COVID-19: Financial Reporting Implications
(accurate at 14 April 2020)
We have analysed the financial reporting implications of COVID-19 in two broad categories:
- Front-end - risks, uncertainties, and viability
- Financial Statements
These are considered in greater detail below, please click the links to review each topic.
'Front-end' annual reporting
- Reporting on risks, uncertainties and viability
- Recognition and measurement
- Post-balance sheet event reporting and disclosures
- Impairment of property, plant and equipment and intangible assets including goodwill
- Net realisable value of inventory
- Recoverability of receivables
- Recognition provisions, including onerous contracts
- Idle capacity and vacant property
- Debt modifications and breaches of loan covenants
- Insurance for business interruption
- Revenue recognition
- Share-based payments
- Defined benefit pension schemes
- Sources of estimation uncertainty
Front-end reporting – risks, uncertainties and viability
The level and detail of disclosures surrounding the impact of Covid-19 are dependent upon the significance of the impact that Covid-19 has had, and is expected to have, on businesses’ operations and activities. However, there are three particular areas within the front-end of annual reports where disclosures are expected to be provided:
- Strategic report – Disclosing the principal risks and uncertainties affecting the business, considering the extent of the risk, the degree to which the risk may crystallise, and any mitigating action taken by the company.
- Going concern statement – Disclosing the basis on which management has assessed the company’s ability to continue as a going concern, and where there are any significant concerns, these uncertainties must be disclosed.
- Viability statement (for premium listed companies only) – Disclosing the prospects of the company, such as the ability of the company to continue in operation and meet its liabilities as they fall due over a defined period of assessment, drawing attention to any qualifications or assumptions as necessary.
As companies will be impacted differently by the impact of Covid-19, it is crucial that disclosures are company-specific and tailored to their business, rather than being boiler-plated or generic. Additionally, it is important to ensure that the narrative reporting disclosures are consistent with the business’ financial results and future outlook, as disclosed elsewhere in the financial statements.
Note: A separate briefing covering all of the key narrative reporting issues in greater details to be available shortly.
Financial statement reporting
Recognition and measurement
The impact of Covid-19 has various consequences for how income, expenses, assets and liabilities must be recognised and measured, whether reporting under International Financial Reporting Standards (“IFRS”) or the International Financial Reporting Standard for Small and Medium-Sized Entities (IFRS for SME).
Set out below are some of the key areas where we consider how the measurement and recognition in financial statements could be affected. However, in the first instance, it is important for companies to consider whether the impact is an adjusting or non-adjusting post-balance sheet event.
Post-balance sheet event reporting and disclosures
Depending upon a company’s year-end, the impact of Covid-19 may be an adjusting or a non-adjusting event. For companies with a 31 December 2019 year-end, the spread of the virus after 31 December 2019 is a non-adjusting event because, at that date, only a few cases of the virus had been reported to the World Health Organisation. Accordingly, the subsequent spread, and identification, of Covid-19 after 31 December 2019 does not therefore provide additional information about the conditions that existed as at 31 December 2019 and is therefore a non-adjusting event. 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 labilities and recognition of income and expenses.
Practical implications: Assessing, whether the impact of Covid-19 is an adjusting or non-adjusting post-balance sheet event, will depend on the company’s year-end reporting date, and also on whether an event (in the series of events relating to the spread of Covid-19) is considered by management to provide evidence of a condition that existed at the year-end reporting date.
In light of the information that was available as at 31 December2019 year-end, the Covid-19 outbreak is considered to be as a non-adjusting event in 31 December 2019 financial statements. As such, its impacts should not be factored into the financial statement balances and accounts as of 31 December 2019 but would impact disclosures.
If the impact of the Covid-19 outbreak is material, the entity is required to disclose the nature of the impact and an estimate of its financial effects.
The European Securities and Market Authority (ESMA) guidance issued on 11 March 2020 states that “issuers should provide transparency on the actual and potential impacts of Covid-19, to the extent possible based on both a qualitative and quantitative assessment on their business activities, financial situation and economic performance in their 2019 year-end financial report if these have not yet been finalised or otherwise in their interim financial reporting disclosures.”
As the impact of Covid-19 is evolving rapidly, management will need to carefully consider the accounting requirements of IAS 10 “Events after the reporting period”. The critical issue for management will be deciding on whether the latest developments provide more information about the circumstances that existed at the reporting date.
Impairment of property, plant and equipment and intangible assets including goodwill
Companies need to assess whether the impact of Covid-19 triggers an impairment assessment and, if as a result of that, whether an asset impairment has occurred. Where an impairment review is carried out, companies need to consider the impact of Covid-19 on the inputs and assumptions used for financial projections.
For instance, management must assess whether a trigger event has occurred, such as the loss of key customer and/or supplier or reduction in financial performance due to disrupted production, and consequently assess the impact on the impairment calculations, such as revisions to estimated future cash flows and other key assumptions, such as discount rate and growth rate.
Practical implications: When performing impairment reviews, management should determine estimated cash flow projections based on inputs and assumptions in place as at the date the impairment review is carried out (i.e. as at the reporting date). If estimates are revised after the original impairment review date, these should only be taken into account in revising the impairment review if this occurs before the reporting date. Events after the reporting period, and information received after the reporting period, should be considered in the impairment indicator assessment only if they provide additional evidence of conditions that existed at the end of the reporting period. Accordingly, any changes in estimates, such as a reduction in forecast revenues, that are made after the reporting date (i.e. do not relate to conditions existing at the reporting date) and before the financial statements are authorised for issue, should only be disclosed in the financial statements, if the impact is material.
Likewise, sensitivity analysis that has been performed as at, or during, the reporting period, should not be updated to reflect revisions to future cash flow projections that management has made after the reporting date, however management should consider disclosing the revised sensitivity analysis for changes in the key assumptions where the information is material to users of the financial statements.
It should be noted that it is more important for an entity to provide detailed disclosure of the assumptions taken (and the evidence on which they are based) when uncertainty is greater.
Net realisable value of inventory
Companies must 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.
Practical implications: 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.
For instance, if stock is not able to be accessed because it is held within an isolated location, if stock becomes obsolete because of reductions in demand, or if the estimated costs to be incurred to provide products to customers are increased because of restrictions on accessibility and distribution, these may result in management assessing that inventory should be written down to its net realisable value.
Additionally, it should be noted that excess overhead resulting from “abnormal” production levels (i.e., production levels below the range of normal capacity due to the entity’s workforce having to stay at home), should not be allocated to inventory
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 IFRS need to assess the expected credit losses that will be incurred as a result of the impact of Covid-19 on their customers and recognise credit loss provisions for increases in expected non-recoverability of receivables. In performing this assessment, management must use reasonable and supportable information about past events, current conditions and the forecast of future economic conditions for determining the expected credit losses. The information used must be based on that available as at the reporting date.
Companies reporting under the IFRS for SME 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.
Practical implications: In these unprecedented times, determining the recoverability of receivables will likely be a key source of estimation uncertainty for most companies due to the high concentration of customers likely to be facing financial difficulty or insolvency. 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 shall be reassessed at each reporting date and shall reflect all reasonable information that are available at reporting date. Other than potential changes in the credit terms granted to its customers, given the potential changes in the debtors’ risk profiles as a result of the disruptions caused by the Covid-19 outbreak, management may want to review their provision matrix used in determining the expected credit losses, including the revision of the expected loss rates and assess the potential impairment or write-off of receivables.
Expected credit losses shall not be changed in the year-end financial statements due to subsequent events related to the Covid-19 outbreak.
Recognition provisions, including onerous contracts
For a provision to be recognised, there must be a present obligation (legal or constructive) as at the reporting date as a result of a past event i.e. 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.
Practical implications: The impact of Covid-19 is resulting in many companies changing the way the business is operated 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 (unless onerous contract) 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, for example, where there is expected loss of revenue, and/or increased costs associated with a contract. Where a contract has become onerous, a provision is required to be recognised. An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it, where the unavoidable costs are the least net cost of exiting from the contract (this being the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfill it).
For example, a company has a contract to deliver goods to a customer at a fixed price, however as a result of the closure of the supplier’s operations, the goods cannot be delivered. The company may either cancel the contract or seek to procure the goods from a third party. A provision should be recognised for the onerous contract at the lower of the cost of fulfilling the contract (i.e. the excess of the cost to procure the goods over the consideration receivable under the contract) or the cancellation penalty payable to the customer.
Practical implications: Some contracts that companies enter into may be able to be canceled without any compensation needing to be paid to the other party to the contract, for example many standard purchase orders. Nevertheless, management should carefully review the terms and conditions of contracts to understand where there are cancellation terms with and without penalties and whether there are any specific terms that may release the company of its obligations under the contract.
Where management assesses that a contract has become onerous, then a provision should be recognised. However, if there are specific assets dedicated to a contract, before a separate provision is recognised for the onerous contract, management should carry out an impairment review on the specific assets and recognise an impairment loss where necessary.
It should be noted that any provision for onerous contracts shall reflect the conditions at the reporting date and should not be changed in the year-end financial statements due to subsequent events related to the Covid-19 outbreak.
Idle capacity and vacant property
Where buildings and sites become idle or vacant due to reduced demand and/or the non-availability of workforce, depreciation must continue to be recognised while the asset is idle or retired from active use unless the asset is fully depreciated. Where the facilities are leased, this may be an indicator that an onerous provision may need to be recognised under the IFRS for SME or a right-of-use asset impaired under IFRS.
Practical implications: Companies may be required to temporarily cease operations, such as closing a retail unit or ceasing production on a manufacturing site. For companies reporting under the IFRS for SME, where the premises are rented, this may result in the lease contract becoming onerous. Management should assess the future economic benefits (i.e. the future cash flows expected to be earned from operating the premises) and where they do not exceed the present value of the remaining lease rental payments under the contract, an onerous contract provision should be recognised. Any assessment should reflect the conditions existing at the reporting date.
Debt modifications and breaches of loan covenants
Given that companies are likely to start experiencing financial difficulties, particularly for example as a result of declining demand and customer spending, companies may need to consider restructuring existing loan arrangements or may need to seek additional financing with new or existing lenders. For instance, companies may need to amend terms and conditions of existing loans, such as changing interest rates, borrowing additional funds or modifying other contractual terms. Management must give careful consideration to the requirements in this area as to whether the debt restructuring should be accounted for as a modification or extinguishment of the debt.
Companies may also wish to discuss with their existing lenders whether any changes in debt covenants may be necessary to avoid any potential breaches. Where a debt covenant is breached, this could have an impact on the classification of the loan with the financial statements as current/non-current as at the reporting date. Where the breach triggers a repayment on demand clause i.e. that gives the lender the right to demand repayment at any time at their sole discretion, then the loan should be classified as current, unless a waiver is obtained.
Practical implications: Management should ensure that any waiver, in respect of a breach of a debt covenant, is obtained from the lender as of the reporting date in order to avoid reclassification of a loan from non-current to current. Where a loan is required to be reclassified as a current liability within the financial statements, management should also give consideration to any consequential impact on the company’s going concern status.
Insurance for business interruption
Companies that have insurance policies in place to cover business interruptions must carefully consider the circumstances when recognising any potential pay-out from the policy. Gains receivable under a policy should not be recognised until the contingency is considered resolved and recovery of any pay-out is virtually certain. Prior to this, the policy is likely to be only disclosed as a contingent asset where an inflow of economic benefit is considered probable.
Practical implications: When business is interrupted, an insurance recovery of lost profits or revenue would not be recognised until when it is virtually certain that the loss will be reimbursed.
Management should carefully review the terms and conditions of the insurance policy to understand the nature and level of losses that are covered. It can often be the case that there are uncertainties about whether any, and how much, compensation will be payable and on what terms. When determining, therefore, whether an insurance pay-out may be recognised as an asset, the most reliable source of evidence available to management would be direct confirmation from the insurance company that the claim has been authorised. The company should also consider any stipulation from the carrier (e.g., “pending final review”).
Companies must give careful consideration 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.
Practical implications: Where companies are experiencing reduced consumer demand and spending and/or disruption to production and distribution, management must give particular consideration to assessing whether the ‘probability’ threshold for recognition of revenue under a contract is met, as well as whether variable consideration should or should not be included as part of the transaction price. Accordingly, management should consider carefully the expected impact of discounts, returns, refunds, credits and penalties when assessing the amount of revenue to be recognised.
There also may be an impact on revenue recognition for a situation where it is not probable that the entity will collect substantially all of the consideration, because the criteria for a contract are not met.
Companies may need to modify their share schemes to continue to motivate their employees with share awards in the future e.g. lower exercise prices, amended performance targets or extended option life. It should be noted that modifications to share award schemes may have significant accounting consequences for the share-based payment charge. Management may, therefore, wish to consider modifications to the existing schemes, for example by reducing the exercise pricing or options or modifying performance conditions, to make the awards incentivizing for employees again, or alternatively consider canceling the scheme. Where this is the case, management must consider carefully the requirements to ensure the accounting appropriately reflects the changes made. Modifications that increase the fair value of the share awards granted result in the incremental fair value being recognised, whereas cancellations accelerate the remaining fair value charged to be recognised immediately.
Practical implications: Given the on-going uncertainty that the impact is Covid-19 is having on businesses, especially regarding the length and scale of the impact, management may need to review the impact on its share-based payment charge particularly where the schemes include market performance conditions.
In the future to continue to motivate employees share schemes companies may need to be modify their share awards. e.g. lower exercise prices, amended performance targets or extended option life. It should be noted that modifications to share award schemes may have significant accounting consequences for the share-based payment charge.
Defined benefit pension schemes
The valuations of companies’ defined benefit pension schemes are being significantly impacted as a result of falling stock market prices and consequential reductions in plan asset values. Companies must ensure that the carrying value of the net defined benefit liability (or asset) is reviewed at the reporting date to reflect the current fair value of the plan assets.
Practical implications: The impact of Covid.19 is likely to have had a significant effect on defined benefit schemes and particularly the value of plan assets. Management should consider whether any of the assumptions used to measure employee benefits should be revised e.g. the yield on high-quality bonds.
Where the valuation of the scheme increases a deficit, or reduces a surplus, management should also give consideration to the consequential impact on the company’s going concern status and hence the disclosures to be provided
Sources of estimation uncertainty
Companies must provide disclosures regarding the key sources of estimation uncertainty that management has made in preparing the financial statements, specifically those with a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the ensuing financial year. Disclosures of key sources of estimation uncertainty is vital to ensure that investors and other stakeholders of companies’ financial statements receive transparent information.
Practical implications: Management should assess and disclose information about the most difficult, subjective or complex areas of estimation uncertainty that have been faced when preparing the financial statements. Disclosure should include: the nature of the assumptions or other estimation uncertainty; sensitivity of carrying amounts to the methods, assumptions, and estimates underlying their calculation; and the expected resolution of the uncertainty and the range of reasonably possible outcomes within the next financial year.
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