Understanding the difference between UK and US accounting standards in the event of a tech business sale
Read time: 6 mins
Dave Butcher is a BDO partner with a specific focus on the Anglo-US tech market.
As a private UK company, you can choose which accounting standard you follow – IFRS or UK GAAP – in presenting your financial information. But, as Dave explains, it’s a decision you need to make early on in your business journey, and one which will be informed in large part by where you see the future of the business and what your plans are...
So, what’s the difference between UK GAAP, US GAAP and IFRS?
US GAAP (Generally Accepted Accounting Principles) are the accounting principles, standards and procedures that have to be observed by companies in the US when compiling their financial information.
IFRS (International Financial Reporting Standards) are the international equivalent of US GAAP.
UK has its own GAAP which, though it closely follows IFRS and is likely to be fully supplanted by it eventually, still differs from it in some key aspects.
Are the standards basically the same thing?
In essence, they share the same aims and have the same authoritative weight; they make it easier for investors to extract key financial information and make accurate comparisons between companies.
US GAAP and IFRS have been working on convergence for several years, with significant progress. For example, non-US companies that are registered in the States are generally no longer required to reconcile their financial reports with GAAP if their accounts are already IFRS-compliant.
But whilst the general requirements of financial reporting in the UK are broadly consistent with the requirements in the US, particularly with the introduction of the new revenue and leasing standards that are now applicable in both markets, there are still some differences, particularly in the interpretation of the accounting rules and regulations in both markets.
One difference is that development costs are more commonly recognised as an expense under US GAAP, whereas under IFRS these costs must be capitalised and gradually written off over several accounting periods (for more on this, see below).
But the key difference – and where the real challenge for complete harmonisation lies – is more philosophical. UK GAAP and IFRS generally come from a principles-based background, whereas US GAAP comes from a rules-based background. So whilst the standards are converging in theory, variations remain in practice because the standard setters and market participants are coming from two very different trains of thought. One area where this is very evident is revenue recognition.
How does this difference apply on the issue of revenue recognition?
Historically, revenue recognition under US GAAP has been extremely rules-based, particularly in the software space. The adoption of ASC 606, which is the new US GAAP revenue standard, and the issue of IRFS 15, which is the new international accounting standard for revenue, were intended to be a converged standard, so that there would be no difference between US GAAP and IFRS.
However, whilst the narrative is consistent, the interpretation of those rules can still be very different in the US environment compared to the IFRS environment. This is probably the biggest difference for a tech business to be aware of, because if you’re a UK business looking to be acquired by a potential US investor or US corporate private equity, you’ll find that they will approach this with a very US-focused revenue-recognition thought process, which is still very rules-based, and could mean that you end up with a very different revenue recognition profile to that which you had expected and accounted for.
As a UK business, do I have a choice which standard I use?
As a private UK company, you have a choice between UK GAAP and IFRS; most private UK businesses adopt UK GAAP. If you are a public UK company, however, you're required to adopt IFRS.
How do I decide?
Considerations as to whether you, as a tech business, opt to follow IFRS instead of UK GAAP depend in large part on where you see the future of the business, and what your plans are. If you are targeting a UK public offering or a UK IPO rather than selling out to a US investor or US IPO, then IFRS would be the way to go because that’s what’s required in the UK public market.
Otherwise, there’s generally no strong reason for UK private businesses to adopt IFRS. It’s more onerous in terms of its requirements and its disclosure than UK GAAP, which means an additional compliance cost to the business that it may well not need.
But what if I’m looking to the US for investment or an exit?
The challenge indeed comes when the US comes knocking or if you’re looking across the Atlantic, because there are in practice some differences in interpretation of GAAP between the US and the UK, which will impact on some of your presentations in your financial statements.
"For example, in the UK market, whether you’re applying IFRS or UK GAAP it has some bearing as to what your financial statements will look like. "
A US business looking to acquire a UK business will understand an IFRS set of financial statements better than they will a UK GAAP set of financial statements, because of the greater volume of disclosure that’s required by the IFRS standard and the similarities to US GAAP.
Another big area for tech businesses is the amount of time they spend on research and development of their product. In the UK market, whilst there’s a choice under UK GAAP whether you capitalise the development costs, under IFRS there’s no choice. If you meet some of the criteria, you must capitalise the cost.
So how might that work in practice?
Let’s say you’ve got a development team in the Ukraine that’s working on an app for you. Part of their time will be spent researching – thinking hard about what the next iteration of the app will be, for example. The rest of their time – probably the majority – they’ll spend developing, writing code, testing and actually creating the app or piece of software.
Now the salary or consultancy costs of undertaking that development – not the research phase but the development phase – are a cost to the business: physically, you have to pay money out as a business, either via payroll or to a consultancy firm or individual suppliers.
So, you might decide that all that cost related to the developers relates to development, and you can demonstrate that they meet some of the technical requirements (under IAS 38 or FRS 102). That means that, instead of recording those costs as a cost in the income statement, you can record them as an intangible asset on their balance sheet.
What’s the benefit of capitalising more development cost?
Having this cost as an intangible asset on the balance sheets means that it can be amortised – effectively released to the income statement over a longer period of time. Typically, those costs might be released to the P&L over anywhere between three and five years.
The obvious benefit is the improved EBITDA. If you incur £1million worth of development costs in year one, but only have to declare £250,000 on the income statement every year for four years (rather than taking the whole hit up front), you can significantly inflate your EBITDA number, or your profit, which is obviously an advantage when presenting to investors.
Now every investor in a tech business is going to expect that company to be undertaking development. Otherwise, what's the point of being a tech company? In the UK market, it’s common practice to capitalise at least an element of those costs on the balance sheet because all of the publicity around transactions, especially in the tech space, is about the multiple. So inflating the EBITDA that is disclosed to investors, or in your financial statements, provides better optics for the business.
In the US market, on the other hand, that’s not really possible. Whilst the requirements look the same on paper between IFRS and US GAAP, the interpretation of the rules for the latter is a lot stricter. Because the bar is set a lot higher, a US tech business would generally write off development costs through the income statement as incurred, rather than capitalise anything.
Can a business follow more than one standard at the same time?
Not from a statutory financial reporting perspective. For your publicly available financial statements in the UK, you have to choose either UK GAAP or IFRS.
But from a management reporting perspective, absolutely, yes. You could run in the background a constant report looking at the impact of US GAAP on your numbers, or comparing revenue under US GAAP versus revenue under UK GAAP, especially if the involvement of US investment is already on your radar.
The key of course is to address this issue well in advance and take professional advice from a partner who understands both markets. Running the numbers concurrently in the background is a lot less onerous than suddenly having to change horses in midstream and remodel everything for US reporting.
"As always, thinking ahead about the business roadmap is key, to ensure that you avoid the classic tech mistake of not looking early enough at going international. "
Otherwise, you could find yourself with US due diligence and lawyers coming down on you in the middle of a transaction or funding negotiation, and asking all sorts of difficult questions. If you don’t have an understanding of where they’re coming from, there’s a big risk that you will lose a lot of value on the transaction.
So, the key points to bear in mind are to think ahead and seek advice?
Absolutely. This is a conversation we have with all our clients. Because that’s what you really need to prepare yourself for. Any tech scale-up can, within reason, throw together a set of UK GAAP financial statements that are just about compliant to be filed with Company’s House.
But that’s just a compliance piece; this is about business strategy. It’s about asking: Where do you want the business to be in two, three, five years’ time? What do you need to do to get there, to get the best value for the business at that point in time? And one of the key aspects of that will be your financial reporting and accounting policies, and how they move over that period of time. How do you develop them now such that there’s no erosion of value on a transaction event at that point in time?
How about where a UK business is looking to make a US acquisition?
In that case, you would want to harmonise standards across your group. Bear in mind that the US reporting requirements are a lot less onerous than they are in the UK for a private company. For example, you’re only required to file annual audited financial statements in the US if you are a public company. If you are a private company, there's no statutory requirement to prepare and/or have audited annual financial statements of the business.
So you can get some very, very big businesses that don’t have to have an audit. This can mean some quite onerous catching-up where a US private company suddenly decides to start looking to be acquired or invested in internationally. Again, the obvious way to de-risk that and future-proof the business would be to put that reporting in place from the outset, even if it’s not required domestically, because you know that future investors will want to see audited numbers.
For the same reason, if you’re a UK tech business looking to acquire a US business to bolt onto your group, the cost of financial due diligence for you will be a lot higher than if you had acquired, say, a business in Germany where they were required to have an audit and you can place some reliance on the local audit work.
Are you preparing your tech business for an international sale? Get in touch to find out more about the key accounting principles to be aware of by emailing [email protected].
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