The coronavirus (COVID-19) pandemic has resulted in severe business and economic crisis around the globe. How should your company assess and report the effects of COVID-19 outbreak on the cash flows, financial reporting, and compliance?
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 diseases. As a result, companies are increasingly concerned about the loss of revenue, disrupted supply chains, cashflows, and going concern, which 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 look at what is happening closely. In many industries, operations have stopped, and logistics networks have been disrupted. The restricted movement of people has separated companies from their customers and 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.
The current scenario may not be the complete picture as the destruction Coronavirus has brought along is beyond our thoughts. With the outbreak of COVID-19 continuing worldwide, businesses, large or small, have started developing contingency plans, reworking their financial goals and budgets, and devising possible solutions to address the potential risk and cash flow challenges.
Many entities are aware of the challenges they’ll face as they work on issuing interim or year-end financial statements. As there may be entities who are yet to release their year-end financials, and in such a case, they might have to disclose subsequent material events as a result of the COVID-19 pandemic. The impacts on the entity’s financial position are inevitable, although it may be too early to determine the full extent of financial health.
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, cash flows, and valuations. Let’s take a look at how some of the elements of financial statements may be impacted due to the ongoing situation.
Cash flows and its impact on impairment:
The pandemic’s effect is becoming a significant economic challenge impacting cash flows and working capital of entities in the following areas, which may ultimately result in a going concern and survival issues. Companies must consider dealing in these areas ahead of time to, as being said, “Preventive is better than cure.”
Impairment of Goodwill –
When an occurrence of an event or changes in circumstances has severe implications on the future cash flows 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 crucial 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, the need to perform impairment assessment of long-term assets arises.
As a result of COVID-19, the effects of the economic downturn have produced substantial doubts about the recoverability of the carrying amounts of assets and have triggered an impairment test for long-terms assets for many entities across various 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 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 reduction of demand and shortage of material and labor continues, the manufacturing levels have dropped to low levels. As a result, 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
Certain assets, like an investment property, 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. The situation could 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. If the agreement is breached, the debt will need to be classified on the balance sheet.
According to IFRS 15, revenue from contracts with customers, revenue recognition occurs 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 s the value and estimates of variable considerations such as discounts, bonuses, penalties, and refunds in customer contracts.
As businesses continue to offer products and services to customers affected by Coronavirus, the customer’s ability to pay the company’s outstanding and future invoices will have to be carefully assessed. This could mean recognizing bad debts and even impairment if the current market scenario changes customers’ ability to pay.
The coronavirus outbreak has left many businesses struggling for their survival. As the economic crisis evolves, companies are concerned about the consequences – Will the organization have a deficit working capital at some point of time, and 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 valuable information on potential impact, there may be substantial doubts about its ability to continue as a going concern basis for a foreseeable time. Under this assumption, the company will have to make the necessary disclosure in the financial statements.
Force majeure under agreements
Penalties related to the 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 result in the loss of deposits, but the company may be imposed with penalties. Even if the company has not yet canceled any events, it may still have to consider the issues related to deposits and potential penalties that may arise if the cancellation becomes probable. Hence, it is essential 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. With the current crisis, entities must thoroughly assess the applicability of the existence of a force majeure term under their commitments and contractual arrangement, and exercise them as soon as possible before any default or breach. Where no such clause exists under these agreements, an entity must consider the related risks and plan and execute other options that might be available.
The current economic crisis due to the pandemic is unlike others ever. For many businesses, it is either a death or survival. Given the uncertainties involved, nearly all companies worldwide are struggling as a result of the economic downturn. As events continue to evolve, companies must review their situation as they might require a reconsideration of its business module by capturing realistic numbers, estimating the impact of risks and uncertainties involved, and taking the right actions and steps. The effect of COVID-19 on the cash flows, financial reporting, and compliance must be assessed adequately and transparently, and communicated to the concerned stakeholders, auditors, and the Audit Committee.