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Ind-AS: Considerations For Technology Companies

Published on Tue, Jun 30,2015 | 16:42, Updated at Tue, Jul 07 at 17:05Source : Moneycontrol.com 

IND-AS: CONSIDERATIONS FOR TECHNOLOGY COMPANIES

By: Asgar J Khan, senior professional in a member firm of EY Global

The transition to Ind-AS can be a long and complicated process with many challenges. Experience around the world shows that conversion projects often take more time and resources than anticipated. Due to the nature of technology entities, significant accounting challenges arise in the areas of revenue recognition, share-based payments and outsourcing arrangements. Also, the technology companies in India are more exposed than others to foreign currency variations as they generate significant revenues from export of services. This article highlights few of the challenges that may arise in these areas due to conversion to Ind-AS. The technology companies will find this useful in their convergence efforts.

Revenue Recognition

There is a significant diversity of accounting treatment under Indian GAAP on revenue recognition.  Typically, accounting by companies that are listed in the US market is influenced by US GAAP, which is highly prescriptive and rules based with extensive industry-specific guidance. Other technology companies may not be influenced by US GAAP. In such cases, the accounting practices are more driven from the legal form given in the agreement, rather than their true economic substance. In either case, the application of Ind-AS 115 Revenue from Contract with Customers may change the revenue recognition policies and practices followed.

Under Indian GAAP, the timing of revenue recognition from the sale of goods is primarily based on the transfer of risks and rewards. Ind-AS115 instead focuses on when control of those goods has transferred to the customer. This change in approach may result in a change of timing for revenue recognition for some entities.

Many Indian technology companies are mainly involved in software/ERP implementation and often recognise revenue on percentage-of-completion basis. Under Ind-AS 115 an entity recognises revenue only when it satisfies a performance obligation by transferring control of a promised good or service to the customer. The standard indicates that an entity must determine at contract inception whether it will transfer control of a promised good or service over time. If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time. Three scenarios are specified in which revenue will be recognised over time – broadly, they are when:

(i)         the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.

(ii)        the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. An example would be installing network equipment on the customer’s premises, if the customer controls the equipment during the installation period.

(iii)       the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date. An example would be significantly customising an asset to the customer’s specifications and the entity also has a right to payment for performance completed to date. As a result of the customisation, it is less likely that the entity would be able to use the asset for another purpose (e.g., sell to a different customer) without incurring significant costs to re-purpose the asset.

If revenue is to be recognised over time, a single method (either an input method or an output method) should be used which best reflects the pattern of transfer of goods or services to the customer. If a transaction does not fit into any of the three scenarios described above, revenue will instead be recognised at a point in time, when control passes to the customer. In the technology sector, if an entity is manufacturing items for a specific customer, this may require a careful analysis in light of the new requirements.

Many technology companies provide their customers post contract services (PCS) or maintenance i.e., a right to receive services or unspecified product upgrades/enhancements, offered on ‘when-and-if ¬available’ basis or both offered to customers after the software license period begins or other time provided for by PCS arrangement. Ind-AS 115 requires an entity to evaluate the contractual terms and its customary business practices to identify all the promised goods or services within the contract and determine which of those promised goods or services will be treated as separate performance obligations. A good/service is distinct if the good/service is capable of being distinct (the customer can benefit from the good/service on its own or together with other readily available resources) and the good/service is distinct within the context of the contract (i.e., the good or service is separately identifiable from other promises in the contract). A promised good or service that an entity determines is not distinct is combined with other goods or services until a distinct performance obligation is formed.

Similarly there will be implications of Ind-AS 115 in other areas for technology industry such as accounting for contract modifications, warranties, customer options, non-refundable upfront fees, principal versus agent considerations, right of returns, extended payment terms, consignment and bill-and-hold arrangements.

Determining Functional Currency

Most Indian technology companies have geographically dispersed operations and earn major part of their revenues in currencies other than the Indian rupee (INR). Further, certain companies also incur costs, which are not denominated in INR. This will give rise to an issue regarding determination of an appropriate functional currency. Ind-AS 21 The Effects of Changes in Foreign Exchange Rates lays down specific criteria for such determination. The standard lays down certain primary indicators (i.e. based on sales prices, competitive forces, labour, material and other costs) and secondary indicators (i.e. based on currency in which financing is obtained and operating receipts are retained) which should be considered by the entity in determining its functional currency.

In practice, a situation may arise where the functional currency of a company is not obvious even after considering both the primary and secondary indicators. An example may be where a company’s revenue is denominated in US dollars (USD); however, all its costs are denominated in INR. In such cases, the standard requires the management to use its judgment and determine the functional currency that most faithfully represents the economic effects of the underlying transactions, events and conditions. Thus, it is possible that companies operating in a similar environment can reach different conclusions about their functional currency.

The determination of the right functional currency may have a pervasive effect on a company’s financial statements and also significantly impact the conversion efforts. Ind-AS 101 First-time Adoption of Ind-AS does not contain any specific exemption allowing a first-time adopter to determine cost of its assets and liabilities in a currency other than the functional currency. This will require the company to restate its financial statements retrospectively in functional currency terms.  This will be a huge effort. Ind-AS 21 requires a company to first recognize all its transaction in the functional currency. This effectively means that the company should maintain its books of account in functional currency terms for financial reporting purpose. In addition, to comply with tax and other laws, the company may need to maintain another set of books in INR terms.

Share-Based Payments

Many technology companies use share-based payments as a key component of their compensation programs in order to attract, retain, and motivate employees. Under Indian GAAP, the accounting for such plans is covered by the ICAI Guidance Note on Accounting for Employee Share-based Payments. As allowed under the ICAI Guidance Note, most Indian companies use intrinsic value method for recognition of employee share based payment, resulting in recognition of nil or small compensation cost. Ind-AS 102 Share Based Payment mandates the use of fair value method. This will result in a significant increase in employee compensation cost. Many global entities across the world have set up subsidiaries in India. Normally, the global parent provides ESOP benefits to the employees of its Indian subsidiary. The Indian subsidiary generally does not account for any compensation cost in their Indian GAAP financial statements for the ESOP granted by the parent entity on the basis that they do not have any settlement obligation and clear guidance is not available in this context. This approach is not permissible in Ind-AS. Ind-AS 102 requires the subsidiary, whose employees receive such compensation, to measure the service received from its employees in accordance with the requirements applicable to equity-settled share based payment transactions with a corresponding increase in equity as a contribution from the parent.

Outsourcing Contracts

Technology companies often enter outsourcing arrangements for programming support, data storage, network support, etc. Such arrangements normally take the form of service contracts and are treated as such under the Indian GAAP. Under Ind-AS, appendix C to Ind-AS 17 Determining whether an Arrangement contains a Lease will require companies to assess whether such contracts are or contain a lease. If yes, lease will be accounted in accordance with generic requirements of the standard. Such accounting may have significant implications on the balance sheet of both the service provider and customer, particularly if the arrangement is assessed as finance lease. This is because finance lease accounting will require the service provider to derecognize the underlying asset(s) from its financial statements and the same will get recognized in the financial statements of the customer.  If the lease is evaluated to be an operating lease, straight-lining of leases may have a significant impact.

The outsourcing arrangements in a technology industry may also have to be evaluated for accounting as per Ind-AS 103 Business combinations if the acquisition meets the definition of business. Let us understand this with the help of an example. Entity A provides information technology outsourcing services. Entity B is a telecom company. Entity B’s billing and other information technology systems consume significant computer and staff resources. Entity B uses these systems to provide billing and accounting services to a number of smaller utilities. Entity A and entity B have entered into an agreement under which entity A will provide all of entity B’s information technology services for 12 years. Entity A will acquire all of entity B’s back-office computer equipment, related buildings and third-party service contracts. All staff currently employed by entity B in its information technology function will be transferred to entity A. Entity A will, in addition to providing information technology services, restructure the information technology operations to improve efficiency and reduce the number of employees. In such cases the acquisition by entity A may meet the definition of business as per Ind-AS 103.

Others

In addition to the above, when converting to Ind-AS, Indian technology entities will need to deal with many other accounting differences, such as those related to accounting for property, plant and equipment, intangible assets, business combinations, financial instruments (including hedges), joint ventures, financial liabilities and equity, amortization of intangible assets, presentation and disclosure, etc.

Conclusion

Technology entities should gain an understanding of Ind-ASs and evaluate how it will affect their specific accounting policies and practices. Entities should perform a preliminary impact assessment so they can determine how to prepare to implement the new standards. While the effect on entities will vary, some may face significant changes in accounting. All entities will need to evaluate the requirements of Ind-ASs and make sure they have processes and systems in place to collect the necessary information to implement the standards and make the required disclosures. The experiences of companies that have already been through an IFRS conversion globally have demonstrated that making strategic decisions early in the project prevents duplication of effort, changes in direction, and cost overruns at a later stage.

 
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