COVID-19 IMPACT ON FINANCIAL REPORTING AT A GLANCE

Introduction

South African economy and the whole world is currently battling with the outbreak of COVID -19 corona virus. Many governments have taken stringent measures to arrest the spreading of the virus. The South African President ordered a national lockdown from 26 March 2020 until 16 April 2020. The stringent measures have unfortunately disrupted business operations and heightened the materialisation of market risks like the volatility of assets prices, currency exchange rates, changes in interest rates etc, due to significant increase in economic uncertainty. All these uncertainties and risks result in significant financial reporting implications for the preparers of financial statements and the ability by JSE listed entities and departments, medical schemes, TVETs, SOEs etc, to meet the legislated reporting deadlines.

STAP Sigma hereby provides at a glance some potential financial reporting impacts for the financial periods ending imminently.

Due to the increased economic uncertainty, the preparers of financial statements now need to consider the following:

• Non-financial assets – are PPE, Goodwill and Intangible Assets now impaired considering disruption of business operations?
• Financial Instruments – are the fair values properly determined? Are the economic forecasts used to measure the expected credit losses (ECLs) been updated? Are the credit risks for debtors and other borrowers reassessed? Where the financial instruments are measured at Fair Value, are the Fair Values appropriately determined considering the situation?
• Going concern – is the going concern assumption still applicable considering these developments?
• Employee benefits – is there a need to revisit the accounting for employee benefits considering the fact that some employees are likely to be paid whilst not working during lockdown? Are the assumptions for post-employment benefits reassessed to consider the epidemic
• Are there now some loss-making contract or unavoidable liabilities
• Grants and Donations – are these being accounted for appropriately and in the correct financial year.

Summarised below are the reasons behind some of the questions above:

• Financial Instruments – IFRS 9 , determination of ECLs

The challenge for companies is to incorporate into their measurement of ECLs the forward-looking information relating to the economic impact of COVID-19 that is available without undue cost or effort at the reporting date. 

ECL measurements need to incorporate forward-looking information that is available without undue cost or effort at the reporting date. This may be particularly challenging to do for the economic impact of COVID-19.

The increased uncertainty about potential future economic scenarios and their impact on credit losses may require companies to explicitly consider additional economic scenarios when measuring ECLs.

Existing ECL models will use historical experience to derive links between changes in economic conditions and customer behaviour, and ECL parameters such as loss rates, probabilities of default and loss given default. However, these historical relationships are unlikely to read across to the COVID-19 pandemic. Therefore, adjustments to model results, based on expert credit judgement, could be necessary to reflect the information available at the reporting date appropriately. The expected cash flows used in measuring ECLs may also be affected by any actions planned by the company in response to the epidemic. In addition, limit increases for credit cards may impact the period of exposures.

• Non-Financial Assets – Impairment considerations

COVID -19 Coronavirus 21 day national lockdown certainly has an impact on the recoverable amounts of the non-financial assets like PPE, Goodwill and Intangible Assets. Businesses have been severely disrupted and certainly future free cash flows are negatively affected.  Companies are already confronted with external impairment indicator in the form of COVID -19 Coronavirus epidemic. The question to all financial reporters is rather, is the carrying amount for respective individual assets or cash generating units still exceeding the recoverable amount.

When a triggering event has occurred, management needs to determine the recoverable amount (the higher of VIU and FVLCD1) of an asset or cash-generating unit (CGU), which usually requires management to forecast future cash flows. Budgets and cash flow forecasts prepared by management generally serve as the starting point for the discounted cash flows used in calculating the recoverable amount. Significant assumptions, such as forecast sales volumes, prices, and gross margins, changes in working capital, foreign exchange rates and discount rates will need to be reassessed and updated as appropriate due to the significant changes in economic and market conditions.

Cash flows used in determining FVLCD should be updated to reflect the assumptions that market participants would use based on market conditions and information available at the reporting date.

Making the estimate could be challenging given the degree of uncertainty about the nature, severity and duration of measures taken to contain or delay the spread of COVID-19; how long it could take for business operations and economic activity to return to normal; the expected trajectory of the recovery (i.e. how quickly economic growth will resume) and the likelihood of a recession; and any lasting impact on the economy or the sector.

The discount rate used to discount the forecast cash flows under both VIU and FVLCD might be significantly affected by COVID-19 due to the increase in uncertainty and risks. The discount rate should reflect the impact of changes in interest rates and the risk environment at the reporting date.

• Employee benefits considerations

In responding to the significant deterioration in economic conditions and increased uncertainty as a result of the Covid-19 coronavirus, companies may make changes to or introduce new remuneration policies. The accounting implications of these changes under IFRS Standards, including any employee termination plans, will require careful consideration. 

These events may also impact how companies: measure employee benefits – e.g. updated actuarial valuations of defined benefit liabilities might be required; and recognise share-based payment expenses – e.g. companies may need to revise the estimates used to recognise these expenses and consider the implications of any modifications to these arrangements. Market volatility and changes to remuneration policies may impact how companies estimate and measure employee benefits and recognise share-based payment expenses

Some companies may offer their employees paid absence in addition to any sick or annual leave entitlement. If new paid absence entitlements do not accrue through past service and do not accumulate, then it is unlikely that a company would recognise a liability for these paid absences. Instead, it would expense the cost as absences are taken. Companies will need to consider, more generally, whether they have any legal or constructive obligations to its employees as a result of these events.

If a company implements a restructuring plan that includes employee redundancies, then it recognises an expense and a corresponding liability for termination benefits at the earlier of when it: recognises a restructuring provision under IAS 37 Provisions, Contingent Liabilities and Contingent Assets that includes the payment of termination benefits; and can no longer withdraw the offer of those benefits. A company recognises a restructuring provision when it has a formal plan with sufficient detail of the restructuring and has raised a valid expectation in those affected by the plan – i.e. it has either started to implement the plan or has announced the main features to those affected by it.

Companies may need to consider the potential impact on estimates, including actuarial assumptions used in measuring employee benefits. During periods of mandatory quarantine or lockdowns, employees could be required to use existing employee entitlements – e.g. sick or annual leave entitlements. Therefore, companies may need to consider the impact on the measurement of employee benefits – e.g. they may need to revise estimates of the likelihood and timing of employees using these entitlements. 

There could also be an impact on certain demographic and financial assumptions used to measure these benefits – e.g. the discount rate used to measure the present value of employee benefit obligations. 

Companies preparing interim financial statements should consider whether net defined benefit obligations/assets need to be remeasured. Under IAS 19 Employee Benefits, remeasurements are recognised in the period when they arise; therefore, if adjustments at the interim reporting date are considered to be material, then they will need to be recorded at that date. An updated measurement of plan assets and obligations is required when a plan amendment, curtailment or settlement is recognised. In addition, significant market fluctuations may trigger the need for an updated actuarial valuation.

Practically, many companies obtain actuarial valuations a few months before the reporting date. This is acceptable if the valuation is adjusted for material subsequent events up to the reporting date. Therefore, companies should consider the timing of their actuarial valuation reports and whether they reflect material events between the valuation and reporting date.

Companies with share-based payments whose vesting depends on achieving non-market performance conditions – e.g. earnings per share targets – may need to revise their estimate of the number of instruments expected to vest, which would impact the charge in the income statement over the remaining vesting period. However, expectations of achieving market performance conditions – e.g. achieving a specified total shareholder return and non-vesting conditions – and grant-date fair value are not revised.  Modifications to share-based payment arrangements will need to be assessed as to whether they are either beneficial or non-beneficial to the employee and accounted for accordingly. For example, if plans are modified such that market conditions are easier to achieve, then this may constitute a beneficial modification which increases the value of the award in the hands of the employee. In this case, the incremental fair value is recognised over the modified vesting period.

What next financial reporting teams

Immediately identify the specific financial statements areas that are affected by the COVID-19 coronavirus epidemic and start working on accumulating the information required for financial reporting. What we highlighted in this write up is not exhaustive but a starting guide.