Author: Rob Kruppa, Audit & Corporate Tax, Menzies
There is a long list of challenges that many technology businesses come across within their lifecycle. These include, scaling up, raising funds, proving concepts, maintaining leading market products or even planning an shareholders exit strategy. With many hoops to jump through, often the full impact of these financial statements is not realised.
On the surface financial performance can often look worse than the reality, this is due to the limitations imposed by accounting standards regarding what can and cannot be listed in financial statements.
Selecting the most appropriate accounting policies is often the responsibly of those managing a business. These policies outline how income, assets, liabilities and expenditure are presented in the accounts. Ultimately this presentation can influence those reviewing the documentation.
Making sure these policies are given the appropriate consideration is key to ensure businesses have the best chance of achieving their aspirations and goals in the short, medium and long term.
Below are the key 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.
Technology businesses that are wealthy backed are at a low risk for creditors. Those who have a Statement of Financial Position (Balance Sheet) which show a significant number of creditors and possibly a net liabilities position have an increased likelihood of resulting in a poor credit score. This can flag problems in the future if funding is being sought, especially if the metrics used for the due diligence are heavily influenced by the reported financials.
Research and Development (R&D) tax credits
There are two types of R&D tax schemes in the UK under the corporation tax regime. 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).
Not only are the tax treatments different for these two schemes, the accounting can also vary. Relief received under the SME scheme is relatively simple to account for, 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 known 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 viewed as income above the profit before tax line in the profit and loss account, typically included within other income.
Even though this is an optional treatment, it is one worth consideration. Being able to report higher profit prior to tax figures can be useful, especially where potential investors are reviewing the accounts, or where external funding may be needed.
Intangible assets
A key area for technology businesses as core activities can often result in the development of intangible assets. Making sure to choose the most appropriate accounting policies for the business is key to making a notable 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, customer lists, publishing titles 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.
It is not unusual for technology companies to invest large amounts on key brand development, especially while looking to expand, 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.
However, there is 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”.
Although 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.
Capitalising these costs as development expenditure and creating an asset on the balance sheet is a notable alternative. 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.
However, if 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 company’s financial position.
Another option is 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.
The best course of action for business leaders
The technology sectors fast pace of change often means that business owners and entrepreneurs 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 rkruppa@menzies.co.uk or call 01489 566727