Technology businesses face several challenges through their lifecycle. These range from raising funds, proving concept, scaling up, maintaining a market leading product or even planning an exit strategy for shareholders. These areas often receive a lot of attention but what is not always fully considered is the impact the financial statements can have on them.
Accounting standards dictate what can and cannot be presented in financial statements. As a result, the financial performance may look worse than the reality, particularly in times of change and investment.
There are a number of areas where it is the responsibility of those managing the business to select appropriate accounting policies. These policies ultimately dictate how income, expenditure, assets and liabilities are presented in the accounts. These choices can have a significant impact on the way the accounts are presented and influence those reviewing the accounts, particularly external parties.
It is therefore key to ensure that these policies are given proper consideration to ensure the business has the best chance of achieving its goals and aspiration in the short, medium and long term.
Below are a number of areas to review along with alternatives which could have a more positive impact on the reported financials
Balance sheet values
Technology businesses who invest heavily in new product development can suffer from poor balance sheet values where the investment outweighs the income being generated. Small businesses where the financial statements on public record do not contain the Income Statement (Profit and Loss account), can give an impression of poor performance and financial instability even if this is not the case.
Wealthy backed technology businesses are low risk for creditors. A Statement of Financial Position (Balance Sheet) showing substantial creditors and possibly a net liabilities position are more likely to result in a poor credit score. This can be a problem if funding is being sought, especially if the metrics used for the due diligence are heavily driven by the reported financials.
Research and Development (R&D) tax credits
The corporation tax regime in the UK includes two types of R&D tax scheme. One where qualifying costs are treated under the SME scheme, and one where the qualifying costs are treated under the Research and Development Expenditure Credit scheme (RDEC).
As well as the tax treatment being different for these two schemes, the accounting can also differ. Relief received under the SME scheme is reasonably simple to account for as this is simply included in the profit and loss account as an adjustment to the tax charge either by reducing the charge in the year or by showing a corporation tax refund due.
Relief obtained under RDEC, also referred to as “above-the-line credit” can be treated differently in the accounts. As the alternative name suggests the relief received can be recognised “above-the-line” meaning that this can be recognised as income above the profit before tax line in the profit and loss account, typically included within other income.
This treatment is an optional treatment but one worth considering. The ability to report higher profit before tax figures can be very useful, particularly where external funding may be required, or where potential investors are reviewing the accounts.
This is a particularly key area for technology businesses as often the core activities result in the development of intangible assets. Selecting the most appropriate accounting policies for the business can make a significant difference in the financial statements.
UK accounting standards specifically disallow the recognition of “internally generated” intangible assets. This means that if a business spends money on internally generated brands, logos, publishing titles, customer lists and other similar assets, the entity must recognise these assets as an expense in the profit and loss account rather than capitalise these costs and recognise them as an asset on the balance sheet.
As it is not unusual for technology companies to invest considerable amounts on brand development, particularly while looking for growth, it can often be the case that despite the business holding assets which may well have a substantial value to the outside world, and could possibly be sold, these cannot be recognised at their market value in the balance sheet.
There is however a potentially different treatment for R&D costs. While a project is in pure research phase the company must treat the costs as an expense in the profit and loss account on the basis that the “…entity cannot demonstrate that an intangible asset exists that will generate probable future economic benefits”.
However when the project reaches the development phase there are other possibilities. The business could continue to treat the costs as expenditure and recognise them as a cost in the profit and loss account.
The alternative is to start capitalising these costs as development expenditure and create an asset on the balance sheet. This asset will then be amortised over the expected useful life of the asset. Certain criteria must be satisfied to allow this treatment however this can have significant benefits on the reported figures of an entity.
An example approach to intangible assets
In a very simple example if a technology business spends £2m over a two year period to develop new innovative technology which will last five years, and there is no income obtained in these first two years, under the policy of recognising costs as an expense in the profit and loss account, at the end of the two year period the company could have accumulated losses of £2m and a balance sheet containing a profit and loss account with a negative balance of £2m.
If however the accounting policy is to recognise these costs as development costs and capitalise them as an intangible asset, the situation would change. In this scenario at the end of year two the business could have a profit and loss account showing no loss and a balance sheet with a £2m intangible asset. This is a significant improvement on the financial position of the company.
There is also an option to take this a step further and revalue the asset to “fair value”. This would only prove to be an advantage if the fair value was above the cost of developing the asset but if there is a reliable measurement for this value this could be considered.
What action a business leader take
The fast pace of change in the technology sector often means that entrepreneurs and business owners focus on innovation and routes to market. As a result this leaves these key individuals without the luxury of having time to consider how the outside world may view their statutory accounts.
Selecting accounting policies can have a significant impact on the accounts and how they present the financial position and performance of the business. Financial reporting is not the forte for most entrepreneurial business owners therefore it is key that they work alongside their advisors to ensure that the various options are understood.
For further information on the above, please contact Rob Kruppa at [email protected] or call 01489 566727
Menzies is a top 20 leading firm of accountants, finance and business advisors that operate out of a network of offices across Surrey, Hampshire and London, providing our clients with easy access and local knowledge. Described as the ‘best performing firm outside of the top 10’ by Accountancy Magazine, Menzies has over 400 employees and an annual turnover of more than £40m.