SEP 01, 2020 | Technical Accounting, Financial Reporting | SoluGrowth
The lockdown, social distancing and other nation-wide restrictions, necessitated by the outbreak of COVID-19, had various degrees of impact on financial reporting.
SoluGrowth outlines the level of impact and how organizations can navigate them in the following guide.
As South Africa remains under lockdown in response to the COVID-19 pandemic, many businesses are now facing challenges with regards to financial reporting. From Non-Financial Assets and Financial Assets/Liabilities to Leases, Revenue Recognition, Provisions, Events After Reporting, Going Concern and Income Taxes, this two-part guide unpacks how your business’ accounting is likely to be affected.
A look at Non-Financial Assets
1. Property, plant and equipment (PPE)
With social distancing restrictions and varying restrictions on business activity throughout the lockdown so far, the number of people allowed in offices, factories, warehouses and so on at any given time has been limited. Most companies have not been able to use their PPE assets to generate returns as intended. This can mean some of these assets could become redundant, or will not be able to produce the units they are supposed to produce.
IAS 16 requires entity managers to review the useful lives and residual values on non-financial assets and IAS 36 requires assets to be tested for impairment at least annually. IAS 36 also requires that assets be disclosed at their recoverable amount, where this is measured as the higher of the fair value, less costs to sell, and the value in use.
Calculating an asset’s value in use, uses an estimate of expected future cash flows and expectations about possible variations of these cash flows. This means entities will need to consider, at the end of each reporting period, whether there are factors that indicate the carrying amount could be higher than the recoverable amount. When such indicators do exist, an impairment assessment must be carried out. The ongoing pandemic predisposes many entities to indicators of impairment as it can affect the useful lives of PPE.
The pandemic and related lockdown will also have an impact on assets under construction. IAS 23 Borrowing Costs states that “capitalisation of borrowing costs should be suspended if the construction of the underlying asset is on hold”.
2. Intangible Assets
Intangible assets with definite lives will also need to be considered for impairment under IAS 36. Though Goodwill is not amortized, it is tested for impairment at least annually. Management will need to consider the performance of the underlying investments that resulted in Goodwill to determine if they are impaired or not.
Some inventory might need to be written down as a consequence of reduced demand for certain items. Inventories are measured at costs or net realisable value, whichever is lower, and imposed restrictions on supplying only essential goods and services during lockdown level five, and to some degree three and four, entities will have seen reductions in both demand and sales.
Less inventory movement will result in inventory write-downs to net realisable value, and this may be difficult to determine without more in-depth analysis procedures. Declines in production will also affect how fixed costs such as overheads are allocated to inventory. Generally, fixed costs are allocated according to normal production cost and entities should exclude expenses relating to unused capacity as a part of manufacturing expenses.
Lastly, management must consider the extensive disclosures required under IAS 36, including the complex judgements, estimates and assumptions used to derive the inputs for testing impairments of both goodwill and definite useful-life assets. IAS 2 requires that significant write-downs are disclosed.
Financial Instruments and your obligations
1. Impairment under IFRS 9
Some entities and individuals will not be able to meet their obligations on their held liabilities as these become due. As such, entities that hold instruments such as assets will need to review their Expected Credit Losses (ECL) models. The review should include changes relating to:
• The Debtor’s credit risk, i.e. the likelihood of default due to Covid-19, as some entities are more affected by lockdown than others.
• The extent of the exposure, where the entity should estimate the amount of loss.
IFRS 9 requires entities to consider past events, current conditions, and future conditions to assess their ECL. When customers renegotiate payment arrangements, entities should consider the impact of the renegotiated payment terms on the time value of money. If entities renegotiate the payment terms they must consider whether the renegotiated liability meets the derecognition criteria according to IFRS 9.
For hedge accounting, entities will need to assess the impact of Covid-19 on the “highly probable forecasted transaction” on the hedge according to IAS 39 Financial Instruments: Recognition and Measurement or IFRS 9.
An entity will need to determine whether it can still apply hedge accounting to the forecasted transaction or a portion of it. There are two possible scenarios:
• If an entity determines that a forecasted transaction is no longer highly probable, but still expected to occur, the entity must discontinue hedge accounting prospectively. In this case, the accumulated gain or loss on the hedging instrument that has been recognised in other comprehensive income will remain recognised separately in equity until the forecasted transaction occurs.
• If an entity determines that a forecasted transaction is no longer expected to occur, in addition to discontinuing hedge accounting prospectively, it has to immediately reclassify to profit or loss any accumulated gain or loss on the hedging instrument that has been recognised in other comprehensive income.
2. Fair Value
For financial assets/liabilities that are measured at fair value, entities will need to consider the impact of Covid-19 on the valuation technique.
IFRS 13 Fair Value measurement requires entities to disclose the valuation techniques and inputs used in the measurement, as well as the sensitivity of the valuation to changes in assumptions. In accordance with paragraph 35H of IFRS 7, an entity must explain the reasons for the changes in loss allowance during the period. Entities will need to assess the potential impact that Covid-19 has had or will have on their financial assets, and disclose these changes and assumptions made.
Covid-19 has forced some entities to halt their business operations entirely, which in turn has left them with no revenue. Thus, many lessors have granted lease concession to lessees and lessees should consider these concessions as lease modification.
The International Accounting Standard Board (IASB) has issued an amendment to IFRS 16 Leases, which states that, as a practical expedient, lessees may elect not to assess if the rent concession made due to Covid-19 is a lease modification when certain requirements are met. If a lessee applies this amendment, it should disclose this in the financial statements.
Lessors should consider if the asset, as a result of the loss of rental income, is impaired in accordance with IFRS 9. Lessees should assess if the right of use of an asset is impaired in accordance with IAS 36. (Read Part 1 for more on this).
IFRS 15 Revenue from Contracts with Customers requires entities to recognise revenue when it is probable that the customer will pay the transaction price. Some customers may be unable to meet some of their payment obligations during the pandemic so that entities will have to assess which customers will not pay and not recognise revenue on those transactions.
Revenue is measured at an amount net of any discounts and rebates. Decreases in sales will lead to an increase in expected returns, additional price concessions, reduced volume discounts, penalties for late delivery or reduced prices for customers. These elements require significant judgement and hinge on estimation uncertainty regarding the amount of consideration to be recognised at the contract inception date. The COVID-19 pandemic will, therefore, result in entities having to remeasure their variable consideration.
Some entities might apply Force Majeure to reduce contract scope or get out of the contract entirely. In instances like these, entities should consider whether Force Majeure is a contract modification and how it will affect the contract price and revenue recognition. IFRS 15 also requires that entities disclose information that allows users to understand the nature, amount, timing, and uncertainty of cash flows arising from revenue.
1. Government Grants
Entities that receive Government Relief Grants during the pandemic must assess whether the grant meets the requirement of IAS 20 Accounting for Government Grants and Disclosure of Government Assistance.
Lockdown has, unfortunately, resulted in retrenchments and business restructuring for many entities. IAS 37 states that provisions on these can only be recognised when:
• An entity has a present obligation
• An outflow of resources is probably required to settle the obligation; and
• A reliable estimate can be made.
Management should have created a legal or constructive obligation, by communicating their intentions to all affected retrenchments or restructures for provision to be raised. There should also be a detailed plan for how retrenchments and restructures will be implemented.
2. Onerous contract
An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. Covid-19 may result in contracts becoming onerous if an entity is unable to deliver or if there is a reduction in demand. IAS 37 requires an entity to recognise and measure present obligation under onerous contracts as a provision. It also requires entities to disclose the nature of the obligation and expected timing of the outflow of economic benefits.
Most governments around the world have used economic stimulus packages – namely of income tax concessions, reliefs, and rebates – to assist entities during these unprecedented times. Entities will have to assess the impact of these measures on their accounting for income taxes under IAS 12.
Items such as deferred tax assets and liabilities must be measured at the tax rates expected to be applicable when the asset is realised, or the liability is settled. Entities must also consider the implications of laws that were enacted, or substantively enacted, by the end of the reporting period alongside new tax enactments brought about by the pandemic. Entities will need to make these assessments based on the specific guidance per jurisdiction.
Uncertainties surrounding entity taxes could also see entities recognizing additional liabilities in accordance with IFRIC 23 Uncertainty over Income Tax Treatment for uncertain tax positions.
Events After Reporting
Entities should consider whether the impacts of COVID-19 constitute an adjusting event or a non-adjusting event, under IAS 10 Events After the Reporting Period. An event will be an adjusting event if there is evidence that conditions existed at the end of the reporting period.
If management finds that Covid-19 is a non-adjusting event, the impact on the financial statements will still be significant. This means management will still need to disclose the impact of Covid-19 on their financial statements.
Financial statements are prepared on a going-concern basis, unless management intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. Management should consider the potential implications of Covid-19, and the measures that have been taken to control it, when assessing the entity’s ability to continue as a going concern, factoring in any decline in business operations.
As businesses continue to seek solutions that will enable them to recover from the impacts of the COVID-19 pandemic, quality and accuracy of financial reporting should not fall by the wayside.