A Telco story of Harrowing Accounts

The telecom
industry faces significant accounting and business challenges due to
complexities in the schemes offered to customers, distribution arrangements,
infrastructure sharing arrangements entered by telecom players, etc. Neither
Indian GAAP nor IFRS provide any industry specific guidance. There are few areas
where accounting treatment under IFRS will be different from accounting under
Indian GAAP or industry practices in India, along with some other practical
issues. In December 2009, the research committee of ICAI had issued an exposure
draft of the 'Technical Guide on Revenue Recognition for Telecommunication
Operators' with a view to provide guidance on peculiar revenue recognition
issues in the industry. Perusal of the draft Technical Guide indicates that it
is more based on US GAAP requirements and may provide results that are different
from IFRS. However, the said exposure draft has not so far been issued as the
final Technical Guide.

Bundled Service Offerings

Telecom entities provide package offers comprising handsets, prepaid
minutes, messages, discounts, special offers and other incentives. The decision
to account for a transaction entirely or individual components can have a
significant impact on the results. For example, separating handset sales from
connection revenues may result in increased revenues upfront for the sale of
handsets. Indian GAAP does not currently provide any specific guidance on
revenue recognition for multiple element contracts and hence, inconsistent
practices are followed by various telecom entities.

IAS 18 requires, in certain circumstances, to apply the
recognition criteria to separately identify components of a single transaction
in order to reflect the substance of the transaction. The recognition criteria
are applied to two or more transactions together where they are linked in such a
way that the commercial effect cannot be understood without a reference to the
series of transactions as a whole. The key issue which all telecom entities will
have to face for the adoption of IFRS is whether the components of a single
transaction can be technically and commercially separated; and if so, whether
the fair values can be reliably determined to recognize revenue.

As no specific guidance is available under IFRS, many
entities could well use the hierarchy in IAS 8 accounting policies, changes in
accounting estimates and errors to consider any relevant US GAAP requirement for
determining the fair value of separate components. However, care should be
exercised to ensure that the principles applied are not in conflict with IFRS.

Accounting for IRU

In the telecom industry, entities often buy and sell capacity of each
other's networks, often referred to as an indefeasible right to use (IRU). The
main issue involved here is on revenue recognition-can revenue be recognized
upfront (as an asset sale) or should revenue be recognized over the IRU term as
a provision of service? If it is considered that an IRU arrangement contains a
lease then the appropriate treatment under IFRS would be determined by IAS 17
Leases. IFRIC 4 provides more guidance on this subject. If the IRU is not a
lease, it will have to be ascertained whether the arrangement constitutes sale
of goods or rendering of services. The accounting consequences for sale of goods
and rendering of services would be significantly different.

Under Indian GAAP, no guidance is available on the
identification of leases contained in arrangements or transactions which are not
structured as a lease. Thus, lease elements contained in an IRU may not be
captured by AS 19 Leases, which governs lease accounting in India. The
accounting for IRUs under Indian GAAP is significantly different to that
required under IFRS.

Both, fixed line and mobile operators may enter into a
number of interconnect agreements with other carriers. Industry practice under
Indian GAAP and IFRS is to account for revenue and costs from such transactions
on a gross basis as the carriers are exposed to the gross risks of the
transaction. Interconnect agreements usually allow carriers to settle the amount
on a net basis, which does not normally change the appropriateness of
recognizing the transaction gross. For example, a telecom company may bear the
gross credit risk for non-payment and be obliged to make payments under the
interconnect arrangements irrespective of the level of reciprocal revenue due.

It is common for telecommunication operators to enter into
arrangements with third party content providers to offer a range of services to
their subscribers (ringtones, games and traffic updates) with charges based
either on duration or on quantity. Often, the operator collects the content
revenue from the subscriber and is required to remit the content revenue to the
supplier, net of a percentage is retained as commission. If the operator is
acting as the principal in the relationship with the subscriber, the revenue
should be recognized on a gross basis, with the amount remitted to the supplier
being accounted as a cost of sale. However, if the operator is acting as an
agent for the supplier in its relationship with the subscriber, only the net
amount of commission retained should be recognized as revenue.

Close attention needs to be paid to the details of each
such arrangement since that may have an impact on the accounting. It may be
noted that unlike Indian GAAP, IAS 18 provides specific guidance for determining
whether revenue should be recognized on a gross or net basis.

Asset Retirement Obligations

In the construction of networks, mobile and fixed line operators often build
assets on leased land or premises where an obligation exists (like under the
lease agreement) to reinstate the land or premises at the end of the agreed
term. Provision for such costs is required under IFRS, where they are referred
to as asset retirement obligations (AROs). The obligation is accounted for by
including the present value of the estimated cost of dismantling and removing
the asset as part of the cost of the asset and setting up a provision for an
equivalent amount. The discounting of provisions is unwound over the relevant
period and is accounted for as an interest expense. Under Indian GAAP, AS 29
Provisions, Contingent Liabilities and Contingent Assets require a provision to
be created at the undiscounted amount of an ARO at the time of setting up the
assets.

The challenge in providing for AROs is that often it may
not be evident from the contractual terms that an obligation exists. The
contract may be unclear or silent on restoration requirements at the end of the
contracted period. There might not be express legislation which requires
companies to carry out restoration work. In such cases, entities need to make
their 'best estimate' based on the past experience. Many a times entities
contend that restoration work as per the legislation/contractual arrangement is
not enforced, and hence no cost is incurred by them. For instance, obligations
with respect to cables laid in international waters on the seabed or on coastal
'landing stations' may be unclear and inconsistently enforced. Some consider
that removing the original cables may cause more environmental damage than
leaving them intact. The question that then arises is that should the obligation
not be valued at all, on the grounds that it may not crystallize?

Another complexity in ARO provisions under IFRS is the
assumption of tenor of lease. Many telecom companies enter into agreements to
lease land or property to erect cell sites. These leases can vary in length and
may contain an option to extend the lease. In these circumstances, issues arise
in calculating the present value of an ARO. Should the obligation be based on
the original length of the lease or the extended period?

In practice, an estimate needs to be made of what is
perceived to be the most likely economic life of the asset taking into account
all the above variables. For example, if there is no certainty of renewing the
lease term of a particular site, dismantling and removal costs should be based
on the assumption that removal will be required at the end of the initial lease
term.

Fixed Assets

Typically, this industry faces poor RoI which drives a rigorous investment
approach. Investors focus more on the balance sheet, about 60% of which is made
up of fixed assets. Therefore, losing market reputation and rating is
unaffordable. Compliance with IFRS increases the complexity of verifying and
accounting for fixed assets for most, though not all, telecom entities. National
regulators also focus on these accounting practices.

In 2005, when many global entities adopted IFRS, Ernst &
Young conducted a global online study of the major telecom industry players to
find out how the new environment was affecting them and the management of fixed
assets. Various entities from around the world participated in this study by
providing their time and input. Ernst & Young developed and disseminated an
online survey on the changing reporting and regulatory requirements. The
entities represented had more than $309 bn in combined annual revenues and more
than $298 bn in combined total fixed assets. Until this study was made, there
had been a limited analysis of this topic.

The study brought out the following points:

• Increasing customer demands for new communication
  products and services are pressuring telecom entities to update the existing
  networks or deploy new ones
• Many telecom entities are yet to recognize the need to
  proactively manage potential changes to their fixed asset accounting practices
  and how this impacts their competitive position
• Matching operational realities to changing business and
  customer demands and complying with IFRS are critical for success in the
  telecommunications market
• The financial health of the industry was stabilizing,
  opening the path to renewed profitability and growth, however, the transition
  to IFRS may create earnings volatility
• The entities that succeed in a dynamic environment will
  be those that can adapt to IFRS quickly while proactively managing their asset
  bases
• The pressure to update or replace network assets
  increases the risk of traditional assets being impaired. In the study referred
  above, 62% respondents believed that their current IT systems, accounting
  processes and fixed asset designs were suitable for IFRS adoption
• In the case of telecom entities, IFRS reporting
  requirements will have the greatest potential impact on the management of
  their fixed asset accounting, including component accounting, the estimation
  of useful lives, residual values, impairment, etc.

Other Issues

Under both IFRS and Indian GAAP, start-up costs cannot be capitalized.
Another interesting issue is the straight-lining of operating lease rentals. As
per an EAC opinion, straight-lining is required. But, because land is scoped out
of AS-19, not all of the lease rental may be straight-lined. IFRS also requires
full straight-lining. Accounting for various incentive schemes is another area
where practices may not be consistent. The above issues are directly related to
the telecom sector which are in addition to the generic issues relating to
accounting of acquisitions, financial instruments, hedges, etc.

Dolphy D'souza

The author is partner & national IFRS leader, Ernst & Young

vadmail@cybermedia.co.in