The impact of Covid-19 on financial reporting (Part 1)
SoluGrowth unpacks how your business’s accounting is likely to be affected by Covid-19.
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’s 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 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 amortised, 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, means that 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.
The impact of lockdown on businesses financial reporting is extensive. Read more about these impacts in The impact of Covid-19 on financial reporting (Part 2).