This blog is written by Mr. Awais Mumtaz. Please read this blog and provide your valued comments
Pandemic Implications On Financial Position
In the following blog, prospective implications of following factors are discussed at length:
- Property, Plant and Equipment
- Provisions and Liabilities
- Assets held for sale
- Financial Instruments
Property, Plant and Equipment
The recoverability of non-financial assets is ensured to not exceed the highest amount to be recovered through their sale or use. Generally, their recoverability is based on sale rather than use. IAS 36 impairment of assets deals with the recoverability assessment of assets where indicators exist that non-financial assets may be overstated. These indicators may range from Macroeconomic conditions, to technological change and all the way to obsolescence. The process involves calculating and comparing the recoverable amount with the carrying amount and performing any write downs if necessary. With relevance to recession inducing events such as COVID-19, situations such as declining demand for products and trade disruptions have caused the need for impairments to arise for a large variety of business segments.
Under IAS 16, depreciation of asset starts when it is available for use and unless depreciation is not charged under the ‘usage-base’ method, lockdowns do not disqualify PPE from being depreciated. Moreover, impairment should also be considered where applicable.
IAS 2 requires inventories to be measured at the lower of cost or NRV, and any write downs that arise are to be expensed in the relevant period. In relation to COVID-19, circumstances such as disruptions in transport links, suppressed customer demands are likely to induce the need for further write downs, with specific relevance to perishable goods. However, obstacles such as fluctuating customer demand and changes in costs of producing inventories are likely to hinder accurate NRV estimates. As a result, in certain cases NRV estimates may be based on a similar group, product basis such as end use, geographical locations etc. Value judgments may also be used to arrive to reasonable NRV amounts.
In estimating NRV values companies are to consider all relevant information, special consideration regarding this particular situation should be paid. Which is, for instance, with inventories for committed orders as at 31st March 2020, write downs would be done where the company has reasonable information regarding the customers eventual inability/ unwillingness to pay, otherwise it would be a non-adjusting event not requiring any write downs. A similar approach is also taken with the volumes of inventory, where reasonable knowledge as at reporting date after considering relevant factors require a write down, otherwise not required.
Reduced demand of inventories and cutting back production may lead to a higher fixed cost being allocated to the now reduced inventory costs. However, the extra cost should not be counted as the cost of inventory, instead the unallocated fixed costs should be expensed along with abnormal losses, wastage etc.
Provisions and Liabilities
The impacts of the lockdown measures included all the way from event cancellations to complete closures despite there being contractual obligations outstanding for businesses. These warrant for remedial actions and appropriate accounting measures to be taken when it comes to financial reporting. This is because lockdowns do not exempt companies from fulfilling their contractual obligations unless they have been mutually amended. These would be included as remedial measures and it is advisable for such amendments to be formalized in written amendments to the contract. With regards to the legal provision under IAS 37, the lower of the cost of fulfilling the contract or terminating shall be charged, if the contract is onerous.
Furthermore, non-fulfillment of such contracts should also warrant further checks into the company’s going concern situation as well as any necessary changes that are required in the financial statements. Where the contract in question is an onerous, a provision is to be charged. That is determined by comparing the expected economic benefits with the lower of the unavoidable cost to fulfill the obligation (directly variable with the contract excluding allocated fixed costs) and the costs to terminate the contract.
With regards to leases of office spaces, a similar approach is again taken where the expected economic benefits (inflows expected from the office space and any office space sublet), are compared with the lower of the present value of either fulfilling the lease payments with the costs of terminating the contract. Contracts without a penalty for termination are not onerous and thus no provision is charged.
Restructuring, where there is a detailed formal plan and has been adequately communicated to the related affected parties, a provision is to be created. Communication of such a plan would warrant the creation of a provision as it would now imply a constructive/ legal obligation. COVID-19 has caused businesses to consider decisions such as closing locations to fundamentally changing business operations, and so a provision is likely to be created. Such provisions usually consist of expenses directly related to the restructuring, such as legal and professional fee, and lease termination costs. However, specific considerations regarding adequate and clear disclosures should be present and indirect amounts such as expected gains/losses from asset disposals, administrative costs, ongoing activities should not be involved.
Furthermore, post balance sheet restructuring would classify as an adjusting event and where it is virtually certain that restricting liabilities will be reimbursed would a relevant asset be classified, it would, however, be netted off in the profit & loss account. Future losses would not be a part of the provision but possible impairments of assets should be on the cards.
Facilitative measures during COVID-19, existing companies may be provided with concessions either in the form of variable lease payments or lease modifications (e.g. reduced payment amounts). Lease modifications are treated according to IFRS 16 whereas the former would involve recognition of income/expenses in periods when they occur. Proper classifications of such should be carried out through investigating lease contracts and making key judgements.
The reduced economic activity, lockdowns may cause the need to impair ‘right of use assets’ and as such a charge should be made, however, where the impairment cannot be made at an individual level, the specific asset may be grouped with the (cash generating units) to which it belongs. Furthermore, in the case of leased Investment Properties, such assets are recognized under IAS 40, and so shall not be impaired, but instead be carried at Fair value through profit or loss.
Companies are to reassess the lease periods where lessees have the option to terminate or extend leasing periods, in order to correctly value asset or liability amounts. The COVID situation is likely to enhance the need to reassess the amounts because of the significant impact they can have. Furthermore, the recent change in the SBPs policy rate to 9% also warrants a recalculation of the liability amounts based on the revised discount rate as according to IFRS 16.
Assets held for sale
The resulting situation of COVID-19 may lead to massive downsizing by firms and restructuring which means that the application of IFRS 5 should be applied by companies. Non-current assets which are planned to be sold, where the sale is probable within a year should be classified as such.
Overall, the statement of comprehensive income would contain a single amount of both the profit/loss arising from a discontinued operation and any gain/loss from either the measurement to fair value less costs to sell or on the disposal of non-current assets. Further details of these would be provided in the notes to the accounts.
IFRS 9 requires Expected Credit Losses (ECLs) to be measured on an expected, probability-based amount based off o reasonable and supportable information and applying key valuable judgements. The downward economic impact of COVID-19 may hinder the ability of companies to meet their loan obligations and so the measurements of ECLs are likely to be reassessed. These can range from re-segmenting loan portfolios according to their COVID impact severity, to even assessing assets, loans, receivable amounts at an individual and collective level. Impacts of any extensions in payment terms would also be considered to assesses ECL values.
Where loan terms are re-negotiated, liabilities and obligations are to be derecognized where the difference between the new modified liability amount and the old exceeds a 10% threshold level, otherwise any difference is adjusted to profit or loss.
Typically, the fair value of an asset or liability is the amount paid or received for it in an orderly market, however due to the uncertainty created as a result of COVID-19 the amounts for such items are likely to be reassessed at the current market conditions and a deal of key judgements by management is likely needed as the future potential value at a future date is not applicable.
With regards to bank overdraft balances, although they are typically considered in Financing activities according to IAS 7, however where there is an imminence to repay the overdraft and where the company has an enforceable right, the balance is netted off in the ‘cash and bank’ section of the statement of financial position.
The COVID-19 circumstances may have prompted companies to take out loans in order to aid possible liquidity crises. These may either be at market rate (if on commercial terms) or below market rate (interest free loans, loans from directors/sponsors). The treatment of different classifications of loans and can be summarized in the table below;
|Repayment term of interest free loan
|Accounting of interest free loan
|A short-term loan fulfills the criteria of financial instrument and is classified as financial liability.
|The short-term loans that are expected to be repaid in the near future should generally be recorded at the loan amount, as the loan amount is likely to be a sufficiently close approximation to fair value in most of the cases.|
|Loans repayable on-demand
|Interest free loan repayable on demand fulfills the criteria of financial instruments and is classified as a financial liability.||The interest free loans that are repayable on demand should generally be recorded at the loan amount.
|Loan repayable at the discretion of borrower
|Where the interest free loans are repayable at the discretion of the borrower, then such loans do not fulfill the classification criteria for a financial liability as there is no contractual obligation to deliver cash or another financial asset to the lender. These loans are considered as an equity contribution by the owners of the company.||The loan proceeds of the interest free and below market interest loan that is repayable at the discretion of the borrowers should be reflected in the statement of changes in equity.|
|Loans repayable at a specific date||Interest free loan repayable as per a specific term fulfills the criteria of a financial instrument and is classified as a financial liability.||The loan proceeds of the interest free and below market interest loan should be compared with its fair value. The fair value is calculated as present value of the future repayments discounted using the prevailing market rate of interest for a similar instrument (similar as to currency, term, type of interest rate and other factors) with a similar credit rating. Any difference between the gross amounts of the loan proceeds and the fair value is recognized in equity, considered as a capital contribution from the parent of the company, director or sponsor.
Subsequently, the loan should be measured at amortized cost, using the effective interest method. This involves ‘unwinding’ the discount, such that, at repayment, the carrying value of the loan equals the amount to be repaid.
The unwinding of the discount should be reported as interest expense in the statement of profit or loss.
In case of a breach of a long-term loan covenant, the whole loan would be classified as a current liability where the company does not have the right to defer payment at least after 12 months after the balance sheet date. However, if the lender does allow to refinance and thus provide a period of more than 12 months, then the loan is reclassified as a long-term liability.
September 14, 2020