The financial reporting implications of Covid-19

The outbreak of the coronavirus (Covid-19) has had significant and unprecedented impact. 

We are not yet in a position to know or to measure all the consequences of the current public health crisis for businesses, whether they be economic, social, etc. However, some effects of the crisis are already making themselves felt on operations, as well as on companies’ financial position and performance, and this has thrown up a number of accounting issues for companies.

In this article we consider the accounting implication of the Covid-19 outbreak on financial statements prepared in accordance with FRS 102.  This may be particularly useful for groups which may be required to prepare consolidated financial statements under IFRS but have elected to apply FRS 102 in UK subsidiary entities, as the accounting result of addressing Covid-19 under FRS 102 may diverge from the direction taken under IFRS.

Accounting implications of the Covid-19 outbreak on FRS 102 financial statements as at 31 December 2019

On 30 January 2020, the World Health Organization (WHO) declared a Public Health Emergency of International Concern over Covid-19 outbreak, which was then further qualified as pandemic on 11 March 2020. Containment decisions and announcements of governments’ support to the economies were taken subsequently on different time scales around the world. In the context of financial reporting, the emerging view of the impacts of the crisis on financial statements as at 31 December 2019 is as follows:

1. The accounting qualification of the post balance sheet events:

• the post balance sheet events related to the Covid-19 outbreak have been unanimously agreed as non-adjusting events at 2019 year-end, as the sudden spread of the infections and the WHO’s global alert did not occur until January 2020;
• as a consequence, GAAP preparers shall not adjust the amounts recognised in the financial statements as at 31 December 2019, unless the entity’s going concern assumption is undermined;
• the subsequent measurement of assets and liabilities shall therefore only reflect the conditions that prevailed at 31 December 2019 (i.e. irrespective of the effects of the crisis). Additional and tailored disclosures should be considered if management is already expecting that the current events will lead to material adjustments to the carrying amounts of assets and liabilities within the next financial year.

2. The impacts on disclosures within the notes to the financial statements:

• Entity-specific information shall be given on the nature of any material non-adjusting event, as well as an estimate of its financial effect (or a statement that such an estimate cannot be made).

Accounting implications of the Covid-19 outbreak on FRS 102 financial statements as at 31 March 202 or any subsequent date

There is already a consensus that events and information which occur or are obtained after the reporting period, and which are directly linked to the Covid-19 outbreak:

• are not adjusting events if the financial statements are established as at 31 December 2019 (i.e. the entity does not need to adjust the amounts recognised in the financial statements at 31 December 2019)
• are adjusting events if the financial statements are established as at 31 March 2020 or any subsequent date (i.e. the entity shall adjust the amounts recognised in its financial statements). By 31 March the extent of the crisis was known and the key economic support measures had been announced. The measurement of assets and liabilities as at 31 March 2020 (or any subsequent closing date) shall reflect the conditions existing at that date, but information received subsequently, or further details on support measures implemented by governments, may confirm or shed more light on the situation at the end of the reporting period.

For companies whose financial statements are established as at 31 January 2020 or 29 February 2020, discussions are ongoing regarding the potential need for adjustments to reflect events that took place following the WHO’s declaration of a public health emergency on 30 January 2020.

In this uncertain and rapidly-changing environment, the information presented below represents Mazars’ preliminary views. However, it should be noted that many of the topics addressed below are still under discussion within the accounting profession, in conjunction with standard-setters, market regulators and corporate representatives.

1. Impairment testing

Impairment testing will inevitably be one of the major concerns for entities. The Covid-19 outbreak has had a number of impacts that may constitute indications that an asset may be impaired, such as significant falls in demand or prices, closure of businesses, restructuring plans, supply chain disruptions and losses on significant contracts.

Companies will thus inevitably have to carry out impairment tests for all those assets within the scope of Section 27, due to the expected presence of an indicator of impairment.

In addition to carrying out impairment testing, Section 27 also requires reassessment of remaining useful lives, depreciation method or residual values even if the impairment test does not result in a loss.

2. Measurement of inventories

There are a number of aspects to take into account when measuring the net realisable value of inventories in the context of the Covid-19 pandemic: whether they are perishable or seasonal, if they have become partially or wholly obsolete, a fall in turnover, a fall in commodities prices, or a substantial fall in the selling price of inventories. As inventories shall be measured at the lower of cost and net realisable value, the public health crisis could have an impact on the measurement of inventories in the statement of financial position.

Moreover, it is likely that the crisis will also have an impact on the allocation of general fixed costs – for example, the fact that the entity’s workforce has to stay at home could mean that production levels are lower than normal capacity, resulting in fixed costs based on abnormal levels of production. These excess fixed costs should not be included in the measurement of inventories but should instead be recognised as expenses in the period in which they are incurred.

Finally, vacant buildings and idle plant should continue to be depreciated, unless the assets have been permanently abandoned. “Useless” depreciation is not included in the measurement of inventories.

3. Depreciation and amortisation of assets

Some people have suggested that depreciation and amortisation should be put on hold during the period of inactivity or shutdown.

However, it is important to remember that depreciation and amortisation reflect the consumption of economic benefits of the asset in question, based on systematic allocation of the asset’s cost. This leaves little room for manoeuvre.

In nearly all cases (i.e. all those in which assets are depreciated or amortised on a straight-line basis over time), it is not possible to put depreciation or amortisation on hold while the asset is idle. The entity may, however, be justified to extend the useful life of the asset (possibly as it may wear out less quickly while it is idle) and may also need to review the recoverable amount of the asset at the end of its useful life.

The only exception is when an entity uses a usage-based method (e.g. the units of production method), in which case no depreciation or amortisation is recognised during the period of inactivity. However, a long period of inactivity may require the entity to carry out an impairment test.

4. Financial instruments

a) Measuring financial assets at fair value

As long as markets are deemed to be active and transactions between market participants are deemed to be concluded under normal market conditions, assets at fair value (such as shares in  listed companies) shall be measured using observable market prices (i.e. share prices) at the closing date, despite the unusually high volatility.

b) Measurement of impairment losses of financial assets carried at amortised cost

In the current environment, objective evidence of impairment of receivables may be more evident.  This may be apparent in individually assessed receivables balances, in situations where there has been a missed payment or more generally, adverse national economic conditions can also be evidence of impairment. Where there is objective evidence of impairment, the receivable should be written down immediately.

c) Classification of financial liabilities in the statement of financial position

The following events, resulting from the current crisis, may affect the classification of financial debts in the statement of financial position:

• renegotiation of debts: any significant change in the terms of existing debts requires careful attention, and may result in a modification or extinguishment of the underlying financial instrument;
• breach of banking covenants: since this may result in acceleration of the loan repayment, the breach may require the loan to be reclassified as wholly due in less than one year , unless the entity has obtained a waiver from the bank by the relevant closing date at the latest or successfully renegotiated its covenants by this date.

5. Revenue recognition

a) Probability of payment

The current crisis is creating a number of risks related to revenue recognition, especially relating to customers’ ability to meet their payment commitments. There are various criteria to recognise revenue from the sale of goods or rendering of services under FRS 102, one of those being that it is probable that the economic benefits associated with the transaction will flow to the entity.  Therefore, an entity must assess should consider whether it is probable that it will collect the consideration to which it is entitled before booking the revenue.

b) Impact on reliably measuring revenue

The Covid-19 crisis may lead entities to re-estimate variable amounts that are implicitly or explicitly included in the sales contract (i.e. discounts, late penalties, returns expected from customers etc.).

An entity should only recognise revenue when it is capable of being reliably measured.  As a result, any adjustment to the transaction price resulting from one of the above factors which would require a company to re-estimate (and most likely reduce) revenue may cause a delay to revenue recognition.

This point may be particularly relevant to sales with a right of return, for which the entity shall recognise revenue based on its estimate of the number of products that will actually be returned. In the current environment, historic rates of return may no longer be representative of returns expected in 2020 – especially if the right of return is unconditional and is valid for a long period.  

6. Provisions

FRS 102 is clear that it is not permitted to recognise provisions for future operating losses or for costs that will need to be incurred in order to operate in the future. However, these losses may be an indication that some assets have become impaired (refer to section 1 above).

As regards slowdowns in activity, site closures and so on, the crisis does not change the criteria for recognising a provision for restructuring costs. Thus, a provision may only be recognised if the company has a legal or constructive obligation at the reporting date for carrying out the restructuring.  Conversely, entities are not permitted to recognise provisions for costs relating to ongoing activities. These costs shall be recognised in profit or loss when they are incurred. The accounting treatment of severance pay can also be complex and should take account of the facts and circumstances of each specific situation.

Onerous contracts arise when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.  In the current context, identifying onerous contracts may require an entity to assess the legal consequences of any force majeure clauses on the rights and obligations of the parties to the contract. The economic impact of early termination clauses should also be taken into account when determining the amount of any loss at completion.

7. Remuneration

a) Cost of measures to reduce activity

Generally, entities will not be permitted to recognise a provision for the impact of a slowdown in activity as a result of measures taken in response to Covid-19 (such as self-isolation, sick leave or part-time working) since FRS 102 only permits an entity to recognise provisions for the rights accumulated by employees, which the employees will subsequently use. This impact relates primarily to the salaries of employees who have to stay at home and cannot work remotely, the employer’s contribution to reduced hours working agreements, and the employer’s contribution to sick pay.

b) Cost of furloughed staff

The furlough payments which many companies have received as compensation towards the payments to staff would constitute a government grant.  As such, by applying either the accruals or performance model approach in FRS 102, grant income should be recognised in profit and loss in the same period in which the related expense is incurred, and recorded as other income.

c) Measurement of pension balances

The assumptions used to measure pension liabilities are usually reviewed once a year, however FRS 102 does not require a comprehensive actuarial valuation of a defined benefit pension scheme to be carried out annually if the if the principal actuarial assumptions have not changed significantly.  However, in light of Covid-19 it may be necessary to revise some of the actuarial assumptions such as the discount rate or longevity rate etc. Companies should also consider the impact of any provisions for restructuring, which could reduce the number of employees covered by a pension plan.

Equally the value of pension assets is likely to have changed at the current time noting that some asset classes have dropped in value (equities), others risen (gilts) and measurement of others are proving difficult (property).

d) Share-based payments

It may be necessary to revise estimates related to vesting conditions and hence to adjust the number of instruments that are expected to vest. These revisions may be related to the entity’s assessment of whether the performance conditions are met, and whether the service condition will be met if the entity is planning staff reductions.

If the company wishes to modify the terms and conditions of a plan, to lower the requirements for the performance condition or make the vesting conditions more favourable (thus ensuring that plans set up in the past continue to provide a benefit to employees), this modification shall be taken into account if it is beneficial to employees. For accounting purposes, the increase in fair value as at the date of modification (in effect requiring two additional valuations to be undertaken) is recognised over the period remaining until the vesting date and does not affect the expense previously recognised.  The accounting for the original grant date fair value of the award would be unaffected, i.e. it would continue to be expensed as if no such modification had occurred.

8. Deferred tax assets

The negative impacts on the economy caused by the public health crisis and the isolation measures taken in many countries (companies forced to close temporarily, risk of recession, slump in the financial markets, etc.) raise the question of the recoverability of assets, particularly deferred tax assets.

Deferred tax assets are only recognised to the extent that they are deemed to be recoverable, based on:

• the existence of taxable temporary differences at the end of the reporting period, against which the deductible temporary differences may be utilised; or
• an assessment of the probability that future taxable profit will be available.

9. Presentation of the income statement

Some industrial and services companies that are facing the effects of the Covid-19 crisis have expressed a wish to reflect these effects in the financial statements by presenting certain costs and inefficiencies/under-production under a separate heading of the income statement (e.g. “unusual” or “non-recurring” items).

This seems, in theory, to be permissible.  However, in particular, questions have been raised as to whether such a classification would be appropriate given that it would only partially reflect the impacts of Covid-19 as, for many companies, the main consequence of Covid-19 is a significant downturn in activity and revenue, which cannot be reflected in a “non-recurring” sub-total.

However, we believe that if a specific heading for the effects of the Covid-19 is used, classification as “non-recurring” would be possible, but should be limited to the following items:

• incremental costs that are directly related to protective measures implemented (cleaning of sites, protective equipment for employees, etc.);
• costs linked to under-production, provided that it is possible to reliably separate out the portion of general fixed costs not allocated to the cost of inventory production that is directly related to the public health crisis (e.g. costs of production facilities that are temporarily closed as a consequence of the outbreak);
• costs linked to short-time working measures due to shutdown of production sites or similar (to the extent of the net cost borne by the entity, i.e. after government subsidies have been taken into account).

In all cases, entities should be cautious when electing whether to present impacts of the current public health crisis as “non-recurring” and should only do this for items that would otherwise prevent from understanding the entity’s recurring operating performance.

10. Insurance recoveries

It should first be noted that insurance recoveries are contingent assets (not recognised) unless it is virtually certain that the reimbursement will be received. Thus, for an insurance claim to be recognised as an asset, the probability of the compensation must be close to 100%. There may thus be a time delay between the recognition of the damage (as a loss or a provision) and the recognition of the insurance income. The entity has a claim to compensation (although cannot necessarily recognise it) from the point when it recognises the damage: thus, it is not possible for an asset or even a contingent asset to exist before this point. The entity shall disclose contingent assets in the notes once it is probable (but not virtually certain) that the claim will be paid out.

In practice, entities should carefully study the relevant insurance policy to determine a) whether the damage is covered and b) the maximum loss insured. Particular attention should be paid to any exclusions and any contractual conditions relating to reporting the damage, in order to provide sufficient evidence that the compensation is virtually certain. Confirmation from the insurer that the damage falls within the scope of the insurance policy is useful proof that the compensation is virtually certain.

If a reimbursement is virtually certain to be received, the entity can recognise the claim even if there are uncertainties about the amount; however, these uncertainties will affect the measurement of the asset recorded in the statement of financial position. A prudent approach should be used here, taking account of the entity’s ability to provide supporting evidence for its claim for compensation. Any judgements or uncertainties relating to such estimates should be disclosed in the notes.

11. Temporary reduction in lease payments

It is possible at the current time that some lessees may request a reduction in lease payments from their lessors or a lease holiday, either for no compensation or possibly in return for higher payments later in the lease term or other changes to the lease (e.g. extension of term or removal of break clauses).  By definition these are not lease incentives because they are not provided by the lessor to the lessee in order to enter into a new lease or renew a lease, and FRS 102 is silent on the accounting for lease modifications.  However, as lease payments under the operating lease are required to be recognised as an expense over the lease term on, in the majority of cases, a straight-line basis, the most likely impact of the benefit received from the lessor is expected to be spread over the remainder of the lease term.

However, given the lack of guidance in FRS 102 and due to the number of permutations of lease amendments, an alternative accounting policy might be appropriate depending on the facts and circumstances.

12. Capitalisation of borrowing costs

Section 25 ‘Borrowing costs’ permits entities the choice of capitalisation of borrowing costs as part of the cost of the asset that are directly attributable to the acquisition, construction or production of a qualifying asset or expensing them to profit and loss.  Where the entity chooses the capitalisation policy, the capitalisation of borrowing costs as part of the cost of an asset must be suspended if the entity suspends production or construction of the asset.

In practice, for projects that are on hold due to the coronavirus, it is likely that isolation measures and the partial shutdown of economic activity will result in suspension of capitalisation of borrowing costs.

Get in touch

If you would like to speak to a member of our team about Financial Reporting, please contact us today.