To guide auditors as well as chartered accountants, ICAI has developed an advisory note on the ‘Impact of the Coronavirus on Financial Reporting and the Auditor’s Consideration’. The following are the key areas that require particular attention of the business entities in respect of financial statements for the year 2019-20.
Due to the closure of production units and consequently the reduction in the normal production capacity, it would become necessary for the business units to write down inventories to ‘Net Realisable Value’.
Net realizable value is nothing but the net amount that a business unit expects to realize by selling inventory during the ordinary course of business. In other words, the net realizable value is equal to the estimated selling price less estimated cost of completion and sale.
Since fixed production expenditure allocated to each unit of production is based on the normal production capacity, business units would have to reduce such an expenditure due to disrupted production as a result of coronavirus.
Impairment of Non-Financial Assets
According to the accounting standards, every entity needs to assess whether there is a need for the impairment of assets at the end of each reporting period. Such an assessment must be carried out only if there are factors indicating that non-financial assets require impairment.
If such indications exist, then the business units will have to estimate the recoverable amount of assets which is nothing but higher of fair value less costs of disposal and value in use.
Further, to recognize an impairment loss, the business units assess future cash flows, estimate the time value of money and risks associated with a specific asset. Due to COVID-19, revenues and profitability of business units are impacted to a great extent as a result of operations coming to a standstill. Therefore, to determine the possibility and the value of impairment loss, business units would have to consider whether:
- disruption in economic activity is an indicator of impairment
- any changes are to be made in the assumptions used for assessment of impairment before COVID-19 outbreak
- any adjustments to be made to the assumptions used to determine the discount rate
- forecasts or budgets for future cash flow need to be updated
- assumptions to determine the fair value needs to be reconsidered, etc
Business units have to recognize and measure the impairment loss on financial instruments such as loans, trade receivables, investment in debt instruments, etc, based on Expected Credit Loss (ECL). Due to the spread of COVID-19, the economic activity of business units contracted to a great extent and hence it might have a great impact on the ECL and its classification.
Therefore, business entities have to consider the following factors while recognizing impairment loss on such financial instruments:
- deciding between recognizing 12 month ECL or lifetime ECL. This is based on categorizing the credit exposures into three buckets:
- Stage I – indicates no significant increase in credit risk
- Stage II – indicates a significant increase in credit risk
- Stage III – indicates credit impairment
- While measuring ECL, following risk parameters need to be considered:
- risk of default
- the estimated amount of loss in the event of default
- exposure at default due to the utilization of undrawn limits and loan commitments
- Entities would have to develop scenarios to consider the potential impact of COVID-19
- Business units would have to consider events like lenders of the borrower, borrower’s financial difficulty, gran of concession to a borrower, etc in order to determine whether the financial asset is credit-impaired or not
- Business entities would also need to consider any prudential regulatory actions like repayment holidays, reduction in interest rates, etc
- Entities need to disclose the impact of COVID-19 in terms of methods, assumptions, and information used to estimate ECL
- In case it is not possible to assess the impairment loss due to lack of information, business entities should disclose the same.
Fair Value Measurement
To calculate fair value, business entities either use a market price approach or valuation techniques. However, due to the impact of COVID-19 on financial and capital markets, the business entities would have to consider its impacts on various assumptions including discount rates, credit spread, etc.
For hedge accounting, the following are the factors that business entities need to consider :
- in case of cash flow hedge accounting used for certain forecasted transactions, entities need to assess whether a given transaction still qualifies a highly probable forecast transaction
- business entities need to assess hedge ineffectiveness and record its impact in P&L
- entities need to estimate the fair value of derivatives and consider the impact of COVID-19 on underlying assumptions
For leases, the accountants need to consider the following factors:
- While accounting for leases, consideration must be given to the revised terms of lease arrangement or concessions given by a lessor to a lessee in terms of lease payments, rent-free holidays, etc.
- The changes in variable lease payments linked to revenue from assets also need to be considered
- The risk associated with COVID-19 must be considered while taking the discount rate used to determine the present value of the new lease liabilities
- Determination of whether to treat compensation given by the government to the lessor for giving concession to the lessee as a lease modification or government grant
- Entities also need to determine if any lease arrangement has become burdensome due yo COVID-19
While determining the amount of revenue to be recognized, factors like increase in sales return, decrease in volume discounts, higher price discounts, etc due to COVID-19 need to be considered.
Besides this, business entities also have to consider the impact of COVID-19 on the revenue of the business entity and make a disclosure of the same.
In addition to this, some firms may have postponed the recognition of revenue due to increased uncertainty of collection as a result of COVID-19. Thus, they need to disclose the circumstances in which revenue recognition has been postponed
Provisions, Contingent Liabilities, and Contingent Assets
Due to COVID-19, some contracts might have become onerous due to the increase in the cost of material, labor, etc. Therefore, management should assess whether any of its contracts have become onerous. Onerous contracts are the ones where the costs of meeting obligations exceed the economic benefits. Thus, if there are any onerous contracts, entities need to account for the same.
Further, impairment losses pertaining to such contracts need to be recognized before declaring such contracts as onerous. Additionally, any liability imposed due to delay in supply must also be considered. In case the firms are unable to assess whether the contracts are onerous due to lack of information, the same should be disclosed.
A business entity needs to make a provision for restructuring costs only if:
- general criteria for the provisions are met
- there is a detailed formal plan for restructuring
- there is evidence that the entity has started to implement the restructuring plan, etc
In case a business entity has an insurance policy to cover losses due to events like COVID-19, they must recognize the insurance claims, only if the insurance entities have accepted the claims and would neet its obligations.
Recognition of Provision
A provision needs to be recognized only if:
- An entity has a present application
- The outflow of resources is required to settle the obligation
- A reliable estimate can be made
Modifications or Termination of Contracts or Arrangement
Some entities may have to modify or terminate certain contracts that come under the purview of the requisite Indian Accounting Standards or Accounting Standards or guidance notes. These accounting standards may include IND AS 19 – Employee Benefits, AS 15 Employee Benefits, IND AS 102 – Share-Based Payments, Guidance Note on Accounting for Employee Share-Based Payment, etc. Accordingly, it is advised that the entities need to consider the specific requirements of these standards to account for modifications or termination.
Going Concern Assessment
Business entities need to assess the impact of COVID-19 and measures undertaken with regard to its ability to continue as a going concern. Furthermore, the entity also needs to consider the impact of COVID-19 after the reporting date and seize to prepare financial statements on a going-concern basis if:
- Management intends to liquidate the business
- Seize training
- Has no other realistic alternative but to liquidate or seize training
In addition to this, entities also need to make a disclosure of material uncertainties that would have a great impact on the entity’s ability to continue as a going concern.
Business entities having deferred tax assets should reassess forecasted profits and recoverability of deferred tax assets due to the uncertainty arising due to COVID-19.
Also, management needs to consider the impact of COVID-19 on its plans to distribute profits from subsidiaries and whether it needs to reconsider recognition of any deferred tax liability related to undistributed profits.
Consolidated Financial Statements
Business entities use the financial statement of parent and subsidiaries to prepare consolidated financial statements which are drawn to the same date.
As per IN AS 110, the difference between the reported dates should not be more than 3 months whereas as per AS 21, this difference should not be more than 6 months.
Property, Plant, and Equipment
As per accounting standards, useful life and residual life of PPE need to be revised annually. Due to COVID-19, there is a higher chance that PPE can remain underutilized or not utilized at all for a certain period of time. It is important to note that as per accounting standards, depreciation needs to be charged even if PPE remains idle.
Also, the business entity needs to review the residual life and useful life of an asset as they might have been impacted due to COVID-19. Hence, if there are any changes from previous estimates, such changes need to be accounted for.
Presentation of Financial Statements
While preparing financial statements, business entities need to consider the following provisions:
- as a result of COVID-19, some entities may breach loan covenants leading to an increase in liability, as well as liability, becoming current. However, if the lender agrees after the reporting period but before the approval of financial statements that the payment of such loans demanded by him was not a consequence of the breach of the contract, then such liability would not be taken as a current liability
- entities need to disclose assumptions made about the future as well as the estimation of uncertainty that may have a significant risk of adjusting the carrying amount of assets and liabilities in the next financial year due to COVID-19
- due to the impact of COVID-19 on the financial position and performance of entities, the entities need to make adequate disclosures and give explanatory notes regarding the impact of COVID-19 on its financial position, performance and cash flows. This should be undertaken in order to enhance the quality of financial statements for comparability.
As per the above standards, an entity needs to suspend capitalization of interest when the development of an asset gets suspended. Accordingly, entities have to consider this aspect while evaluating the impact of COVID-19.
Post Balance Events
Entities need to disclose the events occurring after the balance sheet date that showcase material changes and commitments impacting the financial position of the enterprise at the balance sheet date.
Accordingly, business entities would have to disclose the significant recognition and measurement of uncertainties that might have been created due to COVID-19 in estimating different assets and liabilities. They also need to disclose how they have managed financial position and financial performance getting impacted by COVID-19.
Interim Financial Reporting
The provisions pertaining to recognition and measurement applicable to annual financial statements apply to interim financial statements as well. Furthermore, there are no recognition or measurement exceptions for interim reporting. However, the management has to consider whether the impact of COVID-19 is a distinct event for the purpose of evaluating the expected effective tax rate.
Besides this, the business entities need to make a disclosure to reflect the financial impact of COVID-19 on the financial position and performance of the entity and measures taken to contain it.