so open-ended that recognizing the revenue will be deferred, potentially indefinitely. In one situation we saw recently, a 24/7 support arrangement had no expiration date on use. As a result, our client found it difficult to recognize any revenue at all on this element since contractually a customer could use it indefinitely. As a basis for revenue recognition in this situation, the company would need to prove that over time a percentage of their customers no longer used the 24/7 support, even though it was available indefinitely.
Sometimes the customer can’t use the software to their specifications until significant implementation efforts occur. Months and months of consulting may be required. Depending on the way the contract is written, revenue may be recognized on a percentage of completion basis or may have to be deferred on all elements until the customer indicates acceptance of the software.
For companies that follow a typical SaaS model, revenue recognition requires clear documentation of when the customer’s subscription begins. There are too many situations where the only way the accountants could determine that a user had subscribed to the service was when transactions actually started happening. Assuming there is documentation, it is easy to recognize revenue on a monthly basis for the most simple SaaS models.
If the company grants the client the ability to buy the software product today and commits to provide the next version for free, the company cannot book the revenue because they haven’t delivered the product that the customer is buying. This treatment can apply to products other than software, but most commonly comes up with software upgrades and new product releases.
Other Terms and Nuances Can Affect Revenue Recognition
There are specific accounting regulations for extended payment terms whether for a product or service, especially when a contract contains terms that are outside the company’s typical credit policy or different from other contracts in force.
Delivering a product and allowing the customer to pay over two or three years raises questions about collection and likely will delay the full revenue recognition of the contract. The auditor’s decision often comes down to whether or not the company can demonstrate a history of payment in general and from specific customers. Usually early stage companies cannot.
Granting customers specific rights of return or acceptance periods outside of the normal practice for the company can also delay revenue recognition. Issuing significant volume discounts to customers can also pollute recognition of revenue if not handled properly.
Conclusion
Entrepreneurs and their boards should not become so focused on accounting considerations that they let the accounting rules dictate how the business is run. By establishing a process that includes reasonable record keeping and review and by anticipating the basic rules and principles of equity accounting and revenue recognition, company management and boards of directors can avoid surprises. They will understand the implications of the operating decisions they need to make to cause the business to gain traction and grow and will hopefully avoid having to make major accounting adjustments when the auditors or due diligence teams come in.
How to Avoid the Perils of Payroll Taxes
Accounting, Payroll TaxIt is the nightmare scenario for every business owner. A letter from the IRS arrives demanding payment for unpaid payroll taxes. The statement lists the amount owed along with penalties and interest. Thousands of businesses are faced with this situation everyday. Even worse, many of these companies are forced into bankruptcy when they are unable to make the payment demanded.
The IRS also considers the problem of unpaid payroll taxes significant. Payroll taxes represent a significant portion of the IRS’s accounts receivable. Fines for a business that collect the taxes but fail to pay the IRS are significant. The IRS considers this their money that is simply held by the business.
Most unpaid payroll taxes are a function of mistakes rather than deception. Depending on the size of your company, the time to file is quarterly, monthly or even the day after payday. Missing the due date by even one day can generate a sizable fine. Knowing what forms to file and when is the problem for many business owners who have a million other things they are working on.
Timing is not the only problem. The tax rates that must be withheld are a moving target that often change. There are rates for Social Security and Medicare taxes that have rates for withholding from the employee and the employer contribution. These two taxes sum to the Federal Insurance Contribution Act, FICA.
Federal Unemployment Tax and Federal Income Tax must also be collected from each employee and that is just for the federal government. There are also taxes that must be collected for the state and even some local governments.
The various rates, numerous schedules and countless forms are enough to make any business owner’s head spin, but the failure to get it exactly right is even scarier.
The process starts with a letter and then a phone call. If not corrected, an IRS agent will pay you a visit. If they determine your business is salvageable they may work out a payment plan. If however, they determine your business is failing, then they can sell your assets to collect the money ahead of your creditors.
An even worse scenario exists if the company defaults. The IRS can hold the business owner or the officers of the company liable for the unpaid taxes.
With such a complex system and such steep penalties, it is not surprising that so many companies are turning to payroll services to help them navigate the payroll tax maze. Below is the criteria you should use to find the right service.
By getting several quotes and doing some due diligence you will be getting a good payroll service at a reasonable price. Now you can get back to running your business instead of untangling the payroll tax knot.
Why Startups and Entrepreneurs Need Accountants, and How to Choose One
Accounting, Entrepreneur, Startup, Startup Q&AMany first time and even repeat or serial entrepreneurs who launch their startup will initially try wearing the accountant’s hat by doing their own accounting and taxes, in addition to doing everything else in their business. The advent of simple desktop and online or cloud-based bookkeeping software packages like Quickbooks, Xero, Wave, etc., make it easy for even a layperson to keep track of their basic business finances, however, this is still not an efficient nor an effective approach.
In a growing enterprise, there comes a time when it makes sense to hand over the responsibilities for accounting, taxes, and the rest of the financial reporting and analysis to an accountant. For the successful entrepreneur, the right time to choose an accountant for your startup is before you even incorporate, closer to the time you are still developing the idea fully. A well-qualified and experienced outside accountant can make all the difference in how and if the business succeeds, providing valuable insight and first-hand experience. Great CFO‘s can work with dozens of companies over their careers, however great outside CPA’s work with hundreds annually.
Benefits of Startup Accountants:
Accurate and reliable books and records are the foundation of all successful businesses. This is not an easy task for new entrepreneurs, who have no extensive knowledge in accounting, taxation, compensation, and other financial and non-financial factors, but this is much more than just good bookkeeping.
Choosing an outside accounting firm who provides a wide range of services to entrepreneurs and new businesses will help growing companies stay on top of both regulations and opportunities.
How to choose the best startup accountant:
Hiring an outside firm or outside accountant is a good first step for a startup business. This costs them less than a full-time, salaried employee and in addition, gives them a higher level of advice from a certified public accountant (CPA). The accountant will use the latest and greatest accounting and tax software to help them manage the books in a safe and secure way. After determining to choose an outside accountant, it is important to determine the qualifications and other criteria the accountant should possess. Things to look for when choosing the best startup accountant include:
Certifications: It is recommended for startups to look for someone who has professional accounting qualifications like:
CPA (Certified Public Accountant). CPA’s are real financial advisors who can provide more in-depth independent financial assessments about the business. They manage the daily bookkeeping of the business, provide tax advice and prepare tax returns. CPA’s also offers a wide range of other services such as debt management, cost-saving inventory measures, setting short-term and long-term goals, and managing cash flow in businesses.
Industry experience: Business owners often prefer to hire Certified Public Accountants that have experience handling similar businesses in the same industry. It is true that a professional with experience will be aware of the nuances in that particular industry.
Size of the firm: It is wise to look for an accounting firm that is comparable in size to the company. Generally small to medium firms specializes in small business work, provide personalized services and charge less compared to large firms.
Costs and charges: Fee charges are another important factor while selecting a startup accountant. Depending on the extent of work and size of the firm, costs and charges may vary. While it is important to get the right value for the money spent, experts advise that cost should not be the first factor in choosing an accounting firm or a CPA.
Additional services: Additional services may be offered by accounting firms such as specialized business advice apart from their basic accounting services. These specialized services can help startups plan better and grow successfully.
Choosing the best startup accountant is a milestone for many businesses. Choosing outside accountants signals that the company wants to improve its financial position, and position it for growth and success. Hiring an outside accountant should be done early. Many companies wait too long before making this decision which often results in inaccurate and sloppy reporting at a crucial time in the company’s growth.