The fintech sector is booming. Pre-pandemic, it was already growing rapidly and KPMG’s recent report found that the pandemic-driven lockdowns led to a much greater rate of adoption of digital finance by consumers than previously. Most product categories have benefited from the demand, including payment providers such as PayPal and Square that saw a major uptick in users over the pandemic period.
Concurrent with the expansion in consumer adoption venture capital investment in fintech has experienced significant growth over the last two years in a variety of market sectors. According to the Empire Startups report on the focus of VC funding in the fintech sector across the country New York state leads in crypto/blockchain and wealth management while California leads in payments. Trends both in product and investment growth clearly indicate crypto technologies and related consumer products are going mainstream.
It’s also becoming clearer how consumers’ attitudes have changed permanently as a result of spending and saving dynamics during the pandemic. SVB’s upcoming research report identified the next big growth as embedded finance, defined as the “integration of financial services into native software environments”, for example, mobile applications, projecting greater than $230B of additional revenues could potentially be earned by providers in 2025.
Underpinning the VC investment activity is the strong strategic marketplace for startup exits through IPO or M&A with many of the major tech brands, such as Amazon, Apple, and Google, positioning to bring financial products and services to the consumer marketplace both with in-house and acquired technology bases.
This blend of positive market indicators and established trends in consumer demand mean the fintech space will demonstrate very high growth for the next few years at least. The team at Rooled has worked with many leading fintech companies and developed key skills and knowledge around the challenges for finance teams in fintech ventures. Read on for some insights from us in handling accounting and reporting within these companies.
Challenges In Fintech Accounting
FinTech presents several unique challenges for finance and accounting teams in preparing accurate and reliable reporting. Fintechs exhibit greater complexity due mainly to the multiple asynchronous flows of funds through the various partner platforms and various models for earning revenue based on the transactions passing through the product. By comparison, SaaS and e-commerce models typically require relatively fewer sources of data to inform accounting transactions at a given stage of growth.
1. Technology platforms for financial services
The burgeoning ecosystem in the fintech sector means startups can leverage services from a wide variety of providers across banking services, deposit and savings accounts, credit and debit cards, lending solutions, crypto assets, and payment processing. Many fintechs leverage products and APIs from Plaid to link consumer banking accounts to their financial services and products. Know Your Customer (KYC) processes are critical to controlling fraud in the sector and KYC service providers such as IDology and Jumio are used frequently by startups as a component of their Anti-Money Laundering strategy.
In this manner, companies can construct an interconnected suite of services and deliver a unique product to market. This does come with consequent complexity, not only in the technical approach used for interconnecting but also in correctly accounting for the financial activity that flows through between the platforms.
2. Cash flows
Companies should document the structure of how funds flow through their specific product architecture, often referred to as the flow of funds diagram. A clearly defined and up-to-date picture of this is essential for the accounting team to translate activity into financial reporting.
Figure 2.1: Example flow of funds diagram
Resources need to be dedicated to accurate tracking and reporting of the funds flow. Each partner should provide detailed schedules listing activity and usage against the cost sheet agreed in each contract. Any revenue share should be broken out with the gross calculation and partner share. Reports should also provide balance and transaction ledgers for activity in any dedicated accounts, whether primary company or secondary customer assets. The accounting team is then equipped with the data needed to compile the company income statement and balance sheet.
Individual partners also generally require reserve funds to be held within their structure as collateral for the funds flows. Depending on the volume of transactions daily these reserve funds requirements can be considerable. Equity is a comparably expensive source of capital and fintechs can seek financing solutions from banks and sophisticated debt funds to optimize their capitalization structure for such needs.
3. Revenue Recognition
Revenue recognition will depend upon the precise business model, companies typically have multiple sources including a mix of subscription fees, per transaction fee either fixed or proportional, AUM fees, and so on. Certain platforms derive revenue from referral fees, generating income from connecting users to potential additional financial service providers. Interchange fees from card transactions, usually shared with partners based on the value chain, comprise a revenue source for many fintechs.
Fundamental in the reporting of revenue is the rigorous platform reporting and the understanding of the flow of funds.
Frequently it’s appropriate to design schedules that accept as input the native platform reporting and then merge streams and data to produce the revenue and cost outputs with balance reconciliation for posting to the accounting ledger. These schedules are essential backup for any review or audit process, and also create efficiencies when working with outsourced providers such as Rooled.
4. Handling Fraud
Unfortunately, in today’s world, fraud in the fintech sector is almost inevitable. New creators and visionaries in the space by definition seek early adopters with an emerging product and that presents ample opportunity for fraudsters to exact some benefit, despite the protections offered by KYC and AML providers. Such activity can be challenging to represent in the accounting ledger and even more so when preparing financial forecasts. Some types of fraud are relatively standard while others are based on unique exploitation of the processes in a specific company’s product. Close and continual monitoring of transactions and user activity does help to identify potential fraud before the impact becomes significant.
5. Subsidiaries and related parties – Compliance for Broker-Dealer and Registered Investment Advisors
An added facet of fintech companies is brokering investment transactions, informing consumer investors, and providing specific advisory services. Fulfilling these types of services will require the creation of additional entities, usually subsidiaries, registered with the applicable authorities. Such broker-dealer and Registered Investment Advisor (RIA) entities do require specialized governance and compliance procedures, for which sourcing an experienced compliance overseer is highly recommended.
For accounting and financial reporting these entities normally present inter-company and consolidation challenges to the finance team. Leveraging services such as Fathom, if using QuickBooks, or NetSuite’s One World platform will definitely improve efficiencies and make accounting workflows much more robust.
Evolution in fintech consumer products will clearly continue apace sustaining the current growth rate in investment and market opportunity over the next number of years. The challenges for finance and accounting teams in handling the reporting and compliance will continue to grow. At the same time, disruption in the finance tech stack will see much greater efficiencies and capabilities to help deal with these challenges. It’s a very exciting time for fintech and the finance sector in general. Get in contact with us at Rooled to see how we can help.
About The Author
Johnnie Walker is co-Founder of Rooled, which provides outsourced accounting, fractional CFO, and tax services to venture-backed and high-growth companies.
Johnnie was previously VP Sales with inDinero, providing fully outsourced accounting solutions to start-up, emerging high-growth, and established companies where he led sales and BD activities nationwide for the company. Previously, at tempCFO, Johnnie led the East Coast office and provided strategic CFO advisory services to technology ventures and other businesses.
Johnnie is also an Adjunct Associate Professor in impact investing at Columbia Business School also advises several startup businesses, focusing on financial management and investment strategy. Educated in business and engineering, Johnnie has held senior roles in the defense electronics industry, venture capital, and non-profit sectors.
You can connect with him on Linkedin here.