The novel coronavirus (COVID-19) pandemic is spreading around the globe rapidly. The virus has taken its toll on not just human life, but businesses and financial markets too, the extent of which is currently indeterminate. Entities need to carefully consider the accounting implications of this situation.
While the outbreak has had an impact on almost all entities either directly or indirectly, some of the worst-hit sectors are aviation, hospitality, and retail with more and more sectors coming under its radar with widespread lockdowns being enforced across the world.
This article identifies key financial reporting areas that entities need to consider when determining the impact on their business, and on the results, financial position and disclosures in their financial statements. This is not an exhaustive list and there may be other areas that are not included in the article that entities should consider.
(A) GOING CONCERN ASSUMPTION
- The Financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Management of the entity should assess the impact of COVID-19 and the measures taken on its ability to continue as a going concern. The impact of COVID after the balance sheet date should also be considered in assessing whether going concern assumption is appropriate or not.
- Some entities may be experiencing supply chain disruptions. Real estate companies with inventories of under-construction properties could be impacted by a fall in property prices. Seasonal inventories and perishable products might be exposed to the risk of loss due to damage, contamination, physical deterioration, obsolescence, changes in price levels or other causes. 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 AS 2 ‘Inventories’.
- Estimating net realizable value in such volatile market conditions may also is a challenge, on account of the uncertainties presented by the pandemic.
- If an entity’s production level is abnormally low (e.g. due to a temporary shutdown of production), it may need to review its inventory costing to ensure that unallocated fixed overheads are recognized in profit or loss in the period in which they are incurred (i.e. “excess capacity” should be expensed rather than being added to the cost of inventory).
(C) REVENUE RECOGNITION
- Entities to whom AS is applicable may have postponed recognition of revenue due to significant uncertainty of collection in view of the impact of COVID-19. AS-9, Revenue Recognition requires entities to disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties.
- If the entity’s contract with the customer includes variable components (e.g. discounts), the entity must consider whether its previous estimates in this regard continue to be appropriate.
- Certain revenue contracts may also become less profitable or even loss-making. For example, an entity might face penalties because of delays or incur increased costs that cannot be recovered due to replacing employees or finding alternative suppliers. Management needs to consider whether any contracts are in an ‘onerous’ position and whether a liability/provision needs to be recognized.
- Onerous contracts are those contracts for which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. Unavoidable costs under a contract are the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. As a result of COVID -19, some contracts may become onerous for reasons such as the imposition of penalty due to delay in supply of goods or increase in the cost of material, labor, etc. Management should consider whether any of its contracts have become onerous. The same should be accounted for as per AS 29. Management should disclose that it has assessed whether executory contracts are onerous due to the adverse impact of COVID -19. If, the management is unable to assess whether some of the executory contracts have become onerous due to the inadequacy of information, the same should be disclosed.
(D) PROPERTY, PLANT AND EQUIPMENT (PPE) & INTANGIBLE ASSETS
- Due to COVID-19, PPE can remain under-utilized or not utilized for a period of me. It may be noted that the standards require depreciation charge even if the PPE remains idle. Further, COVID-19 impact may have affected the expected useful life and residual life of PPE.
- Significant changes in the extent or manner in which the asset is used or is expected to be used (e.g. idling of a machine such that its future productive capacity may be affected, a machine being used in a manner different from its intended purpose – such as to produce items to support the battle against COVID-19 – which may reduce its future productive capacity
- Significant changes in the legal factors or business climate that could affect the value of the asset (e.g. an entity expects a decrease in its exports to a particular foreign market as a result of lengthy border closings)
- In addition, doubt about the entity’s ability to continue as a going concern is a general indicator of impairment for all assets.
(E) EMPLOYEE BENEFITS
- As a result of difficult economic conditions, some entities have or will downsize their workforce. If the entity offers or is required to pay termination benefits to the affected employee(s), management must consider how and when to account for the liability/expense
- Measuring a defined benefit obligation involves making estimates and the use of assumptions (e.g. the appropriate interest rate, future salary increases, and employee turnover). Given the sudden fall in markets and the decline in high-quality corporate bond rates that have occurred as a result of COVID-19, an entity should consider the impact on its defined benefit obligation(s).
- Entities should have discussions with their actuaries, to ascertain whether COVID-19 has impacted any assumptions in their reports such that their estimates may need to be revisited. The guidance related to subsequent events on whether there may be an adjusting or non-adjusting event should also be considered.
(F) INVESTMENTS (OTHER THAN PORTFOLIO INVESTMENTS)
- In respect of financial assets within the scope of AS 13, Accounting for Investments, entities may have to carefully consider the requirements of making provisions for the decline in the value of investments, which is other than temporary
(G) BORROWING COST/DEBT REPAYMENT
- AS-16 requires that the capitalization of interest is suspended when the development of an asset is suspended. The management may consider this aspect while evaluating the impact of COVID-19.
- Some financial institutions (and other creditors) are providing debt holders with the option to defer principal payments for a period of time. Management will need to assess whether the change in terms represents a modification or extinguishment of the debt obligation and revisit the portion of the debt that is considered current versus non-current.
(H) FOREIGN CURRENCY TRANSLATION
- An entity is required to translate foreign currency transactions into the reporting/functional currency using the spot rate in effect on the date of the transaction. As a practical expedient, an entity may translate revenue earned and expenses incurred in a foreign currency using an average rate. However, some exchange rates are fluctuating significantly during this period of economic uncertainty. As a result, an entity may need to revisit the way it translates foreign currency transactions in its income statement and assess whether its current accounting is appropriate.
(I) INSURANCE CLAIMS FOR BUSINESS INTERRUPTION
- An entity may have an insurance policy that covers losses from business interruption. If the entity is forced to temporarily cease operations as a result of COVID-19, it may be entitled to recover some or all of its losses from its insurance provider. Such claims would be contingent assets in the financial statements if the entity has a clear right to reimbursement. While contingent gains/assets are not recognized in an entity’s financial statements unless they are virtually certain
(J) TAX CONSIDERATIONS
- g. impact of reduced flow of goods and services on transfer pricing agreements; recoverability of deferred tax assets.
(K) LEASE TERM AND CONTRACTS
- Due to COVID-19, there can be changes in the terms of lease arrangements or lessor may give some concession to the lessee with regard to lease payments. Such revised terms or concessions shall be considered while accounting for leases. However, the anticipated revision should not be taken into account.
- The discount rate used to determine the present value of minimum lease payments of new leases may need to incorporate any risk associated with COVID-19.
- If any compensation is given/ declared by the Government to the lessor for providing concession to the lessee, it should be considered whether the same needs to be accounted for appropriately as per AS 19. Whether any assistance received from the government is government grants under AS 12.
- Entities will need to determine whether as a result of COVID -19, any lease arrangement has become onerous. The same should be accounted for as per AS-29.
(L) IMPAIRMENT ASSESSMENT
- AS 28 Impairment of Assets, requires an entity to assess, at the end of each reporting period, whether there is any indication that non-financial assets may be impaired.
- Due to COVID-19, there might be the temporary ceasing of operations or an immediate decline in demand or prices resulting in a lowering of revenues and profitability and reduced economic activity. These are the factors that the management may consider as the indicators that may require impairment testing for the purpose of AS 28.
- If the entity is unable to assess the impact of COVID-19 in estimating the impairment loss due to the inadequacy of information, the same should be disclosed appropriately.
We hope you have found the information in the article useful. Now more than ever the need for clients and their auditor or advisor to work closely together is essential, so if you would like to discuss any of the points raised, please contact us at [email protected]