FASB Simplifies Reporting for Development Stage Entities
Author: Anne Coughlan
On June 10, 2014, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2014-10, Development Stage Entities (Topic 915), which will eliminate the definition of a development stage entity (DSE) from U.S. generally accepted accounting principles (GAAP) and remove the additional disclosure requirements for such entities. FASB also modified Accounting Standards Codification (ASC) Topic 275, Risks and Uncertainties, to clarify that entities that have not begun operation—now called DSEs—are in scope and required to make certain risk and uncertainty disclosures. The update also removed guidance in ASC 810, Consolidation, on evaluating the sufficiency of a DSE’s equity investment to determine whether it is a variable-interest entity.
DSE may be an unfamiliar term; private equity and venture capital firms commonly refer to this type of entity as “seed,” “early stage” or “pre-revenue.” Currently, a DSE is defined as an entity that devotes substantially all of its efforts to establishing a new business and has done either of the following:
- Not begun planned principal operations
- Begun planned principal operations without producing significant revenue
FASB first issued DSE requirements in 1975 to address diversity in practice as entities were using various recognition and measurement methods and different presentation formats. FASB concluded DSEs should present the same basic financial statements and apply the same recognition and measurement requirements for revenues, startup costs and other similar costs incurred that are required of established operating entities; FASB also added other presentation requirements, including cumulative information regarding income statement line items, cash flows and equity transactions.
As technology and markets have continued to evolve, some DSEs have proven to be long-lived or even perpetual. This occurs most often in the pharmaceutical, biotechnology and software sectors, where a company's primary purpose is research and development. These type of companies never get beyond the development stage, instead selling their research to other companies for development. DSEs often have various rounds of funding with complex equity instruments, e.g., warrants or preferred stock, which require voluminous inception-to-date information. Inception-to-date information in financial statements has become much less relevant today with the online availability of public filings and use of research tools such as EDGAR (the U.S. Securities and Exchange Commission's Electronic Data Gathering, Analysis and Retrieval System). Stakeholder concerns about the cost and relevance of these disclosures have led FASB to re-evaluate the original standards. FASB concluded the costs of compliance now exceed the benefits to financial statement users, leading to several changes in the ASU.
Presentation & Disclosure
This ASU eliminates all current DSE presentation and disclosure requirements. Some respondents to the exposure draft expressed concern about losing potentially important information. FASB modified ASC 275, Risks and Uncertainties, to include “activities in which the entity is currently engaged if principal operations have not commenced.” Many entities assumed ASC 275 only applied to entities generating revenues by providing a product or service in the marketplace, which is not the case for DSEs. This ASU ensures that any entity, at any stage, would be required to include a description of its intended or actual business operations. FASB included the following sample language for an entity for which planned principal operations have not commenced.
NewCompany, Inc. is a business that has not commenced planned principal operations. The company is designed to develop and manufacture specialized environmental test equipment for measuring air quality. The company’s first product is a rapid-result test kit to identify certain airborne contaminants in high-risk environments. The company’s activities since inception have consisted principally of acquiring technology patents, raising capital and performing research and development activities. The following illustrates disclosure required by this subtopic of the nature of activities for an entity that has not commenced principal operations.
NewCompany, Inc. is a business for which planned principal operations are the design, engineering and manufacturing of air quality test equipment. The company is currently conducting research and development activities to operationalize certain patented technology it owns so it can manufacture rapid-result test kits for certain airborne contaminants in high-risk environments.
During the last year, the company secured a research facility in Norwalk, Connecticut, which houses all its employees and research and development activities. The company also is in the process of raising additional equity capital to support the completion of its development activities to begin manufacturing the test kits as soon as possible.
The company’s activities are subject to significant risks and uncertainties, including failing to secure additional funding to operationalize its current technology before another company develops similar technology and test kits.
The current rules in ASC 810 for consolidation of a DSE include an evaluation of equity investment at risk to permit the DSE to finance the “activities in which it is currently engaged.” A DSE is considered to have sufficient equity at risk if that equity is sufficient to permit it to finance activities in its current phase. As a result, entities with similar equity structures may come to different conclusions about sufficient equity based on their stage of development. The ASU eliminates this clause, meaning all entities would meet the same consolidation criteria. This removes management judgment in evaluating “current activities” and would lead to more consistent consolidation decisions.
Removing the DSE exception from the sufficiency of equity at risk evaluation will cause some DSEs to be variable interest entities (VIEs), although the consolidation conclusion may not change. If a DSE is deemed to be a VIE, it would be required to complete the following tasks:
- Perform the consolidation analysis under the more complex VIE model.
- Accumulate the information needed to meet the more difficult VIE disclosure requirements, even if consolidation is not required.
- Perform the required reassessment each reporting period.
- Develop, document and test controls over these procedures.
Entities in the development stage often can't obtain traditional financing; by design, they're dependent on the subordinated financial support of equity holders until development is complete. Therefore, many DSEs already are being evaluated for potential consolidation; if not, entities should re-evaluate any current DSEs under these new guidelines. A change in the consolidation entity could potentially affect the reporting entity’s contracts, debt covenants and ability to obtain funding.
Effective Date & Transition
Inception-to-date information & disclosures – For public business entities, the ASU is effective for interim and annual periods beginning after December 15, 2014. For other entities, the effective date is for annual periods beginning after December 15, 2014, and interim and annual periods thereafter. Early application will be permitted for any annual or interim periods for which annual or interim financial statements have not yet been issued. Upon adoption, entities will no longer present or disclose any information required by Topic 915.
Changes to VIE analysis – FASB granted an extra year to implement the changes to the consolidation guidance to allow entities sufficient time to reassess consolidation decisions and accumulate data to prepare consolidated financial statements, if needed. For public business entities, the ASU is effective for interim and annual periods beginning after December 15, 2015. For other entities, the effective date is for annual periods beginning after December 15, 2016, and interim periods beginning after December 15, 2017. Early application will be permitted for any annual or interim periods for which annual or interim financial statements have not yet been issued.
For more information on how these definition changes could affect your organization’s financial reporting, contact your BKD advisor.