“An audit is one of those things that always seems to exist in the future. You think, “Yes an audit will happen someday, but that day is not today.” However, as the CFO of a high-growth company, “someday” is probably sooner than you think. If you are venture-backed, you should anticipate a first audit no later than the completion of your Series B.
While there are a lot things you will be able to do in the months leading up to your first audit, the most important work starts much earlier. Why? We have found that most common problems during a first audit stem from decisions that you will make right now about equity compensation, taxes, and revenue recognition.
Preparing for Your First Audit
The picture below shows the faces of 5 venture-backed CFOs when their first audit caught them unawares:
I know, I know. Bad joke. But the lesson behind this image really is no laughing matter. In fact, the story of these 5 men should be told to every CFO as they’re tucked into bed each night, as a frightening reminder of how things can go bad quickly.
The image you see before you is the last picture of Robert Falcon Scott (center) and his crew as they attempted to become the first to reach the South Pole.
Besides discovering that a Norwegian team had already beaten them there, they also found that they had inadequately planned in advance for the expedition. They brought ponies that couldn’t handle the cold, they didn’t drop enough food off at depots for the return trip, and their base team wasn’t prepared to rescue them if the situation turned bad. Because of extreme conditions and lack of supplies, Scott and his entire team perished in the frozen wastelands of the South Pole.
There is plenty of scholarly debate on what exactly did them in, but many agree that lack of preparation was key to their demise. Scott had planted the seeds of their fate long before they set foot in the South Pole by decisions he had made (or failed to make).
Having worked with thousands of high-growth companies at this stage, we’ve found that the advice in these articles rarely helps to solve the real problems with your first audit. In fact, we’re pretty sure that you could figure out how to “pull together the necessary paperwork” and “create a good relationship with your auditor” on your own.
We’re here to help you dot your i’s and cross your t’s in 3 areas where we have repeatedly seen startups fail so you’re not caught unprepared in a difficult situation.
First, A Word about GAAP
GAAP is one of those terms that technical accounting folks throw around as if we all should know what it means. And, of course, we nod our heads knowingly all the while thinking, “What on earth is this person talking about?”
GAAP is an acronym that means Generally Accepted Accounting Principles. These are the accounting standards established by the Financial Accounting Standards Board (FASB). GAAP provides “guidance” as to the proper way to record transactions across the full range of possible business events. The underlying purpose of GAAP is to create a common accounting approach so that businesses can be evaluated and compared.
As a private company, the owners can decide how they want the accounting records are kept. However, certain business events (e.g., going public, merger, acquisition, financing rounds, etc.) force management to seek audited financial statements. The sole purpose of an audit is for an independent certified public accountant (CPA) to provide an opinion that the books and records are maintained in accordance with GAAP. Before financial statements can be distributed outside the company or filed with the SEC, those statements must adhere to GAAP. In the sections below, we cover some of the areas of GAAP that high-growth companies struggle with the most during their first audit.
The specific rules we’ll be mentioning are referred by their “ASC” number (e.g., ASC 718, or ASC 740). ASC is yet another acronym that means “Accounting Standard Codification”. These are the most recent accounting rules that have been “codified” (meaning accepted) by the FASB and are the rules the auditors will be following to determine if the company’s records follow GAAP.
The 3 Horsemen of the Audit-pocalypse
Our recent survey of just under 100 venture-backed CFOs confirmed that these issues are among the most painful for CFOs. In the results of the survey, note that process items (e.g., documentation and controls) rank very high on the pain scale for many of the CFOs. Accounting processes is a topic for another day. The focus today in on GAAP meaning the technical aspects of how to account for certain aspects of the business.
In our joint experience as confirmed in the survey results, the following 3 areas of GAAP consistently create the biggest headaches during a first-time audit:
- Revenue recognition issues
- Share-based compensation
- Accounting for Income Taxes (Tax Provision)
Click here to download the complete 2018 External Audit Survey of Venture Backed CFOs by Capshare, AdvancedCFO and VPTax.
Let’s look at each in more detail.
Revenue Recognition Issues
According to investopedia, Revenue recognition is an accounting principle under generally accepted accounting principles (GAAP) that determines the specific conditions under which revenue is recognized or accounted for. Generally, revenue is recognized only when a specific critical event has occurred and the amount of revenue is measurable.
While it sounds simple in theory, in practice, determining and implementing a consistent, representative policy for a company can be difficult. For example, should you recognize revenue if you have a signed service contract but you haven’t collected all of the information you need to onboard a client to a software system? What if you don’t have any kind of contract but the customer has paid you a sizable initial down payment? Etc.
Revenue recognition rules are broad and, while generally based in understandable principles, frequently require interpretation in their application. The more you discuss, document, and understand your own policies, the more likely it is that increased likelihood you’ll actually apply the policy correctly.
Exceptions, or ‘found errors’, in first time audits of revenue recognition practices are often grouped into two camps:
- Improper interpretation of revenue recognition rules in setting company policy
- Improper adherence to the agreed upon company policy.
Our purpose is not to list the various rules for revenue recognition, but rather to help you think through the methodology for ensuring proper interpretation and application of policy. Creating structure around how to do this will ensure greater compliance and have you better prepared for your audit.
Do Your Homework
Simply put, there is legwork involved and there are no shortcuts to understanding and developing your own revenue recognition policies. The legwork usually includes and researching GAAP to determine if your company’s application of GAAP is appropriate. Start by documenting thoroughly how your company recognizes revenue. Consider both typical and non-typical entries you may make. Think carefully about period ends when you may have cut-off issues as these are commonly overlooked areas. Other frequently overlooked areas are sales arrangements with refund and return rights or consignment sales.
Getting your internal team acquainted with and bought into revenue recognition policies will yield benefits in both adherence and up-front understanding as deals are created, sold and won. The process of gaining consensus will confirm your understanding of the sales process and secure everyone’s agreement.
But consensus doesn’t stop internally. Crucially, once the internal team agrees on a policy, then it is essential to smooth the way for the audit by explaining your policy to your auditors. This is best done, of course, well before they arrive on site for the audit. Doing so will help you in two ways. First, your auditors will see your willingness to be proactive. Second, you’ll develop a stronger and more defensible position with their help.
Audit Your Own Application
Now that you have set policies and begun implementation, be certain to audit yourself periodically. During each monthly close cycle you should randomly select a handful of transactions to ensure you’re following your own policies. To be extra thorough, you may even select higher risk transactions to test as well.
Hold Your Standards
Inevitably, businesses feel pressure to perform. When pressure mounts, those with lesser understanding of the rigors of revenue recognition policy will either knowingly or unknowingly pressure you to make some exceptions. These frequently include recognizing more sales than should be recognized or accelerating recognition into a period when it was not earned.
Many revenue recognition audit problems occur due to ongoing and subtle pressure to deviate from standard policies to improve financial results.
The earlier and more frequently you communicate your unwillingness to bend, the less likely you will be asked to do something that isn’t appropriate. But if that moment does come, be ready to make a stand. Generally, those doing the asking don’t know the rules, but and with some guidance they’ll gain a better understanding and back off. But even if they don’t, make your stand anyways. It isn’t worth your trading away your integrity.
Finally, it’s important to keep in mind that the understood revenue recognition rules are constantly evolving. Even as we speak, more significant changes in requirements are taking place. However, we are about to experience a more significant change in requirements. Your auditors will be aware of the changes, but it will be beneficial to you makes sense to familiarize yourself with the upcoming changes as well on the horizon. There are many great summaries of the changes online including this one from the scintillating journal of accountancy.
High-growth companies, investor-backed companies, and startups use share-based compensation heavily. And there are a lot of them.
Based on PwC MoneyTree data and data from the National Center for Equity Ownership, I estimate that there are 45,000-63,000 existing venture-backed startups. If there are just as many angel-backed companies, then there are probably 90,000-126,000 startups issuing stock to employees.
How does this affect you in an audit?
Stock Option Expensing (ASC 718)
The first area where most CFOs struggle is stock option expensing. I am going to assume you have basic familiarity with this, but if not, read more about ASC 718 here. In short, when you want to issue GAAP-compliant financials, you will need to expense your stock options.
Just because something isn’t a cash transaction, doesn’t mean you don’t need to expense it. The obligation to expense stock options is undisputed and has been for many years now, even for startups. In fact, because startups use equity compensation so heavily, it can often be a very material part of the company’s expenses.
If you’re an old-school CFO, you may be tempted to skirt the issue by 1) ignoring the issue entirely or 2) using some simple rule-of-thumb that makes sense to you. Don’t do either.
Truth is, many startups don’t expense stock options in the early days. In our opinion, that’s fine. In those early days, you’re fighting to make payroll and create a business that can survive. Who has the time to expense stock options with all that other noise.
But, in my opinion, you should definitely start expensing stock options when you have a full-time employee focusing on finances. To overlook this important detail when you have the resources would be like having a team of snow dogs in the South Pole to carry supplies, but leaving valuable food behind because you didn’t think it was necessary at the time. The important thing is to look ahead, especially when you have the resources to do so.
For the typical CFO, valuing stock options involves some fairly time-consuming Black-Scholes math.
While we have absolute faith that all of you could probably do the math (especially if you have a corporate finance background), the question of whether or not you want to is something else entirely.
Most venture-backed CFOs quickly learn that doing the math and doing it well (at a reasonable cost) are two very different things. I have met many CFOs who try every year to calculate stock option expenses themselves. Eventually, each of them gets sick of it.
Most CFOs try to create an Excel model that can do it for them. There’s no denying that Excel is a fantastic tool, but turning Excel into a model that can effectively and efficiently calculate stock option expenses each year can become an exhaustive multi-year process. Because of the additional logic that needs to be added in each year, it’s no wonder most CFOs throw in the towel a few years down the line.
A while ago we realized that many companies have this headache, which was one of the biggest reasons we built Capshare’s ASC 718 software. Our software handles the most common ASC 718 calculations for thousands of companies. With the click of a button, you can do these calculations instead of spending weeks pouring over Black-Scholes math, or building an Excel model to do it.
When you’re doing your ASC 718 expenses, you’ll discover that a key input is the value of your common stock. Private companies with no liquid market for their shares typically find this value through a 409A valuation.
The bad news is that because the 409A valuation is a key input into the ASC 718 math, your auditors will probably also probe your 409A valuations and process.
This means that your 409A valuations will need to withstand audit scrutiny. To make your 409A valuations audit-proof, you will need to:
- Ensure that whenever you grant stock options, you create or pay for a valid 409A valuation
- Make sure your 409A valuation is defensible (generally this means picking the right 409A valuation firm)
Sometimes the right 409A approach changes depending on your stage. A lightweight 409A option might make sense for a brand-new, 5-person startup. But when you reach Series B or later, you should make sure you are working with a company that can help you navigate more complex issues.
Accounting for Income Tax
Every single business transaction has a tax consequence.
Although tax is its own business process, there would be no taxes to calculate if there were no transactions within the business itself. GAAP requires that the tax results of every transaction be represented in the financial statements.
Based on the most recent data from Audit Analytics, Accounting for Income Tax is one of the top three accounting areas most often found to be inaccurate and to fail internal control requirements. (As we mentioned, documentation and controls are a topic for another day.) There are two reasons for these failures: 1) Tax laws are extremely complex and 2) tax calculations incorporate all other transactions making tax processes the last thing to complete while preparing the financial statements. Being last in the process of closing the books creates significant pressure to move quickly through these complex rules.
The Rule – ASC 740
ASC 740 governs the approach for accounting for income taxes. (Note that it does not address other taxes such as sales tax, property tax, etc.)
ASC 740 is the GAAP code for income taxes.
ASC 740 throws most accountants a curve ball right out of the gate; although we think of taxes as an expense (and they are), the rules require that we account for taxes using a “balance sheet approach.”
When the auditors look at income taxes, their approach will be to verify that the tax balance sheet accounts are accurately represented. Many accountants and even seasoned tax professionals simply don’t think this way, preferring to see income taxes as an expense. To pass your first audit, the first tip is to wrap your head around what taxes look like on the balance sheet.
Startup companies will typically have three income tax related balance sheet accounts. Combining these accounts will ultimately clarify the actual income tax expense that gets recorded on the profit and loss statement. The three balance sheet accounts are: A) Income Taxes Payable, B) Deferred Tax Assets (or Liabilities) and C) Valuation Allowance.
Here is how they work:
Income Tax Payable
The first step in recording income tax is to determine the current income tax payable amount. As previously mentioned, every business transaction has a tax consequence. If you follow the paper trail of transactions (i.e. the trial balance), you’ll discover your “profit (or loss) before taxes” (PBT). This is the starting point for determining your income tax payable.
But it gets more complex because there are hundreds of differences between the GAAP rules and the tax rules that manifest in things like the 50% limitation on meals and entertainment expenses, revenue recognition or share-based compensation as described above. These accounting adjustments are applied to PBT to arrive at taxable income (TI). Taxable income is then multiplied by the appropriate statutory tax rate to arrive at income tax expense.
The company may have made payments throughout the year, which also need to be accounted for. Once this is done, you get the first balance sheet item relating to accounting for income taxes: income tax payable.
A byproduct of determining the income tax payable amount is effective tax rate calculation calculation. ASC 740 does require the financial statement footnote relating to income taxes to provide a “rate reconciliation” showing the walk from the statutory tax rate to the effective tax rate.
As an example of a “rate reconciliation”, assume a U.S.-based company had 1,000 of PBT and the only permanent GAAP and tax difference is the 50% limitation on meals and entertainment. The 50% limitation will never be deductible on any U.S. Federal tax return. For this example, assume the limitation for meals and entertainment is 100. The presentation of the “rate reconciliation” footnote would look like this:
Gross Tax Effected Percent
Profit Before Tax 1,000 350 35%
Non-Deductible Expenses 100 35 3.5
Total Taxable Income 1,100 385 38.5%
In this example, the effective tax rate is 38.5% and is higher than the statutory rate because of the non-deductible expense. Other common permanent GAAP to tax differences that show up on the rate reconciliation and become part of the effective rate calculation are certain stock-based compensation expenses, different statutory tax rates of other countries and states in which the company has a tax liability, and income tax credits and incentives like those provided for research activities.
The next balance sheet item relating to accounting for income taxes are those items that are referred to as “deferred”. Many of the differences between GAAP accounting and tax law are simply a difference in timing of when the item is recognized in the tax books.
Let’s take depreciation on a fixed assets as an example. The total amount of depreciation on that asset is the same for GAAP and tax. However, timing is different. Depreciation deductions for taxes are typically more accelerated than they are for GAAP. This difference in timing (also referred to as “temporary” differences) is what creates a deferred tax item. There are many such differences including reserves, accruals, deferrals, prepaids, etc., etc.
Like income tax payable, deferred items must be accounted for and disclosed through balance sheet accounts called “Deferred Tax Assets” or “Deferred Tax Liabilities”. Companies must track at an item-by-item level each area of accounting that has a different treatment between GAAP and tax.
In the example of the fixed asset depreciation above, the difference in timing between a tax deduction and a GAAP deduction would create a “Deferred Tax Liability” Because the depreciation has been deducted more rapidly on the tax return, the company will have a higher tax bill in a later accounting period thus the “deferred liability”. An item like a bad debt reserve works in the opposite way. GAAP requires an expense in a period typically earlier than tax allow a deduction on the tax return. Therefore, the future tax deduction creates a “Deferred Tax Asset” for the bad debt deduction because the future tax liability will be lower.
Tracking the inventory of timing differences between GAAP and tax can be onerous. To compound the challenge, ASC 740 requires that these timing differences be tracked separately for each tax jurisdiction in which the company must file tax returns. Think of a company that operates in several countries. Each country has its own tax law resulting in different GAAP and tax differences that must be tracked from period to period. The United States poses a particularly challenging burden because each state that imposes an income tax should be treated as a separate taxing jurisdiction with its own inventory of deferred tax items.
Other items, in addition to timing differences, that are considered deferred tax items are net operating loss (NOL) carried forward and income tax credits and incentives to name a few.
An overriding principle in GAAP accounting is that balance sheet items be “conservatively” represented as to their value, meaning that accountants must error on the side of lower values for assets if there is any doubt. This principle holds true with tax items as well.
Assume a company is operating at a tax net operating loss, as many startup companies do. The deferred tax assets, including delayed NOLs, are considered assets on the GAAP books. However, there may be doubt as to what their value is because the company must become profitable before those deferred tax assets can ever be used.
Regardless of the level of doubt, the company still must record the assets as described in the the deferred tax section. However, if the doubt is so great that the auditors do not think there is at least a 50/50 chance (more likely than not) of using the deferred tax assets, an additional accounting entry is required which creates an allowance (much like other allowances such as “Allowance for Doubtful Accounts”), against the deferred tax assets. This allowance is an entry on the books that effectively reduces the value of the deferred tax asset on the GAAP books.
Process & Technology in Accounting for Income Tax
Some time ago, we at VPTax realized that ASC 740 required better processes and internal controls than today’s spreadsheet tools can offer. We use a new SaaS income tax provision application called Tax Prodigy for all our clients. Tax Prodigy allows us to input the tax items we identify through the normal course of preparing tax returns. Once it has the inputs, Tax Prodigy handles the calculations, tracking of the inventory of deferred tax items from period to period, and all the reporting and financial statement disclosures ASC 740 and the auditors demand.
As you can see, accounting for income taxes has layers of complexity that can be challenging for even the most seasoned CFOs. This, plus the fact that preparation for the calculations under ASC 740 can only begin after all other accounting entries have been made makes taxes one of the most challenging areas in the accounting process. This, of course, means that it’s also one of the most challenging areas to audit.
With a little preparation, your first external audit can be a smooth process. It might be not be completely painless.
Our survey of ~100 venture-backed CFOs showed the painfulness of first-time audits for startups created a bimodal distribution.
Click here to download the complete 2017 External Audit Survey of Venture Backed CFOs by Capshare, AdvancedCFO and VPTax.
By following the advice in the article, you should fall into the first category where your audit is less painful and fairly easy. Good luck and let us know if we can help in anyway.”
David Chase, CEO of Advanced CFO
Stephen Day, Partner at VP Tax
Jeron Paul, Founder and CEO of Capshare