Successful start-ups and growth stage companies eventually reach a point where banks or investors require them to issue audited financial statements in accordance with US Generally Accepted Accounting Principles (GAAP).
Making the switch to financial statements that are fully compliant with GAAP (“GAAP financials”) invariably results in significant adjustments to the internal financial statements that founders and investors have relied on for years. Critical metrics such as revenue, net income and equity can change significantly.
Undergoing any audit is a costly and time-consuming process, which can be surprising the first time you go through one. Here are common trouble spots we help our clients prepare for.
Common audit preparation trouble spots:
- Revenue recognition.
- Fundraising transactions.
- Stock-based compensation.
- Capitalization and asset impairment.
- Accrued expenses.
- Document wrangling — the hidden audit cost.
Revenue recognition
To recognize revenue under GAAP requires a comprehensive and complex analysis that can also entail the exercise of significant judgment. When preparing GAAP financials, auditors commonly require adjustments that alter the amount of revenue the company previously recorded in its trial balance. GAAP financials also require substantial disclosure.
Auditors will want to understand each of the Company’s revenue streams and the Company’s terms of sale. Auditors will need to read and analyze your most significant sales contracts as well as a sample of other representative contracts, which can be time-consuming when the terms vary between customers. In addition to performing significant tests of revenue recognition, the auditors will want to review written documentation of company policies regarding revenue recognition. Most or our clients have not formally documented these policies, so they must create the documentation as part of preparing for the audit.
Fundraising transactions
Start-up companies use a variety of methods to raise funds, conserve cash, or both. The most common fundraising vehicles we see are convertible debt, SAFE agreements and preferred stock. These transactions all raise several important accounting issues:
- Whether the funds raised should be reported as a liability or equity (or somewhere in between).
- Whether any features within the agreements should be bifurcated and separately accounted for.
- Whether all or a portion of the transaction should be measured at fair value.
Addressing these issues will require a complex and, in many cases, a lengthy process to carefully analyze the legal documents. If the instrument requires fair value accounting, then the company will need to spend additional resources to obtain those estimates, which will take time.
Companies and their advisors can get creative when structuring equity transactions, and at Kranz we have recently seen a number of convertible debt and other transactions with structures, benefits or unique features that introduce accounting complexity.
Stock-based compensation
As a way to conserve cash, our clients commonly use stock-based awards to compensate key executives and other employees and to retain top talent. The granting of stock-based awards creates several important accounting issues, including those related to:
- The classification of the award as a liability or equity.
- The measurement of the award at fair value on grant date.
- The period over which to recognize the compensation expense.
- How to account for modifications to the awards or awards that employees forfeit.
- How to account for the exercise of the awards.
It is common for companies to use a stock administration system to track activity of stock-based awards and to calculate the related stock-based compensation. The automation of these calculations streamlines the accounting process, but they are not foolproof.
For example:
- The calculations are only as accurate as the data. We have seen numerous cases where the information in the system is inaccurate, incomplete or stale.
- Making these calculations requires the system user to enter a variety of parameters and assumptions, which should be carefully reviewed to ensure they are reasonable and supportable and able to withstand audit scrutiny.
- Ensuring that the stock administration can appropriately handle unique awards, such as performance-based awards.
Capitalization and asset impairment
GAAP requires companies to capitalize certain costs that may have been historically expensed. This ability to capitalize previously recognized expenses improves the company’s balance sheet, but that benefit comes with a caveat.
Some of the GAAP capitalization rules, particularly for software development costs, require significant analysis and the application of accounting standards that require the application of experienced judgment.
While capitalization rules can improve the balance sheet, GAAP also requires companies to write down the value of its assets when they have been impaired. The recognition of these impairment losses can take company management by surprise.
Accrued expenses
Many of our clients accrue some but not all of their expenses and instead recognize the expense when it is paid rather than when the related services were rendered or the goods received.
Preparing GAAP financials will require the company to make adjustments to bring the financial statements from a cash-basis to an accrual-basis of preparation, which requires a review and adjustments to both the balance sheet reporting date as well as the opening balance sheet for the reporting period.
Going forward, the company must create accounting processes that can accurately record these accruals consistently at month-end.
Document wrangling — the hidden audit cost
Auditors will want to obtain, read and analyze all of the company’s significant contracts and agreements. They will need final, executed documents as well as all amendments and modifications. They will also need to read the company’s Board Minutes.
Most of our clients do not have a single library or repository for all of these documents. In the heat of the fundraising close or the rush to an agreement, it is understandable that the executed documents are saved in different files or sometimes not received from attorneys.
Our clients can be surprised at how time consuming it can be to prepare a complete list of all the documents auditors need and then locating these documents in final executed form. Irrespective of auditor needs, we advise our clients that taking steps to obtain and organize their key documents is a good business practice.
A little preparation can go a long way
Most of our clients who undergo their first audit are surprised by the level of effort and amount of time it takes to complete it.
At Kranz, we have experienced consultants who have decades of audit experience and who understand and can anticipate auditor needs.
Using that experience early in the audit process can help a company prepare for what’s to come, resulting in less work and stress on the company’s finance department and adequate preparation for potential audit trouble spots.