Convergence to IFRS: impact on the IT sector - 29 May 2009

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

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