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With the decibel level increasing on the IFRS (International Financial Reporting Standards) front, a natural anxiety among investors is about how the adoption of global norms will impact the different sectors. Thankfully, there are no industry specific standards under IFRS, observes N. Venkatram, IFRS Country Leader, Deloitte Haskins & Sells, Mumbai.
"The effect of adopting IFRS will depend on each individual organisation's circumstances and business practices. That being said, changing to IFRS may affect certain industries more than others," he adds, during the course of a recent telephonic interaction with Business Line.
Excerpts from the interview in which Venkat looks at what the new reporting framework may portend for a few sectors.
Technology, media and telecommunications (TMT) sectors.
The impact of IFRS on the TMT sectors, mainly in the area of revenue recognition, is expected to be high.
These industries usually have a high incidence of what is known as bundled transactions or multiple deliverable arrangements. A common example would be in the mobile segment where packages offered to end users include provision of handsets either at a subsidised rate or free of cost, pre-paid minutes, free SMS, discounts, special offers and other incentives.
In these cases it may be necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. The decision to account for a transaction in its entirety or unbundle the product into its individual components can have a significant impact on an operator's financial statements.
For instance, separating handset revenues from ongoing service may result in increased revenue upfront but there may also be instances where separating a contract into components may defer revenue recognition.
The accounting treatment for indefeasible rights of use (IRU) in the telecom sector will have to be determined by the commercial substance of each individual arrangement. When determining the appropriate accounting for IRUs under IFRS, it will be necessary to first consider whether the arrangement is, or contains, a lease in the light of the provisions of IFRIC 4.
If it is considered a lease, then the appropriate accounting will be determined in accordance with IAS 17. If not considered a lease, it will have to be ascertained whether the arrangement constitutes the sale of goods or the rendering of services. Accordingly the relevant part of IAS 18 will have to be applied to determine the appropriate accounting of revenue.
The media sector could be impacted by the application of SIC-31, Revenue - Barter Transactions Involving Advertising Services, which deals with the circumstances where an entity enters into a barter transaction to provide advertising services in exchange for receiving advertising services from its customer.
Real estate sector.
The realty sector would also be affected due to the provisions of IAS 40 which allow investment property to be measured at cost or using the fair value model with changes in fair value being recognised in profit or loss for the period. Accounting investment properties at fair values can lead to a great deal of volatility in the income statement as well as balance sheet.
Agreements for the construction of real estate take diverse forms - some agreements are for the provision of construction services, others are in substance for the delivery of goods (e.g. housing units) that are not complete at the time of entering into the agreement.
Thus, the percentage of completion method is appropriate for some agreements for the construction of real estate, but for others revenue should be recognised only at the point that the constructed real estate is delivered to the customer.
IFRIC 15 Agreements for the Construction of Real Estate addresses whether an agreement is within the scope of IAS 11 or IAS 18, and when revenue from the construction of real estate should be recognised.
An agreement for the construction of real estate will meet the definition of a construction contract when the buyer is able to specify the major structural elements of the design of the real estate before construction begins; and/or specify major structural changes once construction is in progress.
In contrast, if buyers have only limited ability to influence the design (for example, to select from a range of entity-specified options, or to specify only minor variations to the basic design), the agreement will be for the sale of goods, and be within the scope of IAS 18. Application of IFRIC 15 is expected to have an impact on the timing of revenue recognition for most realty firms.
For infrastructure firms, the application of IFRIC 12, Service Concession Arrangements, could change the way revenues are accounted for. A typical arrangement is a 'build-operate-transfer' arrangement where an operator constructs the infrastructure to be used to provide a public service and operates and maintains that infrastructure for a specified period of time. The operator is paid for its services over the period of the arrangement.
The infrastructure within the scope of IFRIC 12 is not recognised as property, plant and equipment of the operator. This is because the operator does not have the right to control the asset, but merely has access to the infrastructure in order to provide the public service in accordance with the terms specified in the contract.
It is also not treated as a lease as the operator does not have the right to control the use of the asset. Instead, the operator's right to consideration is recorded as a financial asset, an intangible asset or a combination of the two.
The banking industry will also be affected with an impact expected on the capital adequacy ratio. At the highest level, Indian banks, being subject to the RBI's rules-based accounting would require to move towards principles-based accounting of IFRS.
This distinction may prove more vexing than it initially appears, because most accounting and finance professionals in India have been used to the rules of the RBI. The overriding lesson from their years of study and work is this: If you have an issue, look up to the RBI. On the other hand, IFRS is a far shorter volume of principles-based standards, and consequently requires more judgment than Indian accountants are accustomed to.
With less than a year to go before Indian financial statements sync with IFRS (International Financial Reporting Standards), it may be about time for the investing community to also understand the impact of the changes to the earnings of their favourite companies and sectors. Here is N. Venkatram, IFRS Country Leader, Deloitte Haskins & Sells, Mumbai, taking us through some of the implications of the change.
Excerpts from the interview:
What are the areas in a profit and loss account that an investor may have to watch for changes after IFRS comes in to play?
Comprehensive income: The profit and loss account is going to look very different under IFRS. IAS 1 requires that all items of income and expense be presented either in a single statement - a 'statement of comprehensive income'; or in two statements - a separate 'income statement' and a second statement beginning with profit and loss and displaying components of other comprehensive income - 'a statement of comprehensive income.'
Currently, in India, there is no concept of other comprehensive income. Under IFRS, an entity is permitted to classify expenses based on function or on nature, whichever provides information that is reliable and more relevant. Entities classifying expenses by function are required to disclose certain additional information on the nature of expenses. In India, Schedule VI requires an analysis of expenses by nature.
Financial instruments: In the area of 'financial instruments,' you are likely to see major profit and loss impact. Gains and losses arising from derivatives that are not designated as hedging instruments are included in the profit or loss for the period leading to a great deal of volatility in the income statement and drastically changing the reported profit number.
IFRS is likely to restrict the de-recognition of financial assets, which means that fewer gains will be recognised upfront. Investment properties measured using the fair value model will also require changes in fair value to be recognised in the profit or loss.
IFRS has more detailed guidance on revenue recognition; hence there could be a difference in the revenue reported under Indian GAAP and IFRS.
Prior period items: Prior period items are also accounted differently under IFRS, with material prior period items being corrected retrospectively by restating the comparative amounts for prior periods presented in which the error occurred or if the error occurred before the earliest period presented, restating the opening balances of assets, liabilities and equity for the earliest prior period presented. Under Indian GAAP, prior period items are normally included in the determination of net profit or loss of the period in which the error is discovered with a separate disclosure so that its impact on the current profit or loss can be perceived.
Depreciation: Even the depreciation charge under IFRS, based on the component approach and the estimated useful life of an asset, could be quite different than that currently reported under Indian GAAP using the rates specified in Schedule XIV to the Companies Act, 1956.
Deferred taxation, share-based payments: Since the concept of "temporary differences" under IFRS is much wider than the concept of "timing" difference under Indian GAAP, even the deferred tax numbers will be different.
The accounting for share-based payments under IFRS 2 which covers share-based payments both for employees and non-employees could also impact the profit for the period as the use of the intrinsic value for determining the costs of benefits is prohibited under IFRS.
The conversion to IFRS may also change the components and calculation of finance charges and finance income.
Consolidation, JV: In the consolidated financial statements, the inclusion of assets and liabilities at fair values on the date of the business combination will change the related depreciation charge. Recognition of bargain purchases in the income statement will enhance the profit for the year under IFRS.
Also, if instead of using the proportionate consolidation method, the equity method is used for accounting for an interest in a joint venture (JV) under IFRS, the revenue and cost figures reported under Indian GAAP would undergo a change, thereby creating a perception that the volume of business has reduced which is not actually the case.
Would valuation of inventory undergo a change?
There are no significant differences between the Indian Standard and IAS 2. Use of same cost formula for inventories having similar nature and use under IFRS may have some impact on inventory valuation.
For inventories purchased on deferred settlement terms, the difference between the purchase price of inventories for normal credit terms and the amount paid for deferred settlement terms is recognised as interest expense over the period of financing under IFRS.
How will asset valuation be impacted?
IFRS requires greater use of fair values in financial reporting on the ground that fair values are more relevant to users of financial statements than historical costs.
After recognition as an asset, an item of property, plant and equipment can be carried at its cost less any accumulated depreciation and any accumulated impairment losses; or property, plant and equipment whose fair value can be measured reliably can be carried at a re-valued amount, being its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses.
Increases or decreases in an asset's carrying amount as a result of a revaluation are usually recognised in other comprehensive income and accumulated in equity under the heading of revaluation surplus.
Investment properties can be measured using the cost or the fair value model, with changes in fair value recognised in the profit or loss. The extensive use of fair values especially in relation to property, plant and equipment and investment properties may increase the value of net assets.
Under IAS 39, financial assets are classified as fair value through profit or loss, held-to-maturity, loans and receivables or available-for-sale. (Note that these categories will change once IFRS 9 is adopted by an entity).
Held-to-maturity investments and loans and receivables are measured at amortised cost using the effective interest method. Investments classified as fair value through profit and loss are carried at fair value with changes in value being recognised in profit and loss. Gain or loss due to changes in fair value of available-for-sale investments are recognised in other comprehensive income.
Even a non-current asset (or disposal group) classified as held for sale will have to be measured at the lower of its carrying amount and fair value less costs to sell under IFRS. Derivatives (which can be assets or liabilities) will have to be carried at fair value on the balance sheet at each reporting date, thereby leading be to a high degree of volatility in net assets.
Would the current AS-11 (on effects of changes in foreign exchange rates) and AS-30 (accounting for financial instruments used for hedging cash flows) undergo significant changes once IFRS is adopted?
Under Indian GAAP, AS-11 currently deals only with foreign currency forward exchange contracts. There is no standard which deals with other types of derivative instruments. Under IFRS, the accounting for all derivatives is covered by IAS 39. After AS-30 becomes effective, this difference between Indian GAAP and IFRS will cease to exist.
In November 2009 the IASB issued chapters of IFRS 9 relating to the classification and measurement of financial assets. The IASB intends that IFRS 9 will ultimately replace IAS 39 in its entirety. When that happens, AS-30 too will have to be replaced.
Convergence to IFRS: impact on the IT sector
The transition to International Financial Reporting Standards (IFRS) is all set to impact the revenue top-line being reported by IT companies
India Inc is all set to converge with International Financial Reporting Standards (IFRS), effective April 1, 2011, and since comparatives are required, the opening IFRS bell will ring on April 1, 2010. IFRS is a very different accounting framework since it focuses more on substance and is largely fair value driven, which is a significant departure from the current accounting milieu.
All key industries will get impacted and financial results may vary considerably on transition to IFRS. The good aspect about IFRS is that it is cognizant of the concerns that preparers and users of financial statements have and is trying to bridge the gap with US GAAP so that the world can finally be on a common accounting platform. Just as technology is constantly evolving, so is IFRS. Here we will examine a few areas that will majorly impact information technology companies.
First and foremost, IFRS may have a significant impact on the revenue top-line being reported by technology companies. Technology companies enter into lump sum contracts for sale of licenses, implementation fees, warranty, maintenance and free upgrade services, etc., over a period of time.
Under IFRS, a key issue will be to determine whether the components of a single transaction can be separated from an obligations performance standpoint i.e. from a technical and commercial perspective. In such instances, bundled contracts and multiple offerings under a package will require fair valuation of different components and revenues would be recognized accordingly. Indian GAAP does not provide any specific guidance on this and, therefore, inconsistent practices are presently being followed by various companies. Some companies defer the revenue recognition till the entire project is completed. Other companies recognize revenues and provide for costs associated with pending post-sale contractual obligations. Very recently, the research committee of the ICAI has come out with a technical guide on revenue recognition for software companies, which is very similar to SOP 97-2 followed in US GAAP. However, this is not a notified accounting literature under Indian GAAP and companies may not be required to follow it mandatorily.
The other area where IT companies will get impacted is stock options. Under IFRS 2, share-based payments cover non-employees also. If certain non-employee obligations are settled through ESOP, IFRS will require fair value accounting for such options and cost differential between grant price and fair value will have to be recognized. Moreover, subsidiaries will need to account for the ESOP costs for options granted to its employees by the parent company, with corresponding impact in capital contribution by the parent as per requirement of IFRIC 11. This is likely to have a major impact in the case of many IT multinational subsidiaries operating in India, since many of their senior executives are given stock options in the parent company listed in the US/global markets, and where such accounting was not required under Indian GAAP so far.
Another key aspect is that Indian GAAP allows intrinsic method of accounting, in which case the ESOP cost is generally lower since it only takes into account the value of option as at the date of its grant and does not capture the likely accretion in fair value over the entire vesting period. Share based payment costs are expected to increase on application of the IFRS, which will eat into the profitability of IT companies.
Large outsourcing contracts are quite common in the IT sector. Often a significant part of the capacity is being utilized by a specific customer or facilities may be specifically earmarked to cater to the needs of a particular client. Usually in such cases, the pricing of the contract is also agreed on special terms, keeping in mind the costs incurred by the IT company in providing such services. In such scenarios, one will have to evaluate whether provision/receipt of services constitutes or contains a lease arrangement under IFRIC 4. Financial statements would change quite significantly if it is determined that such transactions contain an element of lease, particularly if they satisfy the criteria for a finance lease. Under Indian GAAP, such arrangements are normally considered as those for providing services and not a leasing activity.
IFRS entails discounting of future receivables and payables to their current values using expected interest rates. The application of 'time value of money' concept will have impact on the amounts recorded for long-term security deposits, payables falling due after one year and revenues earned in advance for long-term contracts/ arrangements. Imputed interest amounts will also have an impact on profits reported by IT companies.
Last but not the least, large companies with active treasury operations will also have to comply with IAS 39 on financial instruments, particularly with regard to accounting for derivatives. Under IFRS, hedge accounting is permitted for such transactions provided entities have robust documentation and certain conditions are met. Thus, entities will have to put in necessary process in place to satisfy requirements of IAS 39. Most IT companies have huge exposure to currency movements, so they will need to make immediate preparations for the advent of IFRS and start putting in place systems and processes for derivatives (including embedded ones), as well as hedge accounting.
In summary, convergence to IFRS is not a mere accounting exercise and will have significant business implications. Hence, companies would augur well to start preparing early and not wait for the last moment to rush to converge.
Navin Agrawal is Director, Ernst & Young India Private Limited. The views expressed herein are the personal views of the author and do not necessarily represent the views of Ernst & Young Global or any of its member firms.