COVID-19: Financial Reporting Implications
(accurate at 20 April 2020)
We have analysed the financial reporting implications of Covid-19 in three broad categories:
- Front-end - risks, uncertainties and viability
- Financial Statements
- Filing and other considerations
These are considered in greater detail below, please click the links to review each topic.
The Strategic Report
- Business model and strategy
- Business environment
- S172 statement
- Non-Financial Information Statement
The Directors’ Report
Going Concern and Viability Statements
Corporate Governance Statements
- Recognition and measurement
- Post-balance sheet event reporting and disclosures
- Reporting periods in 2020
- Interim reporting in 2020
- Impairment of property, plant and equipment and intangible assets including goodwill
- Net realisable value of inventory
- Recoverability of receivables
- Recognition provisions, including onerous contracts
- Idle capacity and vacant property
- Debt modifications and breaches of loan covenants
- Insurance for business interruption
- Revenue recognition
- Share-based payments
- Defined benefit pension schemes
- Sources of estimation uncertainty
- Filing accounts at Companies House
- Publishing financial statements for listed companies
Front End Annual Reporting
It is difficult to imagine that there are many active companies that have not been affected in some way by Covid-19. All of them should be informing users of the accounts about the effects on the company’s solvency, profitability and strategy. Even if your company is somehow unaffected, an explanation of why will still be important to the readers of the annual report. The level and detail of disclosures surrounding the impact of Covid-19 are, of course, dependent upon the significance of the impact that Covid-19 has had, and is expected to have, on the business’ operations and activities and there will be no standard format for this.
While the focus is principally on annual reports, many of the areas discussed here will also be of relevance to other areas of corporate reporting, including half-year reports and trading statements and the same insights may be useful for private communication with, for example, banks.
In many cases, the board’s immediate focus is likely to be on survival, or, for some, on dealing with the immediate impact on staff, supply chains and how to deliver goods or services to customers. These concerns will be mirrored by investors, whose focus has shifted abruptly to cash flow and solvency from growth. It is also worth considering, however, what the board’s decisions will look like after a crisis, how the focus on survival has impacted other stakeholders such as employees and suppliers and the company’s reputation. Some of this should appear in this year’s corporate governance and s.172 statements, though a fuller account may be required in the following year. Bear in mind, while dealing with the immediate effects, how the board will account for its actions and what factors are taken into account now are important.
Like the board, investors’ current attention will be on available cash and cash flows, how long the business can survive under lock-down and how resources will be preserved in order to be able to return to normal operations as the crisis abates.
Practical implications: The FRC has produced a very helpful infographic, which addresses five current questions that investors are seeking information on. The Financial Reporting Lab’s guidance suggests a number of helpful areas to consider under the headings of ‘Resources’, ‘Action’ and ‘the Future’. These will be key areas not only for the annual report but also for results and trading statements.
While the financial statements, in general, primarily look at history, the front-end of the annual report, and particularly the strategic report, should not only explain historic results but also look forward. We have grouped matters to consider into the following different sections of the annual report, but given the pervasive impact of Covid-19 many of them can be covered in more than one place:
- The Strategic Report
- Business model and strategy
- Business environment
- S172 statement
- Non-Financial Information Statement
- The Directors’ Report
- Going Concern and Viability Statements
- Corporate Governance Statements
We have grouped items broadly into the three headings used in the FRC’s 2018 guidance on the strategic report.
Business model and strategy
Boards of quoted companies and Public Interest Entities (PIEs) need to tell users about the effects on their strategy: has the crisis required temporary, or permanent, changes in the business model? The business should consider explaining whether the crisis has accelerated or delayed existing plans and strategic progress.
Possible considerations: Examples of the type of questions for companies to consider around business model may include:
Has the business accelerated any moves to selling items online or, for example, started home delivery it previously did not offer?
Are any new products being produced during the crisis?
Has the business sought new customers if, for instance, it previously sold to retail outlets but now able to sell direct to customers.
Have existing capital expenditure plans been cancelled or delayed to save cash and what will the effect of this be when the crisis abates?
Has (or will) new capital expenditure been required to facilitate a change in business model or more automation adopted to reduced dependence on or risk to staff?
Increased levels of remote working or high-level of staff absence may also impact on the effectiveness of the company’s internal controls or in some instances render them unworkable. This, and pressure on resources, may impair the timeliness and accuracy of its management information at a time when this is more important than usual. While such changes will largely be internal, it is worth considering what information the company can provide externally on such matters. There are several possible locations for such information in the annual report for example in business model, risks and uncertainties, or corporate governance. We consider this further under corporate governance below.
Trends and factors
Quoted companies must describe the main trends and factors likely to affect the company’s future performance. Given the situation with Covid-19, they will need to describe the effects on the company’s markets and the resulting effect on the company. In providing information on the period under review, it will be important to explain the extent to which the performance has been influenced by government grants and loans received across the group, recognising schemes vary in different countries.
Possible disclosure considerations: A quoted company might indicate services no longer possible or the proportional sales decline in key markets and the timing of this. If there are indications of recovery or a change in the business model to accommodate the crisis has begun to bear fruit this could be reported.
The report could also describe pricing effects on either its raw materials or its own products as a result of Covid-19, both positive and negative.
Risks and uncertainties
Addressing risks and uncertainties are going to be a key area given the Covid-19 crisis. There are now huge uncertainties as to how long the crisis will continue, when Government support plans will become effective, and when (or under what terms) they will need to be repaid. The longer-term effects on the economy are also unknown.
The effects of Covid-19 may have also exposed a number of risks to which most companies have been exposed in one way or another in the past, but nevertheless these risks were not previously near the top of the company’s risk register.
Potential disclosure considerations: There are several risks that will affect many companies, for example, direct income effects due to sudden falls in sales, bans on operations, and increased bad debts, liquidity effects due to delayed receipt of debtors or possible loss of access to borrowing facilities. Boilerplate disclosures on these are of little use, users of reports know everyone faces them. Companies should describe the sales channels or products most at risk and the potential extent of effect, the exposure to individual or sector bad debts or payment delays occurring or discussed, or the covenants at risk of breach. Companies should also describe their efforts to mitigate the risks and the effectiveness of these.
There will also be risks which are not directly financial, at least immediately: health and safety risks to staff and customers, potential failure of controls due to remote working or staff absence, assets reduced in value or stock rendered obsolete by the lock-down. Again, mitigating measures and alternative uses should be discussed though precise descriptions of plans for certain items (for example disposal of seasonal stock) may be inappropriate due to prejudice to the company’s interests.
There may also be financial risks related to the extent to which companies are dependent on current Government grant and loan schemes continuing to be in place in relation to key operations.
Companies should also describe the impacts of uncertainty about the current situation on their business and plans and what assumptions they have made. They should be able to describe, at least broadly, the impacts on their business under possible scenarios in order to allow investors to assess the resilience of the company.
Potential disclosure considerations:
What assumptions or scenarios has the board considered: how long might the lock-down be, what impacts have been considered for recovery – can the company respond to a sudden surge of repressed demand after the lock-down, permanent reductions in staff, or a lengthy economic downturn?
Has regard been given to the IMF and OB estimates of the economic impacts of the crisis which are seen as influential? If companies consider that their views on future scenarios are not in line with those in their industry it would be helpful to explain the reason for their views.
While users of the annual report will not expect boards to be able to accurately predict the future they may nevertheless be able to indicate areas affected or be able to describe the level of confidence they do have, even if lower than usual, in the company’s prospects.
Covid-19 is likely to have had an impact on both assets recognised in the financial statements and in other more intangible areas like workforce or reputation.
Requirements to report on these non-financial matters appear in several places, with the result that many entities have some requirement to report, although quoted and public interest entities are the most affected.
As a result, the employee/workforce and social impacts are likely to be more significant than usual for a large number of companies. These are considered further under Non-Financial Information Statements and s.172 Statements.
The effect of Covid-19 on business performance will be highly dependent on the year-end. Those with year-ends in December or possibly even January will not reflect the effects of Covid-19 in their financial statements because it was not apparent at the balance sheet date. Those with later year-ends are likely to reflect effects on longer lived assets and liabilities in balance sheets and notes and will, increasingly for later year-ends, show an impact in the income statement from ongoing operations.
The strategic report can, however, look beyond the balance sheet date in a way that the financial statements cannot. More up to date information, particularly for companies that have taken the opportunity to delay publication of their annual reports, is vital to investors seeking to understand Covid-19’s impact.
While boards will likely be unwilling, understandably, to produce profit forecasts in the current environment, they can be more confident of reporting on events that have happened between the balance sheet date and publication of the report, on leading indicators of business such as orders and of known impacts on necessary supplies or services. Boards will also be able, and expected, to provide an indication of their plans for reacting to the crisis in both strategic terms, as already mentioned, and more tactical measures such as: plans for reducing costs, particularly for facilities no longer operating, how they plan to preserve cash and, as discussed further under s.172 reports, how these affect other parties.
The urgency of this information is likely to have resulted in it being provided by way of trading statements for quoted companies and possibly in covenant negotiations with financers, but the annual report should also reflect this information where it is current and material.
Cash resources and cash flow
The cash position will already be disclosed at the balance sheet date, but if there are any known or potential restrictions or concerns about access to the cash due to its location in the corporate structure or geographically either through regulatory, tax or reputational issues these could be explained. Effects on the company’s access to finance through loans or overdrafts could also be material due, for instance, to actual or expected covenant breaches.
Any new sources of liquidity, new equity, new facilities arranged or parent company guarantees which help secure the company’s future should be disclosed.
Effects of mitigating actions such as reduction, delay or cancellation of dividends, changes in supplier or customer financing, changes in pension funding arrangements and delays in capital expenditure could also be provided. Where the board’s plans include actions which, either for this end or because they are required for employee or customer safety, result in reduced cash burn rates, the expected effect and time to reach that effect could be explained in terms of a cash burn rate during a total or partial shut-down of operations.
Any Government support and associated conditions and timing of reversal of these where known should be disclosed where material.
Companies could disclose changes in sales or profitability since the balance sheet date or since the beginning of the lock-down in the countries in which they operate. These could be split by market or product as appropriate. Changes in order books or cancelled orders could be disclosed (with careful consideration of whether the information value outweighs any prejudice to the company’s interests). Known effects on stock in supply chains or goods which may be returned and, of course, known or provided bad debts could be given. Potential changes in of the business’ own or supplier pricing as a result of the crisis due to alternative uses for products or decreased demand may also be useful to users.
In the case of publication later in 2020, companies could consider what signs there are of recovery pre or post balance sheet dates. Are there markets where lock-downs or other Government measures have been relaxed?
In addition to the more obvious effects of lost sales on income, for companies with year-ends after January 2020 there are likely to be effects on assets and liabilities that will need to be described. Some of these may not be obvious e.g. increased stock costs because volume discounts previously expected will not be received and others may be counterintuitive, e.g. accelerated charges from cancellation of remuneration schemes now out of the money. These will require further explanation where material.
While adjustments in KPIs may not be necessary, a description of the effect of the crisis on these and the timing of that effect is likely to be necessary.
Gender pay: While the Government’s suspension of gender pay reporting may be helpful in short-term resource management, it may be worth bearing in mind the impact of reactions to Covid-19 and considering whether these might impact the male and female members of the company’s workforce differently and how this can be explained.
This is a new statement this year and covers a large number of companies unused to reporting in this area (pre the crisis we produced guidance on this which companies may find helpful in producing this for the first time). Responses to Covid-19 will test its effectiveness severely. Whilst the early examples we have seen from public companies relate to business as usual, in those published from now on, boards will need to start to deal far more carefully with how they have balanced the interests outlined in s.172 against one another.
Cash flow measures driven by short-term survival may conflict with the company’s reputation with its customers, relations with employees and suppliers, and the stewardship of assets not recognised in the balance sheet such as corporate know-how and memory. It will also be important to discuss how conflicting interests of different stakeholders were balanced in decisions taken. Whilst earlier year-ends will be reporting on a period prior to the crisis, it seems inappropriate not to say something about how the company is dealing with these issues even if impacts are after the balance sheet date.
How companies conduct themselves in the crisis will reveal much about their resilience and how important they consider their relations with other stakeholders.
Possible disclosure considerations: Since this is a new requirement, most businesses will be reporting on who/what they identify as the key parties for their duty under s.172 for the first time. The crisis may have brought to light dependencies which were not previously considered critical or at-risk. For example: did a key supplier fail or become unable to deliver products, were raw materials unavailable or prohibitively expensive, were some groups of employees unwilling or unable to work? How did the company deal with such issues?
While the s.172 statement should report on the company’s engagement methods pre-crisis and under business as usual it should also look to inform readers how it engaged with other stakeholders as the depth of the crisis became apparent. Who did it consult or negotiate with and how?
How did it consider other parties’ interests when it made decisions as to which suppliers to pay on time or delay payment to, which employees to lay off or furlough? What procedures were followed to establish fairness or consider the company’s future reputation in this?
Non-Financial Information Statement
A non-financial information statement is required for public interest and traded entities with more than 500 staff. Two areas for which coverage is required are the company’s employees and social matters. There is some overlap here with s.172 statements, principal risks and the strategic and operational measures noted above that can be dealt with by cross reference, but some areas may increase in prominence during the crisis.
Possible disclosure considerations: The company could indicate how it dealt with health and safety risks during the crisis: if employees were still coming into the workplace an outline of how social distancing was achieved, what measures were followed to protect customers and if the local community were protected from the impact of employees travelling into the area to work.
THE DIRECTORS’ REPORT
One of the required disclosures in the directors’ report is that of financial risk management objectives and policies. These may have changed to reflect the board’s expectations of movements in exchange rates, increased chance of bad debts or security of finance.
The directors’ report requires disclosure of exposure to price, credit, liquidity and cash flow risks and of important events since the end of the financial year. If the company produces a strategic report, this is likely to be covered there, but if not, disclosure is required in the directors’ report.
The directors’ report also requires disclosure of likely future developments in the business. Again, where there is a strategic report, this will be covered there and cross-refenced from the directors’ report.
The directors’ report for large companies now requires a statement on how the company engaged with employees, and how it has provided information to them and consulted them in decisions likely to affect their interests. Whilst this is likely to be included in the s.172 statement in most cases it still requires cross reference from the directors’ report and is likely to be of substantially higher importance than it would have been in previous years.
The directors’ report for large companies also now requires a statement summarising how the directors have had regard to the need to foster the company’s relationships with suppliers, customers and others and the effect of that regard during the year. As for employees above, this is likely to have a higher prominence than might have been expected when the legislation was passed making it a required disclosure for 2019 year-ends.
Dividend and buy-back policy
For quoted companies, dividend policy and changes to it are likely to be described in several places in the report. Any dividend for the year is a required disclosure in the directors’ report as is information on the company’s repurchase of its own shares. Many companies will have reduced or suspended dividends or buy-backs during the crisis. Dividend policies may have changed and, for quoted companies, some indication of the nature of the change or when it might be reviewed should be provided in the strategic report. The s.172 statement could also address how the board made any dividend decision and how it considered other stakeholders in that process.
GOING CONCERN AND VIABILITY STATEMENT
Whilst these two items are closely linked and therefore considered together below, they are normally placed in different elements of the annual report.
Clearly there is a link here with the principal risks and uncertainties disclosed in the strategic report which will disclose the main risks facing the company. The FRC’s recently issued guidance on Covid-19 notes that companies should disclose judgements and assumptions which have the greatest effect on the financial statements and those relating to going concern are an obvious focus.
The FRC notes that it expects more companies to disclose material uncertainties relating to going concern. These are events or conditions which cast significant doubt on the company’s ability to continue as a going concern. Boards disclose these possibilities, though they should also consider realistic actions they can take and possibilities such as access to government support as mitigating factors.
Possible disclosure considerations: Significant judgements and assumptions in forecasts for assessing whether the company is a going concern are likely to include assumptions as to the period for which the directors assume the lock-down will run in the main territories in which they operate and the way in which countries are likely to emerge from it; judgements as to whether the company qualifies for Government aid and estimates or assumptions about the extent of this; and judgements or assumptions about any key changes in liquidity arising, for instance, from new bank facilities or longer credit terms imposed on or by the company.
The FRC is not entirely clear as to the detail of disclosure it expects here from boards – most would be reluctant to disclose, for instance, the maximum time they believe they can survive in a lock-down unless this extends beyond the going concern horizon. However, an indication that the board has considered at least a minimum period and some indication of the requirement or otherwise for access to Government support and possibly some detail of assumptions as to how the economy performs after lock-down should probably be considered.
It is also worth noting that the FRC’s pre-existing guidance on going concern indicates that the period covered should run at least 12 months from the date of authorisation of the financial statements.
The nature of the current crisis is rather different to previous banking crises or most economic downturns in that the greatest uncertainty is short-term. We may not know the precise timing of lock-down but the biggest hit is in the current year.
The risks causing this level of uncertainty will be the same as those in the going concern review. There are, however, a range of longer-term uncertainties, most obviously the extent and speed of economic recovery after the emergency. It is also possible that there will be permanent shifts in business models, either accelerating those already in progress or in reaction to this crisis. Again, boards should outline the key assumptions and stress or scenario testing they have considered. The FRC does expect companies to provide information about the degree of uncertainty and where it applies to the company.
CORPORATE GOVERNANCE STATEMENTS
Corporate governance impacts may be less obvious, but the effect of remote working, ensuring health and safety of employees and customers and potential unavailability of key staff may make some existing systems unworkable. Management information may also become less timely and less reliable at exactly the time when being able to react rapidly and effectively is most important.
Potential disclosure considerations: Boards will have considered the balance of risk against the need to keep operations functioning and will have developed new ways of operating both as a board and for the systems and controls of the company. Some discussion of these would be helpful to investors as would, where the timing of the report is such as to allow it, some discussion of short-term contingency plans for staff unavailability.
Boards could discuss the timings and agenda of their crisis meetings to help investors understand how they responded. They could discuss any required changes in operations to reflect members unable to attend. They could outline contingency plans which may temporarily be or have been in place in case of unavailability of key management.
Reflection on the current crisis may also lead to changes in business models to increase future resilience – perhaps more diversified and shorter supply chains or higher stock levels and a reassessment of the board’s risk appetite. The corporate governance report offers the company an opportunity to discuss the way these decisions were approached.
It may be necessary to develop new systems, reporting lines or governance and control structures temporarily to monitor the situation and respond rapidly under high levels of stress. The corporate governance or audit committee report may be an appropriate place to discuss these.
Financial statement reporting
Recognition and measurement
The impact of Covid-19 has various consequences for how income, expenses, assets and liabilities must be recognised and measured, whether reporting under International Financial Reporting Standards (“IFRS”) or FRS 102 “The Financial Reporting Standard Applicable in the UK and Republic of Ireland” (“FRS 102”).
Set out below are some of the key areas where we consider how the measurement and recognition in financial statements could be affected. However, in the first instance it is important for companies to consider whether the impact is an adjusting or non-adjusting post-balance sheet event.
Post-balance sheet event reporting and disclosures
Depending upon a company’s year-end, the impact of Covid-19 may be an adjusting or a non-adjusting event. For companies with a 31 December 2019 year-end, the spread of the virus after 31 December 2019 is a non-adjusting event because, at that date, only a few cases of the virus had been reported to the World Health Organisation. Accordingly, the subsequent spread, and identification, of Covid-19 after 31 December 2019 does not therefore provide additional information about the conditions that existed as at 31 December 2019 and is therefore a non-adjusting event. However, for companies with later year-end reporting dates, year-end balances might be affected.
Companies must ensure that non-adjusting events are disclosed within the financial statements, if material. Disclosure should include the nature of the event and an estimate of the financial effect, for example disclosing information about the impact on the carrying amount of assets and labilities and recognition of income and expenses.
Practical implications: When assessing whether the impact of Covid-19 is an adjusting or non-adjusting post-balance sheet event will depend on the company’s year-end reporting date, and also on whether an event (in the series of events relating to the spread of Covid-19) is considered by management to provide evidence of a condition that existed at the year-end reporting date.
In light of the information that was available as at 2019 year-end, the Covid-19 outbreak is considered to be as a non-adjusting event in the 31 December 2019 financial statements. As such, its impacts should not be factored into the financial statement balances and accounts as of 31 December 2019 but would impact disclosures.
If the impact of the Covid-19 outbreak is material, the entity is required to disclose the nature of the impact and an estimate of its financial effects.
The European Securities and Market Authority (ESMA) guidance issued on 11 March 2020 states that “issuers should provide transparency on the actual and potential impacts of Covid-19, to the extent possible based on both a qualitative and quantitative assessment on their business activities, financial situation and economic performance in their 2019 year-end financial report if these have not yet been finalised or otherwise in their interim financial reporting disclosures.”
As the impact of Covid-19 is evolving rapidly, management will need to carefully consider the accounting requirements of IAS 10 “Events after the reporting period”. The critical issue for management will be deciding on whether the latest developments provide more information about the circumstances that existed at the reporting date.
Reporting periods in 2020
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 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.
Practical implications: 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. Significant judgement will be needed to determine the conditions that existed at the balance sheet date and whether, therefore, the amounts recognised in the accounts need to be adjusted. This judgement will be heavily dependent on the reporting year end in question, the entity’s own individual circumstances, and the particular events under consideration.
Interim reporting in 2020
The 2020 interim reporting period will, for companies with calendar year-ends, be the first reporting period when the impacts of the Covid-19 will impact the measurement and recognition of assets and liabilities, income and expenses.
Under IAS 34 “Interim Financial Reporting” an entity shall include in its interim financial report an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period. Clearly, for most companies, the impact of Covid-19 will be significant and therefore will need to be fully and transparently explained.
Given the likely significance of Covid-19 it is expected that for many entities more information will be provided than usual in the 2020 interim financial statements. This disclosure should be entity-specific and should reflect each entity’s circumstances.
Practical implications: For preparing 2020 interim financial statements, companies will need to consider providing additional supplementary disclosures. Our expectation is that investors and other users of the financial statements will want to understand the specific impact of Covid-19 for the business and since the 2020 interims will be the first-time (for companies with a calendar year end) this is reflected in the measurement and recognition of assets and liabilities, income and expenses, disclosure will in practice need to be above and beyond what is typically disclosed. In addition, it should be noted that IAS 8 also requires disclosure of the nature and (if practicable) the amount of a change in estimate that has a material effect on the current period or is expected to have a material effect in subsequent periods.
Impairment of property, plant and equipment and intangible assets including goodwill
Companies need to assess whether the impact of Covid-19 triggers an impairment assessment and, if as a result of that, whether an asset impairment has occurred. Where an impairment review is carried out, companies need to consider the impact of Covid-19 on the inputs and assumptions used for financial projections.
For instance, management must assess whether a trigger event has occurred, such as the loss of key customer and/or supplier or reduction in financial performance due to disrupted production, and consequently assess the impact on the impairment calculations, such as revisions to estimated future cash flows and other key assumptions, such as discount rate and growth rate.
Practical implications: When performing impairment reviews, management should determine estimated cash flow projections based on inputs and assumptions in place as at the date the impairment review is carried out (i.e. as at the reporting date). If estimates are revised after the original impairment review date, these should only be taken into account in revising the impairment review if this occurs before the reporting date. Events after the reporting period, and information received after the reporting period, should be considered in the impairment indicator assessment only if they provide additional evidence of conditions that existed at the end of the reporting period. Accordingly, any changes in estimates, such as a reduction in forecast revenues, that are made after the reporting date (i.e. do not relate to conditions existing at the reporting date) and before the financial statements are authorised for issue, should only be disclosed in the financial statements, if the impact is material.
Likewise, sensitivity analysis that has been performed as at, or during, the reporting period, should not be updated to reflect revisions to future cash flow projections that management has made after the reporting date, however management should consider disclosing the revised sensitivity analysis for changes in the key assumptions where the information is material to users of the financial statements.
It should be noted that it is more important for an entity to provide detailed disclosure of the assumptions taken (and the evidence on which they are based) when uncertainty is greater.
Net realisable value of inventory
Companies must assess whether inventory is held at the appropriate carrying value, being the lower of cost or net realisable value, as at the reporting date. When determining the net realisable value of inventory, management must assess the estimated selling price of the goods less the estimated cost of completion and the estimated costs necessary to make the sale.
Practical implications: Principal factors that may lead to inventory net realisable values being less than cost include a reduction in estimated selling prices, an increase in selling costs or estimated costs to be incurred to make a sale and obsolescence of products - all of which are likely consequences on businesses as a result of the impact of Covid-19.
For instance, if stock is not able to be accessed because it is held within an isolated location, if stock becomes obsolete because of reductions in demand, or if the estimated costs to be incurred to provide products to customers are increased because of restrictions on accessibility and distribution, these may result in management assessing that inventory should be written down to its net realisable value.
Additionally, it should be noted that excess overhead resulting from “abnormal” production levels (i.e., production levels below the range of normal capacity due to the entity’s workforce having to stay at home), should not be allocated to inventory
Recoverability of receivables
Companies are likely to be impacted by the loss of customers and significant reductions in debts being paid due to customer’s experiencing financial or cash flow difficulties.
Companies reporting under IFRS need to assess the expected credit losses that will be incurred as a result of the impact of Covid-19 on their customers and recognise credit loss provisions for increases in expected non-recoverability of receivables. In performing this assessment, management must use reasonable and supportable information about past events, current conditions and the forecast of future economic conditions for determining the expected credit losses. The information used must be based on that available as at the reporting date.
Companies reporting under FRS 102 must assess whether, as at the reporting date, there is objective evidence of impairment, such as a customer being in significant financial difficulty or it being probable that a customer will enter bankruptcy, and where there is such evidence, an impairment loss should be recognised.
Practical implications: In these unprecedented times, determining the recoverability of receivables will likely be a key source of estimation uncertainty for most companies due to the high concentration of customers likely to be facing financial difficulty or insolvency. Management should therefore give careful consideration to indicators that their customers may be experiencing financial difficulty, such as later than normal payments or partial payments, and recognise impairment losses or make realistic provisions based on the losses expected, as necessary to the applicable reporting framework.
Expected credit losses shall be reassessed at each reporting date and shall reflect all reasonable information that are available at reporting date. Other than potential changes in the credit terms granted to its customers, given the potential changes in the debtors’ risk profiles as a result of the disruptions caused by the Covid-19 outbreak, management may want to review their provision matrix used in determining the expected credit losses, including the revision of the expected loss rates and assess the potential impairment or write-off of receivables.
Expected credit losses shall not be changed in the year-end financial statements due to subsequent events related to the Covid-19 outbreak.
We would direct users and preparers of financial statements to more detailed guidance on the accounting and prudential implications of the economic relief measures taken in light of the Covid-19 outbreak as issued through the European Markets and Securities Authority (ESMA) (https://www.esma.europa.eu/press-news/esma-news/esma-issues-guidance-accounting-implications-covid-19) and the statement issued by the European Banking Authority (EBA) for banks covering interpretative aspects on the functioning of the prudential framework in relation to the classification of loans in default, the identification of forborne exposures, and their accounting treatment (https://eba.europa.eu).
Recognition provisions, including onerous contracts
For a provision to be recognised, there must be a present obligation (legal or constructive) as at the reporting date as a result of a past event i.e. there must be an obligating event, it must be probable that the company will have an outflow of economic benefit, and the amount of the obligation can be estimated reliably.
Practical implications: The impact of Covid-19 is resulting in many companies changing the way the business is operated and as a result companies may be experiencing increased operating costs from needing to increase cleaning or employing additional staff to cope with distribution demand, or be experiencing loss of revenue from reduced customer demand. Future operating losses or future operating costs (unless onerous contract) or losses are not permitted to be recognised because they do not meet the conditions to be recognised as a provision.
Furthermore, companies need to consider whether any contracts may become onerous as a result of, for example, where there is expected loss of revenue, and/or increased costs associated with a contract. Where a contract has become onerous, a provision is required to be recognised. An onerous contract is a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it, where the unavoidable costs are the least net cost of exiting from the contract (this being the lower of the cost of fulfilling the contract and any compensation or penalties arising from failure to fulfil it).
For example, a UK company has a contract to deliver goods to a customer at a fixed price, however as a result of the closure of the business’ operations, the goods cannot be delivered. The company may either cancel the contract or seek to procure the goods from a third party. A provision should be recognised for the onerous contract at the lower of the cost of fulfilling the contract (i.e. the excess of the cost to procure the goods over the consideration receivable under the contract) or the cancellation penalty payable to the customer.
Practical implications: Some contracts that companies enter into may be able to be cancelled without any compensation needing to be paid to the other party to the contract, for example many standard purchase orders. Nevertheless, management should carefully review the terms and conditions of contracts to understand where there are cancellation terms with and without penalties and whether there are any specific terms that may release the company of its obligations under the contract.
Where management assesses that a contract has become onerous, then a provision should be recognised. However, if there are specific assets dedicated to a contract, before a separate provision is recognised for the onerous contract, management should carry out an impairment review on the specific assets and recognise an impairment loss where necessary.
It should be noted that any provision for onerous contracts shall reflect the conditions at the reporting date and should not be changed in the year-end financial statements due to subsequent events related to the Covid-19 outbreak.
Idle capacity and vacant property
Where buildings and sites become idle or vacant due to reduced demand and/or the non-availability of workforce, depreciation must continue to be recognised while the asset is idle or retired from active use unless the asset is fully depreciated. Where the facilities are leased, this may be an indicator that an onerous provision may need to be recognised under FRS 102 or a right-of-use asset impaired under IFRS.
Practical implications: Companies may be required to temporarily cease operations, such as closing a retail unit or ceasing production on a manufacturing site. For companies reporting under FRS 102, where the premises are rented, this may result in the lease contract becoming onerous. Management should assess the future economic benefits (i.e. the future cash flows expected to be earned from operating the premises) and where they do not exceed the present value of the remaining lease rental payments under the contract, an onerous contract provision should be recognised. Any assessment should reflect the conditions existing at the reporting date.
Debt modifications and breaches of loan covenants
Given that companies are likely to start experiencing financial difficulties, particularly for example as a result of declining demand and customer spending, companies may need to consider restructuring existing loan arrangements or may need to seek additional financing with new or existing lenders. For instance, companies may need to amend terms and conditions of existing loans, such as changing interest rates, borrowing additional funds or modifying other contractual terms. Management must give careful consideration to the requirements in this area as to whether the debt restructuring should be accounted for as a modification or extinguishment of the debt.
Companies may also wish to discuss with their existing lenders whether any changes in debt covenants may be necessary to avoid any potential breaches. Where a debt covenant is breached, this could have an impact on the classification of the loan with the financial statements as current/non-current as at the reporting date. Where the breach triggers a repayment on demand clause i.e. that gives the lender the right to demand repayment at any time at their sole discretion, then the loan should be classified as current, unless a waiver is obtained.
Practical implications: Management should ensure that any waiver, in respect of a breach of a debt covenant, must be obtained from the lender as of the reporting date in order to avoid reclassification of a loan from non-current to current. Where a loan is required to be reclassified as a current liability within the financial statements, management should also give consideration to any consequential impact on the company’s going concern status.
Insurance for business interruption
Companies that have insurance policies in place to cover business interruptions must carefully consider the circumstances when recognising any potential pay-out from the policy. Gains receivable under a policy should not be recognised until the contingency is considered resolved and recovery of any pay-out is virtually certain. Prior to this, the policy is likely to be only disclosed as a contingent asset where an inflow of economic benefit is considered probable.
Practical implications: When business is interrupted, an insurance recovery of lost profits or revenue would not be recognised until when it is virtually certain that the loss will be reimbursed.
Management should carefully review the terms and conditions of the insurance policy to understand the nature and level of losses that are covered. It can often be the case that there are uncertainties about whether any, and how much, compensation will be payable and on what terms. When determining, therefore, whether an insurance pay-out may be recognised as an asset, the most reliable source of evidence available to management would be direct confirmation from the insurance company that the claim has been authorised. The company should also consider any stipulation from the carrier (e.g., “pending final review”).
Companies must give careful consideration when determining the amount of revenue to be recognised under customer contracts. Revenue may only be recognised if collection of the consideration that the company is entitled to under the contract is probable, when determining the contract’s transaction price, variable consideration may only be recognised if, and to the extent that, it is highly probable that a significant reversal will not occur when the uncertainty is resolved.
Practical implications: Where companies are experiencing reduced consumer demand and spending and/or disruption to production and distribution, management must give particular consideration to assessing whether the ‘probability’ threshold for recognition of revenue under a contract is met, as well as whether variable consideration should or should not be included as part of the transaction price. Accordingly, management should consider carefully the expected impact of discounts, returns, refunds, credits and penalties when assessing the amount of revenue to be recognised.
There also may be an impact on revenue recognition for situation where it is not probable that the entity will collect substantially all of the consideration, because the criteria for a contract are not met.
Companies with employee share award schemes, such as share option schemes, are likely to be significantly affected by falling share prices, thereby resulting in out of the money awards for employees. Management may therefore wish to consider modifications to the existing schemes, for example by reducing the exercise pricing or options or modifying performance conditions, to make the awards incentivising for employees again, or alternatively consider cancelling the scheme. Where this is the case, management must consider carefully the requirements to ensure the accounting appropriately reflects the changes made. Modifications that increase the fair value of the share awards granted result in the incremental fair value being recognised, whereas cancellations accelerate the remaining fair value charged to be recognised immediately.
Practical implications: Given the on-going uncertainty that the impact is Covid-19 is having on businesses, especially regarding the length and scale of the impact, management may need to review the impact on its share-based payment charge particularly where the schemes include market performance conditions.
In the future to continue to motivate employees share schemes companies may need to be modify their share awards. e.g. lower exercise prices, amended performance targets or extended option life. It should be noted that modifications to share award schemes may have significant accounting consequences for the share-based payment charge.
Defined benefit pension schemes
The valuations of companies’ defined benefit pension schemes are being significantly impacted as a result of falling stock market prices and consequential reductions in plan asset values. Companies must ensure that the carrying value of the net defined benefit liability (or asset) is reviewed at the reporting date to reflect the current fair value of the plan assets.
Practical implications: The impact of Covid.19 is likely to have had a significant effect on defined benefit schemes and particularly the value of plan assets. Management should consider whether any of the assumptions used to measure employee benefits should be revised e.g. the yield on high-quality bonds.
Where the valuation of the scheme increases a deficit, or reduces a surplus, management should also give consideration to the consequential impact on the company’s going concern status and hence the disclosures to be provided
Certain additional advice for trustees, employers and administrators has been provided by The Pensions Regulator https://www.thepensionsregulator.gov.uk/en/covid-19-an-update-for-trustees-employers-and-administrators
Sources of estimation uncertainty
Companies must provide disclosures regarding the key sources of estimation uncertainty that management has made in preparing the financial statements, specifically those with a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the ensuing financial year. Disclosures of key sources of estimation uncertainty is vital to ensure that investors and other stakeholders of companies’ financial statements receive transparent information.
Practical implications: Management should assess and disclose information about the most difficult, subjective or complex areas of estimation uncertainty that have been faced when preparing the financial statements. Disclosure should include: the nature of the assumptions or other estimation uncertainty; sensitivity of carrying amounts to the methods, assumptions, and estimates underlying their calculation; and the expected resolution of the uncertainty and the range of reasonably possible outcomes within the next financial year.
Filing and other reporting requirements
Filing accounts at Companies House
Companies House has announced that they may grant an extension on a filing deadline, if it becomes apparent immediately before the filing deadline that the company will not be able to file its financial statements on time due to the impact of Covid-19. Companies may make an application to extend the period allowed for filing their financial statements and it is advised that they should act before the filing deadline is reached.
Practical implications: Companies need to ensure that they apply for an extension before the filing deadline is reached. For further details about applying for an extension, refer to the Companies House website.
Publishing financial statements for listed companies
On 26 March as part of a wider initiative, the FCA announced temporary relief for listed companies facing the challenges of corporate reporting during the coronavirus crisis.
This temporary relief will permit listed companies which need the extra time to complete their audited financial statements an additional two months in which publish them. Currently, under the Transparency Directive, companies have four months from their financial year end in which to publish audited financial statements. Under the temporary relief announced the FCA will, among other things, forbear from suspending the listing of companies if they publish financial statements within 6 months of their year-end.
Given the uncertainty surrounding Covid-19, companies need to continually monitor developments and ensure that they are providing up-to-date and meaningful disclosure when preparing annual reports and financial statements, as the disclosures required to be provided will likely change over time.
There are many areas in the financial statements where there could be implications for your current or future reporting. We consider it important that companies carefully consider the potential implications of Covid-19 when preparing or issuing any financial information.
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