By Stathis Gould & Christopher Arnold
The COVID-19 pandemic crisis and its economic effects mean that investors and other stakeholders need high-quality financial information more than ever.
To this end, accountancy firms, regulators, IFAC member organizations and others have quickly made available advice and guidance on the accounting and financial reporting requirements that will need to be considered in addressing the financial effects of COVID-19 when preparing financial statements. Many of these resources are conveniently available through IFAC’s COVID-19 resource center.
To help consolidate the highlights of this guidance, a summary of key areas to consider is outlined below together with links to key references on the IFAC website.
There will be issues to consider for this year’s reporting as well as in future years. Some companies may first report financial effects in interim financial statements (in accordance with IAS 34 – Interim Financial Reporting), which will likely involve the greater use of accounting estimates. However, information must be reliable and all material financial information relevant to an understanding of the financial position or performance of the company should be appropriately disclosed.
There may also be differences in approach depending on whether financial statements are prepared using IFRS or national GAAP.
How Should Companies Assess COVID-19 Events After the Reporting Period?
IAS 10 Events after the Reporting Period contains requirements for when adjusting events (those that provide evidence of conditions that existed at the end of the reporting period) and non-adjusting events (those that are indicative of conditions that arose after the reporting period) need to be reflected in the financial statements. Amounts recognized in the financial statements are adjusted to reflect adjusting events, but only disclosures are required for material non-adjusting events.
Judgment is required in determining whether events that took place after the end of the reporting period are adjusting or non-adjusting events. This will be highly dependent on the reporting date and the specific facts and circumstances of each company’s operations and value chain. Management may need to continually review and update the assessments up to the date the financial statements are issued given the fluid nature of the crisis and the uncertainties involved.
With respect to reporting periods ending on or before 31 December 2019, there is a general consensus that the effects of the COVID-19 outbreak are the result of events that arose after the reporting date (e.g., in the UK, the Financial Reporting Council has stated that COVID-19 in 2020 was a non-adjusting event for the vast majority of UK companies preparing financial statements for periods ended 31 December 2019). For later reporting dates (e.g. February or March 2020 year ends), it is likely to be a current-period event which will require ongoing evaluation to determine the extent to which developments after the reporting date should be recognized in the reporting period.
If management concludes the impact of non-adjusting events are material, the company is required to disclose the nature of the event and an estimate of its financial effect. If it cannot be reliably quantitively estimated, there still needs to be a qualitative disclosure, including a statement that it is not possible to estimate the effect. Examples of non-adjusting events that would generally be disclosed in the financial statements include breaches of loan covenants, management plans to discontinue an operation or implement a major restructuring, significant declines in the fair value of investments held and abnormally large changes in asset prices, after the reporting period.
How Should Companies Assess Going Concern?
IAS 1 Presentation of Financial Statements requires management to assess a company’s ability to continue as a going concern. The going concern assessment needs to be performed up to the date on which the financial statements are issued. The assessment relates to at least the first twelve months after the balance sheet date, or after the date the financial statements will be signed, but the timeframe might need to be extended.
Material uncertainties that cast significant doubt on the company’s ability to operate under the going concern basis need to be disclosed in the financial statements. It is highly likely that many companies large and small, and particularly in certain sectors, will have issues relating to the current situation that need to be considered by management. There will be a wide range of factors to take into account in going concern judgments and financial projections including travel bans, restrictions, government assistance and potential sources of replacement financing, financial health of suppliers and customers and their effect on expected profitability and other key financial performance ratios including information that shows whether there will be sufficient liquidity to continue to meet obligations when they are due.
Given the significant uncertainty, disclosure should include those significant assumptions and judgments applied in making going concern assessments. Assessments will likely need to include different scenarios with varying assumptions which can be updated to take into account the evolving nature of uncertainties.
Management should assess the existing and anticipated effects of COVID-19 on the company’s activities and the appropriateness of the use of the going concern basis. If it is decided to either liquidate or to cease trading, or the company has no realistic alternative but to do so it is no longer a going concern and the financial statements may have to be prepared on another basis, such as a liquidation basis.
What are Other Significant Effects on Accounting and Reporting to Evaluate?
Throughout 2020, companies will need to review all areas of the accounts that are subject to judgment and estimation uncertainty. The use of forecast information is pervasive in assessing a range of effects in addition to going concern including the impairment of financial and non‑financial assets, expected credit losses, and the recoverability of deferred tax assets.
Fair value measurements (IFRS 13 Fair Value Measurement – FVM)
A change in the fair value measurement affects the disclosures required by IFRS 13, which requires companies to disclose the valuation techniques and the inputs used in the FVM as well as the sensitivity of the valuation to changes in assumptions. Disclosures are needed to enable users to understand whether COVID-19 has been considered for the purpose of FVM. A key question is what conditions and the corresponding assumptions were known or knowable to market participants at the reporting date.
For 2020, fair value measurements, particularly of financial instruments and investment property, will need to be reviewed to ensure the values reflect the conditions at the balance sheet date. This will involve measurement based on unobservable inputs that reflect how market participants would consider the effect of COVID-19 in their expectations of future cash flows related to the asset or liability at the reporting date.
During the current environment, the volatility of prices on various markets has also increased. This affects the FVM either directly – if fair value is determined based on market prices (for example, in case of shares or debt securities traded on an active market), or indirectly – for example, if a valuation technique is based on inputs that are derived from volatile markets. Consequently, special attention will be needed on the commodity price forecasting that’s used in developing fair value conclusions.
Impairment of non-financial assets subject to the requirements of IAS 36 Impairment of Assets. In addition, other relevant standards to consider for management estimates include IAS 16, Property, Plant and Equipment, IFRS 16 Leases, and IAS 37, Provisions, Contingent Liabilities and Contingent Assets
IAS 36 ensures that a company’s assets are carried at not more than their recoverable amount (the higher of fair value less costs of disposal and value in use) and requires companies to conduct impairment tests when there is an indication of impairment of an asset at the reporting date. Indicators of impairment include significant changes with an adverse effect on the company that have taken place during the reporting period or will take place soon in the market or economic environment in which the company operates.
The scope of assets subject to the requirements in IAS 36 is broad. It includes property, plant and equipment (carried at cost or revalued amount), intangible assets (carried at cost or revalued amount), goodwill, right‑of‑use assets (if carried at cost), investment property (if carried at cost), biological assets (if carried at cost) and investments in associates and joint ventures accounted for using the equity method.
Companies will need to assess whether the impact of COVID-19 has potentially led to an asset impairment. For most companies, the economic effects are likely to trigger an impairment test for long-lived assets and other asset groups. Estimates of future cash flows and earnings are likely to be significantly affected by direct or indirect impacts. Asset impairment may also reduce the amount of deferred tax liabilities and create additional deductibles. Ongoing identification and evaluation and re-evaluation are essential to understand the extent of the need for recognition and for what periods.
Valuation of inventories is subject to IAS 2 Inventories, and inventories are measured at the lower of their cost and net realizable value (NRV). In the current environment, the NRV calculation will likely require more detailed methods or assumptions e.g. companies may need to write-down stock due to less sales. Interim inventory impairment losses should be reflected in the interim period in which they occur, with subsequent recoveries recognized as gains in future periods.
Measuring expected credit loss assessments (ECLs) under IFRS 9 Financial Instruments
The COVID-19 impact on credit risk will be more severe and immediate in various sectors. The IASB has published a document responding to questions regarding the application of IFRS 9, which requires companies to incorporate reasonable and supportable information about past events, current conditions and the forecast of future economic conditions into the assessment of ECLs for financial assets not measured at fair value through profit or loss. Such an assessment should be based on information at the reporting date and adjusted for subsequent available information.
The increased credit risk faced by banks and lenders is related to exposures to borrowers in highly affected sectors. Provisions need to be estimated based on the ECL for the entire remaining life of a financial instrument, such as loans to borrowers whose credit risk has increased significantly since origination.
Regulators such as The European Securities and Markets Authority (ESMA) are issuing guidance to help ensure companies faithfully represent ECLs and apply IFRS 9 consistently. The measurement of ECL applies to companies across industries other than financial services but specific considerations and ECL guidance for lenders and banks is available.
ECL is a probability weighted amount that is determined by evaluating a range of possible outcomes. Qualitative and quantitative disclosure enables users of financial statements to understand the effect of credit risk on the amount, timing and uncertainty of future cash flows. This includes the basis of inputs and use of assumptions and estimation techniques.
Hedge accounting – where a company applies hedge accounting as part of its risk management strategy under IFRS 9 Financial Instruments
COVID-19 may reduce the probability of a hedged forecast transaction occurring or affects its timing. Consequently, the hedge accounting criteria in applicable financial reporting standards may no longer be met, for example if a hedged financial asset becomes credit impaired.
If a hedged forecast transaction is no longer highly probable to occur, hedge accounting is discontinued and the accumulated gains or losses on the hedging instrument need to be reclassified to profit or loss. Hedged items in a cash flow hedge that could be affected due to COVID-19 include: Sale or purchase volumes that fall below the levels originally forecasted; planned debt issuances that are delayed or cancelled such that interest payments fall below levels originally forecasted; business acquisitions or disposals that are delayed or cancelled.
Additional disclosures might also be required. For example, IFRS 7 Financial Instruments: Disclosures requires disclosure of defaults and breaches of loans payable, of gains and losses arising from derecognition or modification, and of any reclassification from the cash flow hedge reserve that results from hedged future cash flows no longer being expected to occur. Disclosures include quantitative data, for example about liquidity risk, and narrative disclosure, for example how risk is being managed.
Other accounting and reporting considerations to take note of are covered in the references below and include revenue recognition and contract modification related to variable consideration (linked to IFRS 15 Revenue from Contracts with Customers). Although revenue is accounted for when it happens, there could also be an effect on the assumptions made by management in measuring the revenue from goods or services already delivered. For example, reduced demand could lead to an increase in expected returns, additional price concessions, reduced volume discounts, penalties for late delivery or a reduction in the prices that can be obtained by a customer. A company may also modify its enforceable rights or obligations under a contract with a customer such as granting a price concession in which is it is necessary to consider whether the concession is due to the resolution of variability that existed at contract inception or a modification that changes the parties’ rights and obligations.
Stathis Gould heads up the development of international services for professional accountants working in business and industry at IFAC. A key element of his work is developing thought leadership and guidance in support of finance professionals and their roles facilitating sustainable organizational performance. Before moving to IFAC, he was at the Chartered Institute of Management Accountants (CIMA) responsible for planning and overseeing a program of policy and research. Prior to serving the accountancy profession, Mr. Gould worked in various roles in the private and public sectors in the UK.
Christopher Arnold is the head of SME/SMP and Research at IFAC. He was previously an Audit Manager for Deloitte and qualified as an accountant in a mid-tier accountancy practice in London (now called PKF-Littlejohn). Christopher started his career as a Small Business Policy Adviser at the Association of Chartered Certified Accountants (ACCA).
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