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Based on recommendations from the Private Company Council in July 2013, the Financial Accounting Standards Board issued proposed updates that will improve financial reporting requirements for development stage entities. The proposed changes will apply to the financial reporting complexities for both public and private organizations in the development stage.
A development stage entity represents an organization or company that devotes most of its efforts towards establishing a new business. Primary operations planned for the entity either have not started or have yet to produce significant revenue. These are the development stage entities – whether public or private – that will be affected by FASB recommendations.
What Prompted FASB to Propose Financial Reporting Improvements?
There is a reason FASB thought it was necessary to improve the financial reporting requirement. The primary objective for the Board issuing proposed updates is primarily to reduce the complexity and cost that development stage entities experience with incremental reporting requirements. Currently, established operating organizations and development stage entities have the same requirements based on Generally Accepted Accounting Principles in the U.S.
Both operating organizations and development stage entities must present the same basic financial statements. Additionally, measurement and recognition for revenues, startup costs and similar operational costs incurred are the same for both groups. In addition to these requirements, public and private development stage entities must present information regarding inception-to-date income statement line items, equity transactions and cash flows.
While FASB believes that these changes will help, some users of development stage entity financial statements do not believe the changes will make a significant difference. They explain that distinguishing these entities from established organizations does not produce information that helps with decision-making.
Furthermore, many believe that inception-to-date information and other disclosures required in the financial statements also include information of little relevance. Generally, this is due to multiple products that many development stages entities have under development. Most hardly manufacture a single product and might sell research and development of products to another business.
Common areas where development stage entities exist are technology, biotechnology and pharmaceutical industries. It is not uncommon for firms within these entity groups to remain in the development stage for many years. For some, they could remain in the developing stage into perpetuity.
Technology Eliminates Outdated Practices
Nevertheless, a review of current requirements by FASB revealed that many practices are outdated for the current environment. Much has changes since the mid 1970s and technology, along with biotechnology and pharmaceutical sectors has evolved with those changes.
Because the primary purpose of many companies in these sectors is research and development, most might never last beyond the development stage. In general, these entities are structured by various rounds of funding that have complex equity requirements. Preferred stock or warrants are good examples of the types of equity instruments that development stage entities may use, which require a huge amount of inception-to-date information.
As inception-to-date information continues to become less relevant today than in the past, financial statements are handled differently. Research tools such as the EDGAR system and the availability of online public filings has made inception-to-date all but obsolete for development stage entities.
Concerns from stakeholders prompted FASB to reevaluate the outdated practices. The conclusion of the review is to eliminate inception-to-date disclosures. Costs of compliance exceed the benefits to users, even though some financial statement users disagree with these findings.
Main Provisions of the Proposed Standards
There are a few other provisions in the proposed standards. First, the updated standards would eliminate the distinction of how a development stage entity is defined. Second, related disclosure requirements within GAAP for the U.S. will also be abolished. The purpose of this is to address stakeholder concerns and the relevancy for spending resources to present additional requirements.
For development stage entities with multiple products under development, financial reporting requirements would also change. These entities exist primarily to research and develop certain products. Since they would sell the information to another business for manufacturing purposes, their financial statements would not meet the requirements for current standards.
Although some users disagree with the significance that these changes will make, FASB believes entities will benefit. There will be a reduction in data maintenance and audit costs since entities will no longer need to report inception-to-date information in cash flow statements, income and shareholder equity. Additionally, the proposed changes should help to simplify the consolidation accounting guidance within technology, biotechnology and pharmaceutical industries.
The Board also proposes that development stage entities provide a description of the activities applicable to the entity. During the first year that the development stage entity ceases to exist, it must disclose that previous years of existence was in the development stage. The goal of these proposed amendments is to save reporting costs without reducing the level of relevant information in financial statements.
Effective Date of Amendments
A firm date for the amendments has not been set. Based on the proposal, amendments would become effective in the interim and annual periods of the effective date once they are approved. However, early adoption of the amendments will be permitted even as the Board considers feedback.
Comparison to International Financial Reporting Standards
Comparisons are already being made to provisions in the International Financial Reporting Standards. At this time, IFRS does not have a conceptual distinction of a development stage entity. Therefore, guidance on presentation of financial statements or disclosures for development stage entities is not provided. The acceptance of the proposed updates would actually narrow the differences between IFRS and U.S. GAAP.
FASB Hopeful for Improvements
Although the current proposal by FASB comes as a result of PCC recommendations, improvements are widely anticipated by the Board. Public and private development stage entities can expect improvements that closely mirror their financial reporting needs. Therefore, the Board welcomed feedback from all stakeholders through December 23, 2013, to make sure different perspectives were considered.
Stakeholders were asked to provide input on the proposed update to reporting requirements. Essentially, the Board wanted to know whether the stakeholders agreed with the proposed amendments. If there was disagreement, stakeholders were asked to detail why the proposed amendments would not work. Additionally, the Board wanted suggestions on what would be a better approach.
If stakeholders did not believe that substantive changes would result in the amendments, they were expected to offer an explanation for consideration. The Board wanted to know if consolidating some of the amendments would work better. Information that was previously required included in the proposal for elimination was given careful consideration. Anything that potential and current investors would find useful was expected to remain.
There was other feedback that the Board expected from stakeholders. For instance, they wanted to know if the proposed amendments would lead to substantive changes in the way other existing guidance was applied. Perhaps some amendments would require transition provisions until development stage entities had fully adapted to the new requirements. Additionally, some of the proposed amendments might require special consideration for nonpublic entities.
In the end, FASB remains hopeful that results from the proposed changes will improve – rather than hinder – financial reporting requirements for development stage entities. The objective of financial reporting for any type of entity is to provide useful information for investors, creditors, potential investors, donors and any capital market participant that makes decisions about resource allocations. Credible information will help with making those decisions, which will ultimately benefit all parties that are involved.