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Publication name: Telecoms IFRS document
Publication no: 209 615
November 2004
COMMUNI CATI ONS
IFRS Accounting in the
Telecommunications Industry
I NFORMATI ON, COMMUNI CATI ONS & ENTERTAI NMENT
19514_KPMG_IFRS_Case_Study_Cov 3/12/04 12:25 PM Page 1
1 Introduction 2
2 Revenue recognition 3
2.1 Introduction 3
2.2 Mobile related issues 3
2.3 Fixed line related issues 10
2.4 Capacity sales 17
2.5 Other revenue recognition related issues 25
3 Cost of sales and operating expenditure 26
3.1 Income statement presentation 26
3.2 Cost recognition 28
3.3 Other issues 31
4 Intangible assets 32
4.1 Introduction 32
4.2 Capitalization of intangible assets 32
4.3 Amortization of intangibles 35
4.4 Joint development type arrangements 37
4.5 Joint build type arrangements 38
5 Property, plant and equipment 39
5.1 Network amortization 39
5.2 Basic accounting principles 40
5.3 Dismantling and removal costs 42
5.4 Useful lives 44
6 Impairment 45
6.1 Impairment indicators 45
6.2 Impairment calculations 45
6.3 Recoverability of license costs 46
6.4 Cash generating units 46
6.5 Transition from old technologies to new 47
technologies
6.6 Sensitivity to key assumptions 47
6.7 Impairment reversals 48
7 Inventory 49
7.1 Introduction and general principles 49
7.2 Cost elements 49
7.3 Handsets sold at a loss 50
8 Segmental reporting 52
8.1 Disclosure requirements 52
8.2 Determination of segments 53
8.3 Allocations to segments 54
9 Other relevant issues 55
9.1 Embedded derivatives and IAS 32 and 39 55
9.2 Onerous contracts 56
9.3 Restructuring costs 57
Contents
2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms
are members. KPMG International provides no services to clients. Each member firm is a
separate and independent legal entity and each describes itself as such. All rights reserved.
19514_KPMG_IFRS web_Text 3/12/04 12:13 PM Page 1
2 Discussion of IFRS accounting in the Telecommunications Industry
Telecoms accounting has never been more challenging. Many companies in the
telecoms sector still have to deal with continued skepticism of industry practices
in light of past accounting failures. Further change is now taking place with the
introduction of IFRS.
Where GAAP is clear, few in the industry are willing to push the boundaries of
what is considered best practice for their sector. However, in many areas, it is
evident that applying GAAP to telecoms businesses is not straightforward.
Alternative treatments may often be possible.
Revenue recognition remains a hot topic for the telecoms industry, although cost
recognition follows closely behind particularly the question of whether costs
should be expensed, capitalized or deferred to future periods. Although IFRS has
a specific revenue recognition standard, guidance remains vague in a number of
areas. What is more, no additional IFRS guidance is expected before the
standards become mandatory for EU-listed companies in 2005.
Accounting practice continues to vary among telecoms companies. Increasingly,
however, companies are taking note of U.S. GAAP, especially where local practice
is not prescriptive or permits alternative treatments. IFRS is currently vague in a
number of revenue recognition areas and companies will often consider whether
they should use U.S. GAAP where no IFRS guidance exists. In some cases, they
may consider defaulting to U.S. GAAP except where IFRS is explicitly different.
Given the move to IFRS by EU-listed companies, this publication has been
limited, at this stage, to the discussion of IFRS treatments. However, in light of
the predominance of U.S. companies in the telecoms industry, the scope of this
publication will be broadened, in due course, to include U.S. GAAP.
With continual changes in telecoms accounting, either as a direct result of
changes by the standard setters or shifts in the investment communitys view of
what is appropriate, leaders and managers in the telecoms industry must keep
up to date with accounting developments.
Rather than a definitive guide or a view on what policies should be followed
under IFRS, this publication considers what policies may be followed by
organizations adopting IFRS and what constitutes best practice within the
telecoms industry.
References to compliance with IFRS in the document should be understood as
compliance with IFRS standards issued as at 31 March 2004, unless specifically
stated otherwise. This includes recent amendments to existing IAS standards
that become effective for annual periods beginning on or after 1 January 2005.
1. Introduction
Revenue recognition
remains a hot topic for
the telecoms industry,
although cost recognition
follows closely behind.
2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG
International provides no services to clients. Each member firm is a separate and independent legal entity and each describes
itself as such. All rights reserved.
Discussion of IFRS accounting in the Telecommunications Industry 3
2.1 Introduction
IFRS has a specific revenue recognition standard in IAS 18. A relatively old
standard, last revised in 1993, it is being challenged by new industry developments.
IAS 18 provides limited guidance in a number of areas, especially in respect of
multiple element arrangements. Furthermore, the revenue exposure draft,
expected from the joint Financial Accounting Standards Board (FASB) /
International Advisory Standards Board (IASB) revenue recognition project before
the end of 2004, now looks likely to be delayed. No further guidance is expected
in the near future.
As a consequence, when companies move to IFRS, existing divergence in
revenue recognition policies across the telecoms sector is unlikely to be
significantly reduced. This may be especially true where companies seek to
retain, as far as possible, their existing policies.
IFRS states that where its standards do not cover specific issues, companies
should consider:
The guidance and requirements in standards and interpretations dealing with
similar and related issues; and
The conceptual framework of the IASB, Framework for the Preparation and
Presentation of Financial Statements (the Framework).
The company may also consider pronouncements of other standard-setting
bodies (e.g. the U.S. Financial Accounting Standards Board) and accepted
industry practice, to the extent that they do not conflict with the standards,
interpretations and the Framework referred to above.
In this respect, the revenue recognition section of this document explores the
treatments that might be considered acceptable under IFRS and identifies the
policies which are typically adopted.
2.2 Mobile related issues
2.2.1 Multiple element arrangements
As the range and complexity of services offered by telecoms companies
increases, so does the issue of how to account for them. This is particularly true
in the mobile sector where packages offered to end users may include any
combination of handsets, pre-paid minutes, messages, discounts, special offers
and other incentives. When establishing the most appropriate revenue
recognition, consider first which, if any, of its components should be accounted
for separately and which should be combined.
The decision to account for a transaction in its entirety or to separate it into its
individual components can have a significant impact on an entitys reported
results. Separating handset sales or connection revenues from ongoing service
fees may result in increased revenue upfront but there are also instances where
separating a contract into components may defer revenue recognition.
2. Revenue recognition
...when companies
move to IFRS, existing
divergence in revenue
recognition policies
across the telecoms
sector is unlikely to be
significantly reduced.
U.S. GAAP specifically addresses this issue in Emerging Issues Task Force EITF
00-21 Revenue Arrangements with Multiple Deliverables. Similarly, UK GAAP
addresses the issue of being separable in its recently released Amendment
to FRS 5 Reporting the substance of transactions: Revenue recognition.
However, IFRS guidance is limited with only a brief reference to the issue in
IAS 18 Revenue.
Irrespective of any specific rules, the key issues that are critical to the separable
debate are whether the services can be technically and commercially separated
and, if so, whether fair values can be reliably determined.
These are some of the more common issues that arise in respect of accounting
for multiple element arrangements.
Irrespective of any specific rules the key issues that are critical to any debate on
the separability are whether the services can be technically and commercially
separated and, if so, whether fair values can be reliably determined.
The following discussion focuses on some of the more common issues arising in
respect of accounting for multiple element arrangements.
2.2.2 Handset revenue
Mobile operators typically sell handsets which, while unlikely to represent their
principal operating activity, may constitute a significant revenue stream.
More importantly, the handset sale is typically part of a larger package when the
customer signs up to a tariff package for a specified period. As the handset sale
is upfront, the first question is whether it can be unbundled and accounted for
separately, or whether revenue in respect of the handset should be deferred over
the contract period.
Many operators may account for the handset revenue separately on the basis that
the handset has been delivered, has value to the customer and the fair value can
be established. There are, however, instances where this is not as straightforward.
Dedicated network
Many existing mobile handsets can be used on different operators networks by
simply changing the SIM card. This portability supports the view that, on delivery,
the handset has standalone value to the customer.
However, some handsets, including many 3G handsets, do not have such
portability and in practice can only be used by the customer on one specific
network. In such cases, it is debatable whether, on receipt of the handset,
the customer has obtained anything with standalone value.
In practice, the position may be further complicated where, for instance, a resale
market exists in handsets. In such cases, the handset may have some value if
the customer can sell it on.
...critical to any debate
on the separability are
whether the services
can be technically
and commercially
separated and, if so,
whether fair values can
be reliably determined.
Alternatively, a handset that can only be used on one network in the customers
country of residence, may be compatible with networks overseas. Even though
the handset may technically have some value, in practice this may not be
sufficient to establish a standalone fair value.
Handset sales via distributors
The example above assumes that the operator provides both the handset and the
ongoing service to the end customer. However, in some markets, it is more
common for distributors or retail outlets to sell the handsets to customers and to
connect them to a specific operator.
Where the operator has neither sourced nor provided the handsets, revenue
recognition accounting should be straightforward. However, the position
becomes more complex where the operator also provides the retailer with the
original handsets.
IAS18 states that revenue is generally recognized when the risks and rewards of
ownership have transferred but stipulates that when the buyer acts, in substance,
as an agent, the sale is treated as a consignment sale.
Accordingly, in the case of sales to distributors, the timing of recognition of
handset sales may depend on whether the distributor acts as an agent or
principal (see section 2.3.1). If the distributor acts as principal, the expectation
is that handset sales will be accounted for on delivery; if acting as agent, the
arrangement is likely to show that revenue is recognized once the handsets have
been sold on to the end user. The result is two similar transactions where the
timing of revenue recognition may differ because one is made via a third party
retailer and the other through the operators own distribution channel.
Subsidies
Operators increasingly subsidize the cost of mobile handsets to encourage
customers to sign up. The issue is whether these subsidies should be treated as:
Customer acquisition costs, which can, in certain circumstances, be deferred,
or
Marketing costs, which are typically expensed as incurred.
Where the handset subsidy paid by the operator is directly linkedto the handset
purchased, it might be expected that the operator records handset revenue net of
subsidies rather than treating the subsidy as a cost of sale.
However, where the subsidy can be linked to the ongoing service (say different
subsidies are paid depending on the tariff that the end customer has signed up
to), deferral as a customer acquisition cost may be appropriate. Customer
acquisition costs are discussed in more detail in section 3.2.2.
Timing of consideration
As already considered, it is often appropriate to recognize handset revenue on
delivery rather than over the period of the subsequent services.
Is this appropriate where the consideration is not received on delivery but is
spread over the period of the subsequent service? A typical example is where
the customer signs a contract which states a price for the handset and the rates
for subsequent services. There is no upfront consideration and instead the
customer is charged monthly installments for the purchase of the handset over,
say, two years.
Assuming the contracts are enforced and payment is considered probable, is it
appropriate to recognize the full amount of the consideration due for the handset
on delivery, even though payment is deferred?
From an accounting perspective the timing of receipt of consideration should
not impact the revenue recognition policy. As long as the usual criteria (detailed
above) in respect of handset sales are satisfied (i.e. handset has standalone
value, reliable fair value can be determined and receipt considered probable)
then upfront recognition on delivery may still be appropriate.
However, it should be noted that deferred payment terms do call into question
whether the criteria has been met. Where material, IFRS requires deferred
consideration to be discounted when determining what revenue should
be recognized.
2.2.3 Connection revenues
Activation fees are becomingly increasingly uncommon due to significant
competition in many major mobile markets. However, in some markets, they
continue to be charged when customers connect to operator networks.
Although not usually significant, costs are incurred when connecting customers
to a network (for instance, sending out the SIM card or activating the number).
The question is whether to recognize revenue for the service provided (e.g.
connecting to the network) as a separate product or service, or whether
activation fees should be bundled with handset revenue or spread over the
period of the service contract.
As discussed in the introduction, IFRS contains very limited guidance on the
issue of separation other than to require that transactions should be separated
where required to reflect the substance of the transaction. However, as
activation, without the provision of a handset or ongoing service, has no value
to the customer, such revenues are not expected to be accounted for separately.
IAS 18 states that installation fees are recognized as revenue by reference to the
stage of completion of the installation, unless they are incidental to the sale of a
product in which case they are recognized when the goods are sold.
From an accounting
perspective the timing of
receipt of consideration
should not impact the
revenue recognition policy.
Where connection costs and revenue are considered to be incidental to the sale
of mobile packages (although clearly often not incidental to other telecom products
and services), the question then arises as to whether they are incidental to the
handset sale (and should be recognized in line with the policy adopted for
handset sales) or to the provision of the future services.
While handsets may be used on other networks, any activation fee would be
specific to the network in question. Accordingly, it may be argued that the
activation fee should relate to the future service. However, as often made at the
same time as the handset purchase, there is also a view that payment for
activation fees cannot be separated from payment for the handset.
Finally, IFRS also cites entrance and membership fees. If a wide range of other
services or products are paid for separately, at fair value, the fee should be
identified as revenue where there is no significant uncertainty as to its
collectability. Consequently, so long as activation fees do not impact the price
charged for the ongoing service, for which fair value can be established, it is
appropriate to recognize them upfront under IFRS (i.e. same price charged if no
activation fee).
2.2.4 Pre-paid revenues
In many markets, pre-paid mobile packages are increasingly popular, especially
as gifts, as there is no on-going commitment.
Customers typically pay for on-going services by purchasing cards or vouchers
that entitle them to a set amount of minutes. Increasingly, minutes can be
topped up online or by phone. Irrespective of the specific arrangements, the
accounting issue is when to recognize revenue in respect of services purchased
in advance.
From an accounting perspective, revenue should follow performance rather than
the timing of payment for that performance. This means revenue should be
recognized when calls are made. Simple in theory, it presents significant practical
difficulties where telecoms companies cannot readily track card usage. However,
in many instances, sufficiently reliable estimates can be made.
Accounting for unused minutes presents another issue. Where there is a use-by
date on the card, it is usual to recognize revenue for unused minutes at that time.
Where there is no limit, the position is more complicated.
While IFRS does not address this issue directly, the IASB Framework states that
the preparers of financial statements have to contend with the uncertainties that
inevitably surround many events and circumstances, and that such uncertainties
are recognized by the disclosure of their nature and extent, and by the exercise of
prudence in the preparation of the financial statements.
...revenue should be
recognized when calls are
made. Simple in theory, it
presents significant
practical difficulties where
telecoms companies
cannot readily track card
usage.
It goes on to state that the recognition of income occurs simultaneously with
the recognition of increases in assets and decreases in liabilities, and, therefore
one would only expect revenue to be recognized when the entitys liability (in this
case the obligation to provide a future service) had been extinguished.
Accordingly, one could not expect revenue to be recognized until the entity has
no further liability in respect of unused minutes which could only be the case
when the right to use the minutes actually expires.
A similar issue arises where customers pay for a set number of minutes or texts
each month, but can carry unused minutes or texts forward to future periods.
Again, from an accounting perspective, revenue recognition should be based on
usage rather than billings. Revenue, deferred in respect of carried-forward
minutes should only be recognized when the customer loses any entitlement to
future use.
2.2.5 Free minutes and other offers
There is a myriad of promotions offered by mobile operators to attract new
customers or retain existing ones. While it is not possible to cover all scenarios,
common promotions and their accounting implications are discussed in more
detail below
Free minutes for a set amount of minutes used
IAS 18 requires revenue to be measured at the fair value of consideration
received or receivable. It takes into account the amount of any trade discounts
and volume rebates allowed by the enterprise. Free minutes should usually be
accounted for as a discount or rebate and, accordingly, in an arrangement where
each tenth minute is free, revenue recognized at 9/10ths of the standard rate.
Loyalty schemes
Unlike the straightforward situation illustrated above, where the incentive clearly
represents a discount or rebate, many companies now offer incentives that are
more akin to loyalty schemes run by airlines or retailers.
Say the customer earned a point for each ten minutes used which could be
redeemed as either free minutes; a discount on future handset upgrades or as
phone accessories. The airline industry would typically account for this type of
loyalty program as a marketing or promotion cost, accrued on the basis of the
expected cost of satisfying the offers granted, not as a reduction in revenue. In
the mobile industry, however, the marginal cost of providing additional services is
often minimal (typically just the termination cost if the user dials a landline or a
different network). Accounting for such loyalty programs on a cost basis may give
a significantly different result than assuming it merely represents a deferral of
revenue in respect of future services provided.
Where the value of the incentive is incidental, it is appropriate to accrue the cost
of the promotion. However, when the value of the incentive is not incidental,
then the appropriate treatment under IFRS would be to defer revenue.
...when the value of
the incentive is not
incidental, then the
appropriate treatment
under IFRS would be
to defer revenue.
2.2.6 Modems with ISP services / set top boxes with future
cable services
As with many new services or products, companies are often keen to subsidize
any initial capital cost to encourage customers to sign up to longer term services
and establish a critical customer base.
Different operators adopt different marketing strategies. They may seek to
recover the cost of equipment from the sale of future services; or to at least
cover their costs on the initial sale.
To the extent that any cost represents a customer acquisition cost, the question
is whether that cost should be expensed or deferred over the contracted period
of the future services (see section 3.2.2). From a revenue recognition perspective,
the main issue is whether any proceeds in respect of the upfront equipment sale
(for example a modem or set top box) should be accounted for as revenue
upfront or deferred in some way.
As in the case of handset sales with subsequent services, the key question is
identifying the transaction and whether the arrangement should be split into
separate components or not. While not specifically addressed in IFRS, it is
expected that the sale of equipment is accounted for separately as it has
standalone value to the customer.
This is typically the case when modems are provided. But it may not necessarily
apply to the provision of set top boxes. IFRS gives little guidance and potentially
allows more latitude in acceptable policies than either U.S. or UK GAAP. However,
in the absence of specific guidance, companies will need to consider the
pronouncements of other standard-setting bodies and industry practice.
IFRS requires that when the selling price of a product includes an identifiable
amount for subsequent servicing, that amount is deferred and recognized as
revenue over the period during which the service is performed.
The amount deferred allows for the expected costs of the services under the
agreement, together with a reasonable profit on those services.
This could suggest that if any cable or modem package was priced as an overall
upfront charge with free services going forward, IFRS could allow a high
proportion of the revenue to be recognized upfront, subject to sufficient revenue
being deferred to cover the cost of providing those subsequent services.
However, it would not be appropriate under IFRS to apply this analogy where the
ongoing service is clearly the principal service provided and where related
hardware is secondary. Consequently, where revenue is recognized in respect
of the modem or set top box provided, which under IFRS may typically be
acceptable, the accounting should seek to ensure a reasonable margin is earned
on both components, and that the results of one activity do not distort the results
of others.
2.2.7 Sales of products or services over hand held devices
The mobile phone is increasingly used for much more than just making and
receiving calls, texts or even video messages.
Already common in Japan, and being introduced in other markets, mobile phones
can now be used to pay for a range of services from vending machine drinks to
meals in restaurants. It is necessary to consider the specific risks and rewards
assumed by each party in such arrangements to determine whether gross
inflows should be recorded as revenue by the mobile operator.
Where the role of the operator is limited to collecting and remitting monies due,
rather than taking any part in the actual service provided, the credit risk alone will
rarely be sufficient to justify gross revenue recognition.
For example, where a mobile operator acquires content rights (e.g. football
highlights) and sells them on to its users, gross revenue recognition is expected.
However, where the operator does not control the rights, and pays on a share of
the revenue received, gross recognition is only appropriate where the operator is
exposed to the gross risks of the transaction and is involved in providing the
service (e.g. transmits the highlights over its network to the end user). In this
instance, the gross risks may include:
Business risk (e.g. the risk that sales are insufficient to cover investment
in the content rights)
Non-performance penalties in excess of net income recognized
Operator performs essential part of the service
Operator involvement in determining terms of service provided
Caller has claim over operator for poor performance
Credit risk.
In most cases, exposure to credit risk alone will not be sufficient to enable the
operator to recognize gross revenue. For example, paying for a product using a
mobile would not be accounted for gross even if the mobile operator took on the
credit risk. Here, the operator would receive commission for facilitating the sale and
a fee for taking on the credit risk, but in both cases would be acting as an agent.
2.3 Fixed line related issues
2.3.1 Principal / agent
An area that often gives rise to revenue accounting issues for fixed line operators
is accounting for revenues gross or net. For any individual end-to-end transaction,
a number of different operators may be involved, each earning a share of the
revenues. The question is whether it is appropriate for all or only some of those
involved in the transaction to record revenues gross.
Each entity needs to determine the appropriate revenue recognition treatment for
its individual circumstances. Historically, the communications industry has
accounted for traffic flows on a gross basis. From an accounting perspective,
accounting for a transaction gross or net depends on whether the entity involved
is acting as principal or agent. However, determining this is not so straightforward.
Where the role of the
operator is limited to
collecting and remitting
monies due, rather than
taking any part in the actual
service provided, the credit
risk alone will rarely be
sufficient to justify gross
revenue recognition.
IAS 18 states that revenue includes only the gross inflows of economic benefits
received and receivable by the enterprise on its own account. Amounts collected
on behalf of third parties are not economic benefits which flow to the enterprise
and do not result in increases in equity. In an agency relationship, the gross
inflows of economic benefits include amounts collected on behalf of the principal
and which do not result in increases in equity for the enterprise. The amounts
collected on behalf of the principal are not revenue. Instead, revenue is the
amount of commission.
IFRS gives no guidance on how to determine whether an entity is acting as a
principal or agent in any given transaction. However, the deciding factors are
whether the gross inflows result in increases in equity for the enterprise or
whether they represent amounts collected on behalf of a third party (the
principal). Although not specifically set out in IFRS, an entitys role as principal or
agent will usually depend on whether it takes on the gross risks and rewards of
the transaction or has only a net interest. Other factors, including normal industry
practice and whether the seller discloses that it is acting as agent or principal
are also important.
Credit risk is still one of the determinants in considering whether an entity should
book a transaction gross or net, although other factors will often be more important.
Key factors to consider in the telecoms sector include:
Does the entity have the ability to set the selling price?
Does the entity have control over how it completes its part of the arrangement?
(e.g. can it choose how to route traffic to its destination)
What is established industry practice and would an alternative treatment be
potentially misleading to readers of its accounts?
Does the entity disclose that it is acting as agent?
It is impossible to be definitive about accounting treatments which depend on
the specific terms of each arrangement. Gross vs. net is an area where
companies will need to remain alert to how practice under IFRS develops.
While IFRS provides little guidance industry best practice is increasingly likely
to question some arrangements where gross recognition is currently used.
2.3.2 Accounting for interconnect arrangements
Both fixed line and mobile operators may enter into a number of interconnect
agreements with other carriers. These agreements allow them to terminate or
transit traffic on their respective networks and to provide the end-to-end
capability required by their customers.
In certain cases rates may be regulated, although for a number of international
arrangements, companies are free to set and revise rates as the market dictates.
Historically, the
communications
industry has
accounted for traffic
flows on a gross
basis.
Net settlement
Industry practice is that interconnect revenues are booked gross on the basis
that the carriers are exposed to the gross risks of the transaction.
Interconnect agreements usually allow carriers to settle on a net basis which
does not normally change the appropriateness of recognizing transactions gross,
even if periodic cash settlement may be made on a net basis.
For example, an operator may bear the gross credit risk for non-payment and be
obliged to make payments under interconnect arrangements, irrespective of the
level of reciprocal revenues due. Close attention needs to be paid to the specific
circumstances of each arrangement.
Legal right of offset
Custom and practice is for operators to typically settle on a net basis. However
some operators may seek to further reduce their exposure to other carriers by
entering into agreements that give them the legal right to offset any balances
due from the counter party against balances due to the same party.
Mitigating the settlement risk of the transaction is a sensible commercial
objective. One would not normally expect this to invalidate the policy of
recognizing the gross transaction in the first place. However, ongoing
consideration will be needed to ensure that the policy is neither abused nor
becomes inappropriate.
A carrier may be able to manage the use of its network to reduce cash payments
by managing traffic flows so that services provided to and acquired from a
particular carrier are broadly balanced. This will normally be a valid business
practice from a cash flow management perspective, but it may be necessary to
consider whether the transaction is a normal interconnect arrangement or an
exchange transaction which, under certain circumstances, is not regarded as
revenue under IFRS (see section 2.4.9).
Predetermined volumes
As discussed above, interconnect arrangements are generally accounted for
gross. However, the position may be less clear cut where net settlement and
the legal right of offset exist.
Taking this one stage further, carriers may enter into arrangements where the
rates and amount of traffic to be carried by each party are established upfront.
The substance of the transaction is that the entities agree to exchange services
with the likelihood of any net cash settlement being remote.
For example, carriers A and B may have traditionally terminated relatively similar
amounts of traffic on each others network with typically only a small net
settlement required each month.
Industry practice is that
interconnect revenues are
booked gross on the basis
that the carriers are
exposed to the gross risks
of the transaction.
Carrier A may then enter into an agreement to terminate up to one million minutes
on its network in exchange for carrier B terminating up to one million minutes on
its network with only minutes above these amounts being settled in cash.
Commercially the position may not be much different from the actual trading
formerly recognized by carriers A and B, which was typically accounted for gross.
However, the substance of this arrangement is similar, in many respects, to an
exchange transaction which, in certain circumstances, is not accounted for as
revenue under IFRS. The difference here is that under the new arrangement,
if one party did not complete its contractual obligations (i.e did not terminate
the other carriers million minutes), the other would not receive any consideration.
Accordingly, gross recognition may not be appropriate. In the previous arrangement,
although the traffic carried was in practice often similar, the entities were still
exposed to the gross risks and therefore gross recognition was appropriate.
Establishing fair value
Revenue can not exceed the fair value of the services provided. Entities therefore
need to be able to substantiate fair value where consideration is not received in
the form of cash.
In instances where there is a significant amount of reciprocal interconnect
business between two entities, establishing fair value may not be simple.
Where rates are regulated this is unlikely to be a problem but where entities are
free to set rates, issues may arise. For example, where different rates have been
agreed with different customers or where a small number of operators are
involved, establishing a market price may not be straightforward.
2.3.3 Peering arrangements
Many internet-based businesses enter into peering agreements under which they
obtain access to other operators networks.
A smaller internet provider that connects to a major network might typically pay
a fee but arrangements between similar Tier 1 type operators are not usually
fee-based. Instead the agreement may simply allow reciprocal access to each
others network.
Peering arrangements are not usually recognized as revenue even though a
service is provided and value transferred between operators in much the same
way as under traditional interconnect arrangements. The reason the accounting
differs is not necessarily the service offered, or the ability to monitor it, but rather
the fact that there is no gross exposure for the entities involved. Non performance
by one party does not usually result in any cash compensation being payable to
the other party.
server
2.3.4 Revenue sharing arrangements
Revenue sharing arrangements are increasingly common in the telecoms industry,
especially where a number of different operators are involved in providing one
larger end-to-end transaction. Some examples of the more common
arrangements are discussed below.
Premium rate services
Premium rate services, where the caller pays a premium to the standard call rate
to access additional services are increasingly common. These can include
directory enquiry services, chat lines, other information services or even paying to
vote for a particular person on a television game show. The question arises of
how to account for the share of the gross revenues derived from end customers.
In a simple case there may be three parties involved: the caller, the telecoms
operator and the end service provider. The operator may normally charge the
end user a set rate per minute or per call and pass on an agreed amount to the
service provider (i.e. the call centre providing the information or other service).
The question is whether it is appropriate for the operator to account for the
premium rate service at the gross amount it receives from the caller or at the
net amount retained (in effect as commission earned) after accounting for
payments due to the service provider.
One could argue that the position is no different to traditional voice or other
interconnect arrangements which are typically recognized gross. The contrary
view is that the arrangement is more akin to delivery of a third partys product
where, for example, the courier company is not expected to recognize revenue
according to the gross value of the goods it delivers. However the position in
respect of telecoms companies is more complex. The operator is typically actively
involved in the provision of the service, together with the content provider, rather
than simply delivering a finished product. A number of factors may need to be
considered including:
Is the operator actively involved in the provision of the service?
Is the operators subject to non-performance penalties, if so are these based on
gross or net revenues?
Peering arrangements are
not usually recognized as
revenue even though a
service is provided and
value transferred between
operators in much the
same way as under
traditional interconnect
arrangements.
Diagram 1. Premium rate sevices - one operator
Source: KPMG LLP (UK) 2004
Does the operator have the ability to determine the route the call takes?
Does the operator contribute to the quality of the end service or is it simply
perceived as a delivery mechanism?
Does the operator hold itself out as principal or agent?
Is the operator party involved in establishing the price?
What is industry practice?
Is the treatment consistent with the treatment of other revenue streams?
Is the operator exposed to the gross credit risk?
As discussed earlier, IFRS provides little guidance to determine whether an entity
is acting as a principal or an agent in an arrangement. Industry practice is,
therefore, relevant when determining appropriate accounting. Practice currently
varies under existing local GAAPs and, while the change to IFRS may not result in
an immediate switch to consistent policies across the sector, it is an area in
which practice is likely to develop.
In many cases there will be more than one operator involved and the analysis
of whether gross or net revenue recognition is appropriate may be
significantly different.
Diagram 2. Premium rate services - two operators
Diagram 3. Premium rate services - short stopping
A variation on the scenarios explored above is where the operator effectively
rents a range of international numbers to a service provider and agrees to pass
on a fixed fee to the service provider for each call made to those numbers.
In some cases the operator may earn a fixed fee per call, only pay the service
provider when settlement has been received from the local carrier originating the
call and may even route the traffic so that it is never actually carried over the
operators own network. Prima-facie one would not expect gross revenue
recognition, although the terms of separate arrangements will need to be
carefully evaluated against the criteria discussed above.
Internet service providers
A similar position may arise where ISPs provide their services via another
operators network. If the arrangement is based on a per minute basis, the end
user may pay its network provider for the calls made. The network provider may
then pass on a percentage of the money received to the ISP.
However, where the arrangement is based on a flat rate, the end user may pay
the ISP directly, and the ISP may be billed by the network provider for calls made
to the ISP. Where the network provider receives a gross fee and pays a net
amount to the ISP, it may end up recognizing higher revenue than if it just
received the net amount from the ISP. However, this may be appropriate to the
extent that it matches the credit and other exposures involved.
Again, the position may be further complicated when more than one operator is
involved. Depending on the cash flows and credit risks, the same service may
result in different revenues being recognized by those involved. IFRS provides
little guidance on how to address such complexities. Established industry practice
and full disclosure will remain critical until further guidance emerges.
2.3.5 Bundled services
As the range of value-added services offered by telecoms companies grows, the
issue of being separable and how to account for bundled services becomes
more prevalent. As already discussed, IFRS includes little guidance on when a
transaction should be accounted for as separate identifiable components, and
when it should be considered as a whole.
However, IAS 18 does give a number of examples where it implies separation is
appropriate. For example, when the selling price of a product includes an
identifiable amount for subsequent servicing, IFRS states that the amount is
deferred and recognized as revenue over the period during which the service is
performed. Similarly it states that installation fees should be recognized by
reference to the stage of installation.
Take a service that comprises a number of different components. Under IFRS
one expects to account for them as if they had been provided on a standalone
basis, unless they are interdependent and the substance of the arrangement
requires consideration of the arrangement as a whole.
2.3.6 Installation fees
A common feature of telecom services is that they often require upfront
connection, installation or other costs to be incurred before the ongoing service
can be provided.
The work required can be as little as sending a signal to enable a mobile handset,
to installing equipment at a customers premises, to laying a physical connection.
Where significant, operators may seek to recover costs through separate
connection or installation fees. The issue is whether it is appropriate to separate
out and account for such revenues separately.
IAS 18 specifically addresses the issue of installation fees and states that
Installation fees are recognized as revenue by reference to the stage of
completion of the installation, unless they are incidental to the sale of a product,
in which case they are recognized when the goods are sold.
Where consideration has been received or is separately receivable in respect of
the installation, IFRS could allow revenue to be recognized according to the stage
of completion of the installation. In practice, as installation does not typically take
long and consideration may not be payable until complete, many companies
record installation revenues on completion of the installation.
An additional issue in respect of installation fees is establishing fair values.
Often the fee is included in the subsequent monthly service charge. It will only
be appropriate to separate installation fees, and recognize them on completion of
the installation, where the installation is separable (i.e. could be provided by
another party) and a reliable fair value can be established.
2.4 Capacity sales
2.4.1 Background
Following the filing for bankruptcy of a number of telecoms companies in 2002
and the sharp decline in telecoms stocks, accounting for capacity sales, and in
particular swaps, came in for increased scrutiny and significant press criticism.
However, even the Congressional Hearing into capacity swaps by Global Crossing
and Qwest in September 2002 recognized that there are legitimate arrangements
called IRUs (indefeasible rights of use), and that there is a legitimate accounting
treatment for them. The main issue was not the accounting but whether the
transactions themselves were sham transactions designed to boost revenues.
Under U.S. GAAP, prior to the introduction of FIN 43 in June 1999, industry
practice was to account for capacity sales as sales at the time of delivery and
acceptance. FIN 43 effectively required capacity sales to be accounted for as real
estate sales. This, in most cases, prevented upfront recognition and contributed
to giving the previous accounting treatment a bad name.
In the telecoms industry, entities often buy and sell capacity on each others
networks. While the capacity provider may retain ownership of the network
assets, some contracts convey IRUs to the buyer for an agreed period. Some
contracts convey the right to use identiable physical assets (or identiable
physical components of larger infrastructure assets); others convey the right to
use a specied amount of capacity, dened in terms of an assets output, rather
than the right to use a specic physical item.
The purchase, sale and exchange of capacity is a legitimate commercial practice.
It has been a feature of the industry for many years, but grew in significance
between 1995 and 2001 as carriers sought to extend their networks.
The commercial rationale reflected a number of factors including the cost of
constructing a network, the desire for a secure global presence and the fact that
modern cables are capable of carrying far more traffic than a single carrier can
generate. Few carriers can independently fund the construction of a global
network and, in order to achieve the desired geographic coverage, arrangements
to use other carriers networks are typical. The advantage of an IRU, from the
purchasers perspective, is that it provides security of supply at a known price.
For the seller, an IRU represents a way of funding the cost of construction.
2.4.2 Basic accounting principles
Some of the main issues to consider when accounting for capacity sales are:
Can revenue be recognized upfront (as an asset sale) or should revenue be
recognized over the term of the IRU (as provision of service)?
How should transactions be accounted for where, rather than selling capacity
for cash (or the right to receive cash), an entity exchanges capacity on its own
network for capacity on another entitys network?
2.4.3 Accounting for an IRU as a lease
When determining the appropriate accounting for IRUs under IFRS, it is
necessary to first consider whether the arrangement is, or contains, a lease.
If it is considered a lease, then the appropriate accounting will be determined in
accordance with IAS 17. If not considered a lease, consideration needs to be
given to whether the arrangement constitutes the sale of goods or the rendering
of services. This will establish which part of IAS 18 is relevant when determining
the appropriate revenue recognition treatment.
Contracts that convey rights of use are, in many respects, akin to leases.
The seller typically retains ownership of the asset but conveys the right to use
the asset to the customer for an agreed period of time in return for specified
payments. However, until recently, there has been no specific guidance under
IFRS as to whether IRUs should be accounted for as leases, in accordance with
IAS 17. At the end of 2003 the International Financial Reporting Interpretations
Committee (IFRIC) issued Draft Interpretation D3 Determining whether an
Arrangement contains a Lease.
The purchase, sale
and exchange of capacity
is a legitimate commercial
practice. It has been a
feature of the industry
for many years.
D3 specifically refers to arrangements in the telecoms industry, where suppliers
of network capacity enter into contracts to provide purchasers with rights to
capacity and provides guidance on whether these should be accounted for in
accordance with IAS 17 or not:
D3 sets out the following three criteria which need to be met for an arrangement
to be or to contain a lease;
The arrangement depends on a specific item or items, for example an item of
property, plant or equipment
The arrangement conveys a right to use the item for an agreed period of time
such that the purchaser is able to exclude others from using the item
Payments under the arrangement are made for the time that the item is made
available for use rather than for actual use of the item.
While clearly the terms of specific IRU contracts can vary, in the majority of
cases one could expect a straightforward IRU capacity sale to meet each of the
above conditions as discussed below;
Revenue vs other income
Revenue is income that arises in the course of the ordinary activities of the entity
(e.g. the sale of inventory). Other income such as the sale of an entitys property,
plant and equipment (PP&E) is not revenue but is a gain. Accordingly, capacity
sales out of stock will be reported as revenue whilst sales out of PP&E should be
reported as other income under IFRS.
Arrangement depends on a specific item
IRUs typically identify the specific asset subject to the arrangement, whether a
fiber pair or some other identifiable asset. Under any GAAP, it is difficult to argue
that a sale has been made unless the asset sold can be identified separately.
Where not identifiable, it would imply instead that a service is provided. While
specific fibers on specific cables are clearly separately identifiable and represent
separate tangible assets, the position becomes less clear in respect of segments
of a specific wavelength carried along a particular fiber.
In some cases IRU arrangements may simply give the purchaser the right to use
a certain amount of capacity over a particular route. In these situations, the IRU
would not be accounted for as a lease. The transaction would typically be
accounted for in accordance with IAS 18 as a service rather than as the sale of
goods. Revenue would then be recognized on a straight line basis over the period
of the IRU.
Exclusion of use by others
Invariably, IRUs are for an agreed period of time. Contractually the purchaser will
have exclusive use of the capacity in question. While dark fiber may be clearly
separable and identifiable, the case for lit fiber is more complex.
In its simplest form, lit fiber merely represents dark fiber with electronics at
either end, which may be separable (for example discrete circuit boards). As the
functionality and complexity of the electronics involved increases, the boundaries
as to what is actually sold become somewhat blurred. This becomes important
when considering whether the buyer has exclusive use of, and substantially
assumes all the risks and rewards of the asset identified. In that respect,
portability on behalf of the purchaser, or the sellers ability to substitute alternative
capacity, would typically prevent sales type accounting.
Payments for time available rather than actual use
With the exception of any ongoing operating and maintenance payments,
consideration for an IRU will usually be fixed and not dependent on actual use
of the capacity.
2.4.4 Scope of IFRIC Draft Interpretation D3
Any particular capacity sale by a carrier may represent the sale of a small part of
the total capacity available on any specific route and the seller will retain the risks
and rewards of the remainder.
D3 explains that in some arrangements, the supplier transfers the right to use an
item that is a component or portion of a larger item (e.g. a right to use 50
percent of the capacity of a pipeline). D3 states that how to determine if and
when a right to use a component of a larger item should be accounted for as a
lease is not dealt with in the draft interpretation. It goes on to explain that in
some cases it may be appropriate to treat a right to use a component of an item
as a lease in a manner consistent with the draft interpretation.
Accordingly, it is reasonable for entities to account for capacity sales, that
represent only part of a larger asset, in accordance with D3 so long as the
capacity subject to the IRU is separately identifiable.
2.4.5 Accounting for IRUs in accordance with IAS 17
Assuming IAS 17 is considered applicable, the key issue is whether a capacity sale
should be accounted for as a finance lease or an operating lease. If considered a
finance lease, revenue and profit may be recognized upfront; if an operating lease,
revenue may be deferred and recognized over the term of the IRU.
IAS 17 states that a finance lease is a lease that transfers substantially all the
risks and rewards incidental to ownership of an asset. Title may or may not be
transferred. IAS 17 goes on to state that the substance of the transactions
determines whether a lease is a finance lease or an operating lease. It gives
numerous examples where a lease would normally be classified as a finance
lease. Some of the most applicable to IRU capacity sales are:
The lease term is for the major part of the economic life of the asset even if
title is not transferred
At the inception of the lease the present value of the minimum lease payments
amounts to at least substantially all of the fair value of the leased asset.
Most IRUs are for a period that exceeds the major part of the economic life of
the asset. Typically there will be negligible residual value in the asset at the end
of the lease with the amount paid for upfront for the IRU representing the fair
value of the underlying asset.
2.4.6 Other implications of IAS 17 and D3
While IAS 17 may result in upfront recognition of capacity sales, assuming they
meet the definition of a finance lease, other implications of accounting for IRUs
in accordance with IAS 17 need to be considered.
Disclosure
In addition to meeting the requirements of IAS 32 Financial Instruments, IAS 17
includes comprehensive disclosure requirements for both operating and finance
leases. Many of these relate to future payments due under the lease. For that
reason, if the IRU has been paid in full on acceptance, they may not be applicable
but a general description of the lessees material leasing arrangements will still
be required.
Operating and maintenance services (O&M)
D3 states that IAS 17 should only be applied to the lease element and that other
elements should be separated out. Payments under the arrangement should be
separate and based on relative fair values, recognizing that the purchaser may
need to make estimations.
For IRUs which include O&Ms, either priced separately or included in the IRU
price, payments should be separated into those for the IRU and those for
ongoing O&M services based on their relative fair values. Where O&M is variable
(e.g. a fixed percentage of the overall cable maintenance cost) establishing fair
value should not be an issue. Where O&M payments are fixed this may be
more complex.
2.4.7 Accounting for an IRU which is not a lease
As discussed above, an IRU that is not considered to contain a lease will be
accounted for by the vendor in accordance with IAS 18.
Even if not considered a lease, when determining appropriate accounting for
capacity sales, the key questions are:
Have all the risks and rewards of ownership of the asset been substantially
transferred to the buyer?
Has control of the asset been transferred?
Control is normally taken to be the ability to obtain future economic benets
relating to the asset, and the ability to restrict the access of others to
those benets.
2.4.8 Existing IFRS guidance and UK guidance
IFRS guidance is yet to be finalized as the IFRIC Interpretation is still in draft.
Accordingly it is appropriate to refer to specific guidance from other GAAPs.
UK GAAP specifically addresses accounting for capacity sales (Urgent Issues Task
Force (UITF) Abstract 36). This lists examples of risks that, if signicant and borne
by the seller, indicate that the seller should continue to recognize an asset in its
entirety. These include:
(a) Risk of changes in asset value
(b) Risk of obsolescence or changes in technology
(c) Risk of damage
(d) Risk of unsatisfactory performance (arising, for example,
from performance guarantees)
(e) Risks relating to the sellers obligations to provide continuing access by
operating and maintaining the assets (arising, for example, from exposure to
costs that cannot be recovered from the buyer)
While it may often be clear that the seller retains some of the above risks, it may
be more difficult to determine whether, for those that are retained, they are
significant in terms of the overall transaction. This needs to be considered on a
case-by-case basis.
The provision of ongoing operating and maintenance (O&M) by the seller is a
case in point. O&M will be invariably included, as it is usually impracticable or
prohibitively expensive for the purchaser to arrange its own O&M. However, so
long as sufficient revenue is deferred to cover the costs of providing ongoing
O&M, any exposure to future costs may not necessarily be significant.
2.4.9 Exchange transactions
One of the most contentious aspects of capacity sales accounting is exchanges
of capacity. Sometimes referred to in the press as hollow swaps, the criticism
levied is that, in certain instances, companies had no use for the capacity
they acquired or sold. Agreements to exchange capacity were allegedly used to
inflate revenue or earnings reported. The criticism has also extended to cases
where transactions were settled for cash but where no, or minimal, net cash
changed hands.
While exchange transactions may have been more open to abuse, the nature of
the industry and the geographical coverage of the main players, means the
majority of trade was between a relatively small number of carriers. Exchange
transactions were a means to obtain global capability, considered critical at the
height of the telecoms boom. Furthermore, commercially it is not unusual for
parties to prefer to buy from someone who is already a customer. This should not
in any way invalidate the underlying transactions.
One of the biggest issues in respect of exchange transactions is to help ensure
there is a sound commercial basis for the transaction and to determine the
appropriate fair value at which to record the transaction. If there is no proper
commercial rationale for the transactions or if they are in any way considered
artificial, no accounting recognition should be given to the transaction.
Assuming this is not the case, the two main accounting considerations are:
Can the fair value of the capacity being exchanged be reliably established?
Is the exchange of similar or dissimilar assets?
IAS 18 specifically states that where goods or services are exchanged or
swapped for goods or services which are of a similar nature and value, the
exchange is not regarded as a transaction which generates revenue.
However, aside from the example of commodities suppliers exchanging inventory
to fulfill demand in different locations, IFRS does not go on to define or give any
further guidance on what is considered similar. While some companies may take
the view, for local GAAP purposes, that capacity between London and Paris is
dissimilar from transatlantic capacity because it is a different route, IFRS may not
recognize the transaction because, prima facie, the asset is similar in nature.
The examples given by IAS 18 concern the exchange of commodities such as oil
or milk. Here suppliers exchange or swap inventories to fulfill demand in
particular locations. This is broadly analogous to the exchange of capacity where
capacity in one location is exchanged for capacity elsewhere.
IAS 18 does not currently permit the recognition of revenue in respect of
exchanges of similar assets. However, in its revision to IAS 16 Property, Plant
and Equipment, the IASB removed the distinction between the treatments of
exchanges of similar assets from dissimilar assets as part of the general move for
all transactions to be recorded at fair value.
IAS 16 states that in an exchange of property, plant and equipment cost is
measured at fair value unless (a) the exchange transaction lacks commercial
substance or (b) the fair value of neither the asset received nor the asset given
up is reliably measurable. IAS 16 expands to say that an entity determines
whether an exchange transaction has commercial substance by considering
the extent to which its future cash flows are expected to change as a result of
the transaction.
Accordingly, there are currently inconsistencies between IASs 16 and 18 in how
exchange transactions are accounted for under IFRS. However, for capacity sales,
simply requiring all exchanges to be recorded at fair value would simply shift the
issue from determining whether the assets exchanged are similar, to determining
whether reliable fair values can be established.
On the question of fair value, IFRS provides little practical guidance other than
to explain that fair value is the amount for which an asset can be exchanged,
or a liability settled, between knowledgeable, willing parties in an arms
length transaction.
Clearly, comparative transactions provide some of the best evidence of fair
values. However, for capacity sales, these are not always readily available a
trend that is increasing given the significant fall in IRU sales. While at one stage
the industry was making moves towards bandwidth trading and establishing
standardized terms for trading capacity, in practice this has not materialized.
2.4.10 Capacity purchases
Companies that have never sold capacity may consider that recent accounting
developments in this area have no impact on them. This is not necessarily true.
Companies that have ever bought capacity will need to consider the impact on
their balance sheets where the terms of an IRU have changed.
Many companies that acquire IRUs (indefeasible rights of use) treat the cost as
capital expenditure and include any purchased IRUs as fixed assets. However, the
position may not be so straightforward.
While capacity prices have plummeted and supply continues to exceed demand,
in many markets original sellers of capacity are increasingly offering former
customers the opportunity to exchange the existing capacity they have
purchased for other routes. Sometimes, for operational reasons, they will offer
more capacity on alternative routes so that they no longer have to maintain
unprofitable routes.
By offering to change the terms of the original contract, the risk is that operators
will have to revisit their accounting. For example, once a specific asset is
exchanged for the right to access capacity on a number of alternative routes,
purchasers will need to consider whether the nature of the asset they acquired has
changed. Should it no longer be classified as a fixed asset (i.e. a specific separately
identifiable asset), and instead be treated as prepayment for future services?
Under IFRS, lease classifications are made at the inception of the lease. If at any
time the lessee and lessor agree to change the provisions of the lease, other
than renewing it, in a manner that could have resulted in a different classification
of the lease had the changed terms been in effect at the inception of the lease,
the revised agreement is considered as a new agreement over its term. Similarly
under IFRIC Draft Interpretation D3, a reassessment of whether an arrangement
contains a lease should be made if, and only if, the provisions of the arrangement
are changed. Accordingly, historical IRU purchases will need to be re-visited if
changes in the terms of the IRU are made.
It is important to note that IAS 18 does not have any exemption under IFRS 1
from retrospective adjustments. For that reason, all purchased IRUs may have to
be re-analyzed on adoption to ensure the appropriate treatment.
If there is no proper
commercial rationale for
the transactions or if they
are in any way considered
artificial, no accounting
recognition should
be given to
the transaction.
2.5 Other revenue recognition related issues
2.5.1 Probability of receipt
Often the marginal cost of providing telecoms services is not significant.
As a consequence, compared with other industries, operators may be slower
to discontinue services where the customer is behind on payment.
Consequently, there may be a number of instances where the operator continues
to provide a service where the likelihood of payment is remote. This is especially
prevalent in the co-location sector where space has been let to customers under
long-term arrangements, some of whom have subsequently fallen into significant
financial difficulty.
Where there is no alternative customer for the space, the co-location operator
may continue to invoice for the provision of the space even though payment is
unlikely. From an accounting perspective, is it appropriate to continue to
recognize revenue and provide for it when considered unrecoverable or should
revenue not be recognized in the first instance?
IAS18 states that revenue should only be recognized where it is probable that
the economic benefits associated with the transaction will flow to the enterprise.
Accordingly, irrespective of whether a service is provided and the seller
performing its duty, revenue should not be recognized unless it is considered
probable that payment will be received. Payment does not have to be certain but
there does need to be a realistic expectation that it is forthcoming.
...historical IRU purchases
will need to be re-visited if
changes in the terms of
the IRU are made.
IFRS, through IAS 1, offers considerable freedom for presenting costs in the
income statement. Indeed less analysis will be required when IAS 1, as changed
in the improvement statement, is applied as there is no longer a requirement to
show the results of operating activities as a separate line item.
3.1 Income statement presentation
Further analysis is required either on the face or in the notes to the income
statement. Here IFRS offers a choice between the nature of expense and the
function of expense methodologies as illustrated below.
Some telecom companies currently use a hybrid of the two methods, presenting
cost of sales and gross profit (function of expense method) and then switching to
the nature of expense method for disclosing other operating costs.
This has the benefit of making both gross margin and EBITDA (Earnings before
interest, tax, depreciation & amortization) readily ascertainable from the financial
statements. However, it is not consistent with the either / or choice offered by
IAS 1 and would not be appropriate under IFRS. Irrespective of whether the
nature or function method is adopted, presentation of EBITDA on the face of
the profit and loss account may will still be possible by presenting a sub-analysis
of earnings, as illustrated in the following table:
3. Cost of sales
and operating expenditure
In practice there
has been a great
deal of diversity of
classification between
operators.
Function of expense method
Revenue X
Cost of Sales X
Gross Profit X
Other income X
Distribution costs X
Administritive expenses X
Other expenses X
Profit X
Nature of expense method
Revenue X
Other Income X
Changes in inventories of finished X
goods and work in progress
Raw materials & consumables used X
Employee benefits costs X
Depreciation & amortisation X
Other expenses X
Total expenses X
Profit X
Extract from income statement
Revenue X
Other Expenses (classified by nature or function either on the face X
of the income statement or in the notes to the financial statements)
Analysis of profit operations
Profit before interest, taxes, depreciation and amortisation (EBITDA) X
Depreciation & amortisation X
Profit from operations X
3.1.1 Comparability
For companies that follow either the hybrid approach or function of expense
method, the question arises as to what should be classified as a cost of sale.
There is no direct guidance in IFRS on how to allocate costs between the income
statement captions. However, some guidance on cost of sales may be inferred
from IAS 2 Inventories. It states that inventory costs should include costs of
purchase, conversion and other costs in bringing the inventory to its present
location and condition, including attributable overheads.
So, for a typical fixed line operator one might expect to see the following
included within cost of sales:
In practice there has been a great deal of diversity of classification between
operators, even allowing for differences in cost structures. Of the costs listed
above, interconnect charges and customer tail circuit costs are commonly
reported as a cost of sale. Classification of the remaining items is varied.
It is relatively unusual for companies to include their core network costs within
cost of sales. One possible reason for this may be uncertainty about how to deal
with the costs of under-utilized networks. While it is easy to see that core network
costs represent a cost of sale on a fully utilized network, it is less apparent for
the many networks that were constructed in anticipation of significant volume
increases which have not (yet) been achieved.
For customer acquisition
costs to be deferred
(capitalized), they must
meet both the definition
and recognition criteria
for an asset.
Costs involved in a sale
Customer/Call specific costs
Interconnect charges
Customer tail circuits
Customer specific maintenance and installation costs
Selling Costs
Reseller and agents commisions
Core network costs
Outsourced maintenance costs including O&M charges on fibre leases
Network maintenance including related staff costs
Network operations centre costs
Fibre operating leases
Depreciation
Charge in respect of any of the above costs capitalised
commonly included as a cost
of sales
often included as a cost of sale
sometimes included as a cost
of sale
rarely included as a cost
of sale
In other industries usage variances are readily identifiable. This is far less true
for a telecoms company. It is perhaps understandable that they may choose to
avoid potentially arbitrary allocations between cost captions by allocating the
whole of the cost to a single heading. Therefore, normal variances may be
allocated to costs of sales / stock, and abnormal ones to other operating expenses.
The current state of affairs is unsatisfactory in that companies reported results
are far from comparable. It remains to be seen whether the limited guidance
within IFRS is enough to resolve these differences. For now, inconsistencies of
treatment of both costs and revenues (see section 2) may significantly undermine
the value of gross margin comparisons and projections.
3.2 Cost recognition
The IAS Framework requires that expenses are recognized in the income
statement when a decrease in future economic benefits, related to a decrease
in an asset or an increase of a liability, has arisen and can be measured reliably.
As there is normally a direct association between the earnings of specific items
of income and the costs incurred, the matching principal is still relevant.
Accordingly, the revenue recognition considerations described in section 2 often
dictate the recognition of related costs in the income statement.
This is not always the case. The application of the matching concept does not
allow for the recognition of items in the balance sheet which do not meet the
definition of assets or liabilities. The following examples illustrate some situations
where the matching principle does and does not apply.
3.2.1 Handset sales
Handsets are normally sold as part of a larger package with the value attributable
to the handset accounted for as revenue upon delivery (providing the handset has
standalone value to the customer). In this case, the cost of the handset would be
expensed in the income statement upon delivery as well.
3.2.2 Customer acquisition costs
Often, the more interesting question is when any external customer acquisition
costs should be expensed. Should this be up front at the time of recognizing any
handset or other equipment revenue? Or should it be deferred and amortized in
line with the provision of subsequent services?
For customer acquisition costs to be deferred (capitalized), they must meet both
the definition and recognition criteria for an asset.
IFRS defines an asset as a resource controlled by the enterprise as a result of
past events and from which future economic benefits are expected to flow to the
enterprise. Recognition is only permitted if, as for tangible assets, the resource is
controlled (say by means of a contract), economic benefits are probable and the
cost of the asset can be measured reliably.
The issue therefore, is whether the operator has the right to control access to
future revenue streams (say under an enforceable service contract), and if the
cost of the subsidy can be reliably measured. If these criteria are not met, then
the customer acquisition costs are more akin to a marketing expense and should
be expensed as incurred rather than capitalized and amortized over the contract
life. For example if a customer contract was not signed at that time, unless it was
otherwise legally enforceable, it may not be appropriate to capitalize the
customer acquisition cost.
Historically some entities may have deferred customer acquisition costs based on
the expected customer life, calculated according to historical and anticipated
churn rates. Where historical experience shows that the average customer did
not stay for the full contracted period, the shorter period should be used.
However, where this period is significantly less, it calls contract enforcement into
question (either because an entity is practically unable to or is unwilling to) and it
becomes debatable whether any costs should be carried forward. Where churn
rates indicate that customers are loyal beyond contracted periods, amortization
should only extend to the contracted period beyond this point the operator has
no control over the future benefits that may arise from the customer, even if
considered probable that they will be achieved.
3.2.3 Activation costs
For small sales such as handsets and related services, costs are generally low
and will normally be expensed in the period in which they are incurred. It is
relatively unusual to bill a separate activation fee in such instances. Instead, the
activation fee is recovered via installments paid over the service period. In this
instance, revenues from activation are deferred while costs are recognized in the
period of the activation.
In the case of customer-specific construction and activation activities, (say digging
activities and completing the last mile for fixed line services), costs will not be
incidental and are normally charged to the customer separately. In these cases,
the activation fee shall be recognized as revenue upon activation (taking into
account revenue recognition criteria), and the costs incurred shall be expensed at
the same point in time (having been recorded as work in progress until that time).
If customer-specific construction and activation activities are not charged to the
customer, capitalization of the costs may be appropriate where:
They meet the definition of an asset and reliability criteria (it is probable that
future economic benefits associated with the asset will flow to the enterprise
and the cost of the asset to the enterprise can be measured reliably)
or
They are considered to be an unavoidable cost of taking on the contract to
provide future services (akin to set-up costs), and the contract is expected to
be profitable.
The deprecation term of this asset will usually be the contract term, subject
to impairment reviews, where circumstances indicate that the asset may not
be recoverable.
3.2.4 Subscription fees and network cost
Aside from variable fees based on usage, telecoms companies usually bill fixed
fees for services that are independent of usage by the customer (in combination
with variable fees or separately). A common example is monthly subscriber fees
for data carriage services.
The costs associated with these services are largely fixed and relate
predominantly to the cost of the network itself. As the core network cannot be
allocated to specific customers or products, costs related to it (including costs of
upgrades and maintenance) are capitalized and depreciated over its economic
useful life. This is much longer than the average customer contract term, but
should not be longer than the period over which an entity expects to serve its
current and future customers in a profitable manner.
Because of the lack of a direct relationship between network costs (which are
largely fixed) and the revenues from subscription fees (which depend on the
number of subscribers), capitalization criteria and depreciation considerations
rather than matching determine the accounting treatment for network-related
costs.
3.2.5 Leased lines
Many operators have short-term (i.e. operating) leased line contracts with
other operators. Leased lines may generally be viewed as an expansion of an
enterprises network, but can also relate to a specific customer or product.
In both cases, it is common for periodic (monthly) lease fees to be paid to the
supplier. These costs are expensed as incurred whether they relate to the core
network or individual customers.
3.3 Other issues
3.3.1 O&M costs
Particular judgment is required in respect of O&M (operating and maintenance)
costs incurred under capacity contracts. A separate O&M charge is a common
part of a fiber IRU agreement, as the vendor seeks to pass on an appropriate
share of the ongoing costs of maintaining and operating the fiber.
An accounting judgment is required to ensure the commercial negotiation for the
sale has not resulted in any disproportionate compromises between the capacity
selling price and the agreed contribution towards O&M.
The distinction is an important one. For the potential purchaser, negotiated
reductions in O&M mean a saving on operating expenses. These may be far
more attractive than reductions in finance lease charges which serve to reduce
depreciation expenses and do not, therefore, impact EBITDA.
In practice the parties often agree a sale that is based on the timing and current
value of the aggregate (lease and O&M) payments. They then consider how the
costs should be characterized under the contract. In this situation, consideration
needs to be given to whether the legal form of the agreement fairly reflects the
substance of what has been negotiated. As discussed in IFRIC D3 (see section
2.4.4), assuming that the IRU agreement is considered to contain a lease, IFRS
will require costs to be allocated between the lease and the O&M by reference
to relative fair values.
For larger telecoms companies with experience of letting their own O&M
contracts, there may be objective evidence of the relative O&M cost. For others
the assessment may be more difficult. In any event, it would not be appropriate
to avoid the issue by allocating the entire cost to the capital element of the lease.
To ignore maintenance costs would be inconsistent with the treatment of the
lease as a fixed asset.
An accounting judgment
is required to ensure the
commercial
negotiation for
the sale has not resulted in
any disproportionate
compromises between the
capacity selling price and
the agreed contribution
towards O&M.
4.1 Introduction
Within the telecoms industry, the accounting treatment of 3G licenses acquired
by mobile companies at the height of the recent boom has probably attracted
most public attention. Such licenses are one of the biggest assets on the balance
sheet of many mobile telecoms companies.
To put it into context, over US$100 billion has been invested in Europe alone in
acquiring 3G licenses, with around US$50 billion and US$35 billion paid in
Germany and the UK respectively. In addition to the license costs, some estimate
that a similar sum may end up being spent on building the necessary
infrastructure, with much of this capitalized on companies balance sheets.
Accounting for intangibles in relation to goodwill and, looking ahead, development
expenditure, are especially pertinent to the telecoms industry. Where IFRS is
likely to make an impact is the obligation to capitalize development costs that
meet certain criteria and the requirement to amortize all capitalized intangibles
(though goodwill will become an exception to this).
The three principal questions that need to be addressed for intangibles are:
What should be capitalized?
How should it be amortized?
How should impairments be addressed?
4.2 Capitalization of intangible assets
4.2.1 Basic principles
Although capitalization of tangible fixed assets is a subjective area within
the industry, what can be capitalized as an intangible asset has, historically, been,
much less controversial. This may change as more complex services evolve to
address the greater integration of communication services with corporate
information systems and more content rich services for the ordinary consumer.
Similar to tangible fixed assets, the basic principle is straightforward: for anything
to be capitalized as an intangible, it should be controlled by the entity and be
expected to generate future benefits for the entity. IFRS requires that an
intangible asset is recognized if it meets its definition and recognition criteria.
The definition is an identifiable non-monetary asset without physical substance
where the asset is a resource that is (a) controlled by an entity as a result of past
events; and (b) from which future economic benefits are expected to flow to the
entity. Recognition is only permitted if, as for tangible assets, economic future
benefits are probable and the cost of the asset can be measured reliably. This
applies whether the asset is acquired externally or generated internally, though
there are additional recognition criteria for internally generated assets.
4. Intangible assets
...over US$100 billion
has been invested in
Europe alone in acquiring
3G licenses, with around
US$50 billion and US$35
billion paid in Germany
and the UK respectively.
4.2.2 The identification of appropriate costs
Like tangible fixed assets, the basic principle is that the cost of an intangible
asset comprises its purchase price and any directly attributable expenditure to
prepare the asset for its intended use.
For separate acquisitions this should be straightforward. In acquiring a license,
there may be associated legal and professional fees. However, start-up costs and
general overheads should not be capitalized. What is more, due to the additional
requirement under IFRS, once expensed, costs must not be later capitalized. It
should be evident from the time that costs are first incurred that they meet the
appropriate criteria for capitalization.
If acquired as part of an acquisition, the cost is based on fair value at the date of
acquisition. If this cannot be measured with sufficient reliability, then the costs
fail to meet one of the two essential criteria for recognition as an intangible
asset. For telecoms companies making acquisitions today, the original cost of,a
license (for instance) may not prove a meaningful indicator of value. With no
ready market for the asset, a benchmark may not be available.
Some telecom companies have acquired licenses from the government, either
free of charge or at values substantially below what others have been willing to
pay in separately regulated markets. In such circumstances, IFRS allows a choice:
Account for the intangible asset and the equivalent grant at fair value initially
or
Recognize the asset initially at its nominal amount, plus any directly
attributable expenditure.
The IASB is currently considering revisions to IAS 20 to require grants to be
recognized as income when any conditions are met. A final position is expected
before the end of 2004.
4.2.3 Treatment of borrowing costs
IFRS allows, as a policy choice, borrowing costs to be either expensed as
incurred or capitalized to the extent that they relate to the acquisition or
construction of an asset to be capitalized as part of the cost of that asset.
This applies equally to intangible assets and fixed assets. Given the significant
sums invested in licenses and other intangibles, the amounts involved may be
significant for many telecoms companies. In many jurisdictions this may be a
change from existing accounting practices.
If a policy of capitalization is adopted and funds are borrowed specifically to
obtain an asset, the amount of borrowing costs eligible for capitalization on that
asset should be the actual borrowing costs incurred.
The IASB is currently
considering revisions
to IAS 20 to require grants
to be recognized as
income when any
conditions are met.
To the extent that funds are borrowed generally and used for the purpose of
obtaining assets, the amount of borrowing costs eligible for capitalization should
be determined by applying a capitalization rate to the expenditure on that asset.
The capitalization rate should be the weighted average of the borrowing costs
applicable to the borrowings of the enterprise outstanding during the period,
other than borrowings made specifically for that asset. The amount of borrowing
costs capitalized during a period should not exceed the amount of borrowing
costs incurred during that period.
4.2.4 Other costs that can be capitalized as intangible assets
Research and development costs
IFRS explicitly prohibits capitalization of certain intangible items, including
internally generated goodwill, brands, customer lists and items similar in
substance. This is because they cannot be distinguished from the cost of
developing the business as a whole.
IFRS prohibits the capitalization of research costs. However, IFRS requires
capitalization of development costs if certain criteria are met. It does not allow
companies a choice of which accounting policy to adopt.
1
IAS 38 requires development costs to be recognized if certain criteria are met
(research costs are always expensed as incurred). In summary, the conditions are:
The project is demonstrably technically feasible and there is a clear intention to
complete the project and suitable resources are available to achieve this
The ability to sell or use the asset is demonstrated, including evidence of the
economic benefits that will flow from the sale / use of the asset
The cost associated with creating the asset can be reliably measured.
In practice cost capitalization is likely to be limited by the difficulty of demonstrating
the economic benefits that may flow from the asset. For example, the pricing of
many telecoms services can be volatile and it is not unusual for a new service to
be bundled free as a means of supporting prices on an existing service
In such circumstances, leading telecoms development projects will typically be
expensed as incurred due to uncertainties over the direct benefits. It may well
prove easier for second adopters of a service to capitalize development costs as
a pricing basis may already be established.
A further difficulty arises when identifying the incremental cost associated with
the service. A network upgrade can offer a wide range of benefits, one of which
may be to add a new service to the companys capability. Pinpointing the part
of the cost that specifically relates to the new service may prove difficult or
impossible. In this case IAS 38 is clear: capitalization is only required where
the directly attributable cost can be measured reliably. The ability to allocate
costs between development and maintenance is an important part of
reliable measurement.
1
Under UK GAAP capitalization of development costs is optional.
To date this has not been a significant issue for the telecoms sector as products
have been relatively simple and delivered largely over hard networks. This may
change as networks become more intelligent, as software becomes more critical
in their development and as more sophisticated products combine communication
with customers other IT assets. This is an area to be watched.
Customer acquisition costs
As discussed in section 3.2.2, it is appropriate, in certain cases, to capitalize
customer acquisition costs. Such costs, if capitalized, should be classified as
intangible assets in the balance sheet and will be subject to amortization and
subsequent impairment reviews.
4.3 Amortization of intangibles
While there have been many casualties from the recent telecoms boom and
bust, one area that has fared better than many is the mobile sector.
However, not even the mobile sector is immune to the impact of collapsing
valuations, starkly illustrated by the billions invested in 3G licenses which, for the
most part, have still to prove themselves. Although in many cases delayed, the
introduction of 3G services across Europe is now developing apace, which raises
interesting questions about how to amortize the significant sums invested.
Following the revision of IAS 38 Intangible Assets, IFRS now requires that
intangibles with indefinite lives are not amortized. For assets with finite lives (for
example many telecoms licenses), amortization is, for the most part, unlikely to
be significantly changed as there are few differences between the requirements
of IFRS and other major GAAPs.
UK GAAP, for instance, requires that the method of amortization should reflect
the expected pattern of depletion. And IAS 38 states it should reflect the pattern
in which the assets economic benefits are consumed by the enterprise. In this
respect, consistency across the industry might be expected. However, there are
a number of differences that arise in practice.
4.3.1 Method of amortization
With the exception of the start-up period, many mobile operators amortize
license costs on a straight-line basis. IFRSs basic premise is that the method of
amortization reflects the pattern in which the assets economic benefits are
consumed. This suggests that alternative approaches may be appropriate.
However, IAS 38 goes on to state that unless that pattern can be reliably
determined, a straight-line method should be used. Any amortization pattern
based on actual usage or the number of subscribers may be inappropriate as,
although the current position is known, any future projections are likely to be
below the necessary reliability threshold due to the inherent uncertainty involved.
Additionally most would argue that the potential benefits of a license are
expected to be consumed in the course of time and that consumption is not
affected by the level of benefits achieved. For example the number of customers
on a network. Some companies adopt a sum of the digits approach, in
accordance with their local country GAAP but this is unlikely to be acceptable
under IFRS.
4.3.2 When to start amortization
Amortization reflects the consumption of economic benefits, but when does an
entity begin to consume an economic benefit from 3G or any other licenses?
Companies will usually argue that the license gives them no benefit until the 3G
service is launched. Accordingly, they will start to amortize from the commercial
launch or the commencement of services. This date may not always be clear as,
in practice, a full service may not be available from day one. In the first instance a
launch may be restricted to either a particular geography, or to a limited number
of users (reflecting the current scarcity of handsets).
Once the service is generally available to customers across the entitys network,
amortization should start. However, some companies adopt a policy of ramping
up the amortization charge during the start-up period, rather than amortizing on a
straight-line basis from launch. Conversely, others may amortize licenses over the
period of the license, irrespective of when the network is fully operational and
the entity in a position to obtain the full benefit from the license.
Indeed, IFRS specifically states that amortization should commence when an
asset is available for use, irrespective of whether it is actually used or not. This
suggests that licenses should be amortized from the date they start. However
there is a strong argument that the license is not ready for its intended use until
the network is also ready, and accordingly, that amortization should not start until
both the license and the network are ready for use, which can only be on
commercial launch.
Available for use is defined in IAS 38 as when the asset is in the location and
condition necessary for it to be capable of operating in the manner intended by
management. One could argue that even if an operators network is not ready its
license can be used, say by renting it out to another operator. IFRS would only
require immediate amortization if renting it out was managements intent when
acquiring the asset.
Amortization reflects
the consumption of
economic benefits,
but when does an entity
begin to consume an
economic benefit from
3G or any other licenses?
4.3.3 Residual value
Amortization and depreciation should be from the cost of the asset in question to
the estimated residual value. In the case of intangible assets, IAS 38 states that
the residual value shall be assumed to be zero unless:
a) There is a commitment by a third party to purchase the asset at the end of its
useful life;
or
b) There is an active market for the asset and:
(i) residual value can be determined by reference to that market: and
(ii) it is probable that such a market may exist at the end of the assets
useful life.
These are very tough criteria with which to comply. In most cases the residual
life will be zero as an active market does not exist for the intangibles in question.
4.4 Joint development type arrangements
As operators seek to identify new revenue streams in a saturated market, joint
development arrangements are likely to increase. An example of this could be
strategic alliances between mobile operators and handset manufacturers or
specialist service providers (e.g. news alerts via text messaging). Alternatively,
there may be joint development arrangements between operators themselves as
the industry moves towards fixed-mobile convergence.
While IFRS prohibits the capitalization of research costs, it requires the
capitalization of development costs once certain criteria are met. While some
development activities may result in an asset with physical substance, the
physical element of many telecoms products and services is secondary to its
intangible component the knowledge embodied in it. Where development
relates to an intangible asset, costs can be capitalized only if it is considered
probable that future economic benefits attributable to the asset will flow to the
enterprise and the cost of the asset can be measured reliably. Consequently,
the degree of certainty about the success of the product or service being
developed is key.
4.5 Joint build type arrangements
It is common practice for operators to seek to share the costs and risks
associated with major network build projects. Often a central billing party is set-
up, made up of either the lead operator or a consortium. The central billing party
will manage the project, deal with suppliers, measure progress against
milestones and allocate costs incurred to the various operators.
In many cases the lead operator pays the full costs upfront with the other
operators contributing. Whether the lead operator recognizes the recovery of
costs as income or nets it off against the cost of the asset depends on its
exposure to risks and rewards of ownership.
For example, where the lead operator controls the resulting asset and the
contributors simply obtain the right to use it, it would be appropriate to account
for the gross cost of the asset and any contributions as income (either as a
prepayment for future services or as an asset sale depending on the
circumstances). However if the lead operator and the contributors jointly control
the resulting asset, under an asset sharing arrangement, then one would expect
the lead operator to account for contributions received as a credit to the cost of
the asset.
IAS 31 provides guidance on the accounting and disclosure requirements for the
different types of joint venture arrangements jointly controlled operations,
jointly controlled assets and jointly controlled entities.
As regulations in the marketplace are relaxed, increased sharing of assets such
as networks / sites / masts is expected. Again the appropriate accounting of
these assets will depend on the commercial substance of the arrangement.
5.1 Network amortization
Capitalization of fixed assets can be a subjective area. Though there are few
significant differences under international GAAP about what should be capitalized,
the problem is more usually around interpretation and industry practice.
Industry practice came under increased scrutiny during the first half of 2002
when the press put the spotlight on capitalization policies.
Capitalization of labor is not unusual. Among UK telecoms companies alone,
about UK 1bn of staff costs were not counted as current expenditures but put
down as capital expenditures.
The issue is acute in the telecoms industry as the business model is capital
intensive. Extensive network build goes on during periods of growth but the costs
are deferred over long periods of use. In addition, the nature of the assets built
dictates that a considerable proportion of a companys operations are dedicated to
capital projects during periods of growth. As a consequence, and quite rightly, a
large proportion of a companys total labor costs may be capitalized.
Telecoms is not the only industry to have this capital-intensive model; many utility
or network-based industries such as gas or water are similar. However, what
distinguished the telecoms industry was the perception, largely fuelled by the
Internet boom, that growth in and demand for telecoms products was going to
be exponential.
This caused the market and shareholders to consider the roll-out of networks a
virtue in itself. It was assumed that the companies with the greatest network
coverage would be best positioned to capitalize on the predicted burgeoning
demand.
The focus for evaluating share prices switched from traditional performance
measurement indicators such as EPS and cash flow to earnings before interest,
tax, depreciation and amortization (EBITDA). Capital investment was effectively
free as once capitalized the subsequent depreciation did not impact reported
EBITDA. Both at the EBITDA level, and at an operating level, the capitalization
policies adopted significantly impacted reported performance.
At the time the policies employed were, in the main, valid and based on a sound
rationale. It is only now, with the benefit of hindsight, that some may question
the policies adopted.
5. Property, plant and equipment
Though there are few
significant differences
under international GAAP
about what should be
capitalized, the problem
is more usually around
interpretation and
industry practice.
5.2 Basic accounting principles
One of the main issues regarding capitalization of costs is what assets can
be capitalized.
What constitutes a fixed asset, and consequently what costs should be
considered to be directly attributable to such assets and accordingly capitalized?
What practical implications arise from these policies, and what difficulties, if
any, can lead to the incorrect fixed asset accounting?
5.2.1 Determining which assets can be capitalized
The basic principle underlying fixed asset accounting is straightforward: for any
expense to be capitalized it should contribute to providing future economic
benefits to the entity.
The costs capitalized should meet the recognition criteria of an asset, or be
eligible for capitalization under specific accounting guidance. Matching alone is an
insufficient basis on which to justify deferring costs. Consequently, one needs to
be able to establish control first and then determine the probability that the
economic benefits will flow to the entity while helping to ensure that costs can
be measured reliably. Under IFRS, the benefits do not need to be certain (i.e.
specifically contracted) but do need to be probable rather than merely hoped for.
5.2.2 The identification of directly attributable costs
Under IFRS, assets should be measured, whether acquired or self-constructed, at
cost (amount paid or fair value of other consideration). Allowable costs are those
that are directly attributable to bringing the asset into working condition for its
intended use.
IFRS gives examples of directly attributable costs, including:
Cost of site preparation
Initial delivery and handling costs
Installation costs
Professional fees; and
Estimated cost of dismantling and removing the asset and restoring the site to
the extent that it is recognized as a provision.
Start up costs and general overhead costs should not be capitalized unless they
are directly attributable to the acquisition of the asset, or bringing the asset into
its working condition.
The basic principle
underlying fixed asset
accounting is
straightforward:
for any expense to be
capitalized it should
contribute to providing
future economic benefits
to the entity.
The decision to defer costs is based on fundamental accounting principles.
However, it is not always easy to identify which costs are directly attributable to
any specific asset. As a result, complexities may arise with the practical
application of policies and judgment needs to be exercised. For example, network
build costs may be substantial and it may take a number of years to complete the
network. Similarly the boundaries between network build and network
maintenance may not always be clear. This presents practical problems.
Unless appropriate processes and procedures are in place to allow for accurate
monitoring of spend against the appropriate categories, errors can easily occur.
5.2.3 Capitalization of labor
Other than the cost of physical equipment, staff costs are typically one of the
largest single costs of any network project. In a complex capital program, it is
likely that any given resource pool will be used for more than one project and that
there will be an overlap between construction and maintenance activities. These
factors increase the difficulty of being able to reliably measure and identify which
costs are the incremental costs of construction but do not prevent the policy of
capitalization being appropriate.
Rather than making broad assumptions when allocating expenses to discrete
cost pools, a time recording system may be necessary to profile activities. Capital
projects need to be clearly identified and appropriate controls put in place to help
ensure that the right costs are charged to these projects. This is especially
important where the activity crosses both construction and on-going
maintenance projects.
In any event, major assumptions about deferral of costs should be regularly
reviewed as a project moves through its life cycle because the mix between
construction and maintenance costs will vary. The application of any capitalization
policy requires a number of judgments and assumptions to be made and robust
processes and controls to be in place.
Once established, capital project codes need to be reviewed regularly. This will
help ensure that it remains appropriate to defer costs, and that expected future
economic benefit is still considered probable. This may depend, in part, on being
able to measure the expected performance of a project, largely in financial
returns, which is often not straightforward. Projects often comprise several
different type of asset, with varying useful lives, which can make monitoring
difficult once transferred to the fixed asset register.
5.2.4 Capitalization of finance costs
One area where GAAP does diverge is on the treatment of borrowing costs.
Where material, U.S. GAAP generally requires the capitalization of interest costs
relating to capital projects. IFRS permits it as an allowed alternative treatment
(IAS 23 para10 see section 4.2.3).
Other than the cost of
physical equipment, staff
costs are typically one of
the largest single costs of
any network project.
5.2.5 Capitalization of other costs
An important question is what other type of network costs can be capitalized.
The theory is relatively straightforward and relates to directly attributable costs.
In practice there are a number of costs where the appropriateness of
capitalization, is unclear and may depend on entities individual circumstances.
Some of the more common scenarios are considered below.
Mobile network
Site selection costs:
Under IFRS, start-up and similar pre-production costs do not form part of the cost
of an asset unless necessary to bring the asset to its working condition. The
issue with site selection costs is that until it is clear which sites will be selected,
the probability of future economic benefit from any particular expenditure can not
be determined. However, once virtually certain that a site will be acquired,
capitalization will usually be appropriate.
Operating costs:
When constructing a network, significant operational type costs may be incurred
before it actually becomes operational. These may apply, for instance, to mobile
station site costs or network lease circuit costs. The question is whether these
costs are directly attributable and necessary to bring the asset to its working
condition, say, as part of testing or commissioning the network. IFRS states
that costs of testing whether the asset is functioning properly are directly
attributable costs.
Training costs:
Training costs should not be capitalized on the basis that similar costs are likely to
be incurred as part of the entity's on-going activities. What is more, the
relationship between the expenditure and any future economic benefits that may
be derived from it is usually not sufficiently certain. IAS 16 specifically includes
staff training, in respect of doing business in a new location or with a new class
of customer, as an example of costs which should not be included in the cost of
property, plant and equipment.
5.3 Dismantling and removal costs
As discussed in section 5.2.2 the initial cost of an item of property, plant and
equipment should include the estimated cost of dismantling and removing the
item and restoring the site on which it is located.
In the construction of networks, both mobile and fixed line operators often build
assets on leased land or premises where an obligation exists (under the lease
agreement for example) to reinstate the land or premises at the end of the
agreed term. Provision for such costs is also required under U.S. GAAP where
they are often referred to as Asset Retirement Obligations (AROs).
The obligation is accounted for by including the estimated cost of dismantling and
removing the asset as part of the cost of the asset and setting up a provision for
the estimated present value of the obligation. These are both then unwound over
the relevant period.
Identifying AROs
One main issue with AROs is that it may not be evident that an obligation exists.
The contract may be unclear or silent on restoration requirements at the end of
the contracted period.
In many cases, it is unclear what rectification work needs to be carried out and
entities need to make their best estimate based on past experience. There may
also be cases where rectification obligations exist but they are not enforced in
practice. For instance, obligations in respect of 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 in place.
Similar issues exist where operators have been given rights to locate public
telephone boxes in certain public places. The increase in mobile penetration
rates, has made many of these sites redundant, but there is no immediate
requirement to remove them.
Recognition of asset retirement obligations
For an ARO to be recognized, it should meet the definition of a provision under
IAS 37. Under the terms of a lease, a contractual obligation will often exist to re-
instate land or premises. Alternatively, an entity may be required by local laws
and regulations to remove assets at the end of their useful lives. In the absence
of a contractual obligation, a constructive obligation may exist if there is an
established pattern of past practice or published policies of dismantling and
removing assets.
IAS 37 contains requirements on how to measure decommissioning, restoration
and similar liabilities. However, it does not provide guidance on how to account
for changes in those liabilities. This issue is currently being addressed by IFRIC
which has issued a draft interpretation.
Key assumptions
Mobile operators enter into agreements to lease land / property on which to
erect masts. These leases can vary in length and may contain an option to extend
the lease. In these circumstances, where an obligation exists to reinstate the
land / property, how should the present value of the obligation be calculated?
Should the obligation be based on the original length of the lease or the extended
period? Or should the obligation not be valued at all on the grounds that it may
not crystallize or that it is immaterial?
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.
5.4 Useful lives
Obtaining an accurate picture of companies depreciation policies from public
information is a relatively fruitless task. Most companies give depreciation rates
for very wide ranging asset categories and typically give a broad range of asset
lives. However, what is increasingly clear, is that whichever lives are chosen, they
need to be regularly reviewed to help ensure they still reflect the remaining
estimated useful life of the assets in question.
IFRS requires that the residual value and useful life of an asset is reviewed at
least at each financial year-end. If expectations differ from previous estimates, the
depreciation charge for the current and future periods should be adjusted.
For many telecoms companies, reviews into the estimated useful lives of assets
typically result in a downgrading. This reflects the increasing pace of technological
change, as well as changes within the business.
Where the change in asset life is significant, this may indicate that immediate
impairment rather than a revision to the onward depreciation rate is necessary. At
the other end of the scale, it should be noted that if an asset is still in use and
contributing to the generation of future cash flows, full impairment with no
depreciation charge going forward will rarely be appropriate. In many cases partial
impairment, followed by a reduction in the remaining useful life, will be the most
appropriate approach.
One issue that many mobile operators may face is whether, in situations where
assets are held on sites leased from third parties (e.g. base stations),
depreciation should be limited to the period of the lease.
When determining the appropriate useful life for an asset, an estimate needs to
be made of what is most likely to be the economic life of that asset. It should
take into account what is expected to happen in practice. Where there is no
certainty that the lease term may be extended, and it is impracticable or
uneconomic to move the equipment to another site where it can be used, all
assets on that site should be depreciated over the shorter of their individual
estimated useful lives and the period of the lease for the site.
Following the boom and bust of recent years, many companies in the telecoms
industry have had to adjust their growth projections to reflect lower actual
demand and prices than originally envisaged.
The impact of this on company results is reflected in the scale and frequency of
impairments, either to goodwill (writing off premiums paid for acquisitions at the
height of the boom) or to tangible and intangible assets (writing off much of the
considerable infrastructure established in recent years).
Many of the largest write-offs to date have been in respect of fixed line
operators, although mobile, and particularly 3G investments, have increasingly
come under pressure.
If expectations differ
from previous estimates,
the depreciation charge
for the current and future
periods should be
adjusted.
In the main, the valuation of telecoms goodwill, intangibles or tangible assets is
based on the companys discounted cash flow projections. Due to the highly
sensitive nature of cash flow projections, and the underlying assumptions, they
typically represent one of the most important judgments that directors can make
when preparing their accounts.
6.1 Impairment indicators
Under IFRS, acquired goodwill, intangibles with indefinite useful lives and
intangibles not yet available for use need to be tested for impairment at least
annually. Otherwise there first needs to be an indicator of impairment before an
impairment review is required.
In practice, given the recent significant turmoil in the telecoms sector,
impairment reviews have become an established procedure for many companies.
There are numerous indicators of impairment. Some of the most common to the
telecoms sector include:
Sharp fall in asset market values
Operating losses
Underperformance compared to budget or previous plans
Net asset carrying value in excess of market capitalization
Obsolescence and technological developments
Restructuring or reorganization
Regulatory developments
New or increased competition
Significant change in business strategy or business dynamics.
The range of possible indicators is extensive. Many entities are likely to have
some indicators, except for sectors that are both growing and profitable.
However, the accounting literature consistently refers to significant events.
Accordingly, minor shortfalls against plan or short-term business changes, may
often not represent indicators of impairment.
6.2 Impairment calculations
Having determined whether an impairment review is necessary, next is to assess
what assets or group of assets should be reviewed.
IAS 36 is relatively straightforward, stating that the review should be carried
out in respect of individual assets where practical, or at the lowest level where
the cash inflows generated are largely independent and can be measured reliably.
Although simple in theory, in practice this can lead to significant complications.
Some of the more common difficulties faced by the telecoms sector are
explored below.
6. Impairment
In practice, given the
recent significant turmoil
in the telecoms sector,
impairment reviews have
become an established
procedure for many
companies.
6.3 Recoverability of license costs
Given the large sums invested in 3G and other licenses, the question of
assessing their recoverability independently from the underlying network is a
particular concern for the mobile sector.
Although the external value of licenses may have fallen dramatically in many
cases, their value may still be supported, based on the expected future cash
flows generated from operating the network (value in use). As the network and
the associated license are clearly interdependent and do not generate separate
cash flows, they should be reviewed as one cash generating unit (CGU). This is
because any allocation of underlying cash inflows between the network and the
intangible would be entirely arbitrary.
For many operators it is still early days for 3G services. However, once operations
become more established and actual results compared with initial projections,
the number and scale of license impairments may increase, especially for those
operators that paid significant sums for initial licenses.
6.4 Cash generating units
Establishing what constitutes a cash generating unit (CGU) for accounting
purposes is not typically straightforward but may have a significant impact on
the results of any impairment review.
When monitoring their businesses, some operators may analyze on a geographic
basis and others on a product or even customer basis. When determining the
appropriate CGU for impairment review purposes, the entity needs to establish
the lowest level at which cash inflows from an asset (or group of assets) are
largely independent from cash inflows from other assets (or groups of assets).
This should take into account how management monitors the entitys operations
or how they make decisions about continuing or disposing of the entitys assets
or operations.
However split, because the operators network is often common across many
of its product lines or businesses, the network may need to be viewed on a
geographic country or regional basis.
Monitoring and management of the business may be on a product basis (i.e.
discrete billing systems for discrete ranges of products), but the products will
typically use the same underlying network. While use of the network is
monitored, independent cash inflows may not be identifiable for individual parts
of the physical network. Furthermore, while operations may only be managed and
monitored on one basis, cash inflows may be available on a geographic or
statutory basis.
An important point to note is that under IFRS, consideration needs to be given to
the independence of cash inflows rather than both cash inflow and outflows.
An important point to
note is that under IFRS,
consideration needs to
be given to the
independence of cash
inflows rather than both
cash inflow and outflows.
6.5 Transition from old technologies to new technologies
Again, the mobile sector is a good example of the complications of applying
accounting standards to practical situations.
Companies may only produce detailed formal projections for the business as a
whole, whereas accounting guidance requires a particular set of assumptions to
be followed. For example, accounting requires values in use to be determined by
reference to projected cash flows for those existing assets and not to take
account of cash flows from future enhancement capital expenditure.
Splitting capital expenditure between expenditure to enhance the overall network,
and that required to maintain the existing network is often not straightforward
and can be very judgmental. For instance, many existing 2G operators may have
long-term plans that include the impact of the transition to a 3G environment.
However, cash flow projections cannot be easily separated either because of
interdependencies between the old and new network or uncertainty around
when customers may transition from one service to the other.
Furthermore, as 3G is a new technology, there will often be little external
evidence to support management assumptions. One might expect assumptions
to be in line with those adopted by others in the market, but often there is a lack
of consistency with the result that one operator may attribute no value to a 3G
license and another may consider that the cost is still fully supportable.
While cash flow projections in the past may have been based on assumptions
that were not achieved in practice, current projections are now more likely to
have been revised to reflect factors such as:
Slower take up than originally envisaged
ARPU may not be not significantly above existing 2G levels; or
Many internet applications not applicable to 3G.
6.6 Sensitivity to key assumptions
Under IFRS, estimates of future cash flows, for calculation of value in use, should
be based on recent financial budgets / forecasts approved by management for up
to five years and then a steady or declining growth rate for subsequent years.
For growth businesses, a high level of the value will often be in the period
beyond five years. In this case the overall valuation may be very sensitive to the
long-term growth rates selected and the base cash flows at the end of the
budgeted period. IFRS states that periods beyond five years or growth rates in
excess of the long-term growth rates for the product, industry or country in
which the enterprise operates, can be used so long as they can be justified.
However, it makes it clear that it rarely expects this to be the case.
Where projections are based on budgets / forecasts in excess of five years, IFRS
states that this is justifiable if management is confident that they are reliable.
Management must also be able to demonstrate the ability to forecast accurately
over that longer period a relatively tough hurdle, especially in the telecoms
sector.
A large number of discounted cash flow projections are sensitive to the discount
rate selected. This should be the rate that the market may expect on an equally
risky investment. This is another judgmental area as market information is rarely
readily available for an equally risky investment. Many entities may start with
their own Weighted Average Cost of Capital (WACC) and then make an
adjustment for the specific CGU in question. It should be noted, however, that it
is the WACC of the industry / market in which the entity operates that should be
used rather than WACC of the entity itself.
6.7 Impairment reversals
In the case of goodwill, impairments can not be reversed. Under IFRS, reversals
of impairments other than goodwill need be considered where there is an
indication that the loss no longer exists or may have decreased.
If, since the original impairment, there has been a change in estimates used
to determine the recoverable amount, the carrying amount should be increased
to its recoverable amount, and the impairment loss reversed. Any impairment
reversal is limited to increasing the carrying amount of the asset to the amount
by which it would have been depreciated or amortized had impairment
not occurred.
Inventories generally do not make up a significant part of telecoms operators
balance sheets, as they sell services rather than products. Hardware or
equipment, when sold as part of a package deal, are often obtained directly
from and delivered by the suppliers.
Telecoms companies, however, may have inventories of routers and equipment
used to connect customers to the network, as well as handhelds and other
products that are held for resale.
7.1 Introduction and general principles
Accounting for inventories at telecoms operators raises few issues specific to the
industry. Common classifications of inventories include merchandise, production
supplies, materials and finished goods (the latter may include handsets or other
telecoms equipment for sale).
Inventory, or work in progress, should be accounted for when an entity controls
them, in other words, when it has the risk and rewards of ownership. In
accordance with IAS 2, inventories are stated at the lower of cost or net
realizable value. As technological advances in the telecoms industry are
significant, consideration may need to be given to technical obsolescence when
determining net realizable values.
Under IFRS, any write down of inventory that is no longer required should be
reversed. A reduction in value that occurs after the balance sheet date may not
be recognized at the balance sheet date.
7.2 Cost elements
Inventory held for resale is stated at the lower of (acquisition) cost and net
realizable value. Inventory of equipment held for use in the maintenance of
telecoms systems will normally be stated at cost, including appropriate allocation
of labor and overheads, less provisions for deterioration and obsolescence.
For these inventories, the question arises as to which elements can be included
in the cost, and what is an appropriate allocation of labor and overheads.
IAS 2 states that the cost of inventories should comprise all costs of purchase,
conversion and other costs incurred in bringing the inventory to its present
location and condition. Conversion costs normally include direct material, direct
labor, other direct costs and overheads. Overheads and indirect costs should be
allocated systematically.
The Standards do not provide much guidance on this but, based on Framework ,
it seems acceptable that apart from personnel directly engaged in providing the
service, the cost of supervisory personnel and attributable overheads may be
included when determining the cost of inventory.
7. Inventory
The allocation of fixed overheads to the cost of inventory should be based on
normal operating capacity. Variable overheads should be allocated on the basis of
the actual use of capacity although this may be hard to achieve in practice.
Trade discounts, rebates and similar items and the financing element of deferred
settlements beyond normal credit terms should be excluded from the cost price.
Labor and other costs relating to sales and general administrative personnel may
not be included either, but are recognized as expenses in the period in which
they are incurred.
7.2.1 Reductions of inventory and cost determination
Recognition of inventory will normally cease when the recognition criteria of an
asset is no longer met. For instance:
The cost of inventories is recognized as an expense within cost of sales when
goods are sold or maintenance carried out
The cost of inventories is recognized as an expense when inventory items
have become obsolete
Constructions have been finalized and related costs are transferred to
fixed assets.
Cost can be determined based on the average or first-in first-out basis. IAS 2
does not allow the last-in first-out (LIFO) treatment.
7.3 Handsets sold at a loss
Accounting for inventories raises questions where mobile phones are held by a
telecoms company, knowing that they will be sold to customers as an incentive,
at less than cost. The issue is whether the costs of the handsets should be
expensed while held in stock or when sold to customers at a loss.
The accounting depends, to a degree, on whether the operators business is
considered to comprise the sale of handsets. In such an instance, one would
expect to determine the accounting by reference to IAS 2 Inventories. If the
handsets are considered customer incentives, accounting for marketing costs
may be more relevant.
IAS 2 Inventories
IAS 2 Inventories would require the write down of handsets held in stock where
their net realizable value is considered to have fallen below cost. In this case,
consideration would need to be given to whether the handsets could be sold at
or above cost given local market conditions and practice. Where it is considered
probable, the fact that the operator might choose to subsidize the sale, may not
require an expense to be recognized until they are actually sold at the lower price
or given away.
However, the assumption that the entity had the ability to sell them at a value
above cost would need to be analyzed carefully. This will help ensure that it
was really possible to sell above cost given local market conditions and
competitor practice.
Marketing cost
Where an entitys established practice is to subsidize the cost of handsets as an
incentive to encourage new subscribers, one might only expect to expense the
cost of the handset when it is actually delivered. This would be consistent with
accounting for catalogue printing costs which are typically expensed when the
catalogue is actually distributed rather than when it is printed. Similarly the costs
of filming an advert are typically expensed when the advert is first shown rather
than when it is actually made.
Where mobile operators expense customer acquisition costs on delivery of the
handset, the purchase of the handsets by the operator may represent a
prepayment of a marketing cost. This then be expensed on delivery of the
handset to the end user. One would not expect to revalue that prepayment by
reference to its net realizable value.
For mobile operators who capitalize acquisition costs and amortize over the
period of the contract, as long as the net proceeds of the sold package, including
the handset, is above cost, no impairment of the handsets held would be
necessary. This is where the overall contract is still expected to be profitable.
In this situation, the enterprise would need to demonstrate that its contracts are
not loss making not easy given the difficulties surrounding the allocation of
costs to contracts.
Inventory vs. marketing cost
Whilst not necessary appropriate for all operators, it is expected that most
mobile operators consider the sales of handsets to be an integral part of their
business and accordingly hold them as stock. Where this is the case, the IAS 2
Inventories treatment discussed above would appear to be the most appropriate
accounting policy.
Although it is a disclosure rather than an accounting issue, KPMG member firms
believe that segment reporting by telecoms operators deserves some attention in
this IFRS publication.
Good segment reporting provides information to users of financial statements so
they are better able to understand an enterprises performance, can better assess
its risks and returns, and make better judgments about the enterprise as a whole.
8.1 Disclosure requirements
IAS 14 requires detailed disclosures for primary segments and less detailed ones
for secondary segments.
For the primary segments the following quantitative disclosures are required
per segment:
Revenue, distinguishing between external customers and inter-segment sales
Results of operations (before tax)
Depreciation and non-cash expenses (unless cash flow information is given)
Operating, investing and financing cash flows (as an alternative to the
previous item)
Impairments (and reversals thereof)
The share of results and carrying amount of equity accounted investments that
can be allocated substantially to a single segment
Total assets
Total liabilities
Capital expenditure.
For secondary segments, revenue (external and inter-segment), total assets and
capital expenditure need to be analyzed.
All Information on the segments should be visibly reconciled to the consolidated
financial statements.
Currently, many telecoms companies reporting under local GAAP do not fully
meet the requirements of IAS 14. This means that for many enterprises,
conversion to IFRS may result in significant additional disclosures. In order to
fulfill its requirements, internal reporting structures may need to be revised and
extended, especially regarding the allocation of results and balance sheet items
to segments.
8. Segmental reporting
...for many enterprises,
conversion to IFRS may
result in significant
additional disclosures.
8.2 Determination of segments
IAS 14 determines that segmentation should be based on the dominant source
and nature of an enterprises risks and returns, as well as its internal reporting
structure. The dominant source is usually established from an enterprises internal
organizational and management structure and its system of financial reporting to
directors and the CEO.
Any component that is found to account for 10 percent or more of an enterprises
revenue, operating activities or total assets is a reportable segment.
Even though IAS 14 includes some guidance on determining segments, in
practice the substance of the business will define the applicable segments.
For broadly-based telecoms companies, offering a range of telecommunications
services, business segments rather than geographical areas of operation will
often be the primary basis for segmentation. The less detailed disclosure
requirements for secondary segments would then apply to the geographical
areas.
Examples of (primary) business segmentation currently found within the
telecoms industry are:
Fixed line services / mobile services / other
Retail / wholesale / global services / other
Voice services / data services / IP and hosting / non-recurring services
Consumer division (sub-divided into cable TV, telephony, Internet and other) /
content division (programming etc.)
Companies should tailor segmentation so that it properly reflects their business.
The segment reporting should clearly indicate which part of the business is
continuing and which part is discontinued.
Inter-segment transfers should be measured according to how the enterprise
actually priced the transfers. The transfer price policy for transactions between
segments must be disclosed.
Many companies find difficulty in presenting the extensive segment disclosures
in a clear manner. IAS 14 does not require nor prohibit a matrix presentation, but
in many cases a matrix (separated by year or including comparative figures for
the preceding year) can be helpful. Some telecoms operators present key income
statement items and the assets, liabilities and capital expenditures of each
segment in a separate table. This makes it possible to include further
commentary on performance by segment and is recommended for companies
that strive for ultimate transparency.
Any component that is
found to account for 10
percent or more of an
enterprises revenue,
operating activities or
total assets is a
reportable segment.
8.3 Allocations to segments
While distinguishing revenues and results from operations by segment may not
be especially complex, separating assets, liabilities, capital expenditures, cash
flows, depreciation and impairments for the same segments may prove less
simple.
For example, how should a fixed line operator separate its assets by segment if it
has chosen a primary segmentation by service line (e.g. voice, data, IP and
hosting, and other) yet the main fixed assets, principally the network, are used
for all services?
IAS 14 determines that segmentation should be based on direct attributions or
reasonable allocations to a segment. Furthermore, there should be symmetry and
consistency where items are included in segment result and segment assets.
So, if assets are included in a segment, depreciation on that asset is included in
the same segment.
In making reasonable allocations a certain amount of judgment is involved.
Enterprises are encouraged to make allocations as meaningful as possible, taking
guidance, if necessary, from other international accounting standards, such as
IAS 2 Inventories, and IAS 11 Construction contracts. The appendix to IAS 36
Impairment of assets, includes an example where the headquarters is allocated
to cash-generating units, but it is unclear whether this allocation method is also
suitable for segment reporting.
How and what costs, and assets, are allocated to segments will differ between
enterprises but should be based on the objective of IAS 14: to provide useful
information to users of the financial statements for assessing the risks and
returns of the enterprise as a whole. Disclosure of the allocation method is
important. However, assets that are jointly used by two or more segments as in
the example above should be allocated to segments if, and only if, their related
revenues and expenses (including depreciation) are also allocated to those
segments. In cases where this is not reasonably possible, separate presentation
of central or corporate assets may be the best approach.
A separate other segment may be appropriate as well, so long as sufficient
qualitative disclosure on its content is provided.
Similarly, general administrative expenses, head-office expenses and other
expenses that relate to the enterprise as a whole shall be presented separately.
They may not be allocated to segments, unless they can be directly attributed or
there is a reasonable basis to do so. Again, the enterprises management should
decide what best reflects the substance of the business and provides a fair view
to the users of the financial statements.
Accounting for embedded derivatives in the telecoms industry, as with all other
industries, is likely to be a complex and time-consuming process.
9.1 Embedded derivatives and IAS 32 and 39
One of the first hurdles will be the identification of the embedded derivative in
the first place. This can be exasperated where there are multi-locations and local
decision-makers enter contracts. Once identified, it will be necessary to
determine whether the derivative can be separated from the host contract.
Finally, if separation is established, a fair value will need to be attributed to the
derivative.
9.1.1 What is an embedded derivative?
Derivatives are typically stand-alone instruments, but they may also be found as
components embedded in a financial instrument or in a non-financial contract.
IAS 39 paragraph 22 notes: Sometimes, a derivative may be a component of a
hybrid (combined) financial instrument that includes both the derivative and a
host contract - with the effect that some of the cash flows of the combined
instrument vary in a similar way to a stand-alone derivative. Such derivatives are
sometimes known as 'embedded derivatives'. An embedded derivative causes
some or all of the cash flows that otherwise would be required by the contract to
be modified based on a specified interest rate, security price, commodity price,
foreign exchange rate, index of prices or rates, or other variable.
This definition would, therefore, include host contracts such as insurance
contracts, leases, purchase and service agreements, construction contracts,
royalty or franchise agreements with foreign currencies components, price
clauses related to indices or contingent rentals.
9.1.2 Accounting for embedded derivatives
An embedded derivative that meets the definition must be separated from the
host contract and measured as a stand-alone derivative if its economic
characteristics are not closely related to the host contract. If the economic
characteristics of the embedded derivative are closely related to the host
contract, then it is not separated. IAS 39 provides detailed examples of host
contracts and derivatives that require separation and those that do not.
9.1.3 Common contracts in the telecoms industry
Telecom companies, like other industries, will need to consider current and future
contracts to identify embedded derivatives. This is likely to be a time consuming
process. Below are some common contracts within the industry which may
contain embedded derivatives. The important point to note is that embedded
derivatives can often be contract specific and it will be important to establish
procedures that identify these in the contract-making process.
9. Other relevant issues
Derivatives are
typically stand-alone
instruments, but they
may also be found as
components embedded
in a financial instrument
or in a non-financial
contract.
9.1.3.1 Trade Direct Agreement (TDA)
TDAs are bilateral international contracts between international carriers where
parties contract to purchase and receive a fixed volume of minutes at a fixed
price. Volumes and prices are generally fixed at the same rate in both directions.
The prices are usually fixed in USD or as Special Drawings Rights (SDR). As
these contracts contained fixed currency prices to be settled in the future there is
potentially an embedded derivative. However, IAS 39 considers that where the
transaction is denominated in a currency that is routinely used in international
commerce worldwide (e.g. oil denominated in USD) that there is no separation
and therefore no embedded derivative. As minutes are internationally traded in
USD and SDR, there would not be an embedded derivative.
However, such contracts may not always be denominated in one of these two
currencies. If this were the case, then IAS 39 may still not consider these
contracts separable if denominated in the currency of the primary economic
environment in which any substantial party to that contract resides. For example,
a predominately South African telecoms company entering a TDA with a
predominately UK telecoms would not give rise to an embedded derivative if the
contract were denominated in USD, SDR, RND or STG but would if in any other
currency.
The position is more complicated when selling on TDA entitlements on the refile
market. Whether such a transaction can be considered to be scoped out by
normal sales and purchases exemptions will depend on the particular facts and
circumstances.
9.1.3.2 Operational and maintenance contracts
Operational and maintenance contracts may include embedded derivatives. If
these are volume-related with the economic characteristics of the embedded
derivative, and are closely related to the host contract, then it is not separated.
9.2 Onerous contracts
Commonly associated with property leases, a number of businesses in the
telecoms industry have recently found themselves with lease and other
commitments significantly in excess of the projected economic benefit expected
to result from those leases.
A number of co-location businesses have been left with significant un-let space
with even the most optimistic of forecasts anticipating that future property lease
costs are unlikely to be covered.
Alternatively, companies may have entered into medium or long-term contracts to
lease circuits for which they have no, or very limited use. Under IFRS, where the
unavoidable costs of meeting the obligations of a contract exceed the economic
benefits anticipated under it, provision should be made for the least net cost exit
from the contract. In the case of vacant properties, the expected benefits and
unavoidable costs are typically straightforward to determine. However, in many
cases, it may be impractical to estimate the benefit being obtained and the fact
that a cost may no longer be economic or in line with market prices is an
insufficient basis on which to make a provision.
9.3 Restructuring costs
In recent years, the disclosure of restructuring costs has come under increased
scrutiny by both investors and the accounting regulatory bodies.
While the following guidance is not specific to the telecoms industry, it has been
included here as it is a topical area of interest given continued restructuring in the
industry.
9.3.1 Basic accounting principles
The main issues to consider regarding accounting for restructuring costs are:
At what point can restructuring costs be provided for?
What costs should be included as restructuring costs?
Where should these costs be disclosed in the financial statements?
Restructuring provisions are covered in IAS 37 Provisions, Contingent Liabilities
and Contingent Assets. The standard is very much commitment-based and has
resulted in a move away from large, one-off restructuring charges to charges that
are increasingly recognized over longer timescales as they are incurred. For
instance, where restructuring provides evidence of an existing impairment of
assets, these will continue to be recognized immediately (i.e. earlier than the
main provision itself) but profits on asset sales and costs relating to on-going
activities will fall as incurred.
To qualify as a restructuring under IFRS, the program must materially change
either the scope of business undertaken by an enterprise or the manner in which
that business is conducted. The following are examples of events which may fall
under the definition of a restructuring:
Sale or termination of a line of business
The closure of business locations in a country or region or the relocation of
business activities from one country or region to another
Changes in management structure, such as eliminating a layer of management
and
Fundamental reorganizations that have a material effect on the nature and
focus of the entitys operations.
A provision should only be recognized when:
an entity has a present obligation (legal or constructive) as a result of
a past event
it is probable that a transfer of economic benefits may be required to
settle the obligation
and
a reliable estimate can be made of the amount of the obligation.
If these conditions are not met, no provision should be recognized. Under IFRS,
a constructive obligation to restructure arises when an entity has a detailed
formal plan identifying at least:
The business or part of the business concerned
The principal locations affected
The location, function, and approximate number of employees who can be
compensated for terminating their services
The expenditures that may be undertaken
When the plan may be implemented
Has raised a valid expectation in those affected that it may carry out the
restructuring by starting to implement that plan or announcing its main
features to those affected by it.
For a plan to be sufficient to give rise to a constructive obligation when
communicated to those affected by it, its implementation needs to be planned to
begin as soon as possible. It must be completed in a timeframe that makes
significant changes to the plan unlikely.
Where the entity starts to implement the restructuring plan, or announces its
main features to those affected by it, after the balance sheet date, disclosure may
be required under IAS 10 Events after the balance sheet date if material.
No obligation arises for the sale of an operation until the entity is committed to
the sale, i.e. there is a binding sale agreement. Until there is such an agreement,
the entity may change its mind.
When the sale of an operation is envisaged as part of a restructuring, the assets
of the operation should be reviewed for impairment. Furthermore it might be
necessary to account for non-current assets under IFRS 5 Non-current Assets
Held for Sale and Discontinued Operations. When a sale is part of a restructuring,
a constructive obligation can arise for the other parts of the restructuring before a
binding sale agreement exists.
Gains on the expected disposal of assets are not taken into account in measuring
a restructuring provision, even if the sale of assets is envisaged as part of
the restructuring.
9.3.2 Costs to be included
A restructuring provision should include only the direct expenditures arising
from the restructuring, which are those that are both:
Necessarily entailed by the restructuring
Not associated with the ongoing activities of the entity
The effect of this is that a restructuring provision cannot include costs such as:
Retraining or relocating continuing staff
Marketing
Investment in new systems and distribution networks.
These expenditures relate to the future conduct of the business. They are
charged in the profit and loss account as incurred.
9.3.3 Redundancies
Redundancy costs are often among the most significant cash costs in any
restructuring. Usually it is quite clear that these costs are not associated with
ongoing activities, although this may not always be the case. An example where
costs cannot be provided for is where they may be triggered by a future event
such as failure to win a contract renewal.
Many redundancy programs are expected to be compulsory. However, where
the program is voluntary, provision should be made under IFRS so long as other
conditions regarding plans, implementation and announcements (including
timings), are met. Recognition of the provision may depend upon a probable level
of take-up being determined such that an appropriate level of provision can
be assessed.
9.3.4 Disclosure of discontinued operations
Discontinued operations are defined in IFRS 5 as a component of an entity that
either has been disposed of or is classified as held for sale and:
Represents a separate major line of business or geographical area
of operations
Is part of a single co-ordinated plan to dispose of a separate major line of
business or geographical area of operations; or
Is a subsidiary acquired exclusively with a view to resale.
Operations that do not satisfy these conditions are classified as continuing.
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guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the
future. No one should act on such information without appropriate professional advice after a thorough examination of
the particular situation.
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no audit or other client services. Such services are provided solely by member firms in their respective geographic
areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing
contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents,
partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate
or bind KPMG International or any member firm in any manner whatsoever.
2004 KPMG International. KPMG International
is a Swiss cooperative of which all KPMG firms are
members. KPMG International provides no services
to clients. Each member firm is a separate and
independent legal entity and each describes itself
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KPMG and the KPMG logo are registered trademarks
of KPMG International, a Swiss cooperative.
Designed and produced by KPMGs UK Design Services
Publication name: Telecoms IFRS document
Publication no: 209 615
November 2004
COMMUNI CATI ONS
IFRS Accounting in the
Telecommunications Industry
I NFORMATI ON, COMMUNI CATI ONS & ENTERTAI NMENT
19514_KPMG_IFRS_Case_Study_Cov 3/12/04 12:25 PM Page 1

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