Tech Views

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

Navin Agrawal

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.