- May 4, 2020
- Posted by: IBA LLP
- Category: Articles, Assurance
It is an understatement to say that our world has changed dramatically over the last few months. The novel coronavirus pandemic has resulted in unimaginable loss to the global economy and the loss of human lives has been unprecedented in an era of global peace. Not only are the numbers alarming but, the speed at which the challenges have emerged is intimidating.
Companies will have tough times doing accounting in the backdrop of Coronavirus outbreak. Most companies are likely to be impacted by the COVID-19 coronavirus pandemic, either directly or indirectly, and the increased economic uncertainty and risk may have significant financial reporting implications. So, entities need to carefully consider the accounting implications of this situation.
This is not an exhaustive list and there may be other areas not included in this article that entities should consider:-
Presentation of Financial Statements:-
Due to Covid-19 any materially affected business may justify the low profitability with an additional presentation of line items. When items of income or expense are material, an entity shall disclose their nature and amount separately; with such separate disclosure businesses may explain the reason and facts. Challenge would be while assessing for quantification, for business to justify the rationale and for auditor to certify the same.
It is undoubtedly a challenging time for companies to prepare the financial with below areas to deal with and for auditor to certify.
With extension of time limit provided by regulators relating to financial results, submission of corporate governance report, GST return, etc. would assist in resolving issues to some extent, however some relief in terms of extension of time should be provided to financial institutions, banks, NBFCs for non-performing assets assessment, whereby companies & lenders would get some relief in moment of liquidity crises.
Various aspects like assessing impairments, or recognizing deferred tax assets, or computing revenues would be a challenge during these times.
Impairment of Non-Financial Assets
Management may need to closely review the build-up of any inventories and risk of obsolescence due to reduced demand and prices. This may require higher inventory write-downs to a lower net realisable value. Additionally, reduced production levels or idle capacity may need to be considered for the purpose of inventory valuation – because fixed overheads are absorbed basis normal production capacity.
Impairment of Financial Instruments
This is another important area, where financial assets such as loans, debt instruments, lease, and trade receivables—that are not accounted at fair value through profit and loss—would need to be critically reviewed and estimates of provision for ECL (expected credit losses) be updated to consider any effects of Covid-19. For example, borrowers may be facing liquidity issues resulting in defaults or delays in repayment.
In these times, borrowers may try and renegotiate the terms of repayment, moratorium or other concessions such as lower interest rates. Though lenders may potentially need to recognize higher lifetime ECL provision due to significant increase in credit risk, the borrower may also need to account for such renegotiation of terms as either a modification or extinguishment of that borrowing.
Finally, management will need to consider its financial risk management disclosures. For example, incorporation of the impact of forward-looking information into its ECL estimate, details of any significant changes in assumptions, changes in the ECL resulting from assets moving from one stage to another, etc. NBFCs and asset reconstruction companies are expected to be more significantly impacted due to this and should also comply with the Reserve Bank of India’s latest requirements on the implementation of Ind AS.
Deferred tax Assessment
A deferred tax asset is recognized for deductible temporary differences, unused tax losses and unused tax credits to the extent that it is probable that taxable profit will be available against which the deductible temporary differences can be utilized.
With uncertainty over the estimated profit for future years due to Covid-19, deferred tax assets recognized would be questionable.
Covid-19’s quarantine situation has originated biggest challenge of Cash management cycle for every business, which may result in non-payment of dues of loan instalment, concern over submission of necessary data to lenders, audit of inventories (stocks) for working capital requirements, and payment of salaries which in turn affects the production cycle.
All of the above are trigger for an assessment of impairment which affects financial institution for recognition of non-performing assets.
Leases and Onerous Contracts
The retail, travel, and entertainment industries have been severely hit by Covid-19. Typically, these businesses have significant fixed costs in the form of salaries and non-cancellable lease commitments. The overnight reduction of revenues has negatively impacted their performance, liquidity and may also call into question the continuing ability to operate as a going concern for some businesses. For example, the airline industry’s viability is in question, if governments do not provide the necessary stimulus or bailout. In this regard, lessees may seek concessions from lessors in the form of deferment of rent payment or rent holidays, which may have a consequential impact on the amount of lease liabilities recorded on the balance sheet. Lessors may be adversely impacted, as variable rent basis revenue sharing would plummet.
Certain entities may have entered into contracts with fixed purchase or supply commitments at fixed prices, commonly known as ‘take or pay’ contracts. These entities may need to evaluate whether these contracts have become onerous either due to inability to supply or purchase such fixed quantities at the contractually fixed prices vis-à-vis now lower demand, prices or supply chain disruptions. Any potential losses will need to be accounted in accordance with Ind AS 37. There is also discussion about entities invoking ‘force majeure’ clauses in their contracts, the impact of which may need to be considered for financial reporting.
Cash flow issues would also affect the submission of statutory dues such as Provident Fund, Employee Provident Fund, and Goods and Services Tax. This may result in issue of an adverse opinion by auditors in their audit report.
Fair Value Measurement
Not only the stock market but other markets, too, are affected due to coronavirus as it poses challenges for assessing fair value. What was reasonable and acceptable value till December 2019 is suddenly not acceptable in March 2020.
What businesses should do? Should this call for impairment? Or one may treat this as not the permanent situation and explain the rationale. Such a scenario would be many and discussion between companies and auditors would be core to resolve such position. Especially start-ups and private companies would have significant challenges.
Notified Accounting Standards allows only to recognize revenue when it is probable that the consideration will be collected, or you may say that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.
Now this suggests that to consider not only the customer’s ability but also the intention to pay that amount of consideration when it is due. In current scenario, to identify customer’s ability with long term credit period, pose a big challenge for recognition of revenue. This certainly creates a question for auditor to accept recognized revenue.
Impact on Consolidated Financial Statements
A company’s ability to obtain and provide financial statements or information could be impacted. Companies with significant operations in countries affected may encounter delays in receiving financial data for consolidated financial statements as a result.
Impact of COVID-19 on Property, Plant & Equipment
The provisions of Ind AS 16 and AS 10 require that the useful life and residual life of PPE needs revision on annual basis. Due to COVID-19, PPE can remain under-utilized or not utilized for the period of time. The Standards require depreciation charge even if PPE remains idle. Further, COVID-19 impact may have affected the affected useful life and residual life of PPE. The management may review the residual value and the useful life of asset and, If expectations differ from previous estimates, to account for the changes as an accounting estimate. Also Ind AS 23 borrowing cost requires that interest is to be capitalized in the value of asset but the same is to be suspended when development of asset is suspended.
Change in value of Asset and expected life may be due to the following:
- Significant changes in the extent or manner in which the asset is used or is expected to be used (e.g. machine may remain idle or there may be changes in the amount of production or there maybe changes in working hours of machines or its future productive capacity may also be affected, a machine may also be used in a manner different from its intended purpose which may reduce its future productive capacity)
- Significant changes in the legal factors or business climate that could affect the value of the asset (e.g. an entity expects a decrease in its exports to a particular foreign market as a result of lengthy border closings)
- A decrease in market interest rates which would cause a decrease in the asset’s value in use.
- a decline in, or cessation of, the need for the services provided by the asset.
Impact of COVID – 19 on Capitalization of Borrowing Cost
Under Ind AS 23 Borrowing Costs, a company capitalises borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset – i.e. one that necessarily takes a substantial period of time to get ready for its intended use or sale. These standards require that the capitalisation of interest is suspended when development of asset is suspended i.e. if a company suspends active development of a qualifying asset for an extended period, then it also suspends capitalisation of the borrowing costs for that asset. Borrowing costs eligible for capitalisation reflect the interest expense calculated under the effective interest method. However, the standard does not specify how long an ‘extended period’ of suspension of active development is but a company does not normally suspend capitalisation during a period when it carries out substantial, technical and administrative work. Similarly, it does not suspend capitalisation when a temporary delay is a necessary part of the development process. Therefore, a company may need to apply judgement to determine whether it should suspend capitalisation of borrowing costs. A company needs to consider both the expected length and the nature of the suspension when evaluating whether an interruption caused by the COVID-19 outbreak will continue for an extended period.
Therefore, a company continues to capitalise borrowing costs if:
- The interruption is for only a short duration.
- It continues to perform substantial administrative or technical work; or
- It can demonstrate that the interruption is due to a common external event or is a typical part of the process.
The impact of COVID-19 on the economy, financial markets and entities in particular continues to evolve. The impact on businesses could be very significant to meet performance targets or market expectations which raise the risk of the likelihood of fraud in financial statements yo a higher level. Irrespective of Challenges and Uncertainties there should not be any dilution or non compliance with the auditing standards in Financial Reporting
Author : Gaurav, Riddhima & Dilpreet