Development stage enterprises: audit and accounting issues. (includes related article about financial statement and disclosure requirements)By Bremser, Wayne G., and Rollins, Theresa P.
Entrepreneurial spirit is alive and well in this country. Technological advances have led to the birth of new and exciting industries. With this activity has come the opportunity for CPAs to provide accounting, audit, and management advisory services to start-up ventures. There is also increased risk because a CPA's reports are often used to raise capital, and start-up ventures often have a considerable chance of failure.
In 1975, SFAS 7, "Accounting and Reporting by Development Stage Enterprises," was issued to clarify and standardize reporting practices of development stage companies. Several publications on this topic appeared shortly thereafter. However, the literature has been sparse since then.
THE NATURE OF A
SFAS 7 defines a development stage enterprise as a company that:
* Devotes substantially all its efforts to establishing a new business and has not begun planned principal operations; or
* Has begun operations, but has not generated significant revenue.
A development stage enterprise devotes most of its efforts to financial planning; raising capital; exploring for natural resources; developing natural resources; research and development; establishing sources of supply; acquiring property, plant, equipment, or other operating assets, such as mineral rights; recruiting and training personnel; developing markets; and starting up production.
A company that is e xpanding or developing a new product line would not qualify as a development stage company because it is not devoting most of its efforts to establishing the business. However, a subsidiary of an established firm could be so considered if it issues separate financial statements. The consolidated financial statements would follow reporting practices of an established enterprise.
Before SFAS 7, many development stage companies capitalized their start-up losses and amortized the cumulative losses against revenues of later periods. SFAS 7 acknowledges that development stage companies are involved in different activities than other enterprises, but requires that they issue the same basic financial statements as an established operating enterprise following GAAP; see Exhibit 1 for additional requirements. SFAS 7 does not change industry standards that are considered GAAP. In certain industries, such as oil and gas, sttart-up costs related to exploration and drilling are capitalized. There is little written in accounting literature on start-up costs, and the FASB has not addressed the issue. One Board member saw the need to dissent on the matter of start-up costs.
Investor and creditor needs are different for a development stage company. While its statements reporting cumulative information give an investor a summary of activity to date, users also need information about future prospects. In addition, while GAAP provide guidance on non-cash asset valuation and reporting of current and potential obligations, these transactions usually are more prevalent, material, and harder for the development stage company to value.
The development stage company often issues stock to developers, consultants, and managers in exchange for assets, technology, or services; the development stage compnay often is unable to acquire them for cash. The first accounting problem faced is how to value the stock in these transactions. "Accounting for Nonmonetary Transactions" states that the fair market value of the asset obtained or the stock issued should be used, whichever is most objectively measurable.
Because the stock issued to related parties will not have an objective market value, the development stage company should seek to value the assets or services exchanged. If the asset is material and marketable, such as real estate, the accountant may consider an independent appraisal. Obviously, some assets cannot be easily appraised; evidence of their value may have to be obtained from previous stock transactions.
In light of recent publicity about the use of appraisals in determining the value of real estate held by savings and loan associations, CPAs should be alert for additional professional literature and guidance on this topic.
For example, a consultant was engaged to prepare a business plan for a development stage company and the plan was used in a private placement offering of a securities. The engagement letter stated that a $200 per hour fee was used for the services provided,but payment was to be in common stock valued at $25 per share. The consultant's bill was $20,000 (recoreded as organization costs) and 800 shares were issued. Subsequently, 10,000 shares were issued to 10 different shareholders for cash at an average price of $10 per share with a range of $9 to $13. The auditor would have to stronly suspect that $200 per hour was an overstatement of the value of the services received; more likely, the consultant would have accepted $100 or $80 per hour.
In a review of one development stage company's financial statements, the authors noted that royalty rights, a tchnology license, and consulting services--exchanged for common stock--were valued at the number of shares given times the par value of the stock, which was one cent per share. While the value of the transaction may not be easily determinable, the accountant should seek alternatives to using par value. The parties involved must have had some i dea of the worth of the assets or services exchanged. Unvalued assets or services will result in current and future period income being overstated; depreciation expense on assets will be understated. Similarly, recorded expenses for services will be understated.
Alternatively, the auditor must consider overvaluation and related consequences. Overvaluation may result in future stock prices being inflated. Clearly, the SEC sees this as the greater problem. The SEC will not allow a dollar amount to be assigned to nonmonetary transactions for publicly traded companies when there is not an objective valuation.
The development stage company may also receive donated capital. Many local governments encourage new industries by donating space or services. Again, if possible, the company should assign a market value to these transactions and account for them as an increase in paid-in capital. In addition, any requiremetns or reimbursement conditins placed by the government should be disclosed.
Donations of treasury stock by officers should be viewed with considerable skepticism. Consider the following where 10,000 shares were issued for:
Cash $40,000 Plant and equipment 400,000 Organization costs 160,000 Total $600,000
The average issue price was $60. Two months later the shareholders donated 4,000 shares to the company. Meanwhile, development activities caused corporate assets to decrease to $588,000, resulting in a book valu of $98 per share. The outstanding shares were offered to investors at book value and promoted as a real bargain. Were the nonmonetary assets really worth $560,000?
Initial costs of organizing a company should be capitalized. The organizational period begins when the decision is made to form a company for a specific purpose; the development stage would also begin at this time. The organizational period ends when the initial common stock offering is completed.
Organization costs should be amortized over no more than 40 years. However, often the useful life is less and the greatest benefit of these costs is in the early years. Many firms use five years, the minimum allowed for tax purposes.
When equity securities are issued, related costs would be:
* Underwriters' fees and commissions;
* Attorneys' and CPAs' fees;
* Certificate and registration statements, printing and mailing;
* SEC or state securities commissio filing fees;
* Clerical and administrative expenses; and
These costs can be capitalized as organizational costs, or treated as a reduction in paid-in capital.
Many development stage companies issue stock over time. Only the initial offering costs should be capitalized. Subsequent offering costs should be treated as a reduction to the proceeds of the stock issued. Similar costs are incurred when debt securities are issued, but the accounting alternatives differ. APB 21 stated that debt issuance costs should be treated as a deferred charge (unamortized bond issue costs) and amortized over life of the debt. This was contradicted by FASB Concepts Statement 3 which favored treating them as an expense or a reduction of the related liability, because there was no future economic benefit to support the asset classification. The deferred charge method has the strongest authoritative support and is the most commonly used in practice.
Issuance of Debt
As with the issuance of stock, many debt transactions of a development stage company involve related parties and this relationship must be clearly disclosed. Also, the issuance of debt may be part of a nonmonetary transaction, so the valuation of the assets and services will need to be reviewed and disclosed. The debt's term and interest rate and the security position of the party lending the money should be noted. Potential investors will want to evaluate the debt owners' position vis-a-vis their potential investment.
The classification of the loan between current and long-term must be determined. An officer who also owns a significant block of stock might make a loan due "on demand." The officer's intent is to keep the funds in the company until operations generate enough to repay it without causing liquidity problems. The officer estimates that this will be three or four years hence! While the intent is important, in view of the ability to call the loan at any time, it must be classified as a current liability.
Interest May Have to Be Imputed
In addition, an evaluation of "interest-free" loans from related parties should be made. Sometimes, there is an understanding among the directors that the loan will be repaid with a "fair" rate of interest when funds become available. In one financial statement there were on interest rate disclosures about a related party loan, although the notes to the statements stated the compnay's intention was to repay the loan with interest when funds became available. If an owner intends to collect interest at a later date, it should be accrued currently. If the interest is contingent on a future event, then SFAS 5, "Accounting for Contingencies," applies. If the interest is probable and reasonably estimable, it should be accrued. If it is either reasonably possible or not reasonalby estimable, information about its likelihood and possible amounts should be disclosed.
There may be a simultaneous, issuance of common stock and interst-free debt. For example, common stock and non-interest bearing debt could arise as follows:
Common stock $1 par value $10,000 Paid-in capital $90,000 Note payable, due in 5 years $100,000 Cash received from officer $200,000
The auditor might determine that a reasonable rate of interest is the treasury bond rate plus 4%. Accordingly, interest expenses would be imputed, and the note discounted at 14% to a present value of $56,743. Paid-in capital would be increased by $43,257.
Detail about debt with outsiders should be disclosed in accordance with SFAS 5. Since the survival prospects of a development stage company are often in doubt or significantly less likely than a mature firm, greater detail about significant terms and restrictive covenants is appropriate. The statements should clearly disclose the security for any debt and the priority of payment in the event of default.
ISSUANCE OF "CHEAP STOCK"
The SEC has recently revised its rules for stock or warrants issued prior to an initial public offering (IPO) (SEC Staff Bulletin 83). This stock, called "cheap stock," is issued within one year of the IPO at a price below that of the IPO. The stock must be treated as outstanding for the entire current and historical periods for earnings per share (EPS) computations, similar to stock splits or stock dividends. The SEC will allow the firm to use the treasury stock approach to determine the additional shares outstanding. Under this method, the company will assume that the proceeds from the cheap stock sales (or anticipated sales for warrants), would have been used to purchase its own shares at the IPO price. For example, assume that the company had issued 1,000 shares of stock in the year prior to the IPO at $5 per share. Two months later, the firm issued 10,000 shares at $10 per share for the IPO. The average number of shares outstanding related to the cheap stock would be calculated as follows:
Shares from issuance of cheap stock 1,000 Less: Shares repurchased: Proceeds from cheap stock: 1,000 x $5 = $5,000 Repurchase of shares at IPO price: $5,000/$10 (500) Incremental shares from cheap stock 500
The SEC also state that they would generally not question shares or warrants issued over one year before the IPO, unless there was reason to believe the securities were issued in contemplation of the IPO.
Inventory, property, plant and equipment may be relatively immaterial for many development stage companies. As noted earlier, many of these assets may have been valued by appraisal or other means, which valuation should be clearly disclosed. The audiotr must consider the recoverability of assets when reviewing their cost. Care must be taken not to assign too high a value for a development stage company.
If the company has begun limited productions and has inventory, both the method of valuation (FIFO, LIFO, etc.) and the use of lower of cost or market (LCM) should be disclosed. The development stage company should be careful when applying LCM. With small production quantities, costs to produce may be greater than the market price because of high u nit absorption of overhead.
The useful lives and depreciation method of fixed assets should be disclosed. In addition, the users of the statements would benefit by knowing the use of the asset, such as use for research and development or for production.
Some development stage companies make loans to owners; they often are unable to pay dividends because of cumulative deficits. This type of related party transaction would be of particular interest to potential investors and should be clearly disclosed, setting forth terms, interest rate and likelihood of repayment. In determining the likelihood of repayment, the auditor should consider the owner's personal net worth.
Operating expenses may be part of a nonmonetary transaction. The company should seek a fair basis of valuing these expenses; often there are suitable benchmarks.
Many operating expenses also involve related party transactions, which must be clearly disclosed, as the company may be involved with other entities owned by the same individuals.
Research and development expenditures may be the largest type of expense the company incurs. SFAS 2, "Accounting for Research and Development Costs," requires that these costs be expensed in the period incurred. These costs are not includable in factory overhead that would be capitalized as part of inventory. However, capital expenditures, such as equipment and building space, that benefit more than one R&D project may be capitalized and depreciated over their expected useful lives.
The R&D costs may result in a patent. The specific costs of obtaining the patent should be capitalized and amortized over its useful life. However, these costs include only the application and legal fees related to the patent itself. If the company purchases a patent, it may be capitalized even if the price includes R&D type expenditures incurred by the seller.
Contingent payments, dependent upon successful development of a process or product, are often present in development stage companies. The rules of accounting for contingencies (SFAS 5) apply here. At a minimum, the nature of the contingency must be disclosed, even if no expenses will be recognized until the future. The auditor should investigate the conditions that will satisfy the contingency, to insure that the company begins accruing the expense as the contingency becomes satisfied, even if payment will not be made until later.
ACCOUNTING FOR REVENUES
As with financial statements in general, development stage companies must account for revenues using GAAP. However, SFAS 7 provides that a development stage company which has begun operations should not have "significant" revenues. No definition for "significant" is given, so the auditor's judgment is important.
There may be a desire to remain "developmental" for financial reporting after regular operations have begun, perhaps as an explanation for continued losses. One company reviewed continued to report as a development stage enterprise even though it had assets of almost $2 million and current period revenues of over $350,000. Because cumulative revenues appear significant, perhaps the notes to the financial statements should have indicated why the development stage presentation continued to be appropriate.
More guidance should be given to preparers of developing stage company financial statements on the concept of "significant." Should revenues be compared to forecasted revenues? Should industry ratios be compared to help determine when revenues become significant? For example, published ratios indicate that a sales to assets ratio of 2:1 may be the industry average. If assets are $800,000 and the sales to asset ratio is .1:1, is this significant?
The development stage company probably will have tax losses for more than one year. In selecting the useful lives of assets, inventory costing methods, and the amortization periods for organizational costs, the company may wish to minimize tax deductions in the early years. However, since net operating losses can be carried forward for 15 years, companies that are successful should ultimately be able to obtain tax benefits of the early year losses.
The CPA involved with a development stage company faces a complicated task. As noted throughout, the company frequently has many related party transactions, as well as valuation and disclosure problems. In addition, the auditor must consider near-term financial viability and carefully disclose uncertainties. In some cases, the auditor may question the company's ability to continue in business as a going concern. SAS 59, "The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern," should be consulted. If uncertainties, which are almost always present, or going concern questions exist, then an additional paragraph must be added to the auditor's report to explain the matter.
Many development stage companies do not choose to have their financial statements audited. Instead, they may seek a review or compilation. The CPA involved in an SSARS review should make sure that the scope of the work is clearly noted and that all the required disclosures are present.
The development stage company also provides many challenges. The CPA may be asked to provide services in connection with the financing of the entity, such as helping to prepare forecasts. The CPA may also help set up accounting records and systems. Though the company may have limited resources, the CPA firm cannot make its compensation for audit or review services contingent on the success of the stock offering, since this would be a violation of independence.
IMPROVING REPORTING FOR
Development stage reporting has not changed in almost 15 years. It may be time to consider improvements. First, the definition of significant revenues should be clarified. Perhaps the development stage should really be more than one stage. For example, companies could report that they are either in "pre-production" or "initial operations." The latter stage might include those that have begun selling their products, but who have not reached a break-even production level. The early production stage could be divided into more than one phase. Marketing literature suggests that there are multiple stages in a product's development.
Second, more information should be provided on these companies. In reviewing the financial statements of several development stage companies, the authors found the only comment made about the financial future of the company was in the "going concern uncertainty" paragraph of the auditor's report. This kind of information would not be present for companies that are not audited. A brief discussion in the financial statements of the stage of development and the uncertainties present would help a user's evaluation.
Forecasts of income statements and cash flows are often presented to prospective investors. Wouldn't an analysis comparing the actual to the previously forecasted information allow the investor to draw conclusions on how well the company is meeting its objectives? This could be presented as supplemental information under current standards.
A survey done by the FASB when SFAS 7 was issued found that venture capital enterprises use cash flow forecasts generated from technological, marketing, management and financial information about the company. The additional information suggested in this article would allow the small investor or creditor to do a similar analysis.
POTENTIAL PITFALLS FOR
When the financial presentation includes a forecast, the involvement of the auditor must be clearly defined. The AICPA's "Guide For Prospective Financial Statements" provides the necessary guidance. If the document is submitted by the auditor, then the auditor must have examined, compiled, or reviewed the forecast. If the forecast is included in client prepared statements then the document must note whether:
* He or she examined, compiled, or reviewed the forecast; or
* The forecast was prepared by the company and the auditor did not perform any service on the forecast.
If a second auditor is involved, then the second auditor's report must be included with the forecast. The nature of the auditor's involvement with the historical information must also be clear from the financial statements. For example, the auditor could examine the forecast, but not be involved with the historical statements. In this case the auditor must clearly indicate his or her role and note that the auditor has no responsibility for the historical statements.
The auditor should be careful to follow professional standards, because this is a high risk situation. The development stage company is using the forecast to raise capital, and there is a chance of failure.
To help the development stage company and the auditor, the checklist in Exhibit 2 identifies the unique accounting and auditing problems the development stage company faces.
Wayne G. Bremser, PhD, CPA, is a Professor of Accountancy at Villanova University. Dr. Bremser has served on the Pennsylvania Institute of CPAs' Committee on Quality Control as Chairman, and on the Committee on Report Review, and is a member of the AICPA and the AAA. He is the author of several books and numerous articles in journals including The Accounting Review, The CPA Journal and Journal of Accountancy.
Theresa P. Rollins, PhD, CPA, is an Assistant Professor of Accountancy at Villanova University. She previously worked for Ernst & Whinney and for Colonial Penn Group. Dr. Rollins is a member of the AICPA and the AAA.
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