As emerging technology companies scale and seek additional capital through debt or equity financing, their investors may require them to complete a financial statement audit.

First-time audits are typically time-intensive and challenging for finance teams, as they will be required to prepare their company’s first set of financial statements under U.S. generally accepted accounting principles (U.S. GAAP), which generally requires companies to recast historical transactions to be U.S. GAAP compliant. Often, finance teams do not have the bandwidth or in-house technical capabilities to complete such a critical project.

Stout’s Accounting and Reporting Advisory team guides emerging technology companies through first-time audits by providing expertise in matters related to technical accounting, account reconciliations, and financial statement preparation.

Below, we highlight the various services we provided over the course of a first-time audit to an emerging technology company that provides software-as-a-service (SaaS).

Technical Accounting

We assisted the company with its accounting for revenue, compensation arrangements, debt and equity financing agreements, and internal-use software, which are typical focus areas in financial statement audits of technology companies. After we completed our work, the audit was successfully completed, and there were no errors identified.

Revenue Recognition

Auditors often identify errors in revenue recognition under ASC 606, Revenue from Contracts with Customers (ASC 606), including but not limited to improper evaluation of performance obligations, termination and renewal provisions, and transaction price. Even in cases where the revenue recognition may seem simple, such as contracts with only one product (e.g., a software license) or one service (e.g., software hosted over the cloud) sold with maintenance and support services, it is common for errors to be identified in the application of ASC 606.

We evaluated whether the company’s revenue recognition complied with ASC 606 by reviewing various types of customer contracts and understanding the technology and service promises to the customer to properly identify the performance obligations. We also performed this evaluation by assessing the termination and renewal provisions for material rights (i.e., the option to acquire additional goods or services at discount incremental to the range of discounts typically provided) and evaluating the appropriate treatment of credits and other provision in the transaction price.

Finally, we assisted in reviewing the appropriateness of recognizing revenue for the performance obligation over time versus at a point in time.

Sales Commissions

Companies that provide incentive compensation to their sales teams for booking contracts with customers should assess whether these costs should be capitalized (and subsequently amortized) or expensed in the period incurred in accordance with ASC 340-40, Other Assets and Deferred Costs (ASC 340). Typically, such costs are initially expensed, but a portion should have been capitalized and amortized over the estimated life of the customer.

Auditors generally require companies to provide an assessment of the accounting of their sales commissions, which are often complex, as they may include multiple avenues of earning compensation (e.g., new logos, upsells, renewals, etc.). This adds accounting complexity because the various commissions may not be accounted for in the same manner.

We evaluated whether the company’s commission accounting complied with ASC 340 by reviewing the commission plans and evaluating which commissions should be capitalized and which should be expensed, estimating the amounts to be capitalized, and determining the estimate life of the customer in order to amortize any commissions capitalized.

Share-Based Compensation

Companies often grant stock options to incentivize employees and consultants and allow them to participate in the upside of the company’s growth, which are accounted for in accordance with ASC 718, Share-based Payments (ASC 718). Errors are typically identified with share-based compensation, including but not limited to equity versus liability classification, incorrect grant-date and/or inputs in the calculation of the grant date fair values, and improper expense methodology and/or period over which the expense is recognized.

We evaluated whether the company’s stock option accounting complied with ASC 718 by reviewing the terms of the options granted and evaluating whether the stock options were classified as equity or liability. This required an assessment of vesting conditions and settlement terms, as well as evaluation of the expense recognition methodology based on the provisions of the awards (e.g., time-based versus performance) in addition to the expense attribution period based on the legal vesting period of the awards.

Debt Issued With Warrants

Emerging technology companies often issue debt (e.g., a term loan) with an equity sweetener (e.g., a warrant to purchase common stock) to incentivize the lender to provide financing.

Auditors generally require companies to provide an assessment of the accounting for these arrangements under ASC 480, Distinguishing Liabilities from Equity (ASC 480); ASC 815, Derivatives and Hedging (ASC 815); and ASC 470, Debt (ASC 470), which are highly complex standards. Common errors identified typically include embedded derivatives not being identified and accounted for separately on a recurring fair value basis, warrants recorded to equity instead of being accounted for as a liability at fair value on a recurring basis, and formula errors within the effective interest rate amortization schedules.

We evaluated the accounting for the debt and warrants under ASC 480, ASC 815, and ASC 470, which included documenting the key terms of the arrangements and assessing the key terms under the relevant accounting standard. Our evaluation identified that the debt and warrants were both freestanding financial instruments, the warrants met the requirements to be classified in equity, and the contingent prepayment features did not require bifurcation as embedded derivatives.

As part of this evaluation, we prepared a technical memorandum ready for the auditor’s national office to review as well as the effective interest rate amortization schedule.

SAFE Notes

There has been a recent rise in the popularity of SAFE (Simple Agreement for Future Equity) Notes issued by private technology companies to bridge cash needs until the next equity financing rounds. SAFE Notes are non-interest bearing, do not have a maturity date, and provide investors with the ability to convert the SAFE Note into equity upon a triggering event, which is usually the next equity financing round. They often include a valuation cap and/or a discounted conversion price to incentivize the investors. Additionally, investors will typically have rights to redeem the SAFE Note for a specified cash amount upon a liquidity event.

Like debt issued with warrants, auditors generally require that companies provide an assessment of the accounting for these arrangements under ASC 480 and ASC 815. In almost all cases, SAFE Notes meet the requirements to be accounted for as liabilities at fair value on a recurring basis under ASC 480. Auditors often identify SAFE Notes incorrectly recorded to equity.

We evaluated the accounting for the SAFE Notes under ASC 480, which included documenting the key terms of the arrangements and assessing the key terms under the relevant accounting standard. Our evaluation identified that the SAFE Notes should be classified as liabilities under ASC 480 and remeasured to fair value each reporting period with changes in fair value recorded to the income statement.

As part of this evaluation, we also prepared a technical memorandum ready for the auditor’s national office to review.

Internal-Use Software

Companies often spend significant costs when developing their SaaS offering. Such costs may need to be capitalized as internal-use software and amortized over the useful life in accordance with ASC 350-40, Internal-Use Software, or ASC 985-20, Costs of Software to be Sold, Leased, or Marketed (ASC 350-40).

Auditors generally require that companies perform an assessment of the costs incurred in developing their SaaS offering for capitalization under ASC 350-40. While this is not overly complex, it does take effort and, as private technology companies generally have lean accounting departments, they typically require assistance from outside parties.

We evaluated the company’s software development costs, which included understanding the nature of the costs and development timeline. Our evaluation identified the types of costs that should be capitalized and the time period those costs should be accumulated for capitalization as well as the useful life that the capitalized software should be amortized. As part of this evaluation, Stout prepared a technical memorandum for the auditors.

Account Reconciliations

Auditors may find discrepancies in account reconciliations during first-time audits if subledgers are not properly reconciled to the general ledger, or if the subledger does not reconcile to the underlying support. For example, account reconciliations related to financial instruments issued to investors (including subsequent conversions or redemptions thereof) can be challenging to reconcile if issuances, conversions, and redemptions are not timely and accurately recorded.

We assisted the company with various reconciliations, including reconciling all financial instruments issued to investors (i.e., convertible notes, SAFEs, preferred stock, common stock, stock options, and warrants) to ensure the company’s financial instruments recorded were complete and accurate, as follows:

  • We reconciled all financial instruments from the Carta capitalization tables to the underlying agreements (and vice versa), including recalculations for any financial instruments converted or redeemed to equity
  • We reorganized and adjusted the company’s equity and liability accounts so the financial instruments were appropriately presented in accordance with GAAP
  • We recorded adjustments to the company’s equity and liability accounts to ensure related debt and equity issuance costs were properly recorded and presented

Financial Statement Preparation

After all technical accounting analyses and account reconciliations have been completed, technology companies will then need to prepare a set of financial statements in compliance with GAAP. Preparing footnote disclosures for the first time can be challenging, as GAAP prescribes specific disclosure requirements for each accounting topic.

We assisted the company with the preparation of its first set of financial statements by beginning with the company’s trial balances for the period under audit and performing the following procedures:

  • We reviewed and mapped each general ledger account to the proper financial statement line item presented on the balance sheet and income statement
  • We prepared a comprehensive workbook with all adjusting journal entries identified to bridge the initial trial balance to a U.S. GAAP compliant trial balance
  • We prepared detailed calculations to support amounts stated in each financial statement disclosure, such as share-based compensation disclosure schedules, fair value and financial instruments disclosure schedules, etc.
  • We prepared the balance sheet, income statement, statement of cash flows, and statement of stockholders’ equity in compliance with U.S. GAAP
  • We prepared U.S. GAAP compliant narrative disclosures

Proactive Planning

Emerging technology companies should begin preparing for their first-year audit before the auditors begin their fieldwork. Having the technical accounting evaluation and memorandums, supporting schedules, and U.S. GAAP compliant financial statements will lead to a timelier and smoother first-time audit.