As the impact of Covid-19 on financial statements begins to hit home across the globe, Adam Deller looks at adjusting events, impairments and financial instruments
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This article was first published in the June 2020 China edition of Accounting and Business magazine.
The Covid-19 pandemic has had a severe effect on economic and financial markets, and virtually all industries are facing challenges as a result. The restrictions on movement of people have had well-documented impacts on the leisure, transport, retail and entertainment industries in particular, but the effect on financial statements of entities will be widespread across a variety of industries.
The fall in revenues will have significant impacts on the estimates produced by businesses, and there will be issues arising over a whole range of items, from onerous contracts to impairments and provisions. A number of the major accounting firms have produced excellent resources that clearly and helpfully explain the likely impact, and summarise the key points of accounting standards. These guides will be essential for any company wondering how to apply the specifics of accounting standards in light of the impact of Covid-19.
As the pandemic will lead to companies needing to assess the application of a large number of IFRS Standards, it is not possible to cover each of them here. Instead, we will look at two of the major items that are likely to at least be a consideration for most entities.
Events after reporting period
As the global situation evolves rapidly, entities must consider the requirements of IAS 10, Events After the Reporting Period. As a reminder of the key rule, there are two categories of event covered under IAS 10:
- Adjusting events: an event that provides more information about a condition in existence at the reporting period. These events may result in changes to the figures in the financial statements if necessary
- Non-adjusting events: these are indicative of conditions that only arose after the year end. These will result in disclosures in the financial statements but would not affect the amounts recognised.
The application of the impact of Covid-19 is likely to depend on when an entity’s year-end is. China had alerted the World Health Organization to several cases of an unusual form of pneumonia in Wuhan by 31 December 2019 but the significant information about the virus and its magnitude really only arose in early 2020. This is likely to mean that for entities with reporting periods ending on or before 31 December 2019, they will treat the developments as a non-adjusting event. While the figures in the financial statements are expected to be unaffected, the disclosures should be significant. The disclosures need to explain the nature of the event and an estimate of its financial effect. While this may be extremely difficult to quantify, it is preferable to provide a range of estimated effects compared to not providing quantitative information at all.
If the likely impacts are that the company is no longer a going concern, then the entity will have to change its financial statements. They will have to be prepared on a break-up basis rather than a going concern basis. This means that all items will be held as current rather than non-current, all items will be held at their sale values, and specific items such as provisions relating to its closure will need to be included.
It is safe to assume that for any reporting event ending after 31 January 2020, Covid-19 is going to be an adjusting event. This means that entities are likely to need to review all of the areas that are subject to judgment and estimation, as highlighted above. The impact of Covid-19 on these financial statements is therefore likely to be significant and widespread. Entities will have to spend a lot of time revisiting assumptions and estimations, and the detailed guides mentioned earlier are likely to be extremely useful. While we will not be covering the list of possible impacts, the one specific issue affecting almost everyone is likely to be impairments.
The potential for impairments in the current climate is substantial. There is a clear risk of impairment to goodwill, as the acquisition price of an entity may well have been based on projected cashflows. When the goodwill impairment test is performed annually by entities applying IFRS Standards, they need to compare the carrying amount of the goodwill to its recoverable amount. A key component for assessing recoverable amount is to estimate the present value of future cashflows, which are certainly likely to be diminished.
Goodwill and impairment is a project that remains on the work plan of the International Accounting Standards Board (IASB). It recently released a discussion paper on the subject, and I will look at that in more detail in the future. While this article will not be focusing on the potential goodwill impairment, the final thing to remember is that currently goodwill impairment cannot be reversed, meaning that the current situation could have a long-term effect on that asset value.
One of the most common issues that entities may face is dealing with any potential impairment to receivable assets. This could occur in a number of different ways:
- Covid-19 can affect the ability of borrowers (corporate or individuals) to meet their obligations under loan relationships.
- Entities may be asked by governments to give payment holidays to customers. Even if the borrower is still expected to pay all amounts owed, there could potentially be a credit loss if the lender is not compensated for the lost time value of money.
- Reduced fees or interest rates on loans given could mean that a lower amount is recoverable from these loans.
In the face of this, the IASB has issued guidance for entities in the application of IFRS 9, Financial Instruments, under the current uncertainty. Instruments falling under this guidance include loans, trade and other receivables, lease receivables, contract assets, financial guarantees, loan commitments and debt instruments not measured at fair value through profit or loss. Under IFRS 9, an entity must recognise a loss allowance for expected credit losses (ECLs) on these.
Under IFRS 9, an entity will need to consider the impact of Covid-19 on the allowance for ECLs and whether there has been a significant increase in credit risk. This is something that entities are currently required to do at each reporting date, but the current situation will certainly prompt a substantial review of whether the risk has increased significantly.
If there has been a significant increase, the entity should measure the loss allowance at the lifetime ECLs rather than a 12-month ECL (other than short-term receivables and contract assets, which are always measured using lifetime ECL).
IFRS 9 requires the application of judgment, and entities will need to adjust their approach in determining ECLs following recent developments. Previous models and methodologies applied by entities in establishing ECLs will not have considered the situation under Covid-19, and therefore any existing ECL methodology should not be applied mechanically. The IASB guidance gives the example that an extension of payment holidays to all borrowers in a specific class of financial instrument should not automatically result in all of those instruments suffering a significant increase in credit risk.
Clearly there are huge uncertainties surrounding the eventual impact of Covid-19, but entities are still required to make estimates based on reasonable and supportable information that is available without undue cost or effort at the reporting date. In practice, this information is likely to come from looking at macroeconomic scenarios applied by entities, taking into account the entity’s ongoing credit evaluation process and any financial forecasts for industries and economies.
Despite the difficulties associated with making estimates and assumptions in the face of such uncertainty, it is not expected that this would be a basis for entities to not update their ECL measurements. Indeed, the IASB believes that ECL estimates that are based on reasonable and supportable information will still provide useful information about ECLs, in addition to giving transparency to the users of financial statements.
So as it stands, the guidance is less prescriptive than that handed out by governments to individuals and companies at the moment. As with the application of so many standards, the use of judgment is key. What is certain is that entities will have to spend significant amounts of time revisiting estimates previously made. The old assumptions cannot simply be followed, and new lines will have to be drawn across a range of different balances in the financial statements. The financial statement fallout from Covid-19 may be uncertain, but it is very likely to be substantial.
Adam Deller is a financial reporting specialist and lecturer.
CPD technical article
"It is safe to assume that for any reporting event ending after 31 January 2020, Covid-19 is going to be an adjusting event"