The COVID-19 situation has developed rapidly since the World Health Organisation (WHO) declared the virus a global health emergency on 30 January 2020. Global trade and markets have been significantly disrupted, and many businesses have had to, or will have to, limit or suspend their operations. As the virus continues to spread and disrupt, entities will have to consider its impact on their business and how this should be reported in the financial statements.
Most entities will not be immune to the effects of the coronavirus outbreak and will be affected, either directly or indirectly. Possible side effects of the pandemic include:
- Disruptions to supply chains
- Staff shortages and decreased productivity
- Reduction or suspension of manufacturing activities
- Difficulty raising financing
- Closure of stores
- Volatile financial markets
As the pandemic evolves on a daily basis, it is difficult to know the true extent of its impact. This introduces significant uncertainty, and thus challenges, for preparers of financial statements. Entities will have to undertake a careful diagnosis to understand how COVID-19 affects their financial reporting to ensure all material effects of the outbreak are accounted for and disclosed in their financial reports. Below we highlight some financial statement areas that could be affected.
Going concern
Accounting standards require financial statements to be prepared on a going concern basis unless management either intends to liquidate the entity or cease trading, or has no realistic alternative but to do so. The going concern assessment takes into account events both before and after the reporting date.
Entities with 31 December 2019 and subsequent reporting period ends will have to consider whether coronavirus-related events (such as those listed above) that happened after balance date caused a significant deterioration in their operating results or financial position, or introduced material uncertainties.
Where material uncertainties exist that cast significant doubt on the going concern assumption, appropriate disclosure in the financial statements will be required regarding those material uncertainties.
Impairment of non-financial assets
Non-financial assets (such as buildings, plant and intangible assets) are required to be tested for impairment at the end of each reporting period whenever this is an indicator of impairment.
Intangible assets with indefinite useful lives and goodwill are exceptions to this rule and must be tested for impairment at least annually.
Coronavirus-related events may adversely affect the performance of non-financial assets. For example, a manufacturing plant may become idle during an extended shutdown triggered by the pandemic, changing the extent to which, and/or possibly the way, the plant is used. This would necessitate an impairment test to be performed whereby the recoverable amount of the asset in question is determined and compared to its carrying value.
Where the asset’s recoverable amount is less than the carrying amount, an impairment would have to be recognised in profit or loss.
Trade receivables and expected credit losses (ECL)
The new financial instruments standard, AASB 9, requires that reasonable and supportable information about past events, current conditions and future economic conditions underpin the calculation of losses expected on trade receivables performed at reporting date.
COVID-19 will no doubt negatively impact the ability of debtors (both corporates and individuals) to settle their debts on time, if at all. The extent and severity of default that entities may be exposed to will be dependent on things like industry and geographic location. Forecasts for future economic growth may be revised downwards, increasing the probability of default by debtors. General reductions in asset prices may mean collateral values decrease which would increase loss given default rates. Entities may need to revisit their ECL models to ensure they are appropriately updated to factor in the effects of the pandemic.
Inventories
Under accounting standards, inventory is carried at the lower of cost and net realisable value (NRV). Disruptions to manufacturing and transportation into and out of coronavirus-affected areas as well as depressed demand for an entity’s products may result in the NRV of inventory falling below cost.
Another consideration relates to the allocation of overheads to inventories during times of abnormally low production or when plant is idle (for example during a temporary shutdown of manufacturing facilities). In such scenarios, the amount of fixed overhead allocated to each unit of production is not increased. Instead, unallocated overheads are recognised in profit or loss in the period in which they are incurred.
Deferred tax assets
Deferred tax assets can only be recognised to the extent that it is probable that future taxable profits will be available against which unused tax losses can be utilised. Entities are required to assess the probability of future taxable profits being available to utilise these unused tax losses.
Where the coronavirus outbreak has put the future earnings of entities into ICU, management may have to revisit their assessment of deferred tax asset recognition to ensure it remains appropriate.
Disclosure of evidence supporting recognition of a deferred tax asset will also need to be considered, as required by paragraph 82 of AASB 112 Income Taxes.
Borrowing covenants
With COVID-19 putting a strain on trading conditions, there is increased risk that entities will breach borrowing covenants. This could affect the classification of liabilities at reporting date.
For example, should an entity breach a specific loan covenant prior to reporting date that allows the lender to call on the loan at any time (i.e. making it repayable on demand), such a loan would have to be classified as current. Where such a breach only occurs after reporting date, it would be a non-adjusting event requiring disclosure in the financial statements where it is material. Such post-balance date breaches would also have to be factored into the going concern assessment.
Revenue recognition
Revenue is the top line in an entity’s statement of financial performance and is often a critical number for investors, analysts and other stakeholders. Under AASB 15 Revenue from Contracts with Customers, revenue cannot be recognised until collection of the consideration to which the entity is entitled is probable. A critically ill trading environment has seen the closure of production facilities and stores as well as cash shortages which could very well affect the ‘probable collection’ assessment. The amount and/or timing of revenue recognition could be impacted as a result.
In addition, entities are required to estimate variable consideration. Such estimates could be significantly affected by the current pandemic events.
Subsequent events
Entities are required to identify events that take place between balance sheet date and the date the financial statements are authorised for issue. Numbers are adjusted for those events (known as adjusting events) that provide evidence of conditions that existed at the end of the reporting period. Where events are indicative of conditions that arose after balance sheet date (known as non-adjusting events), entities are required to assess if these events are material. If they are, the nature of the event and its estimated financial effect would be disclosed in the financial report.
The spread of COVID-19 started in China before 31 December 2019 but the situation was not declared a ‘public health emergency of international concern’ until 30 January 2020. Things have evolved rapidly since then, with countries taking extreme measures to curb the spread of the disease. City lockdowns, domestic and international travel restrictions, shuttering of schools and non-essential services, and bans on mass gatherings are some such measures. These measures have significantly disrupted trading conditions.
Entities that have reporting periods ended 31 December 2019 will have to assess whether the impact on business operations, assets and liabilities were affected by the outbreak itself or by the subsequent measures taken to curb the spread of it. Many such entities may conclude that the ‘event’ (such as the shutdown of non-essential services) did not provide evidence of conditions that existed as at 31 December 2019 and will thus treat it as a nonadjusting event. Where the impact of the outbreak and subsequent containment measures is material, disclosures of such events as well as the estimated financial impact will be required in the financial statements. Due to the substantial uncertainty surrounding the pandemic and the extent of disruption it will cause, entities will find it challenging to estimate the financial impact, in which case a statement to this effect is required.
Other disclosures
Entities are required to disclose information about assumptions and sources of estimation uncertainty at balance date that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
Recent events have certainly increased the risk that carrying amounts of assets and liabilities may require material adjustments within the next financial year. Entities affected either directly or indirectly by COVID-19 will have to carefully consider the disclosures necessary to help users of financial statements understand its impact on the assumptions and judgements made by management that underly the numbers.
Areas that could be affected, apart from those discussed above, include provisions (such as employee benefit provisions and onerous contract provisions), contingent assets and liabilities, the probability of meeting performance targets in business combinations that have contingent consideration, and the likelihood of meeting vesting conditions in share-based payment arrangements.
Concluding thoughts
It is expected that COVID-19 and its impact on the world as we know it will continue to evolve over the coming months. More information comes to light on a daily basis and entities will have to continuously evaluate the situation as it applies to them to determine the financial reporting impact and adequately disclose this. Users of financial statements generally expect explicit, transparent and entity specific disclosures. In unprecedented times such as these, this expectation will only be higher.
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