In line with the global trend, the Institute of Chartered Accountants of India (ICAI) has proposed convergence of Generally Accepted Accounting Standards (GAAP) in India with the International Financial Reporting Standards (IFRS) effective April 1, 2011.
Consistent with its previous record of being an early adopter of international best practices, the Indian technology sector has taken the lead with several companies being early adopters of IFRS, three years ahead of the mandatory time for the transition.
In part, this early adoption of IFRS was triggered by a change in the rules of the US Securities and Exchange Commission (SEC), whereby foreign companies listed in the US could replace US GAAP with IFRS.
Accordingly, US listed Indian companies such as Infosys, Satyam Computers and Sify have already filed financial statements prepared in accordance with IFRS with the SEC. There are several other companies which are evaluating this option actively.
Since companies such as Infosys have set the benchmark for industry reporting practices (for example, US GAAP adoption was fairly common in the Indian technology sector, in part, due to reporting practices adopted by Infosys and other large peers), IFRS may soon replace US GAAP as the benchmark within the Indian technology sector.
Similarly, while several European peer group technology companies now solely report using IFRS, several US companies are also likely to present IFRS financial statements as IFRS becomes more common in the US.
The transition to IFRS will improve comparability of reported business performance of Indian technology companies with technology companies globally and will result in greater transparency about company’s activities to various stakeholders, that is, investors, customers, etc. The transition will also provide impetus to cross-border acquisitions, enable partnerships and alliances with foreign entities and lower the integration costs.
Experience of technology companies that have transitioned to IFRS shows that sector executives need to analyse the impact IFRS adoption will have on all aspects of their operations, including: accounting policies and procedures; financial reporting and disclosures; information technology (IT) systems and the processes used to accumulate and report financial information, including new or revised IFRS-compliant data and calculations; modifications to business processes and controls supporting those processes, including internal controls to support related certifications of the chief executive officer and chief financial officer; contractual and legal obligations, such as financial covenants and employee incentive plans based in whole or in part on GAAP-reported metrics; training both finance and non-finance staff on changes to policies, procedures, and the new foundation for judgments; and managing communications with the executive team, audit committee, investors, and employees.
Although Indian GAAP is similar to IFRS in certain respects, many differences exist. These can be significant and have enterprise-wide implications. In addition to the several challenges along the path to transition that are applicable to all companies, due to the prevalent nature of certain transactions, technology companies in India face certain additional challenges in the area of revenue recognition, business combination , share-based payments and derivatives and hedging activities.
A very significant and common issue is the accounting for multiple element contracts. For example, a software company usually enters into a composite contract for sale of software licence, implementation and ongoing maintenance services. Further, in many cases they provide free upgrades and other free add-on software.
Although Indian GAAP is similar to IFRS in certain respects, many differences exist. These can be significant and have enterprise-wide implications.
Currently, there is lack of guidance under Indian GAAP to account for such multiple-element contracts and also for determination of objective and reliable evidence of fair values for each such element. In practice, several technology companies, account for each deliverable within the overall arrangement based on the prices stated in the contract with no separate evaluation of the fair value of each element. This may result in a deferral of revenue in several cases where upfront recognition is currently followed. Additionally, internal reporting systems and processes would need to evolve to ensure availability of sufficient benchmark data to support the fair value allocation.AcquisitionsMany technology companies have made acquisitions and are evaluating further inorganic growth. Transition to IFRS may impact accounting for such business combinations in various ways. Under IFRS, the date of acquisition/consolidation is based on the date when control is obtained and not merely based on the terms stated in the contract. This would generally defer the date from which revenues and operations of the acquired company are consolidated. Further, under IFRS, net assets taken over, intangible assets and contingent liabilities are recorded at fair value compared to carrying value under Indian GAAP. This may impact post acquisition profit due to higher amortisation and depreciation charge. Adoption of IFRS will require a change in the financial reporting process to factor in determination of fair value of acquired assets and liabilities, including several assets and liabilities where publicly quoted prices are not available.Stock option arrangementsMost of the technology company uses share options to attract and retain employees. Indian GAAP on share-based payment to employees (for example, employee stock options) provides entities with a choice to either adopt the intrinsic value method or the fair value method. Substantially all Indian companies have currently opted to adopt the intrinsic value method under which no compensation cost is recognised for at options that have an exercise price equal to the share price on the date of the grant. IFRS mandates the use of the fair value method, whereby the fair value of the options is determined using an option pricing model such as the Black-Scholes-Merton Model or the Lattice Model. This would usually result in recognition of compensation cost even if the options are at-the-money on the grant date. On adoption of IFRS, most Indian companies that have issued share-based payments may need to record previously unrecognised compensation cost relating to these awards, based on the fair value approach. Additionally, IFRS only permits accelerated method of amortisation for awards that vest in a graded manner whereas Indian GAAP permits straight-line method of amortisation for awards. Resultantly, this will have a significant impact on income statement of technology companies in the initial period of option grants.Similarly, Indian GAAP does not have any guidance on accounting for share-based payments to non-employees (for example, contractors and customers) and accordingly diversity exists among various companies. However, IFRS requires accounting based on fair value method for all share-based payments whether granted to employees or non-employees.Companies would need to re-evaluate their compensation strategies (including the cash: option mix) to determine the optimal use of share-based payment arrangements.Derivatives and hedging activitiesMost Indian technology companies have significant foreign exchange exposure due to foreign currency sales. Several of these companies enter into forward contracts and other derivatives to economically hedge these exposures. IFRS provides that all derivative financial instruments need to be recorded at fair value at each reporting with changes in fair value reported in the income statement, unless specific hedge accounting criteria are met. Thus, a company would be exposed to significant income statement volatility as changes in exchange rates start impacting current earnings even if they arise out of derivatives taken to hedge forecasted sales. If a company seeks to avoid this volatility through hedge accounting (that seeks to record the exchange rate changes only in the period when the forecasted sales occur), it needs to adhere to stringent hedge accounting documentation and monitoring requirements. Financial reporting processes would need to be changed to determine the fair value of derivatives and meet the complex hedge accounting documentation and other requirements. Lastly, several companies may realise that the derivative instruments that have historically used (for example, leveraged options) to economically hedge their exposure, do not even meet the basic requirements for hedge accounting. This may result in a change in business practices and the nature of contracted derivative instruments.In conclusion, in addition to the inevitable mandatory adoption, the benchmarks within the Indian technology sector are likely to move from US GAAP to IFRS due to the early adoption by leading companies. This would not only result in several areas of financial reporting differences and financial impact, but would require changes to financial reporting processes and systems.
(The author is Head of US GAAP and IFRS Services, KPMG. firstname.lastname@example.org)