Impact of IFRS on the telecom sector : Dialling a new reporting framework

As Indian companies get poised to converge with IFRS
commencing April 1, 2011, one of the industries which will witness significant
changes in the financial statements is the telecom industry. This article seeks
to discuss these changes and their related impact in greater detail.

Presently in India, revenue recognition is governed by the
principles outlined in AS-9 ‘Revenue Recognition’. The corresponding standard
under IFRS — IAS 18 ‘Revenue’ along with related IFRICs serve as the required
starting point for developing accounting policies, even if they are not
necessarily specific to the telecom sector. The key changes from the present
accounting practices with respect to revenue recognition are as follows :

Telecom companies often offer customers bundled products,
which involve multiple components such as sale of equipment when the customer
signs up for a service contract. A typical example of this would be the schemes
where companies offer mobile handsets, modems, set top boxes, etc. (either at
full price or subsidised prices or at no separate price) when the customer signs
up for the respective services.

Under IFRS, IAS 18 has detailed guidance for identification
of arrangements having more than one component and their consequent separation
for the purposes of revenue recognition. Due to limited guidance available under
Indian GAAP for the same, entities presently account for such arrangements based
on their legal form and not based on the substance of such transactions.

IAS 18 requires that two or more transactions be considered a
single arrangement “when they are linked in such a way that the commercial
effect cannot be understood without reference to the series of transactions as a
whole.”

Having identified the transactions which are part of a single
arrangement, the standard requires entities to identify the various components
of the arrangement and account for the respective component based on the
applicable revenue recognition criteria.

For the purposes of separation of components the following
criteria is required to be fulfilled :

There is no specific guidance in IAS 18 for allocation of the
overall consideration to the respective components. However, based on the
guidance available in IFRIC 13 revenue could be allocated to components using
either of the following methods :

Using the relative fair values, the total consideration is
allocated to the different components based on the ratio of the fair value of
the components relative to each other. Using the residual method, the
undelivered components are measured at fair value and the remainder of the
consideration is allocated to the delivered components.

Telecom companies generally charge less for deliverables in a
bundled arrangement than they charge for each component separately. The relative
fair value method allocates this discount across all separately identifiable
components while the residual method would result in allocation of the discount
to undelivered components.

Telecom companies generally offer customers bonus talktime
without any additional revenue for the same. Presently under Indian GAAP,
revenue recognition is based on actual utilisation of talktime by the customer
with no revenue being recognised while the bonus talktime is being used. Under
IFRS, revenue recognition per minute is to be adjusted for the impact of the
bonus talktime (after considering the impact of forfeiture).

For example, Telecom T runs a promotion for its prepaid
telecom base. A customer purchasing a standard prepaid card for Rs.50 normally
would receive 100 minutes of calling time. However, during the promotion the
customer receives an additional 20 bonus minutes.

The revenue per minute of airtime is Rs.0.42 (50/120).
Therefore T will recognise revenue of Rs. 0.42 for every minute of airtime used
by the customer assuming that the customer shall use the bonus minutes entirely.

Activation revenue is normally collected from customers at
the point of their entry into the network. Accounting practices under Indian
GAAP varies with some companies recognising the activation revenue upfront,
while others recognising it over the expected life of the customer on the
network.

Under IFRS, such revenue is recognised over the expected life
of the customer and is not permitted to be recognised upfront.

Telecom companies often offer customer loyalty points for
amounts spent on airtime and a customer can redeem those points for money off
their monthly bill or obtain a handset upgrade. Presently under Indian GAAP, due
to limited guidance telecom companies do not defer any revenue on account of the
loyalty points.

IFRIC 13 provides specific guidance with respect to
accounting for customer loyalty programs with the following features:

In addition to loyalty points offered by telecom companies,
IFRIC 13 would cover a wide range of sales incentives that might include, for
example, vouchers, coupons and discounts or renewals.

In summary, IFRIC 13 requires revenue to be deferred to account for an entity’s future obligation in respect of loyalty programs awarded. Recognition of revenue in accordance with IFRIC 13 would require allocation of revenue to award credits. Allocation of revenue is to be based on either relative fair value method or fair value of the award credits (i.e., residual value method). In estimating the fair value credits the telecom company is required to consider the following:

Revenue from award credits is recognised as the telecom company fulfils its obligations to provide the free or discounted goods or services or as the obligation lapses.

Gross v. net presentation of revenue:

IAS 18 provides specific guidance for determination of gross or net presentation of revenue. For example, arrangement with respect to content available for downloads, involve the telecom companies earning a commission based on user access to the content. Typically such arrangements do not result in the telecom companies acquiring content rights. Accordingly, an assessment shall be required to be performed for gross v. net presentation based on the specific features of the arrangements.

Capacity transactions:

Telecom companies often enter into arrangements whereby they convey to other telecom companies ‘the right to use’ equipment, fibres or capacity (bandwidth) for an agreed period of time, in return for a payment or a series of payments. In relation to such capacity transactions, the telecom companies can be either providers (sellers) or customers or both. The capacity sellers usually retain the ownership of the network assets and convey the ‘right to use’ the asset to the customer for an agreed period of time. An agreement that conveys the exclusive right to use is generally referred to as ‘indefeasible right of use’ (IRU) in the telecom industry.

IRU contracts may not be described explicitly as lease contracts, but what matters is the substance of the agreement, which should be evaluated to determine whether the arrangement constitutes a lease. The analysis is based on the requirements of IFRIC 4 and accordingly based on the fulfilment of the following conditions:

For the purpose of determining whether the arrangement conveys a right of use for specified assets, the telecom companies shall be required to assess whether:

(a)    the customer has the ability or right to operate the asset (including to direct how others should operate the asset), and at the same time obtain or control more than an insignificant amount of the asset’s output;

(b)    the customer has the ability to control physical access to the asset while obtaining more than an insignificant amount of the asset’s output;

(c)    the possibility of another party taking more than an insignificant amount of the asset’s output during the term of the arrangement is remote, and if yes, whether the customer pays a fixed price per unit of output which is not based on market price.

The facts and circumstances of the case would determine whether the customer acquires the right to use interchangeable capacity from an overall physical telecom asset; or whether the customer acquires the right to use a specific portion of the physical asset (for example, a physically identifiable portion of the wavelength) . Generally, rights to use ‘general capacity’ would not qualify as leases. However, rights to use specific telecom assets/portion of telecom assets may qualify as leases.

Property plant and equipment:
Depreciation:

Presently in India, telecom companies depreciate their fixed assets primarily based on the rates prescribed in Schedule XIV of the Companies Act, 1956. However, some companies depreciate certain fixed assets at rates based on the respective useful lives of the assets.

Under IFRS, companies are required to depreciate property plant & equipment based on their useful lives. The revised draft of Schedule XIV prescribes indicative useful lives and unlike its predecessor, is not expected to represent the minimum rates. Accordingly, all companies including the telecom companies will have to charge depreciation based on the useful lives of the related item of property plant and equipment.

Components of cost of property plant and equipment:

Presently, under Indian GAAP, companies capitalise costs which may not be directly attributable to bringing the fixed asset into its present location and condition. E.g., foreign exchange fluctuations related to long-term borrowing with respect to fixed assets are currently permitted to be capitalised under Indian GAAP.

However, under IFRS, only those costs which are directly attributable to bringing the asset into its present location and condition are permitted to be capitalised. Accordingly, items like foreign exchange fluctuation, administrative expenses, etc. shall not be permitted to be capitalised to the cost of property plant and equipment.

Asset retirement obligations:

As per the requirement of AS-29 ‘Provisions, Contingent Liabilities and Contingent Assets’, companies are required to recognise the entire undiscounted value of asset retirement obligation as a part of the cost of the related item of property plant and equipment.

However, under IFRS, IAS 37, the corresponding standard, requires the obligation to be discounted and accordingly, the present value of the asset retirement obligation is required to be included in the cost of the asset.

Deferred credit arrangements:

Telecom companies often have arrangements with creditors for purchase of property plant and equipment requiring payment on deferred terms i.e., on deferred credit terms. Under Indian GAAP, no specific adjustment is required for such arrangements and accordingly the related item of property plant and equipment is capitalised at the gross value of the amount payable to the creditor.

However, under IFRS, since all financial instruments have to be fair valued on initial recognition, the liabilities towards purchase of property plant and equipments (being financial liabilities) are required to be discounted on initial recognition. Accordingly, the related item of property, plant and equipment shall be capitalised at the present value of the amount payable to the creditor at the end of the extended credit period. The unwinding shall be through accrual of interest expense on the discounted liability for each reporting period.

Conclusion:

As the convergence date with IFRS is approaching, telecom entities have to be well prepared to ensure that the transition is smooth. Entities also have to be mindful of the ‘carve-outs’ (areas where accounting treatment under the IFRS converged standards in India may differ from IFRS issued internationally) which are being presently considered by the regulators.

Lastly, telecom companies would need to carefully consider the impact of IFRS convergence on their IT systems. This is especially true for changes impacting revenue recognition, given that revenue recognition in the telecom industry is highly technology-intensive.