Technology firms are among the fastest growing companies in Singapore in recent years. This, in part, is due to the pace of technological innovations and disruptions across nearly every industry. It is also attributable (in no small measure) to the government’s effort to transform the country into a technology hub, and to encourage the development of various start-up ecosystems at the same time.
However, as technology companies grow, they also face several practical challenges in the application of financial reporting standards (“FRS”). In this article, we will share some of the issues we have commonly seen in technology firms.
Research and Development (“R&D”) Costs
To build brand identities and grow businesses, technology companies frequently expend resources on the acquisition or development of intangible assets, in particular intellectual property (“IP”). However, this R&D process usually entails significant expenditure from commencement of the research up until the products or services are ready for deployment or use. This brings forth the discussion as to whether these costs can be capitalised.
FRS 38 Intangible Assets states that any costs incurred from research should be expensed immediately. On the other hand, the IP arising from development shall be recognised if, and only if, certain conditions are met. Such conditions include being able to demonstrate technical feasibility of completing the intangible asset so that it will be available for use or sale; able to generate probable future economic benefits; and the availability of adequate technical, financial and other resources to complete the development and to use or sell the IP.
In other words, FRS 38 requires technology start-ups to differentiate between research and development activities. Judgement is also required to determine whether all the criteria set out in FRS 38 are met for the development costs to be capitalised; such as whether the intangible asset is able to generate probable future economic benefits. This often involves subjective assessments and forecasting of future streams of revenue.
Technology start-ups must also measure the costs incurred. On this note, a common struggle faced by such firms is the inability to maintain proper accounting records due to the lack of financial resources, which then results in the erroneous application of FRS 38.
Employee share options is a key compensation model for technology start-ups to attract and retain talent. Under FRS 102 Share-based Payment, share options offered to employees should be recognised at fair value on the date of grant. From our experience, this is an area commonly overlooked by technology start-ups because many of them are not aware of this requirement. Other practical challenges include the lack of relevant in-house expertise to perform a valuation exercise. To compound the problem, the assumptions applied in the valuation exercise is often highly judgemental because no information on comparable market price is available.
It is also common for technology start-ups to offer share options to employees without formal agreements or with agreements that do not contain sufficient details; including option grant date, exercise price, vesting conditions and other conditions concerning termination of employment. The lack of such pertinent information creates difficulties for a proper valuation exercise to be made. In many cases, the FRS 102 was therefore not complied.
Technology start-ups usually raise funds by issuing
- preference shares,
- convertible loans, and
- simple agreements for future equity (“SAFE”).
Again, these present challenges for such firms because the accounting for such instruments are generally not straightforward.
For example, preference shares come in many forms with various combinations of redemption and dividend rights, convertibility to ordinary shares, etc. Depending on the exact nature of the preference shares being issued, under FRS 32 Financial Instruments: Presentation, the classification of these shares could be either equity or liability to the issuer.
Similarly, based on our observations, many technology start-ups also do not correctly account for convertible loans. To attract investors for funds, we have witnessed different types of convertible loan arrangements made by these companies. As the name implies, a convertible loan is a “fixed-income debt security that yields interest payments, but can be converted into equity shares. The conversion from loan to equity can be done at certain times during the loan’s life and is usually at the discretion of the loan holder." (Source: https://www.investopedia.com/terms/c/convertiblebond.asp)
FRS 32 sets out how convertible loans should be classified and presented. For a start, the issuer needs to consider whether the convertible loan is a compound financial instrument that contains both a liability and an equity component. This classification as equity or debt have a significant impact on the quantum of the entity’s net equity and, consequently, an impact on its key ratios. In addition, if the conversion features are classified as derivative liabilities, these are subsequently measured at each reporting date at fair value through profit or loss, which could potentially result in significant volatility in the entity’s earnings.
Lastly, we are increasingly seeing technology start-ups entering into SAFE agreements with investors whereby, typically, an investor provides an investment to the entity that will be converted to preference shares when a qualifying capital raise event occurs in the future. It is not repayable like debt (although some agreements provide for cash repayments when there is a change of control), non-interest bearing, and no maturity date. In other words, the risks and rewards are more aligned with an equity investor, and there is a possibility that these SAFEs would never be converted. Generally, most SAFEs would be classified as liability if we go through the evaluation process under FRS 32. At the same time, due to the ability to convert into equity instruments, the conversion feature would also need to be assessed and appropriately classified.
As mentioned above, due to the complexity of the transactions, it can be challenging for technology start-ups to apply and comply with the relevant FRS. This is accentuated by the fact that most of these firms may lack the necessary financial resources and knowledge.
For enquiries on how our Technology, Media & Telecommunications team can assist you in your accounting matters, please contact us:
Partner & Industry Lead, Technology, Media & Telecommunications
T +65 6594 7876
How Ya Wen
T +65 6594 7652