Financial Reporting & Auditing considerations on account of Covid-19

Due to increased economic uncertainty it may have major financial reporting consequences like on Supply chains, distribution chains, cash-flows, demand, price variations, facility access, workforce availability, debt obligations, contract cancellations, are experiencing turbulence. The role of preparers of financial statements, audit committees, auditors and regulators become critical in this situation. Distilling the impact through the requirements of existing accounting and auditing requirements frameworks and communicating it effectively will enable financial markets to base their decisions on such robust and dependable inputs.

There will be issues to consider for this year’s reporting as well as in future years. Every entity would need to consider the financial impact on itself and the areas of the financial statements that will be affected along with determining the required disclosures and areas that are likely to require close consideration include the following:

(1) Impairment of assets

Impairment of assets becomes the foremost financial reporting consideration, given that testing of impairment is predominantly based on the earnings. The assumptions such as the fall in demand, impact of lockdown, fall in commodity prices, decrease in market interest rates, manufacturing plant shutdowns, shop closures, reduced selling prices for goods and services, cost of capital, etc. may have a meaningful impact on the impairment testing performed by entities. Whilst most entities would perform impairment testing on an annual basis, the current Covid-19 situation would qualify for being an ‘indicator’, thereby requiring entities to test for impairment even in the interim.

(2) Going concern

Financial statements are prepared on a going concern basis unless management intends either to liquidate the entity, or has no realistic alternative but to do so. With business models being challenged especially in the travel, hospitality, leisure and entertainment segments, companies may need to consider the implications on the assessment of going concern and whether these circumstances will result in prolonged operational disruption, which will significantly erode the financial position of the entity or otherwise result in failure. It is the responsibility of management to make an assessment as to whether the entity is a going concern or otherwise. The unprecedented and uncertain nature of the pandemic makes it imperative for an entity to evaluate various scenarios that are possible and assess their impact on the assumption of going concern. Inability to satisfy the assumptions of going concern would lead to deviation from historical cost-based accounting. Management should also expect an informed and sometimes contrarian dialogue with auditors on the aspect of going concern.

(3) Valuation of inventory

With social distancing norms in place, entities may not have been able to carry out their annual physical inventory count fully or even partially on the cut off date. Due to the lockdowns, auditors and companies may need to rely on additional alternate procedures to gain comfort on the position and valuation as on 31st March, 2020.

Companies would need to assess whether, on their reporting date, an adjustment is required to the carrying value of their inventory to bring them to their net realizable value in accordance with the principles of Ind AS 2 –Inventories and AS 2 – Valuation of Inventories. Given the pandemic, net realisable value calculation will likely require more detailed methods and assumptions, e.g. write-down of stock due to lesser expected price realisation, reduced movement in inventory, expiry of perishable products, lower commodity prices, or inventory obsolescence. The usability of raw materials and work in progress may also require close consideration. A typical question arises in relation to allocation of overheads to the valuation of inventory. If an entity ceases production or reduces production for a period oftime, significant portions of unallocated fixed production overheads (e.g., rent, depreciation of assets, some fixed labour, etc.) will need to be expensed rather than capitalised, even if some reduced quantity of inventory continues to be produced.

(4) Lease and onerous contracts

The implications of force majeure provisions on contracts and leases remain to be tested. It is possible that there may be changes in the terms of lease arrangements or lessors may grant concession to  essees with respect to lease payments, rent-free holidays, additional days in subsequent period, etc. Such revised terms or concessions shall be considered while accounting for leases which may lead to the application of accounting relating to the modification of leases. However, generally anticipated revisions are not taken into account..

(5) Expected credit loss (ECL)

ECL is an expectation-based probability weighted amount determined by evaluating a range of possible outcomes. It enables entities to make adequate provisions for nonrealization of financial assets including trade receivables. Ind AS 109 – Financial Instruments requires an entity, amongst other matters, to also evaluate the likelihood of the occurrence of an event if this would significantly affect the estimation of expected losses of financial assets. In assessing the expected credit loss, management should consider reasonable and supportable information at the reporting date. Covid-19 impact would require to be factored in the ECL probability model of entities. Expected credit losses may increase due to an increase in the probability of default for financial assets. Additionally, the effects of the coronavirus may trigger a significant increase in credit risk, and therefore the recognition of a lifetime ECL provision on many financial assets. Event-based provisioning in relation to specific instances, like a customer turning insolvent or a specific financial investment getting affected, would continue to be factored in irrespective of the ECL.

(6) Revenue recognition and borrowing costs

Ind AS 15 – Revenue from Contracts with Customers often requires a company to make estimates and judgements determining the timing and amount of revenue to be recognised. Covid-19 may result in a likely increase in sales returns, decrease in volume discounts, higher price discounts, etc. Entities may need to account for returns and refund liabilities towards the customers whilst recognising the revenue. Ind AS 115 requires an entity to defer a component of revenue to be recognised when the contract includes variable consideration. This may result in some entities recognising a contract liability rather than revenue, if significant uncertainty exists surrounding whether the entity will realise the entire consideration. Separately, the guidance on borrowing costs requires an entity to suspend the capitalisation of borrowing costs to an asset under construction for such extended periods that the actual construction of the asset is suspended.

 (7) Deferred tax

Ind AS 12 – Income Taxes requires that the measurement of deferred tax liabilities and deferred tax assets shall reflect the tax consequences that would follow from the manner in which the entity expects, at the end of the reporting period, to recover or settle the carrying amount of its assets and liabilities. Covid-19 could affect future profits and / or may also reduce the amount of deferred tax assets or create additional deductible temporary differences due to various factors (e.g. asset impairment, non-utilisation of available losses, change in projections). Entities having deferred tax assets on account of accumulated tax losses would need to reassess their measurement with a newer set of business projections.

Entities may have considered the assumption of ‘indefinite reinvestment’ and not recognised deferred tax on accumulated undistributed earnings of subsidiaries. Such assumptions may need to be revisited to determine if they remain appropriate given the entity’s current cash flow projections.

(8) Fair value and hedge accounting

Ind AS 113 – Fair Value Measurement recognises the fact that observable inputs being considered for deriving fair value may be either of (i) observable market price (quoted price in an active market – Level 1) or (ii) application of valuation techniques (Level 2 and Level 3). With 1,500 companies trading at their 52-week low on the Stock Exchange, the fair value measurement considered by entities may need a re-look across all three methods of observable inputs. While volatility in the financial markets may suggest that the prices are aberrations and do not reflect fair value, it would not be appropriate for an entity to disregard market prices at the measurement date, unless those prices are from transactions that are not orderly. The financial assumptions in a valuation model like discounting rate, weighted average cost of capital, etc. that are considered in a Level-3 valuation would need a reassessment. Hedge effectiveness assessment is required to be performed at the inception and on an on-going basis at each reporting date or in case of a significant change in circumstances, whichever occurs first. The current volatility in the markets may result in an entity requiring to either re-balance the hedge where applicable, or discontinuing hedge accounting if an economic relationship no longer exists, or the relationship is dominated by credit risk. Certain opportunistic and speculative transactions may also take place. When a hedging relationship is discontinued because a forecast transaction is no longer highly probable, a company needs to determine whether the transaction is still expected to occur. If the transaction is: (i) still expected to occur, then gains or losses on the hedging instrument previously accumulated in the cash flow reserve would generally remain there until the future cash flows occur; or (ii) no longer expected to occur, then the accumulated gains or losses on the hedging instrument need to be immediately reclassified to profit or loss.

(9) Disclosures and management guidance

Transparent disclosures should be made on the effects and risks of this outbreak on the entity. The Securities and Exchange Commission instructed publicly traded companies to provide ‘robust’ disclosures on the impact of Covid-19 on their operations and results. Entities would need to disclose the impact of Covid-19 on their performance, including qualitative aspects of the business.