Due to the COVID-19 outbreak globally, there have been restrictions to continuous business operation as a result of measures taken by the government to contain the spread of the virus; for example there have been closure of borders, travel restrictions and a total lockdown of some states. These developments not only separate many companies from their customers, affecting demand in the process, but they also cut down supplies needed from vendors, making normal operations impossible. Many companies now cut down expenditures and even negotiate immediate payments from customers, borrowers, to help them through this period. All these factors point to a lower prospect for growth and business risk is increased. As financial reporting involves the use estimates and assumptions relating to the operational and financial ability of a company, it becomes necessary to take a close look at areas that are highly affected by estimates and assumptions. The specific financial reporting areas to be covered in this article are as follows:
• Events after the reporting period
• Going concern
• Impairment of non-financial assets
• Allowance for Expected Credit Losses (ECL)
• Fair value measurement
• Inventory valuation
• Non-current assets held for sale
Events after the reporting period
This is defined by IAS 10 Events after the reporting period as those events, both favorable and unfavorable, that occur between the year end and the date on which the financial statements are authorized for issue.
There are two types of events that can be identified:
• Adjusting Event: An event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period, including an event that indicates that the going concern assumption in relation to the whole or part of the enterprise is not appropriate. IAS 10 requires the adjustment to assets and liabilities for these types of events.
• Non-Adjusting Event: An event after the reporting period that is indicative of a condition that arose after the end of the reporting period. IAS 10 requires that these types of events should not be adjusted for but disclosed if material.
Is the COVID-19 an adjusting event?
This depends on the reporting date and whether there is reliable information that suggests the outbreak existed before or after the year end. The World Health Organization (WHO) reported on its website that on 31 December 2019, a number of unknown cases of pneumonia were reported to WHO-China, thus for entities with a reporting period of 31 December 2019, this represents an adjusting event. However, for many entities, the existence of the virus itself will not have an impact on its assets and liabilities. The subsequent measures taken by government in order to control the virus is a non-adjusting event as they do not provide evidence of a condition that existed as at the reporting date. Many entities only had disruptions to their business due to these measures taken by the government. This means that assets and liabilities will not be adjusted to reflect the impact of these measures but rather, an estimate of the financial effect will be disclosed if material. Where this is impracticable, the entity should disclose that a reasonable estimate of the effect cannot be made.
What about Going Concern?
IAS 10 Events after the reporting period explains that an entity shall not prepare its financial statements on a going concern basis if management determines after the end of the reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but to do so. Therefore, if management concludes that the impact of the COVID-19 outbreak, or related government measures have led to a difficult financial situation after the reporting date such that the going concern basis is no longer appropriate, then the financial statements will need to be adjusted. This applies irrespective of whether such events would have been non-adjusting or adjusting.
Due to the uncertainty regarding how long the government measures will remain effective, entities should also disclose material uncertainties that may cast significant doubt on the ability to continue as a going concern. For example, continuous operating losses, loss of financing without an alternative, and the death of a key management personnel due to COVID-19.
Impairment of non-financial assets
IAS 36 Impairment of Assets requires entities to perform an impairment test at the end of each reporting period when there is any indication that an asset or cash generating unit (CGU) may be impaired (i.e. the carrying amount is greater than the recoverable amount). This excludes goodwill and intangible assets with indefinite useful lives for which an impairment test should be performed annually. Entities will need to assess whether the impact of COVID-19 or measures taken to contain them has led to an asset impairment. Their financial performance, including estimates of future cash flows and earnings, may be significantly affected by the impacts of recent events. One indicator of impairment is a significant economic change with an unfavorable effect on the entity. Therefore, due to the effect of measures taken by the government and its impact of operations, entities will need to perform an impairment assessment of non-financial assets.
The recoverable amount of an asset or CGU is the higher of the fair value less cost to sell and the value in use. The fair value is the amount that will be received to sell the asset in an orderly transaction between market participants, while the value in use is determined by estimating and discounting the future cash flows that will be derived from using the asset or CGU. Key attention is needed on the determination of value in use. It is important that assumptions made are reasonable and reflect the most likely estimate of the future cash flows to be generated over the remaining life of the asset or CGU after factoring recent events.
Allowance for expected credit losses (ECL)
Due to the impact of COVID-19 and measures undertaken by government, the current situation is indicative of a general decline in the economy and this increases credit risk on financial instruments. Where there has been a significant increase in the credit risk of financial assets, IFRS 9 Financial Instruments requires that a lifetime ECL is recognized. The application of judgement is required in determining ECL. IFRS 9 Financial Instruments requires that entities should measure ECL in a way that reflects reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions. With the current outbreak of COVID-19 and the uncertainty surrounding it, many of the assumptions used prior to this event will need to be updated to reflect the current and forecast economic conditions. Therefore, when considering forecasts of economic conditions, entities should factor the effects of COVID-19 and the impact of related government measures when evaluating possible outcomes.
Fair Value Measurements
IFRS 13 Fair Value Measurement defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements should reflect market participant views and market data at the measurement date under current market conditions. As with the determination of value in use under IAS 36 Intangible Assets and the assumptions made therein, it is important to pay particular attention to fair value measurements based on unobservable inputs (Level III) and to ensure that the unobservable input used reflect how market participants would consider the effect of COVID-19, or government measures in their expectations of future cash flows related to the asset as at the reporting date.
IAS 2 Inventory requires that Inventories should be measured at the lower of their cost and net realizable value (NRV). In the current economic environment, decreased demand may create pressure on the prices of certain products. For example, products with fast approaching expiration dates are likely to be sold at below their cost. Also due to increased inventory turnover and cost of holding inventory, entities may generally prefer to sell very quickly below cost due to the uncertainty surrounding when next normal sales can occur. It may therefore be necessary to focus highly on NRVs and to ensure inventories are not stated at more than their realizable value.
The impact of government measures may also lead to idle capacity. For example, as a result of shortage of supplies or manpower. IAS 2 requires that in this case, fixed production overheads should be allocated to inventory based on normal capacity. The remaining unallocated amount should be expensed immediately.
The current environment may require entities consider resolutions to potential financial difficulties that are likely to arise, and this includes the consideration of restructuring. For example, a highly considered response by entities will be downsizing and divestments. It is important to ensure that restructuring provisions are only recognized when the constructive obligation is created in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Also, the current environment and with its evolving impacts from COVID-19, increases the likelihood that entities will breach contracts due to liquidity issues or operational difficulties which may consequently result in litigation. Where applicable, entities should only recognize a provision if the outflow of economic benefits is probable and the amount can be measured reliably. Where this is not the case, a contingent liability should be disclosed.
Non-Current Assets Held for Sale
Restructuring plans due to the impact of COVID-19 may mean that there are plans to dispose of certain assets or business. IFRS 15 Non-Current Assets Held for Sale and Discontinued Operations requires that non-current assets or any part of a business that is available for immediate sale in its present condition and completion of such a sale within one year is highly probable should be classified as held for sale and written down to their fair value less costs to sell if this is lower than their carrying amount. These assets or disposal groups are not depreciated and are presented separately in the statement of financial position.
Other financial reporting considerations
The COVID-19 outbreak and measures taken by government may impact on other financial reporting areas and proper consideration should also be given to them. Some of these areas include:
• Recoverability of deferred tax assets – IAS 12 Income Taxes
• Variable considerations – IFRS 15 Revenue from contract with customers
• Provision for onerous contracts – IAS 37 Provisions, Contingent Liabilities & Contingent assets