ISSUES TO CONSIDER WHEN PREPARING FINANCIAL STATEMENTS – AS OF DECEMBER 31, 2019 - YEAR-END FINANCIAL REPORT
Subsequent Events
According to International Accounting Standards (IAS) 10, Subsequent Events, subsequent events are events, both positive and negative, that occur between the end of the reporting period and the date when the financial statements are authorized for issue. There are two types of subsequent events:
a. Events that provide evidence of conditions that existed at the end of the reporting period (adjusting events); and
b. Events that provide evidence of conditions that arose after the end of the reporting period (non-adjusting events).
IAS 10 requires entities to adjust the amounts recognized in their financial statements to reflect adjusting events that occur after the reporting period and to not adjust amounts recognized in the financial statements to reflect non-adjusting events that occur after the reporting period. In making these determinations, entities must exercise judgment and carefully consider the events and actual circumstances.
Significant economic downturn due to COVID-19-related conditions began in the first quarter of 2020. Therefore, an entity that has not yet issued financial statements as of the end of 2019 needs to assess the estimated impact of COVID-19 and the economic effects related to its business operations as a subsequent event, whether it should be adjusted or not.
For non-adjusting events, entities (both directly and indirectly affected) should consider disclosing the nature of the event and estimate the impact on the financial statements if it can be reliably measured and quantified, or state that such an estimation cannot be made.
Problem of continuity of operations
COVID-19 can have a significant impact on an organization's operations. The issue of going concern is distinct from matters related to "subsequent non-adjusting events." A decline in current or future operating results and the financial position after December 31, 2019 may indicate the need to assess whether the going concern assumption remains appropriate or whether significant uncertainties cast doubt on the entity's ability to continue as a going concern.
Entities anticipating the impacts identified and expected to arise in connection with COVID-19 should evaluate whether presenting the financial statements on a going concern basis is appropriate or whether disclosure of significant uncertainties related to the going concern is warranted. If the going concern assumption is no longer appropriate and it is expected that the impact will be pervasive, fundamental changes from the accounting basis to a liquidation or alternative basis may be necessary.
ISSUES TO CONSIDER WHEN PREPARING FINANCIAL STATEMENTS – POST DECEMBER 31, 2019 - YEAR-END FINANCIAL REPORT
For entities with financial year-ends or reporting periods ending in 2020, similar assessments need to be performed as discussed above. Additionally, COVID-19 and related economic impacts will affect other financial reporting areas, such as fair value measurement and impairment.
Here are some areas that may impact financial statement presentation:
Fair value measurement: Financial instruments
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Entities need to consider the appropriateness and reliability of market prices. COVID-19 has caused volatility in financial markets; however, it may not be appropriate to disregard market prices at the measurement date unless those prices are from infrequent transactions. The liquidity of financial markets and the ability to access major markets with current restrictions will also be considered, as well as potential impacts on the hierarchy levels: Level 1 to Level 2 and Level 3.
These considerations are crucial for entities when assessing the impact of COVID-19 on their financial statements, especially in areas involving fair value measurement and asset impairment.
Determining the principal market should be viewed from the entity's perspective. Due to travel restrictions, certain specific assets may not be sold in their most advantageous market. This could also affect adjustments made to Level 2 inputs since common Level 2 adjustments are based on the condition or location of the assets. We believe that this will have the most significant impact on non-financial assets.
Consideration of fair value: non-financial assets
International Financial Reporting Standards (IFRS) provide entities with the option to measure assets at fair value. Some of these standards include the following:
IAS 40, Investment Property, provides entities with an option to measure qualifying assets at fair value.
IAS 16, Property, Plant, and Equipment, provides entities with an option to use the revaluation model where fair value can be measured reliably.
IAS 41, Agriculture, requires entities to recognize biological assets at fair value less costs to sell unless fair value cannot be measured reliably.
Here are some factors that entities should consider when estimating the fair value of their non-financial assets:
Measures such as lockdowns, social distancing, travel restrictions, and isolation may lead to an increase in remote working and affect the vacancy rates of commercial buildings.
Lockdowns and border restrictions can impact entities' access to primary or most advantageous markets. For example, the inability to transport unused machinery or equipment to a neighboring country where prices are typically higher.
Reduced risk-free interest rates and changes in market liquidity can impact the discount rate used in estimating fair value.
Additional factors specific to the impairment of non-financial assets should also be considered.
Impairment of fair value: non-financial assets
Entities with financial instruments (meaning amounts receivable from customers or lessees, loans and other receivables, debt instruments measured at fair value through other comprehensive income, and contract assets) within the scope of IFRS 9 must apply the expected credit loss (ECL) model for impairment. We anticipate that
COVID-19 may have the following impacts:
Entities are required to estimate expected credit losses over either a 12-month or a lifetime horizon, depending on the nature of the financial instrument. At each reporting date, entities must assess whether there has been a significant increase in credit risk on a financial instrument since initial recognition. If there has been a significant increase in credit risk since initial recognition, entities typically need to recognize a loss allowance equal to the lifetime expected credit losses.
Organizations holding financial instruments representing customer loans or other parties will need to understand whether those customers or other parties have been significantly impacted by COVID-19, such as experiencing or expected financial difficulties. For entities not applying the simplified lifetime expected credit loss approach, financial instruments previously measured using 12-month expected credit losses will need to be remeasured using lifetime expected credit losses.
To measure expected credit losses, entities are required to incorporate both current conditions and future economic conditions in their forecasts. If a debtor's business is expected to be significantly affected by COVID-19, the risk of default may be higher, resulting in a larger expected credit loss. Entities will also need to combine and augment the likelihood of default scenarios due to the virus.
Entities using the simplified approach to measure expected credit losses and even those using the full lifetime expected credit loss model will need to reassess the current and future economic scenarios related to the impact of COVID-19.
Investments in joint ventures and associates
Entities applying the equity method of accounting for joint ventures or significant associates may need to assess the impact of COVID-19 on their investments and determine whether there are indications of impairment.
Impairment of non-financial assets
IAS 36, Impairment of Assets, requires entities to test goodwill and indefinite-lived intangible assets at least annually, and other non-financial assets whenever there are indications that an asset may be impaired. Current measures mandated by governments, such as temporary business closures and social distancing, will impact most businesses and may be an indication of impairment.
Here are some factors that entities should consider when determining the recoverable amount of non-financial assets or Cash-Generating Units (CGUs):
Impact of closures, social distancing, travel restrictions, and isolation measures on expected revenue and operating costs.
The impact that COVID-19 will have on previously estimated growth factors for discounted cash flows.
Reduction in risk-free interest rates and changes in market liquidity, and their impact on discount rates.
In the face of future uncertainties, constructing probability-weighted scenarios into expected forecasts.
In IAS 1, Presentation of Financial Statements, entities are also required to disclose information related to assumptions they make about the future and other significant sources of estimation uncertainty at the end of the reporting period when there is a significant risk of material adjustment to the carrying amounts of assets and liabilities within the next financial year.
Inventory
Inventory must be measured at the lower of cost or net realizable value, with losses recognized when the net realizable value of inventory is lower than its original cost. Due to the impact of COVID-19, the net realizable value of inventory may decrease due to lower demand or lower commodity prices. Decreased demand for oil due to COVID-19 leading to a significant drop in oil prices is just one example of the type of inventory that may incur losses.
Furthermore, in response to the virus, some entities are temporarily suspending production. These entities may need to reconsider their inventory costing methods to allocate their capitalized fixed overhead costs into the income statement.
Restructuring
Entities significantly affected by COVID-19 may consider reducing their workforce, closing business locations in a country or region, restructuring, or selling or disposing of a group of assets or divisions.
From an accounting perspective, entities should consider the following:
a. Contingent liabilities can only be recognized when the entity:
1. Has a detailed formal plan for the restructuring, specifying at least:
i. The business or part of the business involved;
ii. Key affected positions;
iii. Locations, functions, and the estimated number of employees to be compensated upon termination of their services;
iv. Expenditures to be incurred; and
v. When the plan will be implemented; and
2. Has communicated a valid expectation to those affected that it will carry out the restructuring by either commencing the plan or announcing its key features to those affected.
b. A long-term asset will be classified as held for sale and measured at the lower of the carrying amount and fair value less costs to sell if the carrying amount will be primarily recovered through a sale transaction rather than continuing use.
c. Whether the sale of a segment or a group of assets represents discontinued operations under IFRS 5, Non-current Assets Held for Sale and Discontinued Operations.
High-risk contracts
A high-risk contract is defined as a contract in which the unavoidable costs to fulfill the obligations under the contract exceed the expected economic benefits to be received under that contract. Unavoidable costs under the contract reflect the minimum net costs of exiting the contract, which are the lower of the costs of fulfilling the contract and any compensation or penalties arising from non-performance. Recent developments and economic impacts of COVID-19 may lead to high-risk contracts, including:
Revenue Contracts with Penalties for Late Delivery and Increased Contract Completion Costs due to rising material costs (due to supply chain delays and shortages) and labor costs (due to employee quarantines or home delivery arrangements).
Cancellation of contracts with significant financial penalties due to quarantine and closures.
If an entity identifies high-risk contracts, the current obligations under the contract are recognized and measured as a provision.
Debt agreements and covenants
If the impact of COVID-19 causes disruptions leading to cash flow issues, entities may need to amend the terms of existing debt agreements or seek waivers for debt covenants. Therefore, borrowers may need to determine whether changes to existing debt agreements can be accounted for as modifications or extinguishments under the accounting requirements of IFRS 9. If covenant breaches or other violations have occurred at the balance sheet date, the borrower should also consider the reclassification of long-term debt under IAS 1, Presentation of Financial Statements.
Borrowers should be aware that if covenant violations occur, lenders must waive them before the entity's reporting date. Failure to do so may result in the debt being classified as current, even if the waiver is subsequently obtained.
Government Grants
With the significant impact that COVID-19 has had on the economy, governments are responding by providing grants to support the finances of small businesses. Entities need to assess the terms and conditions associated with these grants to determine the appropriate recognition timing. Non-repayable government grants become receivables to offset costs or losses incurred or to provide immediate financial support to the entity with no future related costs will be recognized as income or loss in the period in which the grant becomes receivable.
Revenue Recognition
An entity accounts for a contract with a customer within the scope of IFRS 15, Revenue from Contracts with Customers, only when it is probable that the entity will collect the consideration it's entitled to receive in exchange for the goods or services to be transferred to the customer. When assessing the collectibility of an amount that is subject to consideration, an entity will consider only the customer's ability and intention to pay that amount when it becomes due. Due to COVID-19 negatively affecting the creditworthiness of customers, entities should analyze this criterion more rigorously and gather evidence to support or rebut that collectibility is probable at the time the consideration is due.
Under IFRS 15, variable consideration is estimated and included in the transaction price to the extent that it is highly probable that a significant revenue reversal will not occur when the uncertainty related to the variable consideration is subsequently resolved. Consideration in contracts can vary due to discounts, refunds, performance bonuses, and incentives. COVID-19 has led to the closure of manufacturing and supply businesses, non-essential goods and services, and countries encouraging citizens to stay at home. Therefore, demand for non-essential products will decrease, and this may lead to businesses returning a large volume of items to suppliers. Furthermore, the overall decrease in economic activity will result in lower consumer spending. As a result, COVID-19 will significantly impact estimates of various forms of variable consideration. We anticipate that entities may need to recognize larger refund liabilities and adjust consideration to reflect incentives related to volume and performance bonuses that are no longer probable. For organizations providing warranties to customers, organizations should assess the terms and conditions of these warranties and the impact of COVID-19 on warranty terms and revenue deferral (in the case where warranties are separate performance obligations).
Entities will also need to assess whether termination penalties and rights to payment for work performed to date remain enforceable. With some companies terminating contracts and facing financial difficulties, governments may enact financial support laws for businesses, and some termination and payment rights may no longer be effective. This could impact contract durations and revenue recognition models.
Financial risk management disclosure
Organizations are required to disclose the extent of financial risks, such as credit, liquidity, and market risks, and how these risks are being managed. Entities should consider whether COVID-19 has affected their risk mitigation plans, such as deferring payments of receivables and delaying payments to suppliers.
Insurance receivable
Some entities may hold insurance for business interruptions or losses. Insurance receivables should only be recognized at the point when it is virtually certain, and substantially after the corresponding loss event has occurred. Due to the prevalence of "force majeure" and similar clauses in insurance contracts, we believe that the "virtually certain" test is typically met when the insurer acknowledges the intent to settle a claim. Entities must recognize the amount received from insurance as other income in the statement of profit and loss.
Other considerations
COVID-19 leads to various other considerations in the preparation and presentation of financial statements, including:
The appropriateness and continuity of accounting for risk prevention due to changes in the effectiveness of risk prevention or transactions no longer deemed highly probable.
The probability of achieving income and volume targets in measuring random contingencies, discounts, customer incentive payments, and bonuses.
The ability to meet market-based operating conditions, such as stock prices in share-based payment arrangements.
Increased volatility in stock option valuations resulting in higher fair values and share-based payment costs. Similarly, the cancellation of employee stock options may lead to the immediate recognition of expenses.
Determining the useful life and residual value of assets under IAS 16.
Reviewing whether deferred tax assets are fully realizable, especially if the entity has a net operating loss that is set to expire in the near future.
Interim financial reporting
According to IAS 34, Interim Financial Reporting, entities are required to provide explanations of significant events and transactions that are relevant to understanding changes in the financial position and performance of the entity since the end of the most recent annual reporting period. Therefore, entities should commence or continue assessing the impact of COVID-19 on financial performance compared to the year-end report.