FC Training’s Umar Tariq looks at how the pandemic has changed financial reporting.
The UK Chancellor of the Exchequer recently predicted that the UK economy will shrink by 11.3% this year, the biggest fall in output in 300 years. Covid-19 is affecting the whole economy and almost all industries are facing challenges, directly or indirectly, associated with the new economic conditions resulting from the efforts to contain the virus. Industries such as travel, hospitality, leisure, and retail have seen sharp declines in revenues due to regulatory requirement and social distancing measures. The continuation of these ‘circumstances’ could result in an even broader economic downturn, which could prolong the negative impact on many entities financial results.
In many cases, businesses immediate focus is likely to be on survival, for some, on dealing with the immediate impact on staff, supply chains, and how to deliver goods or services to customers. Therefore, the focus has shifted abruptly to cash flow and solvency from growth.
The current attention will be how long the business can survive under lock-down and how resources will be preserved in order to be able to return to normal operations as the crisis abates. While the financial statements primarily look at history, they should also look forward.
Users of the financial statement may not expect management to be able to accurately predict the future. They may nevertheless be able to indicate areas affected or be able to describe the level of confidence they do have, even if lower than usual, in the company’s prospects.
The impact of Covid-19 has various consequences on how income, expenses, assets and liabilities must be recognised and measured, when preparing financial statements, whether reporting under International Financial Reporting Standards ‘IFRS’ or ‘FRS 102’ – the Financial Reporting Standard Applicable in the UK and Ireland.
The FRC has produced helpful information which addresses the key areas that need to be considered on how the measurement and recognition in financial statements could be affected due to Covid19. However, it is important for companies to consider whether the impact is an adjusting or non-adjusting post-balance sheet event.
There are key areas of considerations that need to be made by the accountants who are responsible in preparing financial statements of the company and those who sign them off.
Here they are: Events after reporting date: IAS 10 Depending upon a company’s year-end, the impact of Covid-19 may be an adjusting or a non-adjusting event. For UK companies with a 31 December 2019 year-end, the Financial Reporting Council has stated, the spread of the virus after 31 December 2019 is a non-adjusting event for the majority of companies. This is because at that date, only a few cases of the virus had been reported to the WHO and the subsequent spread and identification of Covid-19 after 31 December 2019 does not provide additional information about the conditions that existed as at 31 December 2019. However, for companies with later year-end reporting dates, year-end balances might be affected.
Companies must ensure that non-adjusting events are disclosed within the financial statements, if material. Disclosure should include the nature of the event and an estimate of the financial effect, for example disclosing information about the impact on the carrying amount of assets and liabilities and recognition of income and expenses. If an estimate cannot be made, then the entity is required to disclose the fact.
Events and information which occur, or are obtained, after the reporting period, and which are directly linked to the Covid-19 outbreak are adjusting events if the financial statements are established as at 31 March 2020 or any subsequent date. The entity should adjust the amounts recognised in its financial statements.
This is because by 31 March, the extent of the crisis was known and the key economic support measures had been announced. The measurement of assets and liabilities as at 31 March 2020 or any subsequent closing date should reflect the conditions existing at that date, but information received subsequently, or further details on support measures implemented by governments, may confirm the situation at the end of the reporting period.
For companies whose year ended as at 31 January 2020 or 29 February 2020, discussions are ongoing regarding the potential need for adjustments to reflect events that took place following the WHO’s declaration of a public health emergency on 30 January 2020.
Significant judgement will be needed to determine the conditions that existed at the balance sheet date and whether, the amounts recognised in the accounts need to be adjusted.
This judgement will be heavily dependent on the reporting year end in question, the entity’s own individual circumstances, and the particular events under consideration.
Assessing Going Concern: IAS 1 The standard requires financial statements to be prepared by assessing a company’s ability to continue as a going concern and this needs to be assessed up to the date of the issue of the final accounts. The assessment relates to at least the first twelve months after the balance sheet date.
The FRC’s recently issued guidance on Covid-19 notes that companies should disclose judgements and assumptions which have the greatest effect on the financial statements and those relating to going concern are an obvious focus.
It is most likely many companies small and large, particularly in some sectors, will continue to have disruptions of their operations due to ongoing restrictions, and this needs to be considered by management carefully.
There are wide verities of factors to take in to account by management in establishing going concern judgements. This includes travel bans, government assistance and potential source of financing of a companies activities, liquidity of suppliers and customers and their effect on their profitability, debt repayment and other key financial performance ratios.
The FRC notes that it expects more companies to disclose material uncertainties relating to going concern.
These are events or conditions which cast significant doubt on the company’s ability to continue to trade for at least the next 12 months.
The degree of consideration required, conclusion reached and level of disclosure that needs to be made will depend on the facts and circumstances in each case, because not all entities will be affected to same extent.
If management’s view is the company is no longer a going concern, the financial statements may have to be another basis such as liquidation.
Non financial assets
Impairment of assets: IAS 36 states an asset is impaired when an entity is not able to recover its carrying value either by using the asset or selling it. The scope of assets subject to this requirement includes plant and property, equipment, intangible assets, goodwill, right of use of asset, investment property, etc An entity performs an impairment test to estimate the recoverable amount of the asset. The recoverable amount is the higher of the fair value(FV) less cost of disposal of the asset and the value in use(VIU).The value in use is defined at the present value of the future cash flows that the asset is expected to generate.
The standard requires at the end of each financial period that an impairment test needs to be performed on the entity’s non-financial assets such as goodwill and indefinite life intangible assets. For other classes of assets within the scope of the standard, an entity is required to assess whether there are any indications of impairment. The impairment test only has to be carried out if there are indications the assets are impaired.
The 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.
Temporarily ceasing the operations, decline in demand of product and service rendered or prices are clearly events that indicate impairment. Companies need to assess whether the impact of Covid-19 has potentially led to asset impairment. For most companies, the economic effects are likely to trigger an impairment test for long lived assets and other group of assets.
Managements are required to disclose specifically the assumptions used to establish going concern and its sensitivities in the context of entities assets and its operations.
Valuation of inventory: In valuation of inventories IAS 2 requires, companies to assess whether inventory is held at the appropriate carrying value, being the lower of cost or net realisable value, as at the reporting date. When determining the net realisable value of inventory, management must assess the estimated selling price of the goods less the estimated cost of completion and the estimated costs necessary to make the sale.
Principal factors that may lead to inventory net realisable values being less than cost include a reduction in estimated selling prices, an increase in selling costs or estimated costs to be incurred to make a sale and obsolescence of products, all of which are likely consequences on businesses as a result of the impact of Covid-19.
Entities should assess the significance of any write downs and if they require disclosure in accordance with IAS 2.
Property plant and equipment: Disruption due to Covid19 mean, property plant and equipment is underutilised or not utilised for a period of time.
As mentioned above under IAS 36, the impairment test should be made for this class of asset when there is an indication. In addition to that, IAS 16 requires that depreciation continues to be charged to the profit and loss account while the asset is temporarily idle.
Financial instruments and lease
Credit loss assessment: If an entity has any financial instruments within a scope of IFRS 9 such as loans, trade and other receivables, debt instruments which are not measured at fair value through profit, Covid-19 impact needs to be evaluated by the credit loss assessment model.
Recoverability of receivables: Companies are likely to be impacted by the loss of customers and significant reductions in debts being paid due to customer’s experiencing financial or cash flow difficulties.
Companies reporting under FRS 102 must assess whether, as at the reporting date, there is objective evidence of impairment, such as a customer being in significant financial difficulty or it being probable that a customer will enter bankruptcy, and where there is such evidence, an impairment loss should be recognised.
Management should therefore give careful consideration to indicators that their customers may be experiencing financial difficulty, such as later than normal payments or partial payments, and recognise impairment losses or make realistic provisions based on the losses expected, as necessary to the applicable reporting framework.
Expected credit losses should not be changed in the financial statements due to subsequent events related to the Covid-19 outbreak.
Leases considerations: A lesser and a lessee might renegotiate the terms of a lease as a result of Covid-19.A lessor might grant a lessee a concession of some sort in connection with lease payments. In some cases, a lessor might receive compensation from local government as an incentive to offer such concessions. Both lessors and lessees should consider the requirements of IFRS 16 Leases and as to whether the concession should be accounted for as a lease modification and spead over the remaining period of the lease. Lessors and lessees should also consider whether incentives received from a local government are government grants.
Other financial instruments consideration: Impact of the changes to the terms of any borrowing or loan agreement because of action taken by government or renegotiation of terms between a borrower and a lender needs to be taken into account in preparing a financial statement. To determine the impact, both parties should apply the guidance in IFRS 9, whether the change to the terms results in de-recognition of the loan, reclassification or recognising a modification as gain or loss.
Additional disclosures might be required. IFRS 7 for example, requires disclosure of defaults and breaches of loans payable, gains and losses arising from de-recognition or modification of loan.
Non financial obligations
Recognition of provisions: According to IAS 37, for a provision to be recognised, there must be a present legal or constructive obligation as at the reporting date as a result of a past event.
There must be an obligating event, it must be probable that the company will have an outflow of economic benefit, and the amount of the obligation can be estimated reliably.
The impact of Covid-19 is changing the way businesses are operating and as a result companies may be experiencing increased operating costs from needing to increase cleaning or employing additional staff to cope with distribution demand, or be experiencing loss of revenue from reduced customer demand.
Future operating losses or future operating costs or losses are not permitted to be recognised because they do not meet the conditions to be recognised as a provision.
Furthermore, companies need to consider whether any contracts may become onerous as a result of an expected loss of revenue, and increased costs associated with a contract. An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceeds the economic benefits. An example of this could be, an operating lease for aircraft, restaurants or retail spaces. Where a contract has become onerous, a provision is required to be recognised.
IAS 37 requires that an entity discloses the nature of the obligation and the expected timing of the outflow of economic benefits if provision is recognised in the financial statements.
Measurement issues relevant to financial instruments
Fair value measurement (FVM): IFRS 13 defines fair value as price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at a measurement date (exit price) at the reporting date.
Fair value of an asset or liability at the reporting date should be determined using the applicable standard. The objective of FVM is to convey the FV of the asset or liability that reflects conditions as of the measurement date not at the future date. Events and transactions occurring after the measurement date may provide insight into the assumptions used in estimating FVM at date of measurement.
They are only adjusted for FVM to the extent where they provide additional evidence of conditions that existed at the measurement date and these conditions were known or knowable by market participants.
During the current environment, physical inspections might not be possible or there might not be an active market to establish fair value (FV).The volatility of prices on various markets increased and this will affect FVM either directly or indirectly. Therefore, special consideration needs to be given on commodity pricing that is used in developing FV conclusions.
Disclosures are needed to enable users to understand whether Covid-19 has been considered for the purpose of FVM. For 2020, fair value measurements, particularly of financial instruments and investment property will need to be reviewed to ensure the values reflect the conditions as at balance sheet date.
Other areas of considerations
Revenue from contract with customers: Entity’s sales and revenue might decline as a result of reduced economic activity following the steps taken to control Covid-19.This is accounted for when it applies.
Companies must give careful consideration to the relevant standard when determining the amount of revenue to be recognised under customer contracts. Revenue may only be recognised if collection of the consideration that the company is entitled to under the contract is probable, when determining the contract’s transaction price, variable consideration may only be recognised if, and to the extent that, it is highly probable that a significant reversal will not occur when the uncertainty is resolved according to IFRS 15.
Management should consider carefully the expected impact of discounts, returns, refunds, credits and penalties when assessing the amount of revenue to be recognised.
IFRS 15 requires that entities to disclose information that allows users to understand the nature, amount, timing and uncertainty of cash flows arising from revenue.
Assistance from government: Government responded to the impact of Covid-19 with a variety of measures and introduced a range of initiatives to help businesses including, the Corona virus Job Retention scheme, tax and business rates holidays, and grants for certain sectors.
Management should consider whether this type of assistance received from government meets the definition of a government grant in IAS 20. Government grants may not be recognised until there is reasonable assurances that the entity will comply with the conditions attached to it and its certain that the grant will be received.
Grants are recognised either on the performance model or the accrual model. Income related grants are presented as part of profit or loss, either separately or under a general heading such as ‘other income’. Some government assistance may involve deferral of tax payments or other tax allowances.
The accounting treatment for tax allowances may need to be accounted for under IAS 12 ‘Income Taxes’ rather than IAS 20. Please make reference to the relevant standard, if this is applicable for the business in question.
• The article is not intended to cover all aspects of Covid-19 impact on entities financial performance, rather to give guidance on key areas of considerations. Further areas of consideration include, but not limited to, differed tax assets (IAS 12), Employee benefits (IAS 19), share based payments (IFRS 2) and contingent assets (IAS 37) in the case of recovery of insurance policies which are certain.
• Each entity needs to consider the applicable standard, the transactions and contracts it has entered into and the environment in which it operates, and what might be considered material to its users when determining the impact of Covid-19 on the financial statements.
• FC Practical Accountancy Training has a course developed for those who would like to advance their accountancy careers in to semisenior/senior level by giving training on how to produce annual statutory accounts using account finalisation software. For details of the course please contact us at https://www.fctraining.org/
• Umar Tariq, is a senior training consultant at Future Connect Training.