How will the COVID-19 pandemic affect your Financial Statements?

Covid 19 and financial statement

The coronavirus (COVID-19) pandemic has resulted in severe business and economic crisis around the globe. Many countries have launched quarantine measures to prevent the spread of communicable disease. As a result, businesses are increasingly concerned about the loss of revenue and disrupted supply chains, and hence cashflows and going concern. And this brings us to accounting and reporting. Yes, with fluctuating valuations and uncertain volatility, these areas are also being affected.

To understand the current market situation, we have to closely look at what is happening. In many industries, operations have stopped and logistics networks have been disrupted. The restricted movement of people has not only separated companies from their customers but has severely eroded customer purchasing power, resulting in reduced demand. The resultant situation has forced businesses to defer non-essential spending and offer concessions to their customers. With dwindling revenue and mounting losses, financial risk has further wreaked havoc in the industry.

This may not be the complete picture as the destruction Coronavirus has brought along is beyond our thoughts. With the outbreak of COVID-19 continues all around the world, businesses, large or small, have started developing contingency plans, reworking their financial goals and budgets and devising possible solutions to address the potential risk.

Many entities are aware of the challenges they’ll face as they work on issuing interim or year-end financial statements of their companies. As there may be entities who are yet to issue their year-end financials, and in such a case, they might have to disclose material subsequent events as a result of the COVID-19 pandemic. The impacts on the financial position of the company are inevitable, although it may be too early to determine the full extent of financial health yet.

Since the estimation process is inherent in financial reporting, the current market conditions have prompted entities to take a closer look at impairment, contingency plans and valuations. Let’s take a look at how some of the elements of financial statements may be impacted due to the ongoing situation.

Impairment of Goodwill

When an occurrence of an event or changes in circumstances has serious implications on the future cash flow of the entity and may reduce the fair value of a reporting unit below its carrying amount then, under the accounting rules, a goodwill impairment analysis will be required. However, it is important to understand the severity of the triggering events and whether the impacts will be temporary or permanent.

Impairment of Long-term Assets

An impairment loss can be defined as the drastic reduction in recoverable amount of the fixed asset. When the carrying value of certain assets or asset classes exceeds its fair value, due to adverse changes in the business climate, then the need to perform impairment assessment of long-term assets arises. 

The effects of economic downturn, as a result of COVID-19, have produced substantial doubts about the recoverability of the carrying amounts of assets and thus have triggered an impairment test for long-terms assets for many entities across a variety of industries around the world.

Net Realizable Value of Inventories

IAS 2 Inventories provides guidance on the accounting treatment of inventories that includes determination of the cost of inventories, subsequent recognition of an expense and any write-downs to net realizable value. Any subsequent losses need to be recognized immediately.

The COVID-19 outbreak has affected this estimate due to a decline in the level of demand and disrupted supply chains. Perishable products that have short shelf lives or seasonal goods are particularly at high risk of impairment.

Companies are required to make necessary disclosures concerning the write-down of inventories to net realizable value.

Reduced manufacturing levels and increased capacity costs

Since operations in many organizations have curtailed, production capacity has reduced drastically as a result. While the shortage of material and labor continues, the manufacturing levels have dropped to extremely low levels. This means companies are unable to allocate excess fixed overhead costs to production due to idle production capacity. Underutilized capacity due to excess fixed overhead will have to be expensed in the same period it is incurred.

Impairment of receivables and investments

Given the current situation of economic downturn and financial crisis, companies should consider the impacts of significant fluctuations in the value of investments and evaluate for potential impairment. Investments that are particularly affected by COVID-19 are debt and equity instruments issued by entities. The process of evaluation, however, varies for different types of instruments.

Fair value measurements

There are certain assets, like an investment property, that are measured at fair value and require significant disclosures related to its fair value measurement. Given the current situation of a volatile market, performing a valuation can be extremely challenging for companies.

Companies may be required to use expert valuers to assess the fair value of assets for which quoted prices aren’t available. Nonetheless, entities cannot ignore the latest market prices in the valuation process. Also, according to IAS 34, specific disclosures concerning fair value measurement is a mandatory requirement.

Debt modification and loan covenants

Due to declining revenue and increased operating costs, as a result of the COVID-19 pandemic, companies are facing acute cash flow challenges. This may mean seeking additional financing, revisiting existing debt arrangements or even obtaining waivers and renegotiating debt contracts. Whatever debt modification arrangements are made by the company, accounting and reporting treatments will have to be considered accordingly. In any case, if the agreement is breached, the debt will need to be classified on the balance sheet.

Revenue recognition

According to IFRS 15, Revenue from contracts with customers, revenue recognition takes place when it is probable that the company will receive substantially all of the consideration from the customer to which it is entitled. At any point in time, if the collection isn’t probable then the company is required to evaluate whether the existing arrangement still qualifies as a revenue contract under IFRS 15.

The negative impacts of the COVID-19 outbreak have compelled companies to assess the value and estimates of variable considerations such as discounts, bonuses, penalties and refunds in customer contracts.

As companies continue to offer products and services to customers affected by Coronavirus, the ability of the customer to pay the outstanding and future invoices of the company will have to be carefully assessed. This could mean recognition of bad debts and even impairment if the current market scenario changes the ability of a customer to pay.

Going concern

The coronavirus outbreak has left many businesses struggling for their survival. As the economic crisis evolves, companies are concerned about the consequences – Will the business have enough cash flow to survive through the next 12 months?

Using the principle, it is the management’s responsibility to assess whether the company will continue to remain in business considering the current circumstances. Due to the absence of significant information on potential impact, there may be substantial doubts on the company’s ability to continue as a going concern basis for a foreseeable period of time. Under this assumption, the company will have to make the necessary disclosure in the financial statements.   

Force majeure under agreements

Penalties related to termination of contracts and force majeure clauses

The failure to meet contractual obligations are met with significant penalties. As an example, many organizations might have to cancel events and conferences, which will not only result in the loss of deposits but the company may be imposed with penalties. Even if the company has not yet cancelled any events, they may still have to consider the issues related to deposits and potential penalties that may arise in the future if the cancellation becomes probable. Hence, it is important to review all available contracts and force majeure clauses as such non-recurring costs will need to be appropriately measured and disclosed in the company’s financial statements.

Final Thoughts!

Given the uncertainties involved, nearly all companies around the globe are struggling as a result of the economic downturn. As events continue to evolve, companies are required to capture accurate numbers and estimation of the impact of risks and uncertainties involved. It is important that the impact of COVID-19 on financial statements are adequately communicated to the concerned stakeholders, auditors and the Audit Committee.

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