Akhlesh Chowla, Partner, Price Waterhouse & Co.
The telecom industry in India is going through a transitionary phase in more ways than one. Companies are engaging in tariff wars and battling to retain and capture customer share, while facing the risk of eroding profitability and cash flows. Further, the possibility of consolidation in the industry is well documented, signs of which are visible with companies seeking to acquire or merge assets or businesses to prepare for the competition. As a result, significant accounting matters arise in the areas of revenue recognition, leases, financial instruments, property, plant and equipment, and acquisition and disposal of businesses and assets, amongst others. With the introduction of the new Indian Accounting Standards (converged with the International Financial Reporting Standards) (Ind AS), Indian telecom companies would have to gauge their impact on each of these areas.
Ind AS is relatively more prescriptive and elaborate in many areas, compared to the current Indian Generally Accepted Accounting Principles (GAAP) and, therefore, is likely to have a significant impact on the financial statements of telecom companies adopting it. Some of the examples discussed below potentially impact the earnings of the company as well as have an impact on the recognition of assets or liabilities that were earlier not recorded under Indian GAAP. With telecom companies being highly leveraged, it could also have an impact on debt covenants.
Revenue recognition
Ind AS provides more prescriptive guidance on revenue recognition than under Indian GAAP. The telecom industry is increasingly offering several products/services as a bundle to customers. These include the bundling of modems and dongles with service, activation and provision of service, and the sale of mobile handsets along with service. These arrangements are referred to as multiple-element arrangements. These arrangements should be accounted for as separate transactions, where the substance of the transaction is such that an individual product/service is independent of each other. This determination can change the way revenue is recognised for service and product offerings. The revenue could now be spread over a period of time, whereas earlier the same was recognised upfront and vice versa. For instance, under Ind AS, recognition of revenue from activation depends on the nature of the services provided. An entity must determine whether an upfront fee related to installation or activation is a separate component of the transaction. The activation fees are generally recognised over the period during which the communication services are provided to the customer. However, under Indian GAAP, companies may be recognising the same upfront. Further, more complexities get added as companies are increasingly entering into alliances and revenue sharing arrangements with third parties for content and other services.
Therefore, adoption of Ind AS may impact key performance indicators such as average revenue per user. Revenue in the telecom industry is also significantly dependent on technology, that is, interaction of the company’s billing systems with the network and the reporting software. The adoption of Ind AS could require the companies to reassess the configurations of the billing systems and also the processes and controls to ensure appropriate realignment with the accounting principles of Ind AS.
Impact on existing arrangements
Companies may need to relook at the terms of the contract and consider accounting implications that did not exist earlier under Indian GAAP. Many operators enter into indefeasible rights of use (IRU) arrangements to manage costs and speed of roll-out. There is no specific guidance on determining whether an arrangement contains a lease under Indian GAAP. However, Ind AS provides guidance in such assessments. The accounting treatment is determined by the agreement’s commercial substance and can be very judgemental, and has to be based on the details of each agreement. Such arrangements typically have more than one component such as operations and maintenance, in addition to the asset. Ind AS requires each component to be accounted at its relative fair value. Application of this guidance could lead to companies capitalising these costs, where such costs were earlier charged to profit and loss or vice versa.
Property leased plant and equipment
Most networks are constructed on leased premises. In many of these leases, the companies incur an obligation to reinstate the premises to their original condition. The costs of dismantling network assets and restoring the land premises to their original condition should be capitalised as part of the initial cost of constructing the network. There was no specific guidance in Indian GAAP on this; however, Ind AS specifically requires this to be recorded as part of the cost of the asset and a corresponding liability. This may lead to an additional depreciation charge as well as interest charge due to the impact of discounting this liability to give effect to the time value of money.
The most significant change that Ind AS brings about as compared to Indian GAAP is the focus on fair value accounting.
Another significant impact on leases for telecom companies is on straight-lining of rentals. Under Indian GAAP, lease rentals were straight-lined over the period of lease for any escalations during the period. Under Ind AS, where the escalation relates only to inflation, no straight-lining is required. As a result, companies will have a lesser expense charge in the initial years of the agreements, with an increase in subsequent years under Ind AS, which was an even charge through the period of the lease under Indian GAAP.
Financial instruments
The most significant change that Ind AS brings about as compared to Indian GAAP is the focus on fair value accounting. One of the areas where fair value accounting impacts telecom companies is accounting for financial instruments and derivatives. This is primarily because the cost of spectrum and capital intensity make telecom companies highly leveraged. Companies often hedge these loans with derivative instruments to protect against interest rate changes and foreign exchange risks. Ind AS requires these derivatives to be fair valued. Whilst the changes in fair value would generally go to earnings directly, subject to certain conditions, it could be accounted initially as reserves and then subsequently released to earnings, as applicable. This may lead to volatility in earnings over the period. Under Indian GAAP, companies would generally take only losses on these derivatives rather than both gains and losses.
Adoption of Ind AS would also require companies to relook at the existing funding agreements. A simple example is for redeemable preference shares, which is a common funding mechanism, and would need to be assessed whether it is in substance debt or equity, whereas under Indian GAAP, preference shares are considered as equity.
Business combinations
With increasing consolidation in the industry, companies acquiring other businesses would need to apply business combination accounting. Ind AS generally requires the use of fair value of the acquired assets and liabilities. This value may or may not have been recorded in the account books of the acquired company. For instance, upon a potential acquisition, the acquirer would need to assign a fair value to the customer relationship on acquisition. Customer relationship would not be accounted for as an asset in the books of the company being acquired and amortised as an expense over a defined period. The process of fair valuation and recognising additional assets is generally expected to result in a lower goodwill (as compared to Indian GAAP) and with a different charge to the profit. As a result, this increases the complexity of management judgement around identifying and measuring acquired assets and liabilities.
The way forward
All telecom entities that adopt Ind AS will be affected by the significant increase in applying management judgements, the increase in required disclosures, and changes to operational processes and system changes. The changes clearly extend beyond accounting and disclosures. Whilst telecom companies adopting Ind AS from April 1, 2016 will work through these challenges, there are more potential changes on the anvil and this will be a continuous process as businesses get more complex and accounting interpretations and new standards cope with these complexities. New revenue recognition and leasing standards have already been proposed under the International Financial Reporting Standards, which may be adopted by India in future.
