POTENTIAL COVID-19 IMPACT ON FINANCIAL REPORTING AND AUDITING
PART A: FINANCIAL REPORTING IMPACT
What started in the Chinese city, Wuhan in Hubei province during December 2019 as an outbreak of unknown virus, was declared as a Pandemic by World Health Organization (WHO) on 11 March 2020 with a name tag of COVID-19. This Pandemic has created global disruption at an unprecedented level and at such speed that most of us could not comprehend even couple of weeks earlier. Along with great human toll and impact on public health, COVID-19 has also created devastating effect on global trade, commerce and industry with consequential implications on financial reporting by the affected entities and audit of financial statements of those entities.
Although COVID-19 originated during December 2019 but as at 31 December 2019 it was not widely known outside China nor any impact of this was felt anywhere outside China. COVID-19 started to get global attention only towards end of January 2020 when WHO declared this as health emergency on 30 January 2020. Finally, on 11 March 2020 WHO declared it a Pandemic and by this time COVID-19 has created a global shock and disturbance not seen in many decades.
To tackle outbreak of COVID-19, many countries went for complete lock down running into weeks, closed international borders with restriction on movement of people, implemented social distancing and other strict conditions. All these measures have severe effects on global trade and commerce in many forms ranging from supply chain disruptions to closures of business activities. To support business and economic activities during this critical time and ensure liquidity in the market Governments across the world has announced various types of economic stimulus program.
The Government of Bangladesh has also announced a number of economic stimulus packages for affected businesses. The major stimulus packages declared so far are creation of BDT 5,000 crore loan fund at 2% interest rate with relaxed repayment term for export-oriented industry to pay labour wages for next three months, special loan funds with lower interest rate of BDT 30,000 crore for big industries and service sector and BDT 20,000 crore for small and medium enterprises (SMEs) including the cottage industries, Export Development Fund (EDF) loans, extension of tenure for settlement of foreign currency loans, reduction in CRR requirement, re-fixation of repo rate, direct purchase of additional government securities in excess of SLR requirement from secondary market on market price etc.
Since every business and industry would have different impacts from COVID-19, it is very important for each entity to make its own individual assessment. We have considered COVID-19 impact on financial reporting in two groups; one group are those entities with 31 December 2019 reporting date and the other group are those entities with the reporting date of 31 March 2020 or later. Entities preparing interim financial statements for the quarter/period ended 31 March 2020 shall also be considered in the second group.
- First Group of Entities with reporting period ended on or before 31 December 2019
For entities with the reporting date of 31 December 2019 or earlier, the financial reporting effects of the COVID-19 outbreak are generally non-adjusting events (with the exception of going concern) because the significant changes in business activities and economic conditions as a result of COVID-19 events took place well after the reporting date (i.e. declaration of pandemic and actions taken to contain the COVID-19 outbreak).
IAS 10 has defined non-adjusting event as an event after the reporting period that is indicative of a condition that arose after the end of the reporting period, and an adjusting event as an event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period and on the other hand. As stated above, applying this definition of IAS 10, for entities with reporting period ended on or before 31 December 2019 other than going concern COVID 19 related matters are most likely to be non-adjusting events. In Bangladesh, all Banks, NBFI, Insurance companies and their subsidiaries as well some foreign-owned/ multinational entities are classified into this Group. Depending on the timing of the financial statements authorized for issue, disclosure of COVID 19 related subsequent events including potential financial impact, if known, may require in the financial statements or annual report of these entities.
Management should consider the potential implications of COVID-19 when assessing the entity’s ability to continue as a going concern. An entity is no longer a going concern if management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so. In assessing whether the going concern assumption is appropriate, management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the date when the financial statements are authorised for issue. Material uncertainties that might cast significant doubt upon an entity’s ability to continue as a going concern should be disclosed in accordance with IAS 1.
The assessment will be specific to the entity's circumstance and also to consider external supports expected by the entity (i.e. declaration of salary support for export industry, deferral of loan repayment, additional borrowing at lower interest rate etc.). While conducting going concern assessment, the entity need to specifically consider the extent of operational disruption, potential reduction in demand for products or services, contractual obligations due or anticipated within one year, potential liquidity and working capital shortfalls and access to existing sources of capital. In making its going concern assessment, IAS 10 Events after the Reporting Period requires an entity to consider events up to the date of authorization of the financial statements.
If the entity is a going concern, the financial statements should be prepared on a going concern basis. If not, they should be prepared on a basis other than going concern. An entity shall not prepare its financial statements on a going concern basis if events after the end of the reporting period result in the going concern basis becoming inappropriate. Due to such rapid changes in economic environment from COVID-19, an entity at 31 December 2019 reporting date may be a going concern, but on the date when financial statements are authorised for issue no longer a going concern due to COVID-19 impact, and in such case the going concern basis shall not be used.
- Second group of entities with reporting period ended on or after 31 March 2020 including interim reporting
For entities with reporting periods ended on 31 March 2020 or subsequent date (i.e. 30 June 2020) as well as those entities reporting interim financial statements for the Quarter/period ended 31 March 2020, all COVID-19 related impacts are current period events requiring appropriate recognition in the financial statements.
Changes in the economic activity caused by the Pandemic will cause many entities to renegotiate the terms of existing contracts and arrangements, and even cancellation of contracts/orders. As we have seen in Bangladesh, many overseas buyers of local RMG and Textile products abruptly canceled or deferred confirmed orders and some even refused to accept those orders awaiting shipment or in the final stage of delivery. Such situation may result in multiple implications on financial reporting including but not limited to going concern assumption, revenue recognition (IFRS 15), inventory valuation (IAS 2), impairment assessment (IAS 36), onerous contract (IAS 37), debt servicing and compliance with covenants (IFRS 7), etc. In addition, contract modifications may result changes in terms of financial assets and liabilities (IFRS 9), leases (IFRS 16), compensation arrangements with employees (IAS 19), etc.
Similarly, an entity use forecast information (i.e. cash flow, production capacity utilization, etc.) for multiple purposes such as, the impairment of non‑financial assets, expected credit losses, fair value of assets and liabilities, the recoverability of deferred tax assets and the entity’s ability to continue as a going concern. Because of COVID-19 impact, preparation of reliable forecast information can be challenging and need to be closely monitored as this can have pervasive impact across multiple elements of financial statements.
The key potential financial reporting impacts are summarised as follows:
- Impairment of non-current assets and goodwill
Due to the lower demand of products, many entities would reduce its operation and some may have closed the operation altogether resulting lesser utilization of capacity and hence potential impairment of PP&E. Also due to adverse impact on future cash flows resulting from lower sale/demand of products or services, any goodwill recognized during business combination may need to be impaired (IAS 36).
- Significant Increase in Credit Risk (SICR) and Expected Credit Losses (ECLs)
IFRS 9 sets out a framework for determining the amount of expected credit losses (ECL) that should be recognised. It requires that lifetime ECLs be recognised when there is a significant increase in credit risk (SICR) on a financial instrument. Management shall apply judgment and adjust their approach to determine ECLs in different circumstances. A number of assumptions and expectations underlying the way ECLs have been implemented previously may no longer remain valid in the current situation resulted from COVID-19. Therefore, each entity needs to re-assess their credit risk, timing and uncertainty of future cash flows, moratorium in repayment declared by Government, potential insolvency of customer and other related factors to calculate provision for impairment of financial assets (IFRS 9).
IFRS Foundation on 27 March 2020 has issued a publication on “
Due to significant changes in macro-economic assumptions as well as entity specific conditions from COVID-19, key estimates and variable previously used for fair value measurement of assets and liabilities (i.e. Level 2 and Level 3 inputs) may be no longer valid and hence require re-assessment and supported by the latest input (IFRS 13).
Due to cancellation of orders and modification of contractual arrangement with customers factors such as probability of return, further discount, timing of transferring risk and reward due to supply chain disruption need to be assessed before recognizing revenue (IFRS 15).
Since inventories shall be measured at lower of cost and net realizable value, subsequent reduction in selling price of goods or cancellation of customer orders may indicate lower net realizable value of related inventories and hence write down may require (IAS 2).
Due to COVID-19 there may be changes to remuneration policies and especially for defined benefit plan changes in key actuarial assumptions (i.e. lower discount rate, lower return from financial assets due to reduced interest rate) which shall be considered (IAS 19).
- Provisions for Onerous contracts
Delay in fulfilment of contractual obligations may result in penalties or compensation claims unless otherwise protected and need to be provided for (IAS 37).
If any deferred tax asset is recognized on carry forward tax losses the related assumption need to be revisited especially whether the entity can still make adequate taxable profit after COVID-19 impact which will be available to offset such carry forward tax losses (IAS 12).
With adverse impact in business many leases which were earlier expected to be renewed and therefore used in calculation of lease assets/liabilities may not be renewed now and hence need to be revisited along with new calculation of lessee’s incremental borrowing rate on account of change in its borrowing costs consequent to lower interest rate, decline in its credit rating, etc. (IFRS 16).
COVID-19 would impact insurer from lower policy renewal, refund of premium for business cancellation, higher claims, and lower returns from investment. On the other hand, an entity taking insurance policy may need to assess whether it is entitled to any claim/ compensation from loss of profits and business disruption including timing of recognition of such claim/ compensation.
- Government stimulus package
As stated above, the Government of Bangladesh has announced a number of economic stimulus packages for affected businesses. However, so far all these packages are effectively loan arrangement with easier repayment option and at reduced borrowing rate to be disbursed by Banks and NBFIs. Therefore, further scrutiny of these incentives are required along with other existing regulatory frameworks, before an assessment can be made whether such incentive would fall under ‘IAS 20: Accounting for Government Grants and Disclosure of Government Assistance’. Since any impact of Government Stimulus packages would take place only after 1 April 2020, we shall cover this in more detail in our subsequent analysis.