IFRS for Technology Companies: Closing the GAAP? KPMG LLP

Transcription

1 ELECTRONICS, SOFTWARE & SERVICES IFRS for Technology Companies: Closing the GAAP? KPMG LLP

2 Contents What Does IFRS Mean for Technology Companies? 2 IFRS for SEC Registrants 3 Overview of U.S. GAAP Compared with IFRS 4 Revenue Recognition 4 Other Accounting Areas 18 Internal IT Can Facilitate the Changeover 21 Harmonization of Internal and External Reporting 24 People, Processes, and Controls 25 Closing Comments 27 Appendix: Technical References 27 KPMG LLP Can Help 28 Note: Throughout this document KPMG [ we, our, and us ] refers to KPMG International, a Swiss cooperative, and/or to any one or more of the member firms of the KPMG network of independent firms affiliated with KPMG International. KPMG International provides no client services.

3 Global adoption of IFRS appears closer every day. Conversion to International Financial Reporting Standards (IFRS) from U.S. GAAP (generally accepted accounting principles) for financial reporting can change the accounting for transactions, including revenue recognition, and affect a company s people, processes, information systems, and controls. Technology companies know about the demands of convergence. Where once media content, enterprise systems, personal computers, and mobile devices had limited interoperability, today s digital transformation of content and improved standardization enable more seamless communication among most of these technologies, driving adoption rates and use across all platforms. Globalization of capital markets has created a similar drive toward a unified, worldwide financial reporting language. IFRS, as issued by the International Accounting Standards Board (IASB), is a single set of high-quality accounting standards now in use in more than 100 countries, including five of the Group of 8 (G8) forum. The number of countries permitting or requiring the use of IFRS has been rising steadily, and large and emerging economies such as Brazil, Canada, China, India, Japan, and South Korea are preparing for adoption. The United States, with U.S. GAAP, is one of the last major markets to consider adoption of IFRS. But there is increasing U.S. support for a single set of global accounting standards among preparers, investors, auditors, standard-setters, and regulators. Global use of a single set of high-quality financial reporting standards promises many benefits: It has the potential to facilitate comparability of financial information among international competitors, eliminate dual reporting by subsidiaries in foreign localities, allow easier expansion into foreign markets, increase the mobility of finance professionals, and provide easier access to capital markets around the globe. IFRS for Technology Companies: Closing the GAAP? is the first in KPMG s series on industry-specific issues facing technology companies currently using U.S. GAAP as they consider a transition to IFRS. We provide background on the current state of IFRS U.S. GAAP convergence efforts from a regulatory and standard-setter perspective, discuss how IFRS compares with U.S. GAAP in key accounting areas for technology companies, and share views on how transition may affect business processes, systems, and people. Our primary focus here is revenue recognition, given its importance to the sector. We also briefly discuss sharebased payment and research and development, which will be addressed in more detail in future publications.

4 2 IFRS for Technology Companies What does IFRS mean for technology companies? The momentum toward IFRS is real. Many believe it is only a matter of time until all major economies allow or require IFRS as the local financial reporting framework. Experience of technology companies that have transitioned to IFRS shows that sector executives need to analyze the impact IFRS adoption will have on all aspects of their operations, including: Accounting policies and procedures Financial reporting and disclosures Information technology (IT) systems and the processes used to accumulate and report financial information, including new or revised IFRS-compliant data and calculations Modifications to business processes and controls supporting those processes, including internal controls to support related certifications of the chief executive officer and chief financial officer Contractual and legal obligations, such as financial covenants and employee incentive plans based in whole or in part on GAAP-reported metrics Training both finance and nonfinance staff on changes to policies, procedures, and the new foundation for judgments Managing communications with the executive team, audit committee, investors, and employees.

5 Closing the GAAP? 3 IFRS for SEC Registrants Effective for years ending on or after November 15, 2007, the U.S. Securities and Exchange Commission (SEC) no longer requires foreign private issuers who prepare financial statements in accordance with IFRS as issued by the IASB to reconcile their financial results to U.S. GAAP. The SEC rule does require foreign private issuers who elect to obtain relief from reconciling to U.S. GAAP to make a full and unreserved statement of compliance with all of IFRS as issued by the IASB. This can affect foreign private issuers who prepare their financial statements in countries where IFRS has been locally modified (for example, European Union endorsed IFRS). To address whether IFRS is appropriate for U.S. domestic issuers in view of its increasing global acceptance, the SEC issued a concept release and held roundtables in 2007 and may issue a proposal for public comment later this year (2008). The proposal is expected to contain a road map of action steps to be accomplished for all U.S. public companies to adopt IFRS. The action steps may include: Revisions to SEC rules and regulations to reflect IFRS rather than U.S. GAAP Consideration of the need for further convergence between U.S. GAAP and IFRS Plans for funding the IASB Governance and monitoring of the IASB A cost-benefit analysis on various issues associated with allowing or mandating IFRS in the United States. We encourage issuers, investors, educators, and others to actively participate in the SEC s consideration of these issues. In the meantime, the Financial Accounting Standards Board (FASB) and the IASB have been collaborating on standards development to reduce or eliminate differences between U.S. GAAP and IFRS. While the Boards have made some progress, many accounting and disclosure differences remain. U.S. GAAP and IFRS accounting models differ in areas such as the classification of debt and equity, consolidation, and impairment of long-lived assets. In other areas such as revenue recognition, accounting for income taxes, share-based payments, and pensions the standards are conceptually similar, but companies may still find significant accounting and disclosure differences when such standards are applied to their specific facts and circumstances. Even certain accounting terms, such as probable and fair value, are defined differently under U.S. GAAP and IFRS. While there is no current timeline for allowing or requiring the use of IFRS for U.S. public companies, one lesson we have learned from experiences around the world is that adoption of IFRS is a multifaceted and often multiyear process. Companies currently entering into long-term contracts for hosting, outsourcing, maintenance, and term or subscription licenses may find many of these contracts still in effect when a transition to IFRS is allowed or required, with a potential impact on contractual sales compensation as well as financial reporting. Companies that have agreements, such as debt and loan arrangements or employee-incentive plans that span multiple years and include covenants or performance targets linked to U.S. GAAP metrics, also may discover that adopting IFRS requires revisions to those agreements. Required changes to IT systems and processes and employee training may take a significant period of time to plan and implement. Those and other issues highlight the critical need to obtain and develop an early understanding of the key differences between IFRS and U.S. GAAP as they pertain to the technology sector. Experience has shown that adoption of IFRS is a multifaceted and often multiyear process.

6 4 IFRS for Technology Companies Overview of U.S. GAAP Compared with IFRS Applying IFRS to technology company transactions may require greater use of judgment. U.S. GAAP applicable to technology companies includes industry-based AICPA Statements of Position (SOPs) and Technical Practice Aids (TPAs), FASB Statements (FASs) and Emerging Issues Task Force (EITF) consensuses, and guidance from the SEC through Staff Accounting Bulletins (SABs), speeches, and other informal interpretations. IFRS, however, does not have the extensive industry- or transactionspecific financial reporting guidance of U.S. GAAP, nor does it have the same level of interpretive guidance. As a consequence, applying IFRS to technology company transactions may require greater use of judgment. Some believe the lack of detailed guidance in IFRS is a shortcoming, while others say U.S. GAAP s complex detail has resulted in arrangements structured to comply with the accounting requirements. Part of the global attraction to IFRS is that it is not governed by any single country. To date the SEC has been sensitive to the fact that it does not own IFRS and consultation with other regulatory bodies is important. Taking regulatory positions to develop consistency and transparency across companies is not unique to the United States, and thus the views of regulatory bodies around the globe may influence how IFRS is applied. Of particular interest as more jurisdictions adopt IFRS is whether preparers, auditors, and regulators will call for more detailed guidance on the application of IFRS in the future. Based largely on the experience of Wave I countries transitioning to IFRS, we generally found that IFRS was initially applied with a local accent, meaning that companies had a tendency to look to their national GAAP when applying and interpreting IFRS. More and more in today s environment, competitors previously reporting under different national GAAPs are looking at each other s application of IFRS to avoid unwittingly becoming outliers in the application of IFRS within their industry sectors. As experience with IFRS matures, we are seeing signs that certain industries are working to increase the comparability of financial reporting within their sectors. We are also seeing that Wave II adopters are thinking more about industry practices than previous national practices when applying IFRS. What will remain unknown until U.S. companies migrate to IFRS from U.S. GAAP is how U.S. technology companies will apply IFRS to areas covered in greater detail under U.S. GAAP. One such area is revenue recognition, in particular for software arrangements and multipleelement arrangements, where IFRS contains substantially less guidance. We have chosen to focus on revenue recognition here because of its importance to technology companies, but the significance of IFRS U.S. GAAP differences for revenue recognition and other topics will vary by company. Revenue Recognition For technology companies reporting under U.S. GAAP, the revenue recognition literature contains detailed and, in the view of some, prescriptive guidance. The guidance for the sector is particularly expansive and includes more than three-dozen TPAs that address implementation issues for software transactions. Many hardware providers find that they also are subject to those requirements because the marketing, post-sale support, and research and development (R&D) spending associated with their product offerings is increasingly focused on software that is embedded within the hardware.

7 Closing the GAAP? 5 Compounding the issue has been the trend toward multiple delivery models for products and services, such as outright sales, licensing/leasing, subscription and software-as-a-service arrangements, and the bundling of products and services that may be subject to different pieces of accounting literature. Technology companies that offer bundled solutions have to evaluate the interplay of different sources of revenue recognition guidance under U.S. GAAP, including SAB 104, Revenue Recognition; SOP 97-2, Software Revenue Recognition; SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts; and EITF 00-21, Revenue Arrangements with Multiple Deliverables, when assessing the accounting guidance applicable to bundled deliverables and whether they are separate units of accounting (see Appendix on page 27). In contrast, IFRS contains general principles for revenue recognition and separation of multiple-element arrangements, with limited interpretive or industry-specific guidance. Those principles are contained primarily in two standards: International Accounting Standard (IAS) 18 Revenue, which applies to the sale of goods, rendering of services, and royalties for use of intellectual property IAS 11 Construction Contracts, which applies to the construction of assets similar but not identical to the scope of SOP 81-1 under U.S. GAAP. In situations where U.S. GAAP contains detailed interpretive guidance on applying broad revenue recognition principles, companies may consider the guidance in U.S. GAAP under the IFRS hierarchy in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, as long as that guidance is not in conflict with IFRS. When IFRS does not cover a particular issue, IAS 8 permits an entity to consider relevant guidance and requirements in other authoritative national accounting standards (and interpretations) that are based on a conceptual framework similar to that of IFRS. For example, U.S. GAAP contains more interpretive guidance on evaluating whether a vendor is acting as a principal or an agent ( gross versus net revenue assessment) in a transaction with a customer. Additionally, for software and software-related transactions, SOP 97-2 and related interpretive guidance is far more extensive than the general guidance on revenue recognition under IFRS. U.S. GAAP may be a point of reference for interpreting IFRS in these situations provided the guidance does not contradict the general guidance in IFRS. Some key questions to consider are: In what situations can existing U.S. GAAP revenue recognition policies be applied under IFRS? What areas may require a policy change to comply with IFRS? In what areas may alternative accounting policies be available? Technology vendors frequently sell multiple products and services, including hardware, software licensing, ongoing post-contract support (PCS), and services such as installation, implementation, and training. Some of the key application issues of revenue recognition under both IFRS and U.S. GAAP are: Defining the arrangement what constitutes the entire revenue arrangement with the customer Accounting for multiple-element arrangements determining whether deliverables should be accounted for as separate units of accounting, and if so, allocation of the arrangement consideration among the units of accounting of the arrangement Determining the fair value for deliverables of the arrangement Evaluating the significance of remaining deliverables Determining the appropriate revenue recognition approach for individual units of accounting. As experience with IFRS matures, we are seeing signs that certain industries are working to increase the comparability of their financial reporting within their sectors.

8 6 IFRS for Technology Companies A challenge for some technology companies is to determine the entire arrangement with the customer, including all of its deliverables. Defining the Entire Revenue Arrangement with the Customer A challenge for some technology companies is to determine the entire arrangement with the customer, including all of its deliverables. Vendors commonly use separate contracts for different aspects of the customer relationship, such as license agreements for software, separate PCS addendums governing ongoing support, and statements of work for services. Agreements also can include additional purchase options and rights for scalable and upgradable solutions, and common business practices provide for services outside the explicit purchase specifications, such as general product helpdesk support and downloadable upgrades. Identifying which deliverables should be evaluated as part of a multiple-element arrangement can have a significant impact on timing and the amount of revenue recognition if all obligations are not fulfilled by period end. Linkage of Separate Contracts U.S. GAAP software revenue recognition guidance provides indicators for companies to consider in deciding whether separate contracts and transactions entered into with a customer should be accounted for (1) as distinct revenue arrangements or (2) as, in substance, a single multipleelement arrangement. In practice, these indicators often have been considered when evaluating the substance of nonsoftware arrangements as well. IAS 18 requires that two or more transactions be considered a single arrangement when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. The International Financial Reporting Interpretations Committee (IFRIC) discussed indicators to consider regarding the linkage of separate contracts, but did not reach a consensus. Given the lack of specific IFRS guidance on factors to consider in evaluating the linkage of transactions, we believe the indicators included in the U.S. GAAP software revenue recognition literature may be useful in evaluating whether multiple revenue contracts should be linked under IFRS. Additionally, the indicators considered by IFRIC (but never finalized) may be useful in making that assessment.

9 Closing the GAAP? 7 IFRS and U.S. GAAP indicators differ in certain respects (see the table at right), but the underlying concepts are similar when viewed as a whole: Separate contracts or purchase orders are combined into a single, linked arrangement for accounting purposes where the commercial substance is that the series of contracts or agreements represent a single overall arrangement. In addition, we believe that IAS 11 guidance on combining contracts also should be considered when determining whether multiple contracts constitute a single arrangement under IFRS. IAS 11 calls for combining multiple contracts into a single arrangement when: The group of contracts is negotiated as a single package The contracts are so closely interrelated that they are, in effect, part of a single project with an overall profit margin The contracts are performed concurrently or in continuous sequence. In summary, when an arrangement involves multiple deliverables, either because multiple deliverables are included within a single arrangement or because deliverables in separate contracts are linked into a single arrangement for accounting purposes, the arrangement consideration should be allocated to each of those deliverables regardless of how the transaction(s) is legally structured. As an example of applying linkage criteria, consider a customer who issues a purchase order for hardware that includes a general right to return the hardware within 90 days. The hardware runs on proprietary software for which the parties were still negotiating a licensing fee at the time of the hardware purchase. A purchase order for the software license was not issued until 60 days after delivery of the hardware. Although the transactions were executed separately, the substance of the arrangement is that it IFRS IFRIC deliberated on indicators regarding the linkage of transactions and reached a tentative conclusion that transactions should be linked into a single accounting arrangement if any of the following indicators are present: The transactions are entered into at the same time or as part of a continuous sequence and in contemplation of each other. The transactions, in substance, form a single arrangement that achieves or is designed to achieve an overall commercial effect. One or more transactions considered on its own does not make commercial sense, but when considered together they do. The contracts include one or more options or conditional provisions for which there is no genuine commercial possibility that the option(s) or conditional provision(s) will (or will not) be exercised or fulfilled. The occurrence (or nonreversal) of one transaction is dependent on other transaction(s) occurring. Source: IFRIC minutes, July 2002 Meeting U.S. GAAP Under U.S. GAAP any of the following factors may indicate that a group of contracts or agreements should be accounted for as a single linked arrangement (list is not all-inclusive): The contracts or agreements are negotiated or executed within a short time frame of each other. The different elements are closely interrelated or interdependent in terms of design, technology, or function. The fee for one or more contracts or agreements is subject to refund or forfeiture or other concession if another contract is not completed satisfactorily. One or more elements in one contract or agreement are essential to the functionality of an element in another contract. Payment terms under one contract or agreement coincide with performance criteria of another contract or agreement. The negotiations are conducted jointly with two or more parties (for example, from different divisions of the same company) to do what in essence is a single project.* In addition, EITF contains a presumption that separate contracts with an entity entered into at or near the same time have been negotiated as a package and therefore should be evaluated together, unless there is sufficient evidence to the contrary. * Source: TPA , Software Revenue Recognition for Multiple-Element Arrangements

10 8 IFRS for Technology Companies Both U.S. GAAP and IFRS require vendors to consider the commercial substance of the customer arrangement when evaluating revenue recognition. consists of both hardware and software; if a software-licensing fee could not be agreed upon within the 90-day return period, the customer could return the hardware. We believe that under both U.S. GAAP and IFRS the separate contracts would be treated as a single multiple-element arrangement. While in this example U.S. GAAP and IFRS support the same conclusion, in other situations it is possible that a different conclusion would be reached under IFRS than under U.S. GAAP because the indicators used to evaluate linkage differ in some respects. Identifying Deliverables in an Arrangement Deliverables can be explicitly stated in a contract or understood based on the vendor s historical business practices or marketing materials. Obligations also can include rights to future when and if available deliverables, such as software upgrades, which are included in most PCS arrangements. Such rights carry no legal requirement to deliver anything to the customer but rather an obligation to make future deliverables available when and if the vendor develops them. Other future deliverables, such as training and services that are not essential to the functionality of the product, may be included in the overall arrangement. Furthermore, technology vendors who license products to other vendors or original equipment manufacturers (OEMs) as part of strategic alliances and product outsourcing arrangements sometimes agree to participate with the other party on joint product development steering committees. Evaluating whether these participation obligations are considered a deliverable of the revenue arrangement versus a governance provision is another consideration. Both U.S. GAAP and IFRS require vendors to consider the commercial substance of the customer arrangement when evaluating revenue recognition, including when and if available obligations as well as implicit and explicit deliverables. While there is more formal and informal guidance for identifying deliverables under U.S. GAAP than there is under IFRS, we would generally expect companies identifying deliverables in an arrangement under IFRS to reach a similar conclusion to the one they would reach currently under U.S. GAAP. Accounting for Multiple-Element Arrangements Where multiple deliverables have been identified in an arrangement, U.S. GAAP contains an abundance of guidance (including SOP 97-2, EITF 00-21, SOP 81-1, and FASB Technical Bulletin No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts) for evaluating whether the deliverables can be treated as separate units of accounting for revenue recognition, and if so, how to allocate the arrangement consideration among the separate units of accounting. This becomes important since in many arrangements contract performance extends over more than one reporting period. While IAS 11 criteria for segmenting contracts into units of accounting are similar to SOP 81-1 for construction-type contracts, IFRS contains very limited guidance on identifying separate units of accounting outside of construction-contract arrangements. There is, however, a requirement under IFRS to assess the substance of a transaction when determining whether multiple deliverables should be separated or combined for accounting purposes. IAS 18, paragraph 13 states: [I]n certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.

11 Closing the GAAP? 9 In addition, similar to U.S. GAAP, the allocation (or no allocation) of arrangement consideration to deliverables in a contract does not generally dictate whether revenue should be allocated to that deliverable. Example 11 in the Appendix to IAS 18 states: When the selling price of a product includes an identifiable amount of subsequent servicing (for example, after sales support and product enhancement on the sale of software), that amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement, together with a reasonable profit on those services. Collectively, these IFRS principles suggest that distinct deliverables in an arrangement should be separated for accounting purposes and that a fair value allocation approach (discussed in the next section) should be used. Assessing whether the substance of the transaction calls for separating or combining multiple deliverables for purposes of revenue recognition requires judgment. As IAS 18 provides limited guidance on the identification of the units of accounting or the process for allocating the arrangement consideration to the units of accounting, companies applying IFRS may consider the multiple-element separation guidance in U.S. GAAP where it does not conflict with IFRS. For instance, EITF contains guidance on whether delivered items have stand-alone value, which may be useful when evaluating the substance of the arrangement under paragraph 13 of IAS 18. However, because of the limitations on the ability to separate deliverables or allocate revenue in certain situations under EITF or SOP 97-2, we believe that applying U.S. GAAP guidance on separation and allocation could, in certain situations, give results inconsistent with the requirements of IAS 18. For example, under U.S. GAAP for arrangements subject to SOP 97-2 or EITF 00-21, no portion of a fee can be allocated to delivered items for purposes of revenue recognition if it is subject to forfeiture, refund, or other concession if an undelivered item is not delivered. No judgment as to likelihood of collection or concession is allowed. IFRS does not have a comparable contingent revenue rule. Instead, IAS 18 requires that receipt of economic benefits be considered probable as one of the general criteria for revenue recognition. Given the different criteria for revenue recognition, a company will need to carefully evaluate whether it would be required to change its accounting policies in this area to comply with IFRS. The application of policies and professional judgment to the facts of an arrangement could lead to a conclusion similar to U.S. GAAP or not. Consider a vendor s sale of a phone system that requires noncomplex hookups that could be performed by the customer or another vendor. The vendor sells the phone system with installation included for US$10,000. The vendor is able to determine the fair value of installation services to be US$50 based on the price charged by other vendors for installation services. The vendor has always successfully completed the installation when the customer requests it. A particular customer arrangement includes both the system and the installation, with 80 percent of the price due on delivery of the phone system to the customer s premises and the remaining 20 percent due once installation is complete. The phone system is delivered to the customer on December 30 and the installation occurs on January 2.

12 10 IFRS for Technology Companies Under U.S. GAAP, because US$2,000 (20 percent) of the price is not payable until the installation is completed that portion is subject to the contingent revenue provisions of paragraph 14 of EITF and therefore would be deferred at December 31. Under IFRS, although the US$2,000 is payable upon installation, if the vendor s history of successful installation in prior arrangements makes it probable that the US$2,000 will be collected, it is possible to conclude that the full US$9,950 (US$10,000 total arrangement consideration less US$50 allocated to installation) in revenue is recognizable at the time the phone system is delivered. Where full or partial payments for delivered products are linked to performance of future services, vendors also must assess whether the service portion should be treated as a separate deliverable of the arrangement or whether the service forms such a significant part of the product sale that revenue recognition should be precluded on the delivered product until the subsequent service is performed. This could be done through (1) a general evaluation of when risks and rewards of ownership transfer occur, a delivery concept under both U.S. GAAP and IFRS, or (2) based on interpretive guidance in U.S. GAAP, such as the essential to the functionality criteria in SOP 97-2 or the stand-alone value concept in EITF Fair Value Considerations in Multiple-Element Arrangements Revenue under both U.S. GAAP and IFRS is measured at the fair value of the consideration agreed to by the parties, including any trade discounts and rebates. Determining fair value for some or all deliverables of a multiple-element arrangement can be critical to the allocation of arrangement consideration to its separate units of accounting. U.S. GAAP has specific requirements for how to support the existence of fair value for undelivered units of accounting in the arrangement. When fair value cannot be established for all undelivered items, the arrangement would be considered a single unit of accounting. Under U.S. GAAP, if the arrangement is separable into multiple units of accounting and if fair value is established for each unit of accounting, revenue is allocated to the various deliverables based on their relative fair value (regardless of amounts stated in the contract for each deliverable). If objective evidence of fair value is not available for all units of accounting but does exist for all undelivered units, arrangement consideration is allocated using the residual method, whereby each undelivered unit of accounting is measured at fair value, and the remaining arrangement consideration is allocated to the delivered units of accounting. Thus, under the residual method any discount embedded in the arrangement will be allocated to delivered units of accounting, ensuring that revenue is not front-end loaded where fair value does not exist for all deliverables. Under U.S. GAAP for software arrangements (SOP 97-2), objective evidence of fair value is restricted to vendor-specific objective evidence (VSOE), meaning that the company cannot look to similar products sold by competitors to establish fair

13 Closing the GAAP? 11 value for its own products. This limitation was included in SOP 97-2 because of concerns about the ability to determine similarity of competitive products given the proprietary nature of software. VSOE of fair value for software arrangements generally is limited to the amount the company charges when the product or service is sold separately. Under EITF for non-software deliverables, the pricing of similar products is an allowable basis for determining fair value of a deliverable. Companies have spent significant time and effort on processes and systems to determine if VSOE of fair value can be established for common undelivered products and services. This has been especially important for technology companies that sell more-complex bundled offerings where some deliverables may rarely be sold separately or at consistent pricing. Unlike U.S. GAAP, IFRS does not prescribe the basis for determining fair value of the deliverables or the method for allocating the arrangement consideration to the units of accounting. IFRIC 13 Customer Loyalty Programmes does provide guidance on two methods. Paragraph BC 14 of IFRIC 13 states that the amount allocated to the award should be equal to either (1) the components fair value (irrespective of the fair value[s] of the other components: the residual method ) or (2) a proportion of the total consideration based on the fair value of the award credit relative to the fair value(s) of the other components of the sale (the relative fair value method). The concept of relative fair value also appears in paragraph 13 of IFRIC 12 Service Concession Arrangements, which states: If the operator performs more than one service under a single contract or arrangement, consideration received or receivable shall be allocated by reference to the relative fair values of the services delivered, when the amounts are separately identifiable. IFRS does not explicitly address, nor envisage, whether a reverse residual approach would be acceptable for allocating revenue to deliverables of a multiple-element arrangement. The reverse residual approach refers to situations where the fair value is unknown for the undelivered unit but is known for the delivered unit. Under IFRS, the threshold for establishing objective evidence of fair value is not as high as it is for U.S. GAAP, and different approaches for determining fair value of the deliverables may be acceptable. These approaches include: The price charged by the vendor when an identical unit of accounting is sold separately (VSOE) The market price of a reasonably similar product or service sold by the vendor or a competitor (adjusted for significant differences between the similar product or service and the deliverable in the arrangement) The expected cost of supplying a product or service together with a reasonable profit margin (cost-plus). In circumstances where costs and a reasonable profit margin can be supported, cost-plus can be an acceptable basis under IFRS for determining fair value of undelivered units of accounting for purposes of allocating arrangement consideration to the deliverables. This can be a significant difference from U.S. GAAP, which does not consider cost-plus to be objective evidence of fair value for purposes of separation and allocation under SOP 97-2 and EITF Given that IFRS allows for use of marketcomparable sales prices and cost-plus in certain situations to determine the fair value of deliverables within the arrangement, technology companies, particularly non-software companies with arrangements within the scope of SOP 97-2, may find that there are fewer revenue deferrals

14 12 IFRS for Technology Companies in multiple-element arrangements under IFRS. However, some practical considerations remain: IFRS permits the use of market comparables as evidence of fair value for software arrangements, but in practice it may be difficult to determine whether another vendor s product is sufficiently similar, given the proprietary nature of technology products. However, we believe that market comparables may be more readily available for service deliverables such as installation, customization, implementation, and training. Where pricing charged by other companies for similar products and services is obtainable, such as hourly or daily service rates, this may give companies that did not have sufficient VSOE of fair value for these services under U.S. GAAP the ability to separate these deliverables and recognize revenue allocated to delivered units of accounting under IFRS. A cost-plus approach may require new data-tracking systems and processes as well as new policies for what is included in cost and how a reasonable profit margin is supported. This will be especially important on PCS and other post-sale support services that can have very high margins. Such changes may involve operations and IT personnel and require significant effort for companies with multiple products and services. Judgments may include whether or to what extent to allocate R&D expenditures for new product features and enhancements as part of the cost of PCS in an arrangement, and whether to allocate a portion of previous R&D expenditures now embedded in the core product. R&D costs benefit multiple customers, and it can be difficult to determine appropriate allocations (i.e., the denominator) where such features or enhancements are included in both upgrades provided under PCS and the latest software product to be sold separately. Where when and if available upgrades are included as part of the service offering, we believe that some amount of R&D cost should be included in the determination of the fair value of the deliverable when using a cost-plus approach (a customer perspective) even though this amount is not necessarily part of the contractual performance obligation. Though the contractual renewal rate approach described in SOP 97-2 is not specifically covered in IFRS, we understand that many software companies use it as a basis for establishing fair value for commonly renewed services, such as PCS. Where a contractual renewal rate approach is applied under IFRS for purposes of determining fair value of undelivered services, there should be support that the optional renewal term and fee are substantive. Though not required, companies reporting under IFRS could consider the interpretive guidance in SOP 97-2 and related TPAs when evaluating whether a renewal rate is substantive. 1 In addition to practical considerations, technology companies reporting under U.S. GAAP will need to consider the impact, if any, that the determination of fair value under IFRS will have on their accounting policies. For example, if a company established fair value of its deliverables based on VSOE, it may elect a policy to continue to use this approach to establish fair value of the deliverables under IFRS. Indeed, this may be preferable where companies have been able to establish VSOE of fair value using existing processes and systems. However, in instances where a company was unable to establish fair value of its deliverables under U.S. GAAP, it should consider whether continuing to defer revenue for delivered items in a multiple-element 1 For a discussion, see Software Revenue Recognition: An Analysis of SOP 97-2 and Related Guidance, Third Edition, KPMG LLP (U.S.), 2007.

15 Closing the GAAP? 13 arrangement would be compliant with IFRS, including supporting why other acceptable IFRS-compliant measures of fair value would be inappropriate for undelivered items in the arrangement. Evaluating the Significance of Remaining Deliverables Prior to SOP 97-2 and SABs 101 and 104, U.S. GAAP applicable to technology companies allowed for more judgment in assessing the significance of remaining obligations to the overall arrangement when determining the impact of undelivered obligations on revenue recognition. In practice, there was diversity in how vendors evaluated the significance of future obligations having relatively small incremental costs but seen by the customer as providing significant benefits. An example of this for software vendors was the accounting for specified or unspecified rights to future software upgrades, which often had nominal incremental cost associated with delivery once R&D was completed. Some vendors also argued that when and if available deliverables should be viewed as a contingency that could be disregarded for purposes of revenue recognition or, at a minimum, for which probability of delivery could be assessed. In response to perceived diversity in practice, U.S. GAAP took a customer-focused approach to negotiated deliverables and obligations, restricting a company s ability to deem a deliverable to be inconsequential. This is especially the case for software arrangements where exemptions exist only for warranty for delivered products and PCS arrangements that meet the criteria in paragraph 59 of SOP 97-2 (e.g., bug fixes ). Revenue arrangements or portions thereof not governed by the software literature under U.S. GAAP also require evaluation of future obligations, based primarily on SAB 104 and EITF 00-21, to assess whether a future obligation is inconsequential or perfunctory to the arrangement. If inconsequential or perfunctory, the deliverable would not be treated as an element of the arrangement for purposes of the multiple-element revenue recognition model in EITF If other than inconsequential or perfunctory, the item would be treated as an element of the arrangement. In practice, under U.S. GAAP it is rare for a vendor to be able to conclude that an obligation included in the arrangement is inconsequential or perfunctory. Under IFRS the criteria for determining what should be treated as a deliverable of the arrangement for purposes of applying the revenue allocation and recognition criteria are less clear. Under IAS 18 certain deliverables, such as standard warranty terms included with the sale of product and incidental post-delivery installation services (e.g., where the installation is simple in nature, requiring only unpacking and basic power connections) are exempt from requiring a separate allocation of revenue. In these situations, paragraph 19 of IAS 18 does acknowledge that warranties and other costs to be incurred after shipment of goods can be accrued when the product is delivered and revenue is recognized. As is the case under U.S. GAAP, we believe this should be interpreted narrowly and not extended beyond warranty and similar costs (i.e., basic installation).

16 14 IFRS for Technology Companies We believe a customer-focused approach should be applied to remaining obligations when evaluating the substance of an arrangement under IAS 18. Issues that U.S. GAAP technology companies have wrestled with in these areas are equally relevant under IFRS. They include (1) whether an arrangement provides the customer rights to when and if available software or to bug fixes and insignificant improvements and (2) the complexity of any remaining installation services. Therefore, we believe that technology companies may consider the guidance in SOP 97-2, SAB 104, and EITF when evaluating the substance of an arrangement for purposes of determining the arrangement s deliverables. In addition, IFRIC 13 recently provided some thoughts on distinguishing future obligations in an arrangement. The basis of conclusions states: [T]he aim of IAS 18 is to recognize revenue when, and to the extent that, goods or services have been delivered to a customer. Paragraph 13 [of IAS 18] applies if a single transaction requires two or more separate goods or services to be delivered at different times; it ensures that revenue for each item is recognized only when that item is delivered. In contrast, paragraph 19 applies only if the entity has to incur further costs directly related to items already delivered, e.g., to meet warranty claims. This reflects a view under IFRS that future obligations to deliver products and services should be treated as separate deliverables of a multiple-element arrangement. Companies should apply reasonable judgment under IAS 18 to assess the significance of remaining deliverables to fairly reflect the substance of the transaction. We believe that, in general, technology companies should reach similar conclusions under IFRS and U.S. GAAP about the significance of remaining obligations in determining whether those obligations represent accounting deliverables under the arrangement. That notwithstanding, given IFRS has an expectation that multiple elements of an arrangement will be treated as separate units of accounting rather than having to meet specific separation requirements as under U.S. GAAP, we expect there to be fewer circumstances under IFRS where relatively minor undelivered items that constitute deliverables will result in significant deferrals of revenue for delivered items. Regardless of the significance of remaining obligations, costs must be reliably measurable under IFRS prior to recognizing revenue for the transaction. If they are not, revenue is deferred not only for the portion of the sale still to be completed but also for the delivered goods and services. This is similar to the U.S. GAAP requirement for a reasonable estimate of warranty costs in order to recognize revenue on delivery of a product bundled with a post-delivery warranty period.

17 Closing the GAAP? 15 Determining the Appropriate Revenue Recognition for Individual Units of Accounting Recognizing Revenue for Goods and Services The recognition principles in IAS 18 that apply to individual units of accounting for the sale of products are similar to SAB 104 s general revenue recognition principles. The graphic below illustrates the correlation of these IFRS and U.S. GAAP principles. IAS 18 Goods and Services Probable future economic benefits Revenue can be measured reliably Costs can be measured reliably Additional requirements for sale of goods: Significant risks and rewards of ownership transferred No retention of managerial involvement to the degree of ownership nor retention of effective control SAB 104 Persuasive evidence of an arrangement Collectibility reasonably assured Price fixed or determinable Delivery occurred/services rendered Source: KPMG LLP (U.S.), 2008 The general criteria described above are applied to each separable unit of accounting of the arrangement; for instance: The sale of products, including software, is governed by the principles for the sale of goods. Services related to the software sold are recognized as they are performed. For customized software or products, revenue is recognized based on the stage(s) of completion. For software licensing arrangements, revenue is accounted for in accordance with the substance of the license arrangement. While the focus of this publication has been on issues regarding multiple-element arrangements, there are other areas where the application of the general revenue recognition criteria for goods or services may be different under IFRS and U.S. GAAP. A few of these are discussed below. Other differences or potential differences, such as the more specific guidance under U.S. GAAP for sales rebates and volume discounts, are discussed in IFRS Compared to U.S. GAAP. 2 We will address some of these potential areas of differences and their practical application to technology companies in future publications. 2 IFRS Compared to U.S. GAAP, KPMG LLP (U.S.) and KPMG IFRG Limited, a U.K. company, limited by guarantee, May 2008

18 16 IFRS for Technology Companies Establishing evidence of a customer arrangement can be challenging for many technology companies. Evidence of an Arrangement Establishing evidence of a customer arrangement can be challenging for many technology companies, in particular for those having long-term relationships and non-boilerplate contractual agreements with customers. Last-minute negotiations can result in the vendor providing additional products, services, upgrade rights, or offers of discounts on current or future purchases in exchange for various customer commitments near period end. This is problematic since revenue generally should not be recognized for delivered items prior to a final understanding of the rights and obligations for the entire arrangement; allocating arrangement consideration to delivered items when all obligations, including remaining undelivered items and consideration, are not known is not practicable. U.S. GAAP for technology companies under SAB 104 and SOP 97-2 requires persuasive evidence of an arrangement between the parties as a condition for recognition of revenue on delivered items. What constitutes persuasive evidence depends on the vendor s customary business practice and can vary by distribution channel, class of customer (customer or product type, geographic region, or size of customer), or even certain individual customers. This requires documentation consistent with the various business practices and customerspecific circumstances, provided that transaction documentation exists to evidence the rights and obligations agreed on by appropriately authorized parties. To improve consistency across companies and to reduce risk of fictitious transactions, U.S. GAAP provides detailed guidance about what constitutes persuasive evidence of an arrangement. For instance, when a software vendor customarily uses signed contracts or if a signed contract will be executed between the parties for a particular arrangement, both parties must sign that contract prior to the end of the reporting period for revenue to be recognized in that period. Where negotiations have been completed but a contract was not signed by one of the parties because of administrative issues such as a legal counsel signatory being on vacation there can be heavy consequences, as lack of persuasive evidence as of the end of the reporting period results in full deferral of revenue, even in cases where delivery has occurred and payment has been made in full. Other problematic persuasive evidence areas under U.S. GAAP are letters of intent that are subject to further formalization in a written contract or where purchase orders have terms and conditions linked to an unsigned master agreement. IFRS requires that there be a final understanding between the parties for the terms of the arrangement to be known, but the criteria of IAS 18 for revenue recognition specify that revenue is recognized when it is probable that future economic benefits will flow to the company and that revenue and costs can be measured reliably. In many cases for technology companies where final contract negotiations can result in amendments for discounts or concessions or where a product is delivered but the final scope of related services, such as implementation or rights to future upgrades, is still being negotiated, a reliable estimate of costs and revenue cannot be supported until such time as the final contract is executed by the parties. Also, prior to having a legally binding purchase agreement, it would be difficult to conclude that other recognition criteria for product sales had been met (that risks and rewards of ownership had transferred and that the seller does not have continuing involvement or effective control over the goods to be sold).

19 Closing the GAAP? 17 IFRS revenue recognition criteria may result in different conclusions from U.S. GAAP as well as affect a company s current accounting policies when: Inconsequential administrative matters delay formal contract signing by a party but clear evidence exists to support that appropriate authorities had agreed to the arrangement Legally binding purchase orders have been issued (perhaps with payment in full) for orders that have terms and conditions referenced to a framework 3 agreement whose term has expired and where substantive support exists that renewal of the framework agreement will not alter the consideration and obligations under the purchase orders. However, in each of the above scenarios, care must be taken before concluding that revenue can be recognized on delivered items under IFRS. Consideration should be given to whether prior to period end sufficient documentary support exists that the transaction is enforceable and that final agreement on the terms, explicit and implicit rights, and obligations have been reached by the appropriate parties. Extended Payment Terms In general, under both IFRS and U.S. GAAP payment terms need to be evaluated to determine whether collectibility is reasonably assured. However, SOP 97-2 has specific guidance on the impact of extended payment terms on revenue recognition for software arrangements. Licensing fees are presumed not fixed or determinable if payment of a significant portion is not due until after expiration of the license or more than 12 months after delivery. TPA , Overcoming Presumption of Concessions in Extended Payment Term Arrangements and Software Revenue Recognition, provides factors to consider in determining whether this presumption can be overcome. If the presumption is not overcome, revenue cannot be recognized until the fees become due and payable. SOP 97-2 requires that the assessment as to whether the fees are fixed or determinable due to extended payment terms be made at the outset of the arrangement and precludes the use of a rolling 12-month basis (recognizing revenue for amounts due within the next 12 months). IFRS does not contain SOP 97-2 s specific guidance on extended payment terms; instead IFRS requires that both the amount of revenue and costs be reliably measurable prior to revenue recognition and it is probable that future benefits will flow to the seller. Because IFRS does not presume that an extended payment-term arrangement prevents the consideration from being fixed or determinable as SOP 97-2 does, it is possible that vendors could reach a conclusion that revenue is recognizable. However, in making the evaluation the vendor will need to consider the impact of the extended payment terms on the ability to reliably measure revenue and costs because of the time value of money, credit risk associated with the extended payment terms, the potential for fee reductions, and the risk of future concessions. Depending on the particular arrangement, a result under IFRS could differ from the U.S. GAAP conclusion and affect current accounting policies. Similarly, the criteria used to overcome presumption of concessions in extended payment terms under U.S. GAAP could be considered under IFRS to support or refute the measurability of revenue and costs where extended payment terms exist. The accounting for extended payment terms in software arrangements under IFRS is an area where there may be diversity in practice. Technology companies transitioning to IFRS from U.S. GAAP should consider their existing policies and monitor the development of international practice in this area. The effect of payment terms on revenue recognition can be different under U.S. GAAP and IFRS. 3 A framework agreement is a general term for agreements with providers that sets out terms and conditions under which specific purchases can be made throughout the term of the agreement.

20 18 IFRS for Technology Companies Future Developments: The Revenue Recognition Project Currently, the FASB and the IASB are working jointly on developing a comprehensive model for revenue recognition. It is expected that they will issue a discussion paper later in We encourage companies to monitor the status of the project and consider responding to the discussion paper. Other Accounting Areas Other areas of interest to technology companies include share-based payments and the accounting for R&D costs. We discuss these topics briefly here and will expand on the discussion of these and other issues in future publications. Share-Based Payment Share-based compensation remains a key part of many technology companies employee retention and incentive compensation strategies. The measurement and recognition models for share-based payments are generally similar under IFRS and U.S. GAAP, but there are a number of differences, for example: Recognition of compensation cost for awards with graded vesting based only on satisfying a service condition. U.S. GAAP permits companies to make an accounting policy choice for awards that are earned (vested) in installments (tranches), with vesting linked only to continued employment. Companies can elect to either recognize the compensation cost on a straight-line basis over the longest vesting tranche or treat each tranche as a separate award for attribution purposes (graded vesting attribution). Under IFRS, it is required that graded vesting awards be recognized on a tranche-by-tranche basis (graded vesting attribution). To illustrate, here is the difference for a grant of 300-share options that vest one third at the end of each year of a three-year period: - Straight-line Method. Total compensation cost is recognized on a straight-line basis over the three-year vesting period. - Graded Vesting Method. The total compensation cost of the share option grant is recognized over the three separate service periods required to vest: 12, 24, and 36 months. This results in frontloading the compensation cost of the award. In the first year, all of the compensation cost for the first 100-share-option tranche is recognized; half of the compensation cost for the second 100-share-option tranche is recognized; and one third of the compensation cost for the third 100-share-option tranche is recognized. Recognition of income taxes on sharebased payments. Under FAS 123 (revised 2004), Share-Based Payment (FAS 123R), a deferred tax asset is recognized based on the cumulative compensation cost recognized in income to date without regard to the current status of the company s stock price. Under IFRS, the deferred taxes are adjusted each period to reflect the current tax benefit that would be realized if the awards were exercised at the balance sheet date. As a consequence, companies tax provision can be more volatile under IFRS than under U.S. GAAP. Classification of awards as liability or equity. FAS 123R permits certain cashsettleable awards to be classified as equity (e.g., awards where the employee must hold the stock for six months before it can be put back to the company), whereas under IFRS awards that are cash settleable at the employee s option generally would result in a liability being recognized even if there is a required holding period.