How the pandemic is tearing up the financial reporting landscape with focus on going concern and impairment
This paper principally addresses the implications of the current health emergencies for financial reporting and what is required by accounting standards. It looks at what may be required soonest, finalizing 2019 accounts, but also looking ahead to the issues that may need to be prepared for when reporting on 2020.
The accounting treatments set out below are consistent with reporting under IFRS, IFRS for SMEs and many national GAAPs drawing on them including FRS102 the main standard for the UK and Ireland. For any differences there is a reference to the specific IFRS and the major one is the treatment of impairments on financial assets as explained below.
There is one disclosure noted below which is not required of small companies under FRS102. Micro entities using FRS105 have essentially to make none of the disclosures mentioned.
Reporting dates in 2019 that are not yet approved
This may cover for example 31 December 2019 year ends.
- In most cases outside of China the COVID19 outbreak and consequent emergency are events that occurred in 2020 and so under many GAAPs any consequent events, for example travel bans, lockdowns or major disruption to the economy, can be treated as non-adjusting events after the reporting period. The values of assets and liabilities and income and expenditure are unaffected and need not be altered.
- There would however be disclosure requirements of the nature of the effects of COVID19 and the estimate of its financial effect if that can be made, or a statement that it cannot be made. Precise estimates are going to be impossible but ranges and some assumptions may be an alternative. Stating no effect can be estimated may make the going concern basis more difficult to support.
- Perhaps most importantly financial statements are assumed to be prepared on a going concern basis and this must be done as at the date of approval. If there are material uncertainties that may cast doubt on the ability to continue as a going concern then this needs to be disclosed including the reason why nevertheless that basis was used.
- If the going concern basis cannot be used then the values of assets and liabilities would have to be adjusted to net realizable or net settlement value even for these 2019 accounts.
- It is probable that auditors will be including in many cases the going concern issue as an emphasis of matter in their reports. This is likely to be very widespread, but it is not a qualification or negative audit opinion. A number of jurisdictions are granting extended filing deadlines for the submission of accounts whether for listed companies or other privately held ones.
Reporting dates in 2020
These may include interim financial statements for the 2020 year or years ending in 2020.
There is more doubt about whether for January or February reporting dates the consequences of the COVID19 are adjusting or non-adjusting events. This will depend on the particular circumstances and when the major impacts occurred in different parts of the world. For reporting dates of March and later then they generally will be adjusting.
This means that assets and liabilities will need to be measured including the effect of the health emergency. There are many potential impacts and the notes below draw attention to some of the more significant ones. Any standards that require consideration of future cash flows or the likelihood of events could be impacted – for example deferred taxes or revenue recognition.
Assets – Key issues
- One of the most significant will be assessing expected credit losses on financial assets such as corporate and personal loans, some leases, mortgages and credit cards measured at amortised cost under IFRS9 for banks and others. Many more may move from Category 1 (expected credit losses over the next 12 months) to lifetime expected losses given that the consequences of the virus outbreak will provide a significant increase in credit risk for many borrowers especially in certain sectors where economic activity has been impacted such as leisure, travel and retail. For trade and some lease receivables, and other short term assets where provisions are for expected lifetime or total losses will of course need to be estimated in changed circumstances. Estimating credit losses from events with few precedents to go on will be challenging. A number of governments have taken action to suspend repayments or provide lenders with guarantees and these should be reflected in the estimations of loss. Lenders may be granting payment ‘holidays’ which may not amount to defaults. There may be some issues around the certainty of entitlement and how the borrowers may be able to manage any catch up afterwards.
- IFRS for SMEs, FRS102 and many other national GAAPs use incurred loss models. For these impairments and many of the same considerations will also apply in those cases. The effects of the measures taken may impact impairments with increased defaults or applications for rescheduling. There may be objective evidence of loss even before actual defaults have occurred, because the conditions which will give rise to defaults and losses may already be underway by the reporting date (incurred but not reported).
- Inventories must be stated at the lower of cost and net realizable value based on estimated selling prices and costs to complete. Selling prices and volumes may have changed significantly as a result of measures taken in response to the virus. Some inventory may be perishable. There may be difficulties in arranging physical stocktakes given closure of premises.
- Other assets other than financial assets and inventories are subject to impairment unless they are measured at fair value. While goodwill and intangible assets with an indefinite life under IAS36 need to be tested on an annual basis, others such as other intangible assets, right of use assets and property, plant and equipment need to be tested for impairment only if there are indications that they may be impaired – so called trigger events. It is hard to see in some countries and sectors how COVID19 measures would not be such a trigger and so impairment tests would be needed in more cases.
- Any impairment test whether annual or triggered is based on expectations of future cash flows which in some cases will extend over many years into the future. Where there are significant economic dislocations these estimations have become more difficult than they were already. How long will the relevant disruption last for, how quick will be the recovery and will there be permanent changes?
- For any assets measured at fair value (for example many financial assets, some investment properties and biological assets) this will be at the reporting date and not reflect subsequent changes. While many markets have continued to provide reliable prices, some may have been affected by significant disruption or a falling away of transactions making it harder to determine the fair values and meaning more may be valued on a Level 3 basis.
- On the plus side there may be types of assets where their depreciation is directly related to their use. If used less or mothballed the depreciation might be proportionately reduced as well.
Liabilities – key issues
- On the liabilities side provisions for restructuring and for onerous contracts may be more likely as a result of any economic recession or dislocation. Falls in interest rates and in the values of some investment portfolios as plan assets, may mean that defined benefit pension costs rise. Companies with a defined benefit pension liability should engage actuarial advice at an early stage.
- For leased properties that are now empty, those leases will not always be onerous contracts if closure is likely to be temporary.
- For those applying IFRS16, rent holidays or other concessions granted to lessees may be lease modifications requiring recalculation of the lease liability and right of use asset.
- Businesses may be considering how any bonuses or incentives should be affected by any closures or severe reductions in activity
- In addition to these measurement issues the economic effects of the pandemic may lead to breaches of loan covenants which would mean that long term borrowings become repayable on demand and so need to be shown as current liabilities.
- Whenever the accounting standards require estimates of the future then the economic downturn and greater uncertainty created by the COVID19 may lead to changes and difficulties in the reporting. Judgements and estimates will need to be made and these need to be consistent across the whole organization. Standards require all significant estimation uncertainties to be disclosed (except for small companies using FRS102).
- All of the measurement effects on assets and liabilities may have very substantial impacts on the reported results. Companies need to give some thought as to how these may be best presented in the financial statements and in other parts of the annual report. This could include separating the performance pre- and post-lockdown for example and considering the presentation of government subsidies, such as furlough schemes for employee retention.
- The issues raised above about the going concern basis and reporting material non-adjusting events may be equally applicable to financial statements with reporting dates in 2020.
Management commentary or other narrative report
All companies will want to discuss the impact of the outbreak of the virus and the implications for their business of the measures taken to combat it in any narrative report accompanying the financial statements (for both 2019 and 2020 reporting dates). This may include explaining the
- strategy adopted in the circumstances
- principal risks and opportunities posed for the business
- mitigations and other actions taken by management in response
- effect on the reported results in 2020, in subsequent trading and the prospects for the future.
Material uncertainties about the resilience of the businesses may be needed in the financial statements for the going concern assumption but may well be discussed further in the management report.
Preparation of the corporate reports
Clearly with staff absences and time required for managing cashflow and other disruptions there may be problems with the ability of companies to prepare financial statements with all the internal controls in place. The performance of widespread impairment reviews will be an accounting resource issue for many companies. As noted above the impact of the virus outbreak will raise in many cases more areas of judgement for the accounting staff, audit committee and directors to deal with than previously.
This paper has just highlighted and pointed to the main issues that are likely to come out of the COVID-19 outbreak.
Much further and more detailed information is available. For example on the ACCA hub under the section trusted sources, including from many national authorities and via the Accountancy Europe site.