How COVID-19 shall affect reporting under IFRS
When in January the world wondered about key challenges in economy for 2020, no one expected COVID-19 to become the chief one. The effects of the pandemic on the global economy are clear enough and market standing changes so fast that today’s projections can undergo unpredictable changes as a result of future scenarios coming true.
Currently, no one is surprised with the often repeated opinion that the pandemic may result in disruptions of production and supply chains, timely restrictions in access to labour for health-related reasons, and that all these factors combined may reduce turnover, profits, salaries and employment. Investments or expansion to new markets may be delayed or stopped due to uncertainty. Funding may be more difficult to obtain. Loan default and volatility of financial instruments measurement are likely to become issues in the finance sector. Public aid in different forms will be of key importance for many industries, such as air transport, tourism or catering. An aid package for enterprises has been announced in Poland. On the EU level, the COVID-19 response includes using money from the Cohesion Fund.
Economic turmoil caused by COVID-19 materially affects financial reporting. And this is not a thing to be left for later, if only because on 12 March ESMA issued special financial reporting guidelines, under which issuers should provide transparent information regarding actual and potential effects of COVID-19 to the broadest possible extent based on quantitative and qualitative analysis of their business operations, current financial standing and performance. The information is expected to be included in the financial statements for 2019, and if these have been already published, in interim financial statements. Therefore, appropriate data preparation should commence without undue delay. The scope of disclosures to be provided in financial statements shall depend on business specifics, industry and markets on which a company operates. The selected areas described below require special attention regarding the potential effects of COVID-19 on IFRS reporting. Let us begin with the observation that most of COVID-19 related events that occurred after 31 December 2019 shall not require adjustments to financial statements in line with IAS 10 “Events After the Reporting Period” for entities preparing financial statements as at that date.
Disclosures to be included in 2019 financial statements and their impact on financial data reported in subsequent periods
When preparing financial statements for 2019 (if not published yet) the following areas should be considered in terms of disclosures in notes regarding areas actually or potentially affected by COVID-19. Further, apart from disclosures, analysis should be carried out related to the correct recognition of financial data in subsequent reporting periods. Please note that although in most cases 2019 data shall not be adjusted (assuming the going concern principle applies), the issues indicated below must be considered when preparing the ones for Q1 2020.
In time of great uncertainty, financial reporting should provide users of financial statements with appropriate information on risk to which an entity is exposed and on judgments underlying the presented financial information. The related disclosures may include each of the following areas and, being judgments and uncertainties, fall under IAS 1 “Presentation of Financial Statements”. In such cases, material judgments (IAS 1:122) should be separated from sources of estimation uncertainty (IAS 1:125).
As far as non-financial assets are concerned (including goodwill), reporting entities should check for possible impairment caused by COVID-19. The outcome of the above measures and estimates of future cash flows may change as a result of the pandemic. IAS 36 “Impairment of Assets” requires reporting entities to carry out impairment tests at each reporting period end, should any indications of CGU impairment occur. Additional impairment tests of assets will be needed in certain entities as a result of COVID-19.
Under IAS 2 “Inventories” inventories are measured at the lower of cost and the net realisable value (NRV). In the difficult economic situation, the calculation of correct NRV may be more difficult than earlier and require additional analyses. Further, if production of an entity, being already low, drops to an extremely low level, for example as a result of a downtime, verification of the assumed inventory cost may be necessary. The purpose of the verification is to make sure that costs not allocated so far shall be included in profit/loss of the period they pertain to, without rolling forward.
The calculation of expected credit losses as required by IFRS 9 “Financial Instruments” shall pose a challenge both for banks and businesses. COVID-19 may affect creditworthiness of both corporations and individuals, as well as their ability to pay loan, trade or lease liabilities. Further, the risk that payments arising from financial guarantees shall become due increases. Uncertainty related to the continuity of production, sales and employment translates into reduction of economic growth projections, which should be included in the impairment model. Input data underlying the expected losses calculation shall be derived from current events (e.g. payment delays), expectations and estimates (e.g. in the form of reduced turnover in a counterparty or client’s industry). Please note that IFRS 9 focuses on the value of assets, the effects on profit/loss being of secondary importance. Therefore, an increase in expected credit losses (ECL) may occur and be charged to profit/loss, while investors or analysts should pay more attention to the value of assets than to performance for the period. From the operational perspective, the current situation will pose a challenge for entities that considered their credit losses immaterial and therefore did not develop sufficient calculation tools. Now, they will have to catch up after first-time adoption of IFRS 9.
IFRS requires fair value measurement of, among others, certain financial instruments or investment property. The fair value calculation should reflect
the perspective of market players and market data available as at the measurement date. Special attention should be paid to fair value measurement based on unobservable input data (Level 3). Entities must make sure that the data used reflect whether and how market players would consider the effects of COVID-19 on expected future cash flows generated by a given asset or liability as at the reporting date. Appropriate disclosures regarding input data underlying Level 3 fair value calculation, including their sensitivity analysis, require attention as well.
IAS 37 defines an onerous contract as one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it Under current circumstances, it may prove necessary to recognise provisions against contracts that provide for liquidated damages for delayed delivery or non-delivery of products or services. Further, provisions may be required as a result of an increase in costs necessary to deliver a contract, for example if personnel in quarantine needs a replacement, or alternative raw material purchases are necessary at prices higher than budgeted. Service contracts concluded in the education or tourism industry, where services will be provided to a number of clients materially lower than economically sound, may also require provisioning.
In tough economic conditions and facing funding problems, entities may consider or implement restructuring plans, such as selling or closing down certain operations or (temporary or permanent) reduction of their operations scale. Such plans should be analysed from the perspective of IAS 37. First, it should be checked whether a given entity has a detailed formal restructuring plan in place; second, whether individuals to be affected by the potential restructuring reasonably expect it to happen. If the analysis indicates that the criteria of IAS 37 are fulfilled, a restructuring provision should be recognised.
If a part of an entity’s business is available for immediate sale in as-is condition, and the probability that the sale shall be concluded within one year is high, the related assets and liabilities should be classified as held for sale in line with IFRS 5. Their measurement should be reduced to the current fair value less costs to sell, if lower than their carrying amount.
In crisis, covenant breaches may become more frequent. Entities should analyse the effects of a breach they may commit on the debt repayment terms (e.g. whether repayment becomes due on demand) and how this may affect the classification of related liabilities as at the reporting period end. In line with general terms, if a breach occurs prior to the reporting period end, and the creditor is thus entitled to demand the repayment within 12 months of the reporting date, the related liability should be classified as short-term one, unless contracts concluded prior to the reporting date exist that entitle the entity to postpone the payment after 12 months of the reporting date. A breach of covenants committed after the reporting period end, e.g. as a result of the COVID-19 pandemic, which is a non-adjusting event in line with IAS 10, should be disclosed in the financial statements. Importantly, in certain cases a breach that occurs after the reporting date may affect entity’s ability to operate as a going concern in line with IAS 1.
Production disruptions and sales reduction may affect liquidity and working capital. Entities may seek measures to manage liquidity risk. Use of alternative funding sources is possible, such as deferred payment to suppliers or agreements concluded with financial institutions, e.g. supplier financing and reverse factoring. Entities may use factoring to pay their liabilities at an earlier date. When making such decisions, they should analyse now to reflect them in disclosures regarding liquidity risk management in line with IFRS 7 “Financial Instruments: Disclosures”. Further, entities should consider requirements regarding disclosures of financial assets transfers, accounting principles and judgments applied when deciding on the presentation of the statement of financial condition and the statement of cash flows with regard to amounts due and paid if reverse factoring is used.
At each reporting period end, a thorough assessment of information that becomes available after the reporting period end but prior to the financial statements publication date must be carried out. Certain data reported in financial statements must be adjusted to reflect events that prove the occurrence of certain conditions at the reporting period end. When non-adjusting events, which may include the effects of COVID-19 observed early this year, are considered material in line with IAS 10, entities are expected to disclose the nature of these events and their estimated financial impact or a statement that the impact cannot be estimated. In relation to reporting periods ended on 31 December 2019 or before that date, in principle it should be assumed that the effects of events after the reporting period end (e.g. decisions made in response to COVID-19) must be disclosed in financial statements but they do not affect figures recognised in 2019 financial statements. For entities whose financial year ends as at another date, e.g. as at 31 March, the effects of COVID-19 for Q1 2020 shall be included directly in the reported items.
If cash flow hedge accounting is used, both under IAS 39 and IFRS 9, attention should be paid to the reasonableness of the assumed high probability of occurrence of the hedged item (e.g. future cash flows generated by export sales or raw material purchases). As far as incentive schemes recognised under IFRS 2 are concerned, their conditions must be considered, as well as the capability to fulfill their terms and conditions (e.g. sales targets, achieving a specified share price level, etc.).
The above considerations do not exhaust the list of IFRS aspects potentially affected by COVID-19. Entities must respond to developments on an ongoing basis and carry out reliable financial reporting in this demanding period.
Financial statements for 2019: going concern assumption
Financial statements are prepared under the going concern assumption, unless entity’s management plans to liquidate it or discontinue its operations, or if there is no other option. An assessment whether the going concern assumption is justified includes events after the reporting period end. The management of entities materially affected by COVID-19 will have to consider the reasonableness of adopting the going concern assumption when preparing financial statements, even if the material effect on their business has occurred after the reporting period end. Should the management become aware of material uncertainties that give rise to serious doubts regarding entity’s ability to operate as a going concern, these uncertainties must be disclosed in financial statements of the entity.
Source: Dziennik Gazeta Prawna nr 62, dodatek Podatki i Księgowość