ifrs accounting in the kpmg -...

kpmg.com

The information contained herein is of a general nature and is not intended to address the circumstances of anyparticular individual or entity. Although we endeavor to provide accurate and timely information, there can be noguarantee that such information is accurate as of the date it is received or that it will continue to be accurate in thefuture. No one should act on such information without appropriate professional advice after a thorough examination ofthe particular situation.

KPMG International, as a Swiss cooperative, is a network of independent member firms. KPMG International providesno audit or other client services. Such services are provided solely by member firms in their respective geographicareas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothingcontained 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 as such. All rights reserved.

KPMG and the KPMG logo are registered trademarksof KPMG International, a Swiss cooperative.

Designed and produced by KPMG’s UK Design Services

Publication name: Telecoms IFRS document

Publication no: 209 615

November 2004

COMMUNICATIONS

IFRS Accounting in theTelecommunications Industry

INFORMATION, COMMUNICATIONS & ENTERTAINMENT

19514_KPMG_IFRS_Case_Study_Cov 3/12/04 12:25 PM

1 Introduction 22 Revenue recognition 3

2.1 Introduction 32.2 Mobile related issues 32.3 Fixed line related issues 102.4 Capacity sales 172.5 Other revenue recognition related issues 253 Cost of sales and operating expenditure 26

3.1 Income statement presentation 263.2 Cost recognition 283.3 Other issues 314 Intangible assets 32

4.1 Introduction 324.2 Capitalization of intangible assets 324.3 Amortization of intangibles 354.4 Joint development type arrangements 374.5 Joint build type arrangements 385 Property, plant and equipment 39

5.1 Network amortization 395.2 Basic accounting principles 405.3 Dismantling and removal costs 425.4 Useful lives 446 Impairment 45

6.1 Impairment indicators 456.2 Impairment calculations 456.3 Recoverability of license costs 466.4 Cash generating units 466.5 Transition from old technologies to new 47

technologies6.6 Sensitivity to key assumptions 476.7 Impairment reversals 487 Inventory 49

7.1 Introduction and general principles 497.2 Cost elements 497.3 Handsets sold at a loss 508 Segmental reporting 52

8.1 Disclosure requirements 528.2 Determination of segments 538.3 Allocations to segments 549 Other relevant issues 55

9.1 Embedded derivatives and IAS 32 and 39 559.2 Onerous contracts 569.3 Restructuring costs 57

Contents

© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firmsare members. KPMG International provides no services to clients. Each member firm is aseparate 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 thetelecoms sector still have to deal with continued skepticism of industry practicesin light of past accounting failures. Further change is now taking place with theintroduction of IFRS.

Where GAAP is clear, few in the industry are willing to push the boundaries ofwhat is considered ‘best practice’ for their sector. However, in many areas, it isevident 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 costrecognition follows closely behind – particularly the question of whether costsshould be expensed, capitalized or deferred to future periods. Although IFRS hasa specific revenue recognition standard, guidance remains vague in a number ofareas. What is more, no additional IFRS guidance is expected before thestandards 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 practiceis not prescriptive or permits alternative treatments. IFRS is currently vague in anumber of revenue recognition areas and companies will often consider whetherthey should use U.S. GAAP where no IFRS guidance exists. In some cases, theymay consider defaulting to U.S. GAAP except where IFRS is explicitly different.

Given the move to IFRS by EU-listed companies, this publication has beenlimited, at this stage, to the discussion of IFRS treatments. However, in light ofthe predominance of U.S. companies in the telecoms industry, the scope of thispublication will be broadened, in due course, to include U.S. GAAP.

With continual changes in telecoms accounting, either as a direct result ofchanges by the standard setters or shifts in the investment community’s view ofwhat is appropriate, leaders and managers in the telecoms industry must keepup to date with accounting developments.

Rather than a definitive guide or a view on what policies should be followedunder IFRS, this publication considers what policies may be followed byorganizations adopting IFRS and what constitutes ‘best practice’ within thetelecoms industry.

References to compliance with IFRS in the document should be understood ascompliance with IFRS standards issued as at 31 March 2004, unless specificallystated otherwise. This includes recent amendments to existing IAS standardsthat become effective for annual periods beginning on or after 1 January 2005.

1. Introduction

“Revenue recognitionremains a hot topic for the telecoms industry,although cost recognitionfollows closely behind.”

© 2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMGInternational provides no services to clients. Each member firm is a separate and independent legal entity and each describesitself 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 oldstandard, 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 ofmultiple element arrangements. Furthermore, the revenue exposure draft,expected from the joint Financial Accounting Standards Board (FASB) /International Advisory Standards Board (IASB) revenue recognition project beforethe end of 2004, now looks likely to be delayed. No further guidance is expectedin the near future.

As a consequence, when companies move to IFRS, existing divergence inrevenue recognition policies across the telecoms sector is unlikely to besignificantly reduced. This may be especially true where companies seek toretain, as far as possible, their existing policies.

IFRS states that where its standards do not cover specific issues, companiesshould consider:

• The guidance and requirements in standards and interpretations dealing withsimilar and related issues; and

• The conceptual framework of the IASB, Framework for the Preparation andPresentation of Financial Statements (the Framework).

The company may also consider pronouncements of other standard-settingbodies (e.g. the U.S. Financial Accounting Standards Board) and acceptedindustry 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 thetreatments that might be considered acceptable under IFRS and identifies thepolicies which are typically adopted.

2.2 Mobile related issues

2.2.1 Multiple element arrangementsAs the range and complexity of services offered by telecoms companiesincreases, so does the issue of how to account for them. This is particularly truein the mobile sector where packages offered to end users may include anycombination of handsets, pre-paid minutes, messages, discounts, special offersand other incentives. When establishing the most appropriate revenuerecognition, consider first which, if any, of its components should be accountedfor separately and which should be combined.

The decision to account for a transaction in its entirety or to separate it into itsindividual components can have a significant impact on an entity’s reportedresults. Separating handset sales or connection revenues from ongoing servicefees may result in increased revenue upfront but there are also instances whereseparating a contract into components may defer revenue recognition.

2. Revenue recognition

“...when companiesmove to IFRS, existingdivergence in revenuerecognition policiesacross the telecomssector is unlikely to besignificantly reduced.”




U.S. GAAP specifically addresses this issue in Emerging Issues Task Force EITF00-21 ‘Revenue Arrangements with Multiple Deliverables’. Similarly, UK GAAPaddresses 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 separatedand, if so, whether fair values can be reliably determined.

These are some of the more common issues that arise in respect of accountingfor multiple element arrangements.

Irrespective of any specific rules the key issues that are critical to any debate onthe separability are whether the services can be technically and commerciallyseparated and, if so, whether fair values can be reliably determined.

The following discussion focuses on some of the more common issues arising inrespect of accounting for multiple element arrangements.

2.2.2 Handset revenue

Mobile operators typically sell handsets which, while unlikely to represent theirprincipal operating activity, may constitute a significant revenue stream.

More importantly, the handset sale is typically part of a larger package when thecustomer signs up to a tariff package for a specified period. As the handset saleis upfront, the first question is whether it can be unbundled and accounted forseparately, 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 thatthe handset has been delivered, has value to the customer and the fair value canbe established. There are, however, instances where this is not as straightforward.

Dedicated network

Many existing mobile handsets can be used on different operators’ networks bysimply 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 suchportability and in practice can only be used by the customer on one specificnetwork. 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 resalemarket exists in handsets. In such cases, the handset may have some value ifthe customer can sell it on.

“...critical to any debate on the separability arewhether the services can be technically and commerciallyseparated and, if so,whether fair values can be reliably determined.”



Alternatively, a handset that can only be used on one network in the customer’scountry of residence, may be compatible with networks overseas. Even thoughthe handset may technically have some value, in practice this may not besufficient to establish a standalone fair value.

Handset sales via distributors

The example above assumes that the operator provides both the handset and theongoing service to the end customer. However, in some markets, it is morecommon for distributors or retail outlets to sell the handsets to customers and toconnect them to a specific operator.

Where the operator has neither sourced nor provided the handsets, revenuerecognition accounting should be straightforward. However, the positionbecomes more complex where the operator also provides the retailer with theoriginal handsets.

IAS18 states that revenue is generally recognized when the risks and rewards ofownership 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 ofhandset sales may depend on whether the distributor acts as an agent orprincipal (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, thearrangement is likely to show that revenue is recognized once the handsets havebeen sold on to the end user. The result is two similar transactions where thetiming of revenue recognition may differ because one is made via a third partyretailer and the other through the operator’s own distribution channel.

Subsidies

Operators increasingly subsidize the cost of mobile handsets to encouragecustomers 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 linked to the handsetpurchased, it might be expected that the operator records handset revenue net ofsubsidies rather than treating the subsidy as a cost of sale.

However, where the subsidy can be linked to the ongoing service (say differentsubsidies are paid depending on the tariff that the end customer has signed upto), deferral as a ‘customer acquisition cost’ may be appropriate. Customeracquisition 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 ondelivery rather than over the period of the subsequent services.

Is this appropriate where the consideration is not received on delivery but isspread over the period of the subsequent service? A typical example is wherethe customer signs a contract which states a price for the handset and the ratesfor subsequent services. There is no upfront consideration and instead thecustomer 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 itappropriate to recognize the full amount of the consideration due for the handseton 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 (detailedabove) in respect of handset sales are satisfied (i.e. handset has standalonevalue, 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 questionwhether the criteria has been met. Where material, IFRS requires deferredconsideration to be discounted when determining what revenue should be recognized.

2.2.3 Connection revenuesActivation fees are becomingly increasingly uncommon due to significantcompetition in many major mobile markets. However, in some markets, theycontinue to be charged when customers connect to operator networks.

Although not usually significant, costs are incurred when connecting customersto 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 whetheractivation 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 theissue of ‘separation’ other than to require that transactions should be separatedwhere required ’to reflect the substance of the transaction’. However, asactivation, 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 thestage of completion of the installation, unless they are incidental to the sale of aproduct in which case they are recognized when the goods are sold.’


“From an accountingperspective the timing ofreceipt of considerationshould not impact therevenue recognition policy.”



Where connection costs and revenue are considered to be incidental to the saleof mobile packages (although clearly often not incidental to other telecom productsand services), the question then arises as to whether they are incidental to thehandset sale (and should be recognized in line with the policy adopted forhandset sales) or to the provision of the future services.

While handsets may be used on other networks, any activation fee would bespecific to the network in question. Accordingly, it may be argued that theactivation fee should relate to the future service. However, as often made at thesame time as the handset purchase, there is also a view that payment foractivation fees cannot be separated from payment for the handset.

Finally, IFRS also cites entrance and membership fees. If a wide range of otherservices or products are paid for separately, at fair value, the fee should beidentified as revenue where there is no significant uncertainty as to itscollectability. Consequently, so long as activation fees do not impact the pricecharged for the ongoing service, for which fair value can be established, it isappropriate to recognize them upfront under IFRS (i.e. same price charged if noactivation fee).

2.2.4 Pre-paid revenuesIn many markets, ‘pre-paid’ mobile packages are increasingly popular, especiallyas gifts, as there is no on-going commitment.

Customers typically pay for on-going services by purchasing cards or vouchersthat entitle them to a set amount of minutes. Increasingly, minutes can be‘topped up’ online or by phone. Irrespective of the specific arrangements, theaccounting issue is when to recognize revenue in respect of services purchasedin advance.

From an accounting perspective, revenue should follow performance rather thanthe timing of payment for that performance. This means revenue should berecognized when calls are made. Simple in theory, it presents significant practicaldifficulties 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 thatinevitably surround many events and circumstances, and that such uncertaintiesare recognized by the disclosure of their nature and extent, and by the exercise ofprudence in the preparation of the financial statements’.


“...revenue should berecognized when calls aremade. Simple in theory, itpresents significantpractical difficulties wheretelecoms companiescannot readily track cardusage”.



It goes on to state that ‘the recognition of income occurs simultaneously withthe recognition of increases in assets and decreases in liabilities, and, thereforeone would only expect revenue to be recognized when the entity’s liability (in thiscase the obligation to provide a future service) had been extinguished.Accordingly, one could not expect revenue to be recognized until the entity hasno further liability in respect of unused minutes which could only be the casewhen the right to use the minutes actually expires.’

A similar issue arises where customers pay for a set number of minutes or textseach month, but can carry unused minutes or texts forward to future periods.Again, from an accounting perspective, revenue recognition should be based onusage rather than billings. Revenue, deferred in respect of carried-forwardminutes should only be recognized when the customer loses any entitlement tofuture use.

2.2.5 Free minutes and other offersThere is a myriad of promotions offered by mobile operators to attract newcustomers or retain existing ones. While it is not possible to cover all scenarios,common promotions and their accounting implications are discussed in moredetail below

Free minutes for a set amount of minutes used

IAS 18 requires revenue to be measured at the fair value of considerationreceived or receivable. It takes into account the amount of any trade discountsand volume rebates allowed by the enterprise. Free minutes should usually beaccounted for as a discount or rebate and, accordingly, in an arrangement whereeach tenth minute is free, revenue recognized at 9/10ths of the standard rate.

Loyalty schemes

Unlike the straightforward situation illustrated above, where the incentive clearlyrepresents a discount or rebate, many companies now offer incentives that aremore akin to loyalty schemes run by airlines or retailers.

Say the customer earned a ‘point’ for each ten minutes used which could beredeemed as either free minutes; a discount on future handset upgrades or asphone accessories. The airline industry would typically account for this type ofloyalty program as a marketing or promotion cost, accrued on the basis of theexpected cost of satisfying the offers granted, not as a reduction in revenue. Inthe mobile industry, however, the marginal cost of providing additional services isoften minimal (typically just the termination cost if the user dials a landline or adifferent network). Accounting for such loyalty programs on a cost basis may givea significantly different result than assuming it merely represents a deferral ofrevenue in respect of future services provided.

Where the value of the incentive is incidental, it is appropriate to accrue the costof 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 notincidental, then theappropriate treatmentunder 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 subsidizeany initial capital cost to encourage customers to sign up to longer term servicesand establish a critical customer base.

Different operators adopt different marketing strategies. They may seek torecover the cost of equipment from the sale of future services; or to at leastcover their costs on the initial sale.

To the extent that any cost represents a customer acquisition cost, the questionis whether that cost should be expensed or deferred over the contracted periodof 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 revenueupfront or deferred in some way.

As in the case of handset sales with subsequent services, the key question isidentifying the transaction and whether the arrangement should be split intoseparate components or not. While not specifically addressed in IFRS, it isexpected that the sale of equipment is accounted for separately as it hasstandalone value to the customer.

This is typically the case when modems are provided. But it may not necessarilyapply to the provision of set top boxes. IFRS gives little guidance and potentiallyallows more latitude in acceptable policies than either U.S. or UK GAAP. However,in the absence of specific guidance, companies will need to consider thepronouncements of other standard-setting bodies and industry practice.

IFRS requires that when the selling price of a product includes an identifiableamount for subsequent servicing, that amount is deferred and recognized asrevenue over the period during which the service is performed.

The amount deferred allows for the expected costs of the services under theagreement, together with a reasonable profit on those services.

This could suggest that if any cable or modem package was priced as an overallupfront charge with free services going forward, IFRS could allow a highproportion of the revenue to be recognized upfront, subject to sufficient revenuebeing deferred to cover the cost of providing those subsequent services.

However, it would not be appropriate under IFRS to apply this analogy where theongoing service is clearly the principal service provided and where relatedhardware is secondary. Consequently, where revenue is recognized in respect of the modem or set top box provided, which under IFRS may typically beacceptable, the accounting should seek to ensure a reasonable margin is earnedon both components, and that the results of one activity do not distort the resultsof others.




2.2.7 Sales of products or services over hand held devicesThe mobile phone is increasingly used for much more than just making andreceiving calls, texts or even video messages.

Already common in Japan, and being introduced in other markets, mobile phonescan now be used to pay for a range of services from vending machine drinks tomeals in restaurants. It is necessary to consider the specific risks and rewardsassumed by each party in such arrangements to determine whether grossinflows 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 willrarely be sufficient to justify gross revenue recognition.

For example, where a mobile operator acquires content rights (e.g. footballhighlights) 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 ofthe revenue received, gross recognition is only appropriate where the operator isexposed to the gross risks of the transaction and is involved in providing theservice (e.g. transmits the highlights over its network to the end user). In thisinstance, 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 theoperator to recognize gross revenue. For example, paying for a product using amobile would not be accounted for gross even if the mobile operator took on thecredit risk. Here, the operator would receive commission for facilitating the sale anda 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 / agentAn area that often gives rise to revenue accounting issues for fixed line operatorsis 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 therevenues. The question is whether it is appropriate for all or only some of thoseinvolved in the transaction to record revenues gross.

Each entity needs to determine the appropriate revenue recognition treatment forits individual circumstances. Historically, the communications industry hasaccounted for traffic flows on a gross basis. From an accounting perspective,accounting for a transaction gross or net depends on whether the entity involvedis acting as principal or agent. However, determining this is not so straightforward.


“Where the role of theoperator is limited tocollecting and remittingmonies due, rather thantaking any part in the actualservice provided, the creditrisk alone will rarely besufficient to justify grossrevenue recognition”.



IAS 18 states that ‘revenue includes only the gross inflows of economic benefitsreceived and receivable by the enterprise on its own account.’ Amounts collectedon behalf of third parties are not economic benefits which flow to the enterpriseand do not result in increases in equity. In an agency relationship, the grossinflows of economic benefits include amounts collected on behalf of the principaland which do not result in increases in equity for the enterprise. The amountscollected on behalf of the principal are not revenue. Instead, revenue is theamount of commission.

IFRS gives no guidance on how to determine whether an entity is acting as aprincipal or agent in any given transaction. However, the deciding factors arewhether the gross inflows result in increases in equity for the enterprise orwhether they represent amounts collected on behalf of a third party (theprincipal). Although not specifically set out in IFRS, an entity’s role as principal oragent will usually depend on whether it takes on the gross risks and rewards ofthe transaction or has only a net interest. Other factors, including normal industrypractice 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 shouldbook 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 bepotentially 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 onthe specific terms of each arrangement. Gross vs. net is an area wherecompanies 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 arrangementsBoth fixed line and mobile operators may enter into a number of interconnectagreements with other carriers. These agreements allow them to terminate ortransit traffic on their respective networks and to provide the end-to-endcapability required by their customers.

In certain cases rates may be regulated, although for a number of internationalarrangements, companies are free to set and revise rates as the market dictates.


“Historically, thecommunicationsindustry hasaccounted for trafficflows on a grossbasis”.



Net settlement

Industry practice is that interconnect revenues are booked gross on the basisthat the carriers are exposed to the gross risks of the transaction.

Interconnect agreements usually allow carriers to settle on a net basis whichdoes 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 beobliged to make payments under interconnect arrangements, irrespective of thelevel of reciprocal revenues due. Close attention needs to be paid to the specificcircumstances of each arrangement.

Legal right of offset

Custom and practice is for operators to typically settle on a net basis. Howeversome operators may seek to further reduce their exposure to other carriers byentering into agreements that give them the legal right to offset any balancesdue from the counter party against balances due to the same party.

Mitigating the settlement risk of the transaction is a sensible commercialobjective. One would not normally expect this to invalidate the policy ofrecognizing the gross transaction in the first place. However, ongoingconsideration will be needed to ensure that the policy is neither abused norbecomes inappropriate.

A carrier may be able to manage the use of its network to reduce cash paymentsby managing traffic flows so that services provided to and acquired from aparticular carrier are broadly balanced. This will normally be a valid businesspractice from a cash flow management perspective, but it may be necessary toconsider whether the transaction is a normal interconnect arrangement or anexchange transaction which, under certain circumstances, is not regarded asrevenue under IFRS (see section 2.4.9).

Predetermined volumes

As discussed above, interconnect arrangements are generally accounted forgross. 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 therates 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 serviceswith the likelihood of any net cash settlement being remote.

For example, carriers A and B may have traditionally terminated relatively similaramounts of traffic on each other’s network with typically only a small netsettlement required each month.


“Industry practice is thatinterconnect revenues arebooked gross on the basisthat the carriers areexposed to the gross risksof the transaction”.



Carrier A may then enter into an agreement to terminate up to one million minuteson its network in exchange for carrier B terminating up to one million minutes onits network with only minutes above these amounts being settled in cash.Commercially the position may not be much different from the actual tradingformerly recognized by carriers A and B, which was typically accounted for gross.

However, the substance of this arrangement is similar, in many respects, to anexchange transaction which, in certain circumstances, is not accounted for asrevenue 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 stillexposed 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 thereforeneed to be able to substantiate fair value where consideration is not received inthe form of cash.

In instances where there is a significant amount of reciprocal interconnectbusiness between two entities, establishing fair value may not be simple. Where rates are regulated this is unlikely to be a problem but where entities arefree to set rates, issues may arise. For example, where different rates have beenagreed with different customers or where a small number of operators areinvolved, establishing a market price may not be straightforward.

2.3.3 Peering arrangementsMany internet-based businesses enter into peering agreements under which theyobtain access to other operator’s 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 usuallyfee-based. Instead the agreement may simply allow reciprocal access to eachother’s network.

Peering arrangements are not usually recognized as revenue even though aservice is provided and value transferred between operators in much the sameway as under traditional interconnect arrangements. The reason the accountingdiffers is not necessarily the service offered, or the ability to monitor it, but ratherthe fact that there is no gross exposure for the entities involved. Non performanceby one party does not usually result in any cash compensation being payable tothe other party.




server

2.3.4 Revenue sharing arrangementsRevenue sharing arrangements are increasingly common in the telecoms industry,especially where a number of different operators are involved in providing onelarger end-to-end transaction. Some examples of the more commonarrangements are discussed below.

Premium rate services

Premium rate services, where the caller pays a premium to the standard call rateto access additional services are increasingly common. These can includedirectory enquiry services, chat lines, other information services or even paying tovote for a particular person on a television game show. The question arises ofhow 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 telecomsoperator 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 theservice 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 thenet amount retained (in effect as commission earned) after accounting forpayments due to the service provider.

One could argue that the position is no different to traditional voice or otherinterconnect arrangements which are typically recognized gross. The contraryview is that the arrangement is more akin to delivery of a third party’s productwhere, for example, the courier company is not expected to recognize revenueaccording to the gross value of the goods it delivers. However the position inrespect of telecoms companies is more complex. The operator is typically activelyinvolved in the provision of the service, together with the content provider, ratherthan simply delivering a finished product. A number of factors may need to beconsidered including:

• Is the operator actively involved in the provision of the service?

• Is the operator’s subject to non-performance penalties, if so are these based ongross or net revenues?


“Peering arrangements arenot usually recognized asrevenue even though aservice is provided andvalue transferred betweenoperators in much thesame way as undertraditional interconnectarrangements”.


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 simplyperceived 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 entityis acting as a principal or an agent in an arrangement. Industry practice is,therefore, relevant when determining appropriate accounting. Practice currentlyvaries under existing local GAAPs and, while the change to IFRS may not result inan immediate switch to consistent policies across the sector, it is an area inwhich 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 effectivelyrents a range of international numbers to a service provider and agrees to passon 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 serviceprovider when settlement has been received from the local carrier originating thecall and may even route the traffic so that it is never actually carried over theoperator’s own network. Prima-facie one would not expect gross revenuerecognition, although the terms of separate arrangements will need to becarefully evaluated against the criteria discussed above.

Internet service providers

A similar position may arise where ISPs provide their services via anotheroperator’s network. If the arrangement is based on a ‘per minute’ basis, the enduser may pay its network provider for the calls made. The network provider maythen 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 paythe ISP directly, and the ISP may be billed by the network provider for calls madeto the ISP. Where the network provider receives a gross fee and pays a netamount to the ISP, it may end up recognizing higher revenue than if it justreceived the net amount from the ISP. However, this may be appropriate to theextent that it matches the credit and other exposures involved.

Again, the position may be further complicated when more than one operator isinvolved. Depending on the cash flows and credit risks, the same service mayresult in different revenues being recognized by those involved. IFRS provideslittle guidance on how to address such complexities. Established industry practiceand full disclosure will remain critical until further guidance emerges.

2.3.5 Bundled servicesAs the range of value-added services offered by telecoms companies grows, theissue of ‘being separable’ and how to account for ‘bundled services’ becomesmore prevalent. As already discussed, IFRS includes little guidance on when atransaction should be accounted for as separate identifiable components, andwhen it should be considered as a whole.

However, IAS 18 does give a number of examples where it implies ‘separation’ isappropriate. For example, when the selling price of a product includes anidentifiable amount for subsequent servicing, IFRS states that the amount isdeferred and recognized as revenue over the period during which the service isperformed. Similarly it states that installation fees should be recognized byreference to the stage of installation.

Take a service that comprises a number of different components. Under IFRSone expects to account for them as if they had been provided on a standalonebasis, unless they are interdependent and the substance of the arrangementrequires consideration of the arrangement as a whole.




2.3.6 Installation feesA common feature of telecom services is that they often require upfrontconnection, installation or other costs to be incurred before the ongoing servicecan be provided.

The work required can be as little as sending a signal to enable a mobile handset,to installing equipment at a customer’s premises, to laying a physical connection.Where significant, operators may seek to recover costs through separateconnection or installation fees. The issue is whether it is appropriate to separateout 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 ofcompletion 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 ofthe installation, IFRS could allow revenue to be recognized according to the stageof completion of the installation. In practice, as installation does not typically takelong and consideration may not be payable until complete, many companiesrecord 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 onlybe appropriate to separate installation fees, and recognize them on completion ofthe installation, where the installation is separable (i.e. could be provided byanother party) and a reliable fair value can be established.

2.4 Capacity sales

2.4.1 BackgroundFollowing the filing for bankruptcy of a number of telecoms companies in 2002and the sharp decline in telecoms stocks, accounting for capacity sales, and inparticular swaps, came in for increased scrutiny and significant press criticism.

However, even the Congressional Hearing into capacity swaps by Global Crossingand Qwest in September 2002 recognized that there are legitimate arrangementscalled IRUs (indefeasible rights of use), and that there is a legitimate accountingtreatment for them. The main issue was not the accounting but whether thetransactions themselves were sham transactions designed to boost revenues.

Under U.S. GAAP, prior to the introduction of FIN 43 in June 1999, industrypractice was to account for capacity sales as sales at the time of delivery andacceptance. FIN 43 effectively required capacity sales to be accounted for as realestate sales. This, in most cases, prevented upfront recognition and contributedto 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 networkassets, some contracts convey IRUs to the buyer for an agreed period. Somecontracts convey the right to use identifiable physical assets (or identifiablephysical components of larger infrastructure assets); others convey the right touse a specified amount of capacity, defined in terms of an asset’s output, ratherthan the right to use a specific 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 significancebetween 1995 and 2001 as carriers sought to extend their networks.

The commercial rationale reflected a number of factors including the cost ofconstructing a network, the desire for a secure global presence and the fact thatmodern cables are capable of carrying far more traffic than a single carrier cangenerate. Few carriers can independently fund the construction of a globalnetwork and, in order to achieve the desired geographic coverage, arrangementsto use other carriers’ networks are typical. The advantage of an IRU, from thepurchaser’s 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 principlesSome of the main issues to consider when accounting for capacity sales are:

• Can revenue be recognized upfront (as an asset sale) or should revenue berecognized over the term of the IRU (as provision of service)?

• How should transactions be accounted for where, rather than selling capacityfor cash (or the right to receive cash), an entity exchanges capacity on its ownnetwork for capacity on another entity’s network?

2.4.3 Accounting for an IRU as a leaseWhen determining the appropriate accounting for IRUs under IFRS, it isnecessary to first consider whether the arrangement is, or contains, a lease. If it is considered a lease, then the appropriate accounting will be determined inaccordance with IAS 17. If not considered a lease, consideration needs to begiven to whether the arrangement constitutes the sale of goods or the renderingof services. This will establish which part of IAS 18 is relevant when determiningthe 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 usethe asset to the customer for an agreed period of time in return for specifiedpayments. However, until recently, there has been no specific guidance underIFRS as to whether IRUs should be accounted for as leases, in accordance withIAS 17. At the end of 2003 the International Financial Reporting InterpretationsCommittee (IFRIC) issued Draft Interpretation D3 Determining whether anArrangement contains a Lease.


“The purchase, sale and exchange of capacityis a legitimate commercialpractice. It has been afeature of the industry for many years”.



D3 specifically refers to arrangements in the telecoms industry, where suppliersof network capacity enter into contracts to provide purchasers with rights tocapacity and provides guidance on whether these should be accounted for inaccordance with IAS 17 or not:

D3 sets out the following three criteria which need to be met for an arrangementto be or to contain a lease;

• The arrangement depends on a specific item or items, for example an item ofproperty, plant or equipment

• The arrangement conveys a right to use the item for an agreed period of timesuch 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 madeavailable for use rather than for actual use of the item.

While clearly the terms of specific IRU contracts can vary, in the majority ofcases one could expect a straightforward IRU capacity sale to meet each of theabove 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 entity’s property,plant and equipment (‘PP&E’) is not revenue but is a gain. Accordingly, capacitysales out of stock will be reported as revenue whilst sales out of PP&E should bereported as other income under IFRS.

Arrangement depends on a specific item

IRUs typically identify the specific asset subject to the arrangement, whether afiber pair or some other identifiable asset. Under any GAAP, it is difficult to arguethat 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. Whilespecific fibers on specific cables are clearly separately identifiable and representseparate tangible assets, the position becomes less clear in respect of segmentsof a specific wavelength carried along a particular fiber.

In some cases IRU arrangements may simply give the purchaser the right to usea certain amount of capacity over a particular route. In these situations, the IRUwould not be accounted for as a lease. The transaction would typically beaccounted for in accordance with IAS 18 as a service rather than as the sale ofgoods. Revenue would then be recognized on a straight line basis over the periodof the IRU.

Exclusion of use by others

Invariably, IRUs are for an agreed period of time. Contractually the purchaser willhave exclusive use of the capacity in question. While dark fiber may be clearlyseparable and identifiable, the case for lit fiber is more complex.




In its simplest form, lit fiber merely represents dark fiber with electronics ateither end, which may be separable (for example discrete circuit boards). As thefunctionality and complexity of the electronics involved increases, the boundariesas to what is actually sold become somewhat blurred. This becomes importantwhen considering whether the buyer has exclusive use of, and substantiallyassumes all the risks and rewards of the asset identified. In that respect,portability on behalf of the purchaser, or the seller’s ability to substitute alternativecapacity, 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 D3Any particular capacity sale by a carrier may represent the sale of a small part ofthe total capacity available on any specific route and the seller will retain the risksand rewards of the remainder.

D3 explains that in some arrangements, the supplier transfers the right to use anitem that is a component or portion of a larger item (e.g. a right to use 50percent of the capacity of a pipeline). D3 states that how to determine if andwhen a right to use a component of a larger item should be accounted for as alease is not dealt with in the draft interpretation. It goes on to explain that ’insome cases‘ it may be appropriate to treat a right to use a component of an itemas a lease in a manner consistent with the draft interpretation.

Accordingly, it is reasonable for entities to account for capacity sales, thatrepresent only part of a larger asset, in accordance with D3 so long as thecapacity 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 saleshould be accounted for as a finance lease or an operating lease. If considered afinance 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 therisks and rewards incidental to ownership of an asset. Title may or may not betransferred. IAS 17 goes on to state that the substance of the transactionsdetermines whether a lease is a finance lease or an operating lease. It givesnumerous examples where a lease would normally be classified as a financelease. 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 iftitle is not transferred

• At the inception of the lease the present value of the minimum lease paymentsamounts 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 ofthe asset. Typically there will be negligible residual value in the asset at the endof the lease with the amount paid for upfront for the IRU representing the fairvalue of the underlying asset.

2.4.6 Other implications of IAS 17 and D3While IAS 17 may result in upfront recognition of capacity sales, assuming theymeet the definition of a finance lease, other implications of accounting for IRUsin accordance with IAS 17 need to be considered.

Disclosure

In addition to meeting the requirements of IAS 32 ‘Financial Instruments’, IAS 17includes comprehensive disclosure requirements for both operating and financeleases. Many of these relate to future payments due under the lease. For thatreason, if the IRU has been paid in full on acceptance, they may not be applicablebut a general description of the lessee’s material leasing arrangements will stillbe required.

Operating and maintenance services (O&M)

D3 states that IAS 17 should only be applied to the lease element and that otherelements should be separated out. Payments under the arrangement should beseparate and based on relative fair values, recognizing that the purchaser mayneed to make estimations.

For IRUs which include O&Ms, either priced separately or included in the IRUprice, payments should be separated into those for the IRU and those forongoing 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 fairvalue 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 leaseAs discussed above, an IRU that is not considered to contain a lease will beaccounted for by the vendor in accordance with IAS 18.

Even if not considered a lease, when determining appropriate accounting forcapacity sales, the key questions are:

• Have all the risks and rewards of ownership of the asset been substantiallytransferred to the buyer?

• Has control of the asset been transferred?

Control is normally taken to be the ability to obtain future economic benefitsrelating to the asset, and the ability to restrict the access of others to those benefits.




2.4.8 Existing IFRS guidance and UK guidanceIFRS 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 TaskForce (UITF) Abstract 36). This lists examples of risks that, if significant and borneby the seller, indicate that the seller should continue to recognize an asset in itsentirety. 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 seller’s obligations to provide continuing access by

operating and maintaining the assets (arising, for example, from exposure tocosts that cannot be recovered from the buyer)

While it may often be clear that the seller retains some of the above risks, it maybe more difficult to determine whether, for those that are retained, they aresignificant in terms of the overall transaction. This needs to be considered on acase-by-case basis.

The provision of ongoing operating and maintenance (O&M) by the seller is acase in point. O&M will be invariably included, as it is usually impracticable orprohibitively expensive for the purchaser to arrange its own O&M. However, solong as sufficient revenue is deferred to cover the costs of providing ongoingO&M, any exposure to future costs may not necessarily be significant.

2.4.9 Exchange transactionsOne of the most contentious aspects of capacity sales accounting is exchangesof capacity. Sometimes referred to in the press as ‘hollow swaps’, the criticismlevied is that, in certain instances, companies had no use for the capacity they acquired or sold. Agreements to exchange capacity were allegedly used toinflate revenue or earnings reported. The criticism has also extended to caseswhere transactions were settled for cash but where no, or minimal, net cashchanged hands.

While exchange transactions may have been more open to abuse, the nature ofthe industry and the geographical coverage of the main players, means themajority of trade was between a relatively small number of carriers. Exchangetransactions were a means to obtain global capability, considered critical at theheight of the telecoms boom. Furthermore, commercially it is not unusual forparties to prefer to buy from someone who is already a customer. This should notin any way invalidate the underlying transactions.




One of the biggest issues in respect of exchange transactions is to help ensurethere is a sound commercial basis for the transaction and to determine theappropriate fair value at which to record the transaction. If there is no propercommercial rationale for the transactions or if they are in any way consideredartificial, 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 orswapped for goods or services which are of a similar nature and value, theexchange is not regarded as a transaction which generates revenue.

However, aside from the example of commodities suppliers exchanging inventoryto fulfill demand in different locations, IFRS does not go on to define or give anyfurther guidance on what is considered ‘similar’. While some companies may takethe view, for local GAAP purposes, that capacity between London and Paris isdissimilar from transatlantic capacity because it is a different route, IFRS may notrecognize the transaction because, prima facie, the asset is similar in nature.

The examples given by IAS 18 concern the exchange of commodities such as oilor milk. Here suppliers exchange or swap inventories to fulfill demand inparticular locations. This is broadly analogous to the exchange of capacity wherecapacity in one location is exchanged for capacity elsewhere.

IAS 18 does not currently permit the recognition of revenue in respect ofexchanges of similar assets. However, in its revision to IAS 16 ‘Property, Plantand Equipment’, the IASB removed the distinction between the treatments ofexchanges of similar assets from dissimilar assets as part of the general move forall transactions to be recorded at fair value.

IAS 16 states that in an exchange of property, plant and equipment cost ismeasured at fair value unless (a) the exchange transaction lacks commercialsubstance or (b) the fair value of neither the asset received nor the asset givenup is reliably measurable. IAS 16 expands to say that an entity determineswhether an exchange transaction has commercial substance by considering the extent to which its future cash flows are expected to change as a result ofthe transaction.

Accordingly, there are currently inconsistencies between IASs 16 and 18 in howexchange transactions are accounted for under IFRS. However, for capacity sales,simply requiring all exchanges to be recorded at fair value would simply shift theissue from determining whether the assets exchanged are similar, to determiningwhether 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 arm’s length transaction.

Clearly, comparative transactions provide some of the best evidence of fairvalues. However, for capacity sales, these are not always readily available – atrend that is increasing given the significant fall in IRU sales. While at one stagethe industry was making moves towards ‘bandwidth trading’ and establishingstandardized terms for trading capacity, in practice this has not materialized.

2.4.10 Capacity purchasesCompanies that have never sold capacity may consider that recent accountingdevelopments 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 ontheir balance sheets where the terms of an IRU have changed.

Many companies that acquire IRUs (indefeasible rights of use) treat the cost ascapital expenditure and include any purchased IRUs as fixed assets. However, theposition 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 formercustomers the opportunity to exchange the existing capacity they have purchased for other routes. Sometimes, for operational reasons, they will offermore capacity on alternative routes so that they no longer have to maintainunprofitable routes.

By offering to change the terms of the original contract, the risk is that operatorswill have to revisit their accounting. For example, once a specific asset isexchanged 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 haschanged. Should it no longer be classified as a fixed asset (i.e. a specific separatelyidentifiable asset), and instead be treated as prepayment for future services?

Under IFRS, lease classifications are made at the inception of the lease. If at anytime the lessee and lessor agree to change the provisions of the lease, otherthan renewing it, in a manner that could have resulted in a different classificationof 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. Similarlyunder IFRIC Draft Interpretation D3, a reassessment of whether an arrangementcontains a lease should be made if, and only if, the provisions of the arrangementare changed. Accordingly, historical IRU purchases will need to be re-visited ifchanges in the terms of the IRU are made.

It is important to note that IAS 18 does not have any exemption under IFRS 1from retrospective adjustments. For that reason, all purchased IRUs may have tobe re-analyzed on adoption to ensure the appropriate treatment.


“If there is no propercommercial rationale forthe transactions or if theyare in any way consideredartificial, no accountingrecognition should be given to the transaction”.



2.5 Other revenue recognition related issues

2.5.1 Probability of receiptOften 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 continuesto provide a service where the likelihood of payment is remote. This is especiallyprevalent in the co-location sector where space has been let to customers underlong-term arrangements, some of whom have subsequently fallen into significantfinancial difficulty.

Where there is no alternative customer for the space, the co-location operatormay continue to invoice for the provision of the space even though payment isunlikely. From an accounting perspective, is it appropriate to continue torecognize revenue and provide for it when considered unrecoverable or shouldrevenue not be recognized in the first instance?

IAS18 states that revenue should only be recognized where ‘it is probable thatthe economic benefits associated with the transaction will flow to the enterprise’.

Accordingly, irrespective of whether a service is provided and the sellerperforming its duty, revenue should not be recognized unless it is consideredprobable that payment will be received. Payment does not have to be certain butthere does need to be a realistic expectation that it is forthcoming.


“...historical IRU purchaseswill need to be re-visited ifchanges in the terms ofthe IRU are made”.



IFRS, through IAS 1, offers considerable freedom for presenting costs in theincome statement. Indeed less analysis will be required when IAS 1, as changedin the improvement statement, is applied as there is no longer a requirement toshow 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 incomestatement. 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, presentingcost of sales and gross profit (function of expense method) and then switching tothe nature of expense method for disclosing other operating costs.

This has the benefit of making both gross margin and EBITDA (Earnings beforeinterest, tax, depreciation & amortization) readily ascertainable from the financialstatements. However, it is not consistent with the ‘either / or’ choice offered byIAS 1 and would not be appropriate under IFRS. Irrespective of whether the‘nature’ or ‘function’ method is adopted, presentation of EBITDA on the face ofthe profit and loss account may will still be possible by presenting a sub-analysisof earnings, as illustrated in the following table:


3. Cost of sales and operating expenditure

“ In practice there has been a great deal of diversity ofclassification betweenoperators”.

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 Xgoods 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 Xof 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 ComparabilityFor 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 incomestatement captions. However, some guidance on cost of sales may be inferredfrom IAS 2 ‘Inventories’. It states that inventory costs should include costs ofpurchase, conversion and other costs in bringing the inventory to its presentlocation and condition, including attributable overheads.

So, for a typical fixed line operator one might expect to see the followingincluded within cost of sales:

In practice there has been a great deal of diversity of classification betweenoperators, even allowing for differences in cost structures. Of the costs listedabove, interconnect charges and customer tail circuit costs are commonlyreported as a cost of sale. Classification of the remaining items is varied.

It is relatively unusual for companies to include their core network costs withincost of sales. One possible reason for this may be uncertainty about how to dealwith the costs of under-utilized networks. While it is easy to see that core networkcosts 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 volumeincreases which have not (yet) been achieved.


“For customer acquisitioncosts to be deferred(capitalized), they mustmeet both the definitionand 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 agent’s 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 costof sale

rarely included as a cost of sale



In other industries usage variances are readily identifiable. This is far less truefor a telecoms company. It is perhaps understandable that they may choose toavoid potentially arbitrary allocations between cost captions by allocating thewhole of the cost to a single heading. Therefore, normal variances may beallocated to costs of sales / stock, and abnormal ones to other operating expenses.

The current state of affairs is unsatisfactory in that companies’ reported resultsare far from comparable. It remains to be seen whether the limited guidancewithin IFRS is enough to resolve these differences. For now, inconsistencies oftreatment of both costs and revenues (see section 2) may significantly underminethe value of gross margin comparisons and projections.

3.2 Cost recognition

The IAS Framework requires that expenses are recognized in the incomestatement 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 itemsof income and the costs incurred, the matching principal is still relevant.Accordingly, the revenue recognition considerations described in section 2 oftendictate the recognition of related costs in the income statement.

This is not always the case. The application of the matching concept does notallow for the recognition of items in the balance sheet which do not meet thedefinition of assets or liabilities. The following examples illustrate some situationswhere the matching principle does and does not apply.

3.2.1 Handset salesHandsets are normally sold as part of a larger package with the value attributableto the handset accounted for as revenue upon delivery (providing the handset hasstandalone value to the customer). In this case, the cost of the handset would beexpensed in the income statement upon delivery as well.

3.2.2 Customer acquisition costsOften, the more interesting question is when any external customer acquisitioncosts should be expensed. Should this be up front at the time of recognizing anyhandset or other equipment revenue? Or should it be deferred and amortized inline with the provision of subsequent services?

For customer acquisition costs to be deferred (capitalized), they must meet boththe definition and recognition criteria for an asset.

IFRS defines an asset as ‘a resource controlled by the enterprise as a result ofpast events and from which future economic benefits are expected to flow to theenterprise’. Recognition is only permitted if, as for tangible assets, the resource iscontrolled (say by means of a contract), economic benefits are probable and ‘thecost of the asset can be measured reliably’.




The issue therefore, is whether the operator has the right to control access tofuture revenue streams (say under an enforceable service contract), and if thecost of the subsidy can be reliably measured. If these criteria are not met, thenthe customer acquisition costs are more akin to a marketing expense and shouldbe expensed as incurred rather than capitalized and amortized over the contractlife. For example if a customer contract was not signed at that time, unless it wasotherwise legally enforceable, it may not be appropriate to capitalize thecustomer acquisition cost.

Historically some entities may have deferred customer acquisition costs based onthe expected customer life, calculated according to historical and anticipatedchurn rates. Where historical experience shows that the average customer didnot stay for the full contracted period, the shorter period should be used.However, where this period is significantly less, it calls contract enforcement intoquestion (either because an entity is practically unable to or is unwilling to) and itbecomes debatable whether any costs should be carried forward. Where churnrates indicate that customers are loyal beyond contracted periods, amortizationshould only extend to the contracted period – beyond this point the operator hasno control over the future benefits that may arise from the customer, even ifconsidered probable that they will be achieved.

3.2.3 Activation costsFor small sales such as handsets and related services, costs are generally lowand will normally be expensed in the period in which they are incurred. It isrelatively unusual to bill a separate activation fee in such instances. Instead, theactivation fee is recovered via installments paid over the service period. In thisinstance, revenues from activation are deferred while costs are recognized in theperiod of the activation.

In the case of customer-specific construction and activation activities, (say diggingactivities and completing the ‘last mile’ for fixed line services), costs will not beincidental and are normally charged to the customer separately. In these cases,the activation fee shall be recognized as revenue upon activation (taking intoaccount revenue recognition criteria), and the costs incurred shall be expensed atthe 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 thecustomer, capitalization of the costs may be appropriate where:

• They meet the definition of an asset and reliability criteria (’it is probable thatfuture economic benefits associated with the asset will flow to the enterpriseand 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 toprovide 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 costAside from variable fees based on usage, telecoms companies usually bill fixedfees for services that are independent of usage by the customer (in combinationwith variable fees or separately). A common example is monthly subscriber feesfor data carriage services.

The costs associated with these services are largely fixed and relatepredominantly to the cost of the network itself. As the core network cannot beallocated to specific customers or products, costs related to it (including costs ofupgrades and maintenance) are capitalized and depreciated over its economicuseful life. This is much longer than the average customer contract term, butshould not be longer than the period over which an entity expects to serve itscurrent and future customers in a profitable manner.

Because of the lack of a direct relationship between network costs (which arelargely fixed) and the revenues from subscription fees (which depend on thenumber of subscribers), capitalization criteria and depreciation considerationsrather than matching determine the accounting treatment for network-relatedcosts.

3.2.5 Leased linesMany operators have short-term (i.e. operating) leased line contracts with other operators. Leased lines may generally be viewed as an expansion of anenterprise’s 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 thesupplier. These costs are expensed as incurred whether they relate to the corenetwork or individual customers.




3.3 Other issues

3.3.1 O&M costsParticular judgment is required in respect of O&M (operating and maintenance)costs incurred under capacity contracts. A separate O&M charge is a commonpart of a fiber IRU agreement, as the vendor seeks to pass on an appropriateshare of the ongoing costs of maintaining and operating the fiber.

An accounting judgment is required to ensure the commercial negotiation for thesale has not resulted in any disproportionate compromises between the capacityselling price and the agreed contribution towards O&M.

The distinction is an important one. For the potential purchaser, negotiatedreductions in O&M mean a saving on operating expenses. These may be farmore attractive than reductions in finance lease charges which serve to reducedepreciation expenses and do not, therefore, impact EBITDA.

In practice the parties often agree a sale that is based on the timing and currentvalue of the aggregate (lease and O&M) payments. They then consider how thecosts should be characterized under the contract. In this situation, considerationneeds to be given to whether the legal form of the agreement fairly reflects thesubstance of what has been negotiated. As discussed in IFRIC D3 (see section2.4.4), assuming that the IRU agreement is considered to contain a lease, IFRSwill require costs to be allocated between the lease and the O&M by referenceto relative fair values.

For larger telecoms companies with experience of letting their own O&Mcontracts, there may be objective evidence of the relative O&M cost. For othersthe assessment may be more difficult. In any event, it would not be appropriateto 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 thelease as a fixed asset.


“An accounting judgmentis required to ensure thecommercial negotiation for the sale has not resulted inany disproportionatecompromises between thecapacity selling price andthe agreed contributiontowards O&M”.



4.1 Introduction

Within the telecoms industry, the accounting treatment of 3G licenses acquiredby mobile companies at the height of the recent boom has probably attractedmost public attention. Such licenses are one of the biggest assets on the balancesheet of many mobile telecoms companies.

To put it into context, over US$100 billion has been invested in Europe alone inacquiring 3G licenses, with around US$50 billion and US$35 billion paid inGermany and the UK respectively. In addition to the license costs, some estimatethat a similar sum may end up being spent on building the necessaryinfrastructure, with much of this capitalized on companies’ balance sheets.

Accounting for intangibles in relation to goodwill and, looking ahead, developmentexpenditure, are especially pertinent to the telecoms industry. Where IFRS islikely to make an impact is the obligation to capitalize development costs thatmeet 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 principlesAlthough 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 toaddress the greater integration of communication services with corporateinformation systems and more content rich services for the ordinary consumer.

Similar to tangible fixed assets, the basic principle is straightforward: for anythingto be capitalized as an intangible, it should be controlled by the entity and beexpected to generate future benefits for the entity. IFRS requires that anintangible 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 pastevents; and (b) from which future economic benefits are expected to flow to theentity. ‘Recognition’ is only permitted if, as for tangible assets, economic futurebenefits are probable and the cost of the asset can be measured reliably. Thisapplies whether the asset is acquired externally or generated internally, thoughthere are additional recognition criteria for internally generated assets.


4. Intangible assets

“...over US$100 billion has been invested inEurope alone in acquiring3G licenses, with aroundUS$50 billion and US$35billion paid in Germany and the UK respectively”.



4.2.2 The identification of appropriate costsLike tangible fixed assets, the basic principle is that the cost of an intangibleasset comprises its purchase price and any directly attributable expenditure toprepare 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 andgeneral overheads should not be capitalized. What is more, due to the additionalrequirement under IFRS, once expensed, costs must not be later capitalized. Itshould be evident from the time that costs are first incurred that they meet theappropriate criteria for capitalization.

If acquired as part of an acquisition, the cost is based on fair value at the date ofacquisition. If this cannot be measured with sufficient reliability, then the costsfail to meet one of the two essential criteria for recognition as an intangibleasset. For telecoms companies making acquisitions today, the original cost of,alicense (for instance) may not prove a meaningful indicator of value. With noready market for the asset, a benchmark may not be available.

Some telecom companies have acquired licenses from the government, eitherfree of charge or at values substantially below what others have been willing topay 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 berecognized as income when any conditions are met. A final position is expectedbefore the end of 2004.

4.2.3 Treatment of borrowing costsIFRS allows, as a policy choice, borrowing costs to be either expensed asincurred or capitalized to the extent that they relate to the acquisition orconstruction 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 significantsums invested in licenses and other intangibles, the amounts involved may besignificant for many telecoms companies. In many jurisdictions this may be achange from existing accounting practices.

If a policy of capitalization is adopted and funds are borrowed specifically toobtain an asset, the amount of borrowing costs eligible for capitalization on thatasset should be the actual borrowing costs incurred.


“The IASB is currentlyconsidering revisions to IAS 20 to require grantsto be recognized asincome when anyconditions are met”.



To the extent that funds are borrowed generally and used for the purpose ofobtaining assets, the amount of borrowing costs eligible for capitalization shouldbe determined by applying a capitalization rate to the expenditure on that asset.The capitalization rate should be the weighted average of the borrowing costsapplicable to the borrowings of the enterprise outstanding during the period,other than borrowings made specifically for that asset. The amount of borrowingcosts capitalized during a period should not exceed the amount of borrowingcosts incurred during that period.

4.2.4 Other costs that can be capitalized as intangible assetsResearch and development costs

IFRS explicitly prohibits capitalization of certain intangible items, includinginternally generated goodwill, brands, customer lists and items similar insubstance. This is because they cannot be distinguished from the cost ofdeveloping the business as a whole.

IFRS prohibits the capitalization of research costs. However, IFRS requirescapitalization of development costs if certain criteria are met. It does not allowcompanies 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 tocomplete the project and suitable resources are available to achieve this

• The ability to sell or use the asset is demonstrated, including evidence of theeconomic 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 demonstratingthe economic benefits that may flow from the asset. For example, the pricing ofmany telecoms services can be volatile and it is not unusual for a new service tobe bundled ‘free’ as a means of supporting prices on an existing service

In such circumstances, leading telecoms development projects will typically beexpensed as incurred due to uncertainties over the direct benefits. It may wellprove easier for second adopters of a service to capitalize development costs asa pricing basis may already be established.

A further difficulty arises when identifying the incremental cost associated withthe service. A network upgrade can offer a wide range of benefits, one of whichmay be to add a new service to the company’s capability. Pinpointing the part of the cost that specifically relates to the new service may prove difficult orimpossible. In this case IAS 38 is clear: capitalization is only required where the directly attributable cost can be measured reliably. The ability to allocatecosts 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 productshave been relatively simple and delivered largely over ‘hard’ networks. This maychange as networks become more intelligent, as software becomes more criticalin their development and as more sophisticated products combine communicationwith 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 capitalizecustomer acquisition costs. Such costs, if capitalized, should be classified asintangible assets in the balance sheet and will be subject to amortization andsubsequent impairment reviews.

4.3 Amortization of intangibles

While there have been many casualties from the recent telecoms boom andbust, one area that has fared better than many is the mobile sector.

However, not even the mobile sector is immune to the impact of collapsingvaluations, starkly illustrated by the billions invested in 3G licenses which, for themost part, have still to prove themselves. Although in many cases delayed, theintroduction of 3G services across Europe is now developing apace, which raisesinteresting questions about how to amortize the significant sums invested.

Following the revision of IAS 38 ‘Intangible Assets’, IFRS now requires thatintangibles with indefinite lives are not amortized. For assets with finite lives (forexample many telecoms licenses), amortization is, for the most part, unlikely tobe significantly changed as there are few differences between the requirementsof IFRS and other major GAAPs.

UK GAAP, for instance, requires that the method of amortization should ’reflectthe expected pattern of depletion’. And IAS 38 states it should ‘reflect the patternin which the asset’s economic benefits are consumed by the enterprise‘. In thisrespect, consistency across the industry might be expected. However, there area number of differences that arise in practice.

4.3.1 Method of amortizationWith the exception of the start-up period, many mobile operators amortizelicense costs on a straight-line basis. IFRS’s basic premise is that the method ofamortization reflects the pattern in which the asset’s economic benefits areconsumed. This suggests that alternative approaches may be appropriate.




However, IAS 38 goes on to state that unless that pattern can be reliablydetermined, a straight-line method should be used. Any amortization patternbased on actual usage or the number of subscribers may be inappropriate as,although the current position is known, any future projections are likely to bebelow the necessary reliability threshold due to the inherent uncertainty involved.

Additionally most would argue that the potential benefits of a license areexpected to be ‘consumed’ in the course of time and that consumption is notaffected by the level of benefits achieved. For example the number of customerson a network. Some companies adopt a ‘sum of the digits’ approach, inaccordance with their local country GAAP but this is unlikely to be acceptableunder IFRS.

4.3.2 When to start amortizationAmortization reflects the consumption of economic benefits, but when does anentity 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 3Gservice is launched. Accordingly, they will start to amortize from the commerciallaunch 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 alaunch may be restricted to either a particular geography, or to a limited numberof users (reflecting the current scarcity of handsets).

Once the service is generally available to customers across the entity’s network,amortization should start. However, some companies adopt a policy of rampingup the amortization charge during the start-up period, rather than amortizing on astraight-line basis from launch. Conversely, others may amortize licenses over theperiod of the license, irrespective of when the network is fully operational andthe entity in a position to obtain the full benefit from the license.

Indeed, IFRS specifically states that amortization should commence when anasset is ‘available for use’, irrespective of whether it is actually used or not. Thissuggests that licenses should be amortized from the date they start. Howeverthere is a strong argument that the license is not ready for its intended use untilthe network is also ready, and accordingly, that amortization should not start untilboth the license and the network are ready for use, which can only be oncommercial launch.

‘Available for use’ is defined in IAS 38 as when the asset is in the location andcondition necessary for it to be capable of operating in the manner intended bymanagement. One could argue that even if an operator’s network is not ready itslicense can be used, say by renting it out to another operator. IFRS would onlyrequire immediate amortization if renting it out was management’s intent whenacquiring the asset.


“Amortization reflects the consumption ofeconomic benefits, but when does an entitybegin to consume an economic benefit from 3G or any other licenses?”



4.3.3 Residual valueAmortization and depreciation should be from the cost of the asset in question tothe estimated residual value. In the case of intangible assets, IAS 38 states thatthe 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 itsuseful 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 asset’s useful life.

These are very tough criteria with which to comply. In most cases the residuallife 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, jointdevelopment arrangements are likely to increase. An example of this could bestrategic alliances between mobile operators and handset manufacturers orspecialist service providers (e.g. news alerts via text messaging). Alternatively,there may be joint development arrangements between operators themselves asthe industry moves towards fixed-mobile convergence.

While IFRS prohibits the capitalization of research costs, it requires thecapitalization of development costs once certain criteria are met. While somedevelopment activities may result in an asset with physical substance, thephysical element of many telecoms’ products and services is secondary to itsintangible component – the knowledge embodied in it. Where developmentrelates to an intangible asset, costs can be capitalized only if it is consideredprobable that future economic benefits attributable to the asset will flow to theenterprise and the cost of the asset can be measured reliably. Consequently, the degree of certainty about the success of the product or service beingdeveloped is key.




4.5 Joint build type arrangements

It is common practice for operators to seek to share the costs and risksassociated 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 partywill manage the project, deal with suppliers, measure progress againstmilestones and allocate costs incurred to the various operators.

In many cases the lead operator pays the full costs upfront with the otheroperators contributing. Whether the lead operator recognizes the recovery ofcosts as income or nets it off against the cost of the asset depends on itsexposure to risks and rewards of ownership.

For example, where the lead operator controls the resulting asset and thecontributors simply obtain the right to use it, it would be appropriate to accountfor the gross cost of the asset and any contributions as income (either as aprepayment for future services or as an asset sale depending on thecircumstances). However if the lead operator and the contributors jointly controlthe resulting asset, under an asset sharing arrangement, then one would expectthe lead operator to account for contributions received as a credit to the cost ofthe asset.

IAS 31 provides guidance on the accounting and disclosure requirements for thedifferent 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 suchas networks / sites / masts is expected. Again the appropriate accounting ofthese 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 fewsignificant 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 2002when 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 putdown as capital expenditures.”

The issue is acute in the telecoms industry as the business model is capitalintensive. Extensive network build goes on during periods of growth but the costsare deferred over long periods of use. In addition, the nature of the assets builtdictates that a considerable proportion of a company’s operations are dedicated tocapital projects during periods of growth. As a consequence, and quite rightly, alarge proportion of a company’s total labor costs may be capitalized.

Telecoms is not the only industry to have this capital-intensive model; many utilityor network-based industries such as gas or water are similar. However, whatdistinguished the telecoms industry was the perception, largely fuelled by theInternet boom, that growth in and demand for telecoms products was going tobe exponential.

This caused the market and shareholders to consider the roll-out of networks avirtue in itself. It was assumed that the companies with the greatest networkcoverage would be best positioned to capitalize on the predicted burgeoningdemand.

The focus for evaluating share prices switched from traditional performancemeasurement 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 reportedEBITDA. Both at the EBITDA level, and at an operating level, the capitalizationpolicies adopted significantly impacted reported performance.

At the time the policies employed were, in the main, valid and based on a soundrationale. It is only now, with the benefit of hindsight, that some may questionthe policies adopted.


5. Property, plant and equipment

“Though there are fewsignificant differencesunder international GAAPabout what should becapitalized, the problem is more usually aroundinterpretation 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 beconsidered to be directly attributable to such assets and accordingly capitalized?

• What practical implications arise from these policies, and what difficulties, ifany, can lead to the incorrect fixed asset accounting?

5.2.1 Determining which assets can be capitalizedThe basic principle underlying fixed asset accounting is straightforward: for anyexpense to be capitalized it should contribute to providing future economicbenefits to the entity.

The costs capitalized should meet the recognition criteria of an asset, or beeligible for capitalization under specific accounting guidance. Matching alone is aninsufficient basis on which to justify deferring costs. Consequently, one needs tobe able to establish control first and then determine the probability that theeconomic benefits will flow to the entity while helping to ensure that costs canbe 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 costsUnder IFRS, assets should be measured, whether acquired or self-constructed, atcost (amount paid or fair value of other consideration). Allowable costs are thosethat are directly attributable to bringing the asset into working condition for itsintended 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 tothe extent that it is recognized as a provision.

Start up costs and general overhead costs should not be capitalized unless theyare directly attributable to the acquisition of the asset, or bringing the asset intoits working condition.


“The basic principleunderlying fixed assetaccounting isstraightforward: for any expense to becapitalized it shouldcontribute to providingfuture economic benefitsto 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 toany specific asset. As a result, complexities may arise with the practicalapplication of policies and judgment needs to be exercised. For example, networkbuild costs may be substantial and it may take a number of years to complete thenetwork. Similarly the boundaries between network build and networkmaintenance may not always be clear. This presents practical problems. Unless appropriate processes and procedures are in place to allow for accuratemonitoring of spend against the appropriate categories, errors can easily occur.

5.2.3 Capitalization of laborOther than the cost of physical equipment, staff costs are typically one of thelargest single costs of any network project. In a complex capital program, it islikely that any given resource pool will be used for more than one project and thatthere will be an overlap between construction and maintenance activities. Thesefactors increase the difficulty of being able to reliably measure and identify whichcosts are the incremental costs of construction but do not prevent the policy ofcapitalization being appropriate.

Rather than making broad assumptions when allocating expenses to discretecost pools, a time recording system may be necessary to profile activities. Capitalprojects need to be clearly identified and appropriate controls put in place to helpensure that the right costs are charged to these projects. This is especiallyimportant where the activity crosses both construction and on-goingmaintenance projects.

In any event, major assumptions about deferral of costs should be regularlyreviewed as a project moves through its life cycle because the mix betweenconstruction and maintenance costs will vary. The application of any capitalizationpolicy requires a number of judgments and assumptions to be made and robustprocesses and controls to be in place.

Once established, capital project codes need to be reviewed regularly. This willhelp ensure that it remains appropriate to defer costs, and that expected futureeconomic benefit is still considered probable. This may depend, in part, on beingable to measure the expected performance of a project, largely in financialreturns, which is often not straightforward. Projects often comprise severaldifferent type of asset, with varying useful lives, which can make monitoringdifficult 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 costsrelating to capital projects. IFRS permits it as an ‘allowed alternative treatment’

(IAS 23 para10 see section 4.2.3).


“Other than the cost ofphysical equipment, staffcosts are typically one ofthe largest single costs ofany network project”.



5.2.5 Capitalization of other costsAn 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 ofcapitalization, 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 costof an asset unless necessary to bring the asset to its working condition. Theissue 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 notbe 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 incurredbefore it actually becomes operational. These may apply, for instance, to mobilestation site costs or network lease circuit costs. The question is whether thesecosts are directly attributable and necessary to bring the asset to its workingcondition, say, as part of testing or commissioning the network. IFRS states that costs of testing whether the asset is functioning properly are directlyattributable costs.

• Training costs:

Training costs should not be capitalized on the basis that similar costs are likely tobe incurred as part of the entity's on-going activities. What is more, therelationship between the expenditure and any future economic benefits that maybe derived from it is usually not sufficiently certain. IAS 16 specifically includesstaff training, in respect of doing business in a new location or with a new classof customer, as an example of costs which should not be included in the cost ofproperty, 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 andequipment should include the estimated cost of dismantling and removing theitem and restoring the site on which it is located.

In the construction of networks, both mobile and fixed line operators often buildassets on leased land or premises where an obligation exists (under the leaseagreement for example) to reinstate the land or premises at the end of theagreed term. Provision for such costs is also required under U.S. GAAP wherethey are often referred to as ‘Asset Retirement Obligations’ (AROs).

The obligation is accounted for by including the estimated cost of dismantling andremoving the asset as part of the cost of the asset and setting up a provision forthe estimated present value of the obligation. These are both then unwound overthe 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 ofthe contracted period.

In many cases, it is unclear what rectification work needs to be carried out andentities need to make their ‘best estimate’ based on past experience. There mayalso be cases where rectification obligations exist but they are not enforced inpractice. For instance, obligations in respect of cables laid in international waterson the seabed or on coastal ‘landing stations’ may be unclear and inconsistentlyenforced. Some consider that removing the original cables may cause moreenvironmental damage than leaving them in place.

Similar issues exist where operators have been given rights to locate publictelephone boxes in certain public places. The increase in mobile penetrationrates, has made many of these sites redundant, but there is no immediaterequirement to remove them.

Recognition of asset retirement obligations

For an ARO to be recognized, it should meet the definition of a provision underIAS 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 lawsand regulations to remove assets at the end of their useful lives. In the absenceof a contractual obligation, a constructive obligation may exist if there is anestablished pattern of past practice or published policies of dismantling andremoving assets.

IAS 37 contains requirements on how to measure decommissioning, restorationand similar liabilities. However, it does not provide guidance on how to accountfor changes in those liabilities. This issue is currently being addressed by IFRICwhich has issued a draft interpretation.

Key assumptions

Mobile operators enter into agreements to lease land / property on which toerect masts. These leases can vary in length and may contain an option to extendthe lease. In these circumstances, where an obligation exists to reinstate theland / 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 extendedperiod? Or should the obligation not be valued at all on the grounds that it maynot crystallize or that it is immaterial?

In practice an estimate needs to be made of what is perceived to be the mostlikely economic life of the asset, taking into account all the above variables. Forexample, 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 removalwill be required at the end of the initial lease term.




5.4 Useful lives

Obtaining an accurate picture of companies’ depreciation policies from publicinformation is a relatively fruitless task. Most companies give depreciation ratesfor very wide ranging asset categories and typically give a broad range of assetlives. However, what is increasingly clear, is that whichever lives are chosen, theyneed to be regularly reviewed to help ensure they still reflect the remainingestimated useful life of the assets in question.

IFRS requires that the residual value and useful life of an asset is reviewed atleast at each financial year-end. If expectations differ from previous estimates, thedepreciation charge for the current and future periods should be adjusted.

For many telecoms companies, reviews into the estimated useful lives of assetstypically result in a downgrading. This reflects the increasing pace of technologicalchange, as well as changes within the business.

Where the change in asset life is significant, this may indicate that immediateimpairment rather than a revision to the onward depreciation rate is necessary. Atthe other end of the scale, it should be noted that if an asset is still in use andcontributing to the generation of future cash flows, full impairment with nodepreciation charge going forward will rarely be appropriate. In many cases partialimpairment, followed by a reduction in the remaining useful life, will be the mostappropriate approach.

One issue that many mobile operators may face is whether, in situations whereassets 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 tobe made of what is most likely to be the economic life of that asset. It shouldtake into account what is expected to happen in practice. Where there is nocertainty that the lease term may be extended, and it is impracticable oruneconomic to move the equipment to another site where it can be used, allassets on that site should be depreciated over the shorter of their individualestimated useful lives and the period of the lease for the site.

Following the boom and bust of recent years, many companies in the telecomsindustry have had to adjust their growth projections to reflect lower actualdemand and prices than originally envisaged.

The impact of this on company results is reflected in the scale and frequency ofimpairments, either to goodwill (writing off premiums paid for acquisitions at theheight of the boom) or to tangible and intangible assets (writing off much of theconsiderable infrastructure established in recent years).

Many of the largest write-offs to date have been in respect of fixed lineoperators, although mobile, and particularly 3G investments, have increasinglycome under pressure.


“If expectations differ from previous estimates,the depreciation charge for the current and futureperiods should beadjusted”.



In the main, the valuation of telecoms goodwill, intangibles or tangible assets isbased on the company’s discounted cash flow projections. Due to the highlysensitive nature of cash flow projections, and the underlying assumptions, theytypically represent one of the most important judgments that directors can makewhen preparing their accounts.

6.1 Impairment indicators

Under IFRS, acquired goodwill, intangibles with indefinite useful lives andintangibles not yet available for use need to be tested for impairment at leastannually. Otherwise there first needs to be an indicator of impairment before animpairment 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 thetelecoms 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 havesome 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, mayoften not represent indicators of impairment.

6.2 Impairment calculations

Having determined whether an impairment review is necessary, next is to assesswhat 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 wherethe 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 therecent significant turmoil in the telecoms sector,impairment reviews havebecome an establishedprocedure for manycompanies”.



6.3 Recoverability of license costs

Given the large sums invested in 3G and other licenses, the question ofassessing their recoverability independently from the underlying network is aparticular concern for the mobile sector.

Although the external value of licenses may have fallen dramatically in manycases, their value may still be supported, based on the expected future cashflows generated from operating the network (value in use). As the network andthe associated license are clearly interdependent and do not generate separatecash flows, they should be reviewed as one cash generating unit (CGU). This isbecause any allocation of underlying cash inflows between the network and theintangible would be entirely arbitrary.

For many operators it is still early days for 3G services. However, once operationsbecome more established and actual results compared with initial projections,the number and scale of license impairments may increase, especially for thoseoperators that paid significant sums for initial licenses.

6.4 Cash generating units

Establishing what constitutes a cash generating unit (CGU) for accountingpurposes 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 geographicbasis and others on a product or even customer basis. When determining theappropriate CGU for impairment review purposes, the entity needs to establishthe lowest level at which cash inflows from an asset (or group of assets) arelargely independent from cash inflows from other assets (or groups of assets).This should take into account how management monitors the entity’s operationsor how they make decisions about continuing or disposing of the entity’s assetsor operations.

However split, because the operator’s network is often common across many of its product lines or businesses, the network may need to be viewed on ageographic 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 willtypically use the same underlying network. While use of the network ismonitored, independent cash inflows may not be identifiable for individual partsof the physical network. Furthermore, while operations may only be managed andmonitored on one basis, cash inflows may be available on a geographic orstatutory basis.

An important point to note is that under IFRS, consideration needs to be given tothe 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 theindependence of cashinflows rather than bothcash inflow and outflows”.



6.5 Transition from old technologies to new technologies

Again, the mobile sector is a good example of the complications of applyingaccounting standards to practical situations.

Companies may only produce detailed formal projections for the business as awhole, whereas accounting guidance requires a particular set of assumptions tobe followed. For example, accounting requires values in use to be determined byreference to projected cash flows for those existing assets and not to takeaccount 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 straightforwardand can be very judgmental. For instance, many existing 2G operators may havelong-term plans that include the impact of the transition to a 3G environment.However, cash flow projections cannot be easily separated either because ofinterdependencies between the old and new network or uncertainty aroundwhen customers may transition from one service to the other.

Furthermore, as 3G is a new technology, there will often be little externalevidence to support management assumptions. One might expect assumptionsto be in line with those adopted by others in the market, but often there is a lackof consistency with the result that one operator may attribute no value to a 3Glicense and another may consider that the cost is still fully supportable.

While cash flow projections in the past may have been based on assumptionsthat were not achieved in practice, current projections are now more likely tohave 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, shouldbe based on recent financial budgets / forecasts approved by management for upto 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 periodbeyond five years. In this case the overall valuation may be very sensitive to thelong-term growth rates selected and the base cash flows at the end of thebudgeted period. IFRS states that periods beyond five years or growth rates inexcess of the long-term growth rates for the product, industry or country inwhich 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, IFRSstates that this is justifiable if management is confident that they are reliable.Management must also be able to demonstrate the ability to forecast accuratelyover that longer period – a relatively tough hurdle, especially in the telecomssector.

A large number of discounted cash flow projections are sensitive to the discountrate selected. This should be the rate that the market may expect on an equallyrisky investment. This is another judgmental area as market information is rarelyreadily available for ‘an equally risky investment’. Many entities may start withtheir own ‘Weighted Average Cost of Capital’ (WACC) and then make anadjustment for the specific CGU in question. It should be noted, however, that itis the WACC of the industry / market in which the entity operates that should beused rather than WACC of the entity itself.

6.7 Impairment reversals

In the case of goodwill, impairments can not be reversed. Under IFRS, reversalsof impairments other than goodwill need be considered where there is anindication 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 increasedto its recoverable amount, and the impairment loss reversed. Any impairmentreversal is limited to increasing the carrying amount of the asset to the amountby 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 orequipment, 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 equipmentused to connect customers to the network, as well as handhelds and otherproducts that are held for resale.

7.1 Introduction and general principles

Accounting for inventories at telecoms operators raises few issues specific to theindustry. Common classifications of inventories include merchandise, productionsupplies, materials and finished goods (the latter may include handsets or othertelecoms equipment for sale).

Inventory, or work in progress, should be accounted for when an entity controlsthem, in other words, when it has the risk and rewards of ownership. Inaccordance with IAS 2, inventories are stated at the lower of cost or netrealizable value. As technological advances in the telecoms industry aresignificant, consideration may need to be given to technical obsolescence whendetermining net realizable values.

Under IFRS, any write down of inventory that is no longer required should bereversed. A reduction in value that occurs after the balance sheet date may notbe recognized at the balance sheet date.

7.2 Cost elements

Inventory held for resale is stated at the lower of (acquisition) cost and netrealizable value. Inventory of equipment held for use in the maintenance oftelecoms systems will normally be stated at cost, including appropriate allocationof labor and overheads, less provisions for deterioration and obsolescence.

For these inventories, the question arises as to which elements can be includedin 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 presentlocation and condition. Conversion costs normally include direct material, directlabor, other direct costs and overheads. Overheads and indirect costs should beallocated 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 theservice, the cost of supervisory personnel and attributable overheads may beincluded when determining the cost of inventory.


7. Inventory



The allocation of fixed overheads to the cost of inventory should be based onnormal operating capacity. Variable overheads should be allocated on the basis ofthe actual use of capacity although this may be hard to achieve in practice.

Trade discounts, rebates and similar items and the financing element of deferredsettlements beyond normal credit terms should be excluded from the cost price.Labor and other costs relating to sales and general administrative personnel maynot be included either, but are recognized as expenses in the period in whichthey are incurred.

7.2.1 Reductions of inventory and cost determinationRecognition of inventory will normally cease when the recognition criteria of anasset is no longer met. For instance:

• The cost of inventories is recognized as an expense within cost of sales whengoods are sold or maintenance carried out

• The cost of inventories is recognized as an expense when inventory itemshave 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 2does 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 atelecoms 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 beexpensed while held in stock or when sold to customers at a loss.

The accounting depends, to a degree, on whether the operator’s business isconsidered to comprise the sale of handsets. In such an instance, one wouldexpect to determine the accounting by reference to IAS 2 Inventories. If thehandsets are considered customer incentives, accounting for marketing costsmay be more relevant.

IAS 2 Inventories

IAS 2 Inventories would require the write down of handsets held in stock wheretheir 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 ator above cost given local market conditions and practice. Where it is consideredprobable, the fact that the operator might choose to subsidize the sale, may notrequire an expense to be recognized until they are actually sold at the lower priceor given away.

However, the assumption that the entity had the ability to sell them at a valueabove cost would need to be analyzed carefully. This will help ensure that it was really possible to sell above cost given local market conditions andcompetitor practice.




Marketing cost

Where an entity’s established practice is to subsidize the cost of handsets as anincentive to encourage new subscribers, one might only expect to expense thecost of the handset when it is actually delivered. This would be consistent withaccounting for catalogue printing costs which are typically expensed when thecatalogue is actually distributed rather than when it is printed. Similarly the costsof filming an advert are typically expensed when the advert is first shown ratherthan when it is actually made.

Where mobile operators expense customer acquisition costs on delivery of thehandset, the purchase of the handsets by the operator may represent aprepayment of a marketing cost. This then be expensed on delivery of thehandset to the end user. One would not expect to revalue that prepayment byreference to its net realizable value.

For mobile operators who capitalize acquisition costs and amortize over theperiod of the contract, as long as the net proceeds of the sold package, includingthe handset, is above cost, no impairment of the handsets held would benecessary. This is where the overall contract is still expected to be profitable. In this situation, the enterprise would need to demonstrate that its contracts arenot loss making – not easy given the difficulties surrounding the allocation ofcosts 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 theirbusiness and accordingly hold them as stock. Where this is the case, the IAS 2Inventories treatment discussed above would appear to be the most appropriateaccounting policy.




Although it is a disclosure rather than an accounting issue, KPMG member firmsbelieve that segment reporting by telecoms operators deserves some attention inthis IFRS publication.

Good segment reporting provides information to users of financial statements sothey are better able to understand an enterprise’s performance, can better assessits 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 onesfor 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 theprevious item)

• Impairments (and reversals thereof)

• The share of results and carrying amount of equity accounted investments thatcan be allocated substantially to a single segment

• Total assets

• Total liabilities

• Capital expenditure.

For secondary segments, revenue (external and inter-segment), total assets andcapital expenditure need to be analyzed.

All Information on the segments should be visibly reconciled to the consolidatedfinancial statements.

Currently, many telecoms companies reporting under local GAAP do not fullymeet the requirements of IAS 14. This means that for many enterprises,conversion to IFRS may result in significant additional disclosures. In order tofulfill its requirements, internal reporting structures may need to be revised andextended, especially regarding the allocation of results and balance sheet itemsto segments.


8. Segmental reporting

“...for many enterprises,conversion to IFRS mayresult in significantadditional disclosures.”



8.2 Determination of segments

IAS 14 determines that segmentation should be based on the dominant sourceand nature of an enterprise’s risks and returns, as well as its internal reportingstructure. The dominant source is usually established from an enterprise’s internalorganizational and management structure and its system of financial reporting todirectors and the CEO.

Any component that is found to account for 10 percent or more of an enterprise’srevenue, operating activities or total assets is a reportable segment.

Even though IAS 14 includes some guidance on determining segments, inpractice the substance of the business will define the applicable segments.

For broadly-based telecoms companies, offering a range of telecommunicationsservices, business segments rather than geographical areas of operation willoften be the primary basis for segmentation. The less detailed disclosurerequirements for secondary segments would then apply to the geographicalareas.

Examples of (primary) business segmentation currently found within thetelecoms 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 iscontinuing and which part is discontinued.

Inter-segment transfers should be measured according to how the enterpriseactually priced the transfers. The transfer price policy for transactions betweensegments must be disclosed.

Many companies find difficulty in presenting the extensive segment disclosuresin a clear manner. IAS 14 does not require nor prohibit a matrix presentation, butin many cases a matrix (separated by year or including comparative figures forthe preceding year) can be helpful. Some telecoms operators present key incomestatement items and the assets, liabilities and capital expenditures of eachsegment in a separate table. This makes it possible to include furthercommentary on performance by segment and is recommended for companiesthat strive for ultimate transparency.


“Any component that isfound to account for 10percent or more of anenterprise’s 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 notbe especially complex, separating assets, liabilities, capital expenditures, cashflows, depreciation and impairments for the same segments may prove lesssimple.

For example, how should a fixed line operator separate its assets by segment if ithas chosen a primary segmentation by service line (e.g. voice, data, IP andhosting, and other) yet the main fixed assets, principally the network, are usedfor all services?

IAS 14 determines that segmentation should be based on direct attributions orreasonable allocations to a segment. Furthermore, there should be symmetry andconsistency where items are included in segment result and segment assets.

So, if assets are included in a segment, depreciation on that asset is included inthe same segment.

In making ‘reasonable allocations’ a certain amount of judgment is involved.Enterprises are encouraged to make allocations as meaningful as possible, takingguidance, if necessary, from other international accounting standards, such asIAS 2 ‘Inventories’, and IAS 11 ‘Construction contracts’. The appendix to IAS 36‘Impairment of assets’, includes an example where the headquarters is allocatedto cash-generating units, but it is unclear whether this allocation method is alsosuitable for segment reporting.

How and what costs, and assets, are allocated to segments will differ betweenenterprises but should be based on the objective of IAS 14: to provide usefulinformation to users of the financial statements for assessing the risks andreturns of the enterprise as a whole. Disclosure of the allocation method isimportant. However, assets that are jointly used by two or more segments – as inthe example above – should be allocated to segments if, and only if, their relatedrevenues and expenses (including depreciation) are also allocated to thosesegments. In cases where this is not reasonably possible, separate presentationof ‘central’ or ‘corporate’ assets may be the best approach.

A separate ‘other’ segment may be appropriate as well, so long as sufficientqualitative disclosure on its content is provided.

Similarly, general administrative expenses, head-office expenses and otherexpenses 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 orthere is a reasonable basis to do so. Again, the enterprise’s management shoulddecide what best reflects the substance of the business and provides a fair viewto the users of the financial statements.




Accounting for embedded derivatives in the telecoms industry, as with all otherindustries, 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 inthe first place. This can be exasperated where there are multi-locations and localdecision-makers enter contracts. Once identified, it will be necessary todetermine whether the derivative can be separated from the host contract.Finally, if separation is established, a fair value will need to be attributed to thederivative.

9.1.1 What is an embedded derivative?Derivatives are typically stand-alone instruments, but they may also be found ascomponents embedded in a financial instrument or in a non-financial contract.

IAS 39 paragraph 22 notes: ’Sometimes, a derivative may be a component of ahybrid (combined) financial instrument that includes both the derivative and ahost contract - with the effect that some of the cash flows of the combinedinstrument vary in a similar way to a stand-alone derivative. Such derivatives aresometimes known as 'embedded derivatives'. An embedded derivative causessome or all of the cash flows that otherwise would be required by the contract tobe 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 insurancecontracts, leases, purchase and service agreements, construction contracts,royalty or franchise agreements with foreign currencies components, priceclauses related to indices or contingent rentals.

9.1.2 Accounting for embedded derivativesAn embedded derivative that meets the definition must be separated from thehost contract and measured as a stand-alone derivative if its economiccharacteristics are not closely related to the host contract. If the economiccharacteristics of the embedded derivative are closely related to the hostcontract, then it is not separated. IAS 39 provides detailed examples of hostcontracts and derivatives that require separation and those that do not.

9.1.3 Common contracts in the telecoms industryTelecom companies, like other industries, will need to consider current and futurecontracts to identify embedded derivatives. This is likely to be a time consumingprocess. Below are some common contracts within the industry which maycontain embedded derivatives. The important point to note is that embeddedderivatives can often be contract specific and it will be important to establishprocedures that identify these in the contract-making process.


9. Other relevant issues

“Derivatives are typically stand-aloneinstruments, but they may also be found ascomponents embedded in a financial instrument or in a non-financialcontract”.



9.1.3.1 Trade Direct Agreement (‘TDA’)TDAs are bilateral international contracts between international carriers whereparties contract to purchase and receive a fixed volume of minutes at a fixedprice. 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’). Asthese contracts contained fixed currency prices to be settled in the future there ispotentially an embedded derivative. However, IAS 39 considers that where thetransaction is denominated in a currency that is routinely used in internationalcommerce worldwide (e.g. oil denominated in USD) that there is no separationand therefore no embedded derivative. As minutes are internationally traded inUSD and SDR, there would not be an embedded derivative.

However, such contracts may not always be denominated in one of these twocurrencies. If this were the case, then IAS 39 may still not consider thesecontracts separable if denominated in the currency of the primary economicenvironment in which any substantial party to that contract resides. For example,a predominately South African telecoms company entering a TDA with apredominately UK telecoms would not give rise to an embedded derivative if thecontract were denominated in USD, SDR, RND or STG – but would if in any othercurrency.

The position is more complicated when selling on TDA entitlements on the refilemarket. Whether such a transaction can be considered to be scoped out bynormal sales and purchases exemptions will depend on the particular facts andcircumstances.

9.1.3.2 Operational and maintenance contractsOperational and maintenance contracts may include embedded derivatives. Ifthese are volume-related with the economic characteristics of the embeddedderivative, 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 thetelecoms industry have recently found themselves with lease and othercommitments significantly in excess of the projected economic benefit expectedto result from those leases.

A number of co-location businesses have been left with significant un-let spacewith even the most optimistic of forecasts anticipating that future property leasecosts are unlikely to be covered.

Alternatively, companies may have entered into medium or long-term contracts tolease circuits for which they have no, or very limited use. Under IFRS, where theunavoidable costs of meeting the obligations of a contract exceed the economicbenefits anticipated under it, provision should be made for the least net cost exitfrom the contract. In the case of vacant properties, the expected benefits andunavoidable costs are typically straightforward to determine. However, in many




cases, it may be impractical to estimate the ‘benefit’ being obtained and the factthat a cost may no longer be economic or in line with market prices is aninsufficient basis on which to make a provision.

9.3 Restructuring costs

In recent years, the disclosure of restructuring costs has come under increasedscrutiny by both investors and the accounting regulatory bodies.

While the following guidance is not specific to the telecoms industry, it has beenincluded here as it is a topical area of interest given continued restructuring in theindustry.

9.3.1 Basic accounting principlesThe 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 Liabilitiesand Contingent Assets’. The standard is very much commitment-based and hasresulted in a move away from large, one-off restructuring charges to charges thatare increasingly recognized over longer timescales as they are incurred. Forinstance, where restructuring provides evidence of an existing impairment ofassets, these will continue to be recognized immediately (i.e. earlier than themain provision itself) but profits on asset sales and costs relating to on-goingactivities will fall as incurred.

To qualify as a restructuring under IFRS, the program must materially changeeither the scope of business undertaken by an enterprise or the manner in whichthat business is conducted. The following are examples of events which may fallunder 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 ofbusiness 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 andfocus of the entity’s 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 detailedformal 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 becompensated 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 therestructuring 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 whencommunicated to those affected by it, its implementation needs to be planned tobegin as soon as possible. It must be completed in a timeframe that makessignificant changes to the plan unlikely.

Where the entity starts to implement the restructuring plan, or announces itsmain features to those affected by it, after the balance sheet date, disclosure maybe 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 tothe 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 assetsof the operation should be reviewed for impairment. Furthermore it might benecessary to account for non-current assets under IFRS 5 ‘Non-current AssetsHeld 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 abinding sale agreement exists.

Gains on the expected disposal of assets are not taken into account in measuringa restructuring provision, even if the sale of assets is envisaged as part of the restructuring.




9.3.2 Costs to be includedA 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 arecharged in the profit and loss account as incurred.

9.3.3 RedundanciesRedundancy costs are often among the most significant cash costs in anyrestructuring. Usually it is quite clear that these costs are not associated withongoing activities, although this may not always be the case. An example wherecosts 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 otherconditions regarding plans, implementation and announcements (includingtimings), are met. Recognition of the provision may depend upon a probable levelof take-up being determined such that an appropriate level of provision can be assessed.

9.3.4 Disclosure of discontinued operationsDiscontinued operations are defined in IFRS 5 as a component of an entity thateither 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 ofbusiness 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.



kpmg.com

The information contained herein is of a general nature and is not intended to address the circumstances of anyparticular individual or entity. Although we endeavor to provide accurate and timely information, there can be noguarantee that such information is accurate as of the date it is received or that it will continue to be accurate in thefuture. No one should act on such information without appropriate professional advice after a thorough examination ofthe particular situation.

KPMG International, as a Swiss cooperative, is a network of independent member firms. KPMG International providesno audit or other client services. Such services are provided solely by member firms in their respective geographicareas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothingcontained 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 as such. All rights reserved.

KPMG and the KPMG logo are registered trademarksof KPMG International, a Swiss cooperative.

Designed and produced by KPMG’s UK Design Services

Publication name: Telecoms IFRS document

Publication no: 209 615

November 2004

COMMUNICATIONS

IFRS Accounting in theTelecommunications Industry

INFORMATION, COMMUNICATIONS & ENTERTAINMENT

19514_KPMG_IFRS_Case_Study_Cov 3/12/04 12:25 PM Page 1

ifrs accounting in the kpmg -...

Documents