The Hindu Business Line : IT: A more vulnerable sector?

If the intangible nature of the software industry makes it difficult to carry out due diligence on the actual sales, then the revenue recognition norms in the industry need to be more meticulous, say experts.

Vidya Bala

The best in practices — best disclosures, best corporate governance, best presentation of financials and high degree of corporate social responsibility. If there is one sector that qualifies on each one of these parameters in India, it is information technology. And not without reason.

For very few other sectors disclose so many details on their financials — how every rupee (or dollar) is earned, where it comes from, in terms of verticals and geographies — and also present an outlook of where the company is headed in the near future.

Expectations indeed run high for IT companies to sustain performance. It is perhaps these high expectations that led to the misreporting and “inflation” of numbers for Satyam Computer — until recently, among the top IT companies in India.

In the wake of the Satyam fraud, one wonders if this glorified sector is vulnerable — possibly even more than traditional manufacturing companies, to fraudulent transactions. This article seeks to highlight why the sector may be more exposed to accounting and reporting-related risks in the Indian scenario.

Intangible

First, what makes IT as a business distinct from manufacturing? Its intangible nature, of course!

In a typical manufacturing company, the tangible nature of goods produced provides scope for physical measurement/verification by auditors, unlike the intangible software services. Obvious as this may sound, its ramifications can be far-reaching.

A tangible product lends itself to lot of external checks, such as excise duty, value-added tax, income-tax and so on. Mr S. Srinivasan, a practising chartered accountant says: “these taxes and duties have an immediate implication on cash outgo.

Hence, there are enough checks and balances at the input and output level or, in other words, enough quantitative reconciliation in place”. An IT company is not only relatively free from some of these checks but also free from service tax (for exports) and enjoys tax-free status in many instances, under the Income-Tax Act.

If the intangible nature of the software industry makes it difficult to carry out due diligence on the actual sales, then the revenue recognition methods adopted by the industry calls for more meticulousness, say experts in the accounting field.

Complex revenue models

IT companies typically operate on ‘time and material’ contracts, where revenue is billed based on man-hours clocked on a project or on ‘fixed price contracts’, where revenue is recognised on percentage of completion method.

This can bring in significant subjectivity in revenue booking. In contrast, the transfer of ‘significant risks and rewards of ownership’ — which determines the point of sale for goods, appears fairly simple when it is applied to manufacturing companies.

Revenue or capital

In software product companies, the debate between the auditors and companies on the classification of expenditure as capital or revenue is often heated. “An expense that is claimed to be spent towards developing a product can be simply capitalised and created as an asset instead of booking it as an expense” says Mr Srinivasan.

Further, the revenue recognition in a product, which is typically a licence fee, followed by annual maintenance contracts, too can be subject to varying revenue models.

It is the complexity involved in the time and value of revenue recognition in these models that provides scope for tweaking the numbers, if one seeks to do so.

While related-party transactions can turn out to be grey areas for both IT and non-IT companies, IT companies that have operations spanning a multitude of overseas locations pose the biggest challenge.

The number of balance-sheets (due to different locations) that need to be consolidated can make it cumbersome and vulnerable.

Local auditors too tend to rely on the information of the auditors in overseas countries (which may have less stringent norms).

A bigger worry, say experts, is the dealings of Indian IT companies with unlisted companies in the US. As US law does not require such companies to be audited, the checks on these transactions remain one-sided (on the Indian side alone).

It is perhaps these limitations that prompt many top IT companies to generate multiple management reports, perhaps to assure themselves and not just the stakeholders.

This may also be reason why the understanding of operations of an IT company may be more crucial for an auditor to go the extra mile in the due diligence process.

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