Common Sense Accounting for Startups

Common Sense Accounting for Startups: Practical Expedients & Materiality

Accounting can often feel like a complex puzzle for startups and small businesses. Among the myriad of rules and regulations, two key concepts play a crucial role in simplifying the process: practical expedients and materiality. 

In this blog, we'll demystify these terms and show how they can help fledgling companies maintain financial accuracy without breaking the bank.

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Defining Practical Expedients and Materiality

Practical Expedients: Simplified accounting methods businesses can choose to follow when applying complex accounting standards. These shortcuts help streamline the accounting process without compromising financial integrity. 

In short: you may be able to take some shortcuts as long as everything still makes sense.

Materiality: Think of materiality as the "big picture" in accounting. It answers the question: "Would a reasonable person consider this information important when making financial decisions?" If not, it might not be worth the effort to delve into every minor detail. Materiality allows businesses to focus on significant financial information while ignoring immaterial items that wouldn't change the overall picture.

In short: don’t sweat the small stuff.

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Examples of Practical Expedients

Here are some common examples of practical expedients that startups may elect to use:

Fixed Assets: 

Componentization: Instead of breaking down a building into its individual components for depreciation purposes (e.g., roof, plumbing, electrical), a practical expedient allows startups to depreciate the building as a whole, simplifying calculations.

Capitalization Threshold: Startups can set a threshold (e.g., $5,000) below which they immediately expense asset purchases rather than capitalizing and depreciating them. This reduces the complexity of tracking smaller asset acquisitions.

Revenue:

Time of Transfer: Instead of recognizing revenue when a product ships, a business might recognize it when the customer takes possession. This practical expedient simplifies revenue recognition, especially for startups with complex shipping logistics.

Performance Obligations: Businesses are often concerned about compliance with ASC 606 and the satisfaction of specific performance obligations. Startups may chose to compare what a fully ASC 606 compliant revenue schedule looks like compared to a simpler straight line approach. If the two are materially similar, it may want to straight line the revenue as it is easier to maintain and record that way.

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Materiality:

Disclaimer: If you're unsure about how to determine materiality or want to ensure compliance with accounting standards, consider consulting with a professional accountant or financial advisor. They can provide guidance tailored to your specific circumstances.

Calculating materiality for startups involves determining a threshold below which financial discrepancies or errors are considered immaterial and don't require further investigation or correction.

Here are some simple ways for startups to calculate materiality:

Percentage of Revenue: One common approach is to calculate materiality as a percentage of your total revenue. For example, you might set a materiality threshold at 5% of annual revenue. Any discrepancies or errors below this threshold are considered immaterial.

Formula: Materiality = (Percentage Threshold) x (Annual Revenue)

Example: If your startup's annual revenue is $500,000, and you set a materiality threshold at 5%, then your materiality threshold would be $25,000.

Percentage of Assets: You can also base materiality on your total assets. Calculate a percentage of total assets and use that as your threshold. This approach is suitable if your startup has a significant asset base.

Formula: Materiality = (Percentage Threshold) x (Total Assets)

Example: If your startup's total assets are $1,000,000, and you set a materiality threshold at 2%, then your materiality threshold would be $20,000.

Fixed Amount: Alternatively, you can establish a fixed dollar amount as your materiality threshold based on what you consider significant for your business. This approach is more subjective but can work well for smaller startups.

Example: You might decide that any discrepancy or error exceeding $10,000 is considered material.

Important considerations for establishing materiality include:

• Industry Benchmarks: Consider industry-specific benchmarks for materiality. Some industries have established guidelines for materiality thresholds based on common practices and standards.
• Common Sense and Impact: Sometimes, it's practical to use common sense and assess the potential impact of discrepancies or errors. Ask yourself if a particular issue would significantly affect your decision-making or financial health. If not, it may not be material.
• Regulatory and Investor Expectations: Review regulatory requirements and investor expectations. Certain regulations or investor agreements may specify materiality thresholds that you must adhere to.

Remember that materiality is not a one-size-fits-all concept. What's material for one startup may not be material for another, depending on factors like size, industry, and business objectives. 

At the end of the day the most important things are that you:

1. Document your materiality threshold and consistently apply it in your financial reporting to maintain transparency and compliance. 
2. Document how and why you determined that threshold, so you can explain it to investors or other interested parties.
3. Periodically review and adjust your materiality threshold as your startup grows and evolves.

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Common Sense Accounting for Startups

For startups, adhering to Generally Accepted Accounting Principles (GAAP) can be a daunting task, especially when resources are limited. 

Leveraging practical expedients and incorporating materiality into your business decisions is essential. Doing so will help with the following:

Cost-Efficiency: Hiring accounting professionals or investing in complex software to handle every minor detail can be costly. Instead, startups can allocate resources where they matter most—growing the business.

Focus on Growth: Constantly worrying about small accounting nuances can divert precious time and attention away from core business activities, hindering growth.

Balancing Accuracy and Pragmatism: Striking the right balance between material accuracy and practicality is key. While accuracy is vital for decision-making, not every detail needs meticulous attention.

In conclusion, practical expedients and materiality provide startups with a pragmatic approach to accounting. By utilizing these tools, businesses can maintain financial accuracy without overspending on GAAP compliance. Remember, while it's crucial to be diligent in financial record-keeping, it's equally important to focus on the bigger picture—growing your startup.