The coronavirus in your Financial Statements

High-quality financial statements are needed in times of crisis

Given the significant uncertainty, more disclosure will be necessary

Assets need to be tested for impairment

Impact on revenue recognition, liabilities and provisions

The author of this articleMario Matthijs - Expert Practice Leader Corporate Reporting
With the coronacrisis now starting to take its economic toll, the challenge to provide high-quality financial statements is present more than ever. The Half Year report will be a first test. Will companies succeed in providing the stakeholders with the right insights, not only for the current business and financial situation but also for its future viability?

The Virus in your Financial Statements

IFRS reporters are facing tough challenges. While high-quality financial statements are needed in times of crisis, the uncertainty caused by the pandemics is unprecedented. 

Decreased demand, closures, supply chain, production disruption and travel bans result in unusual accounting, demanding a higher degree of judgment in financial reporting. Disclosures will need to shed light on all kinds of assumptions, liquidity positions and risk management policies.

Although the impact on companies will differ considerably, this article discusses potential consequences that the corona disruption can have on your upcoming 2020 financial reporting.

IFRS reporters are facing tough challenges

Going Concern Considerations 

IFRS requires management to assess a company’s ability to continue as a going concern. Uncertainty about the company’s ability to operate under the going concern basis requires disclosure in the financial statements. 

Certain highly disrupted industries are in a situation that needs careful consideration by management. Going concern judgments being on the table, it is extremely difficult to predict how the corona pandemic will further impact profitability and whether there will be sufficient liquidity to continue to meet obligations. Potential liquidity shortfalls or insufficient access to capital sources are key considerations in this respect.

Given the significant uncertainty, more disclosure will be necessary and in particular the significant assumptions and judgments applied in making going concern assessments.  Companies can probably skip the 2020 budget to look at other scenarios, including an assessment of how resilient to a shortfall of funds they are.

Sensitivity analysis with varying assumptions is likely to be integrated in the disclosure. Companies need to consider whether they have the ability to continue as a going concern for at least, but not limited to, 12 months from the reporting date. No one has a crystal ball but if we are facing a material uncertainty, it should for sure be mentioned in the financial reporting.

Impairment of  assets

Probably the most acute measurement challenge is asset impairment testing. Companies will need to assess whether Covid-19 has led to an asset impairment indication. For most companies, the economic effects will trigger such an impairment test. 

Assets need to be tested for impairment, be it on a mandatory basis, such as goodwill, or upon the occurrence of an impairment trigger. The impairment trigger, however varying per industry, is undoubtedly here. Relying on an impairment test you did at year-end might no longer be appropriate.  Neither can you wait to execute the impairment tests you used to do in Q3 or Q4. Instead, you will need to reassess now and take a broader range of assumptions in cash flow projections as long-term forecasts are subject to significant uncertainties. 

The scope of assets subject to the requirements in IAS 36 is broad. It includes PPE, intangible assets, goodwill, right-of-use assets, investments in associates and other assets. 

Inventories are measured at the lower of their cost and net realizable value. Also here, an impact is expected. Interim inventory impairment losses should be reflected in the interim period in which they occur, with subsequent recoveries recognized as gains in future periods. Also, remember that IFRS requires that fixed production overheads are included in the cost of inventory based on normal production capacity. Reduced production might affect the extent to which overheads can be included in the cost of inventory.

The disclosure requirements in IAS 36 are extensive. Management should well prepare the disclosure of assumptions and sensitivities, especially in the context of testing goodwill and indefinite-lived intangible assets.

Companies will need to assess whether COVID-19 has led to an asset impairment indication. For most companies, the economic effects will trigger such an impairment test.
Mario Matthys

Expected credit losses (ECL)

Although the impact of Covid-19 on ECL will be particularly challenging for financial institutions, the effect risks to be there for non-financial corporates as well.

Expected credit losses - which at inception non-financial corporates claimed to have limited to no impact on accounting - suddenly gain importance.  Companies really will need to take a deeper dive into this exercise as reliance on historical data is far from being guaranteed in the current situation.

The majority of the non-financial corporates did not adopt the complex credit risk staging analysis but turned to the simplified approach offered by IFRS 9. They developed a provision matrix using historical credit losses, adjusted as appropriate to reflect current conditions and projections of future conditions. Low probabilities of default led to the fact that ECL’s were not material. This may no longer be the case given the impacts of Covid-19. Companies will have to reconsider the appropriateness of past methods and monitor the use of up-to-date information.

Potential impacts on IFRS 16 leases

As a result of the crisis, modifications can be made to contracts.  A lessor and a lessee might renegotiate the terms of a lease or a lessor might grant a lessee some sort of rent relief. In some cases, a lessor might receive compensation from a local government as an incentive to offer such concessions. Both lessors and lessees should consider the requirements of IFRS 16 Leases and whether the change should be accounted for a lease modification and spread over the remaining period of the lease.

In principle, this rent relief is not going to the income statement as a cost reduction but is impacting the right of use asset and lease liability.  However, on 17 April 2020, the IASB decided to provide relief to lessees in accounting for rent concessions arising as a result of the Covid-19 pandemic. An exposure draft sets out a proposal to permit lessees, as a practical expedient, not to assess whether particular covid-19-related rent concessions are a lease modification and, instead, account for those rent concessions as if they are not lease modifications. The Board plans to issue final amendments by the end of May 2020.

When adopting the standard, considerable judgment about options in the contract has been made. Are certain payments still reasonably certain? If not, remeasure, please!

Impairments to right-of-use (ROU) assets could occur as a result of business closures, supply chain disruption, or other consequences of the pandemic that negatively affect the future cash flows expected to be derived from the use of the underlying asset. The ROU asset will have to face the impairment test as well upon any indication of impairment.

Under IAS 37 you need to comply with some conditions before recognizing the restructuring liability
Mario Matthys

Any impact on revenue recognition ?

For sure! An increase in expected returns, additional price concessions to customers, reduced volume discounts, penalties for late delivery, a reduction of minimum purchase commitments…. all of these can affect revenue recognition. 

Companies better check the revenue recognition rules they implemented when adopting IFRS 15. Possibly, additional procedures need to be installed to properly assess the collectability of customer arrangements, consider changes in estimates related to variable consideration or changes in performance obligations as a result of Covid-19.

Impact on liabilities and provisions ?

Management’s actions in relation to the virus should be accounted for as a provision only to the extent that there is a present obligation for which the outflow of economic benefits is probable and can be reliably estimated. Remember that IAS 37 does not permit provisions for future operating costs or future business recovery costs. 

In a difficult economic environment and facing difficulties in obtaining financing, companies may envisage restructuring plans such as downsizing of operations or the sale or closure of part of its businesses. Under IAS 37 you need to comply with some conditions before recognizing the restructuring liability:

  • a detailed formal plan for the restructuring 
  • having raised a valid expectation that you will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by it. 

If both criteria are met, a restructuring provision can be recognized. 

Also, onerous contracts could unexpectedly appear, and management will need to monitor these carefully. Onerous contracts are those contracts for which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. Such contracts might include, for example, supply contracts that the entity is not able to fulfill because of the virus. Management should consider whether any of its contracts have become onerous.

Impact on IFRS 9 hedges

Companies face a higher risk of hedge ineffectiveness and earlier recognition in the income statement.

Hedge ineffectiveness can exist because a difference arises in the amount and/or timing of the hedged item and the hedging instrument.

Companies need to review ‘highly probable forecasted transactions’ and whether they are still expected to occur. If that forecasted transaction is no longer highly probable, but still expected to occur, the entity must discontinue hedge accounting prospectively and defer the gain or loss on the hedging instrument until the forecasted transaction occurs. If the forecasted transaction is no longer expected to occur the entity must immediately reclassify to profit or loss any accumulated gain or loss on the hedging instrument.

The Half Year financial statements are coming up

Companies may report for the first time any financial effects in HY 2020 interim financial statements, which will likely involve the greater use of estimates. Relevant information will need updates and more details than usual in a HY report will need to be provided.

The attention points described above apply definitely to the upcoming interim financial statements. Interim financial information usually updates the information from previous annual financial statements. However, IAS 34 requires an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period. Therefore, additional disclosure should be given to reflect the financial impact of the Covid-19 outbreak, in any case ‘when significant’. The possibility of being significant is more than ever-present through this pandemic.

Think for instance about the following disclosures:

  • the impact of the virus on the results, balance sheet and cash flows and the steps taken to control it; 
  • significant judgments that were not required previously, for example in connection with expected credit losses; 
  • significant estimates, especially in relation to impairment testing
  • impact on deferred tax positions; e.g. reassess recoverability of deferred tax assets from tax losses carried forward.

Adjustments to the carrying amounts included in the financial statements will be required.  How did you quantify them? Even if you cannot quantify them, you need to disclose this as well.

Undoubtedly, the challenge to provide high-quality financial statements is present more than ever. The HY report will be the first test. Will companies succeed in providing the stakeholders with the right insights, not only for the current business and financial situation but also for its future viability? Curious to see if and how preparers of financial statements will take on this challenge.

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The author of this articleMario Matthijs - Expert Practice Leader Corporate Reporting

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