Financial Reporting Implications of COVID-19: In-Depth Analysis for Asset-Based Entities

The COVID-19 outbreak has brought most industries to their knees. Vitor Gaspar, Director of Fiscal Affairs Department of the International Monetary Fund, said that “The expected speed and depth of the contraction in the global economy is unprecedented, much worse than during the 2008-09 financial crisis…”

Given the operational and financial disruptions entities are facing due to this crisis, it is critical for financial controllers, auditors, financial analysts, and other users of financial statements to understand and assess the impact of this crisis on their financial statements. Using the International Financial Reporting Standards (IASs and IFRSs), I have compiled a list of accounting issues and considerations that practitioners and professionals can refer to while dealing with accounts, in an attempt to pave the way to relevant, reliable, and faithfully represented financial information.

In this article, I will address asset-based entities of which I selected eight major industries. If you are interested in service-based industries, you can refer to the article Financial Reporting Implications of COVID-19: In-Depth Analysis for Service-Based Entities.

The extent of impact by a specific accounting issue is indicated by the bar color and height (this is a matter of professional judgment by the author rather than a fact). For ease of reading, I divided the financial reporting issues into three Groups: Group 1: Framework to IAS20, Group 2: IAS 23 to IFRS 7, and Group 3: IFRS 7 to IFRS 17.

Group 1: Framework to IAS 20

* FMCG= Fast moving consumer goods are non-durable household goods such as packaged foods, beverages, toiletries, over-the-counter drugs, and other consumables.

** Brick-and-mortar refers to traditional street-side business that offers products to its customers face-to-face in a store that the business owns or rents.

*** Consumer durables are goods that do not have to be purchased frequently because they are made to last: automotive, appliances, furniture, jewelry, electronics.

A more detailed explanation of accounting considerations and impact by industry for group 1 is provided below:

A. As a result, the crisis might generate conditions that can cast significant doubt upon an entity’s ability to continue. Based on my judgement, the industries most affected are the retail FMCG brick-and-mortar shops (businesses that did not take their products online and optimize their supply chain and sales through digitization are expected to be left behind), consumer durables (which are considered as discretionary or “non-essential”, as opposed to life preserving products such as food, pharmaceutical items, and cleaning supplies), real estate (developers are unable to sell their completed projects due to market stagnation) and building material (which supply the raw material to the contractors, who have many of their projects on hold). The least affected are FMCG retail which went online, and they can supply their products to households under lockdown. In between are energy and chemicals. The defragmented nature of the energy industry, the large size of individual entities and possible government support protects it from going into liquidation or ceasing trading. However, if pressure on commodity prices continues and the OPEC cut in oil production does not achieve its set goals, we might even see energy giants out of business. As for chemical entities, they might see some of their products suspended from production now, but they can still strive on profits and margins from the production of cleaning material, gloves, masks, and other packaging raw material of essential goods.

B. Most industries will be required to make disclosures of significant judgments and key sources of uncertainty. An example are judgments related to expected credit loss from trade receivables held on the balance sheets of all industries. Revenue recognition is also an area requiring judgment (e.g. in complex cases involving multiple element arrangements for consumer durables, which sell the product plus installation, after sales service and warranty or real estate which offers the property plus servicing). Other areas of judgment and uncertainties for all industries would be recognition and measurement of provisions for restructuring and employees’ termination, obligations for long-term employee benefits, assumptions underlying estimation of recoverable amount for impairment tests, and fair value measurements that depend on significant unobservable inputs. FMCG retail online is the least impacted due to the straightforward nature of its revenue recognition, cash business-type and of assets held on its balance sheet, followed by the brick-and-mortar shops for the same reasons.

C. Industries that are expected to face pressures on their cash flows might opt to default on their loan repayments and/or breach loan covenants. Industries with the highest pressure on their cash flows are retail brick-and-mortar, consumer durables, real estate, and building material since they need to cover their high outflow towards fixed operational costs. Energy entities are also expected to face high cash flows pressures due to the decline in energy prices, reduced demand for their products, and their predominantly existing high operating costs. However, many of those entities are cash rich and expected to survive any short-run cash pressures. Industry with the least pressure on cash flow is the FMCG retail operating online, if they can sustain the supply of their products to meet the consumers demand.

D. As per IAS 2 Inventory, abnormal amounts of wasted materials, labor or other production costs are excluded from the cost of inventories and recognized as expenses in the period in which they are incurred. This is more of a concern for manufacturing entities, such as manufacturers of consumer durables, energy upstream entities, chemicals manufacturers, real estate entities that develop properties for sale as inventory and building material manufacturing entities. FMCG online and retail brick-and-mortar shops do not produce inventory, and so are less affected by this accounting issue.

E. All asset-based industries hold inventory at the end of a reporting period and will need to measure inventory at lowest of cost or net realizable value. Net realizable value is the selling price of the inventory item, less costs to complete and costs to sell. Inventory items might be slow moving, become wholly or partially obsolete, or have their selling prices declining given the decline in demand. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased, given the increasing costs of supply chain. Inventory items should be scrutinized by management at the end of reporting period, on an item by item basis, to identify the potential losses. FMCG retail online entities are not loss proof in this area, since they might have a stock of non-essential products purchased prior to the outbreak.

F. The COVID-19 outbreak is considered a major event after the reporting period. However, its impact is not expected to provide evidence of conditions that existed at the end of the reporting period of December 31st, 2019. Nevertheless, if the entity initiated some impairment tests on long-lived assets, or compared inventories’ net realizable value to their carrying amount after the reporting period, or performed an in-depth assessment on provisions resulting from COVID-19, and realized that those losses existed as of December 31st, 2019, then the entity should consider recognizing these losses as of the end of the reporting period of December 31st, 2019. Entities preparing their interim financial statements at March 31st, 2020 are expected to include the impact of COVID-19 on their financial statements as of that date.

G. As a follow-up to point F, COVID-19 probably triggered a set of non-adjusting events after the reporting period which are material. Hence, the nature and financial effect of those events should be fully disclosed by all industries. As per IAS 10 Events After the Reporting Period, examples of non-adjusting events are a decline in market value of investments between the end of the reporting period and the date when the financial statements are authorized for issue, disposal of major subsidiaries, announcing a plan to discontinue an operation, classification of assets as held-for-sale as per IFRS 5 Non-Current Assets Held-for-Sale and Discontinued Operations, implementation of a major restructuring, major ordinary share transaction in an attempt to pump liquidity into the entity, abnormally large changes after the reporting period in asset prices, entering into significant commitments or contingent liabilities or commencing major litigation arising solely out of events that occurred after the reporting period.

H. The crisis and post-crisis periods are expected to result in temporary differences between tax base and accounting base of assets and liabilities due to recognition and reversal of allowance for inventory losses, impairment losses, revaluation of assets to new fair values, and recognition of provisions and allowances. Therefore, this will result in recognition and reversal of deferred tax assets and liabilities. Moreover, entities that have recognized deferred tax assets on their balance sheets are required to assess the need to recognize a valuation allowance against the deferred tax asset balance to show the amount with a more than 50% probability of not being utilized in the future due to non-availability of sufficient future taxable income. The nature of operations of FMCG online or FMCG brick-and-mortar, types of assets on balance sheet and cash-basis sales, would result in less recognition of deferred taxes.

I. Many entities are expected to undergo major restructuring which entails, among other actions, laying off employees. Therefore, a termination benefit liability might be recognized. All entities are expected to tighten the belt in terms of staff costs or benefit from the available time and circumstances to undergo changes in management structure, eliminating a layer of management or simply reducing the headcount. The industry least impacted by this accounting issue is FMCG retail online, as they need the necessary human resources to supply the market during lockdowns.

J. Some industries are expected to receive government grants, support, and subsidies based on the country’s priorities and types of industry. Based on history, it is expected that large energy entities will receive such support as governments attempt to save their economies from an eventual crash. Chemicals, real estate and building material entities have remote possibility of receiving such support, and FMCG and consumer durables entities are not expected to receive meaningful government support.

Group 2: IAS 23 to IFRS 7

A more detailed explanation of accounting considerations and impact by industry for group 2 is provided below:

K. While the COVID-19 outbreak remains uncontained, most entities will be required to suspend the acquisition, construction or production of some or all of their long-lived assets. Examples of such assets can be construction of production facilities by consumer durables, chemicals and building material manufacturers, construction of drilling rigs and refineries by energy entities or development of commercial or residential real estate projects by real estate entities. As per IAS 23 Borrowing Costs, interest charges incurred on debt used to finance these assets during the period of suspension should be recorded as period expense rather than capitalized to cost of asset. FMCG online or FMCG brick-and-mortar are not expected to have major capital assets, except in the instance of the construction of headquarters.

L. An entity operating in any asset-based industry might hold one or more long term interests in associates and joint ventures operating in one more industry. All entities must pay close attention to the extent of recognition and reversal of losses from these interests if the entity is accounting for this interest based on the equity method in accordance with IAS 28 Investments in Associates and Joint Ventures. If the entity holds an interest measured at fair value (example preferred shares) or at amortized cost (example long-term loan) as per IFRS 9 Financial Instruments, the extent of recognition and reversal of losses should also be monitored.

M. As per IAS 36 Impairment of Assets, an entity is required to assess at the reporting date whether there are any indicators of impairment of its assets or more broadly its cash-generating-units. Considering the COVID-19 outbreak, there are both external and internal indicators that an impairment might have occurred. External indicators in the asset-based industries include significant decrease in assets’ market value (e.g. decrease in market price of real estate), significant changes in economic environment with an adverse effect on the entity (e.g. reduced aggregate demand), downgrades in credit ratings and increase in market spreads leading to increase in discount rates used in calculating value-in-use. Internal indicators in the asset-based industries include plans to discontinue or restructure the operation to which an asset belongs (e.g. closure of some retail shops), plans to dispose of an asset before the previously expected date (e.g. closure of factories), evidence is available from internal reporting that indicates that the economic performance of an asset is, or will be, worse than expected (e.g. operating losses or net negative cash flows). Less indicators of impairment of cash-generating-units exist for FMCG retail online industry, while high indicators exist for remaining industries.

N. An entity operating in any asset-based industry might have one or more investments in subsidiaries which resulted in goodwill upon business combination. Those entities are required to test for goodwill impairment at least annually. With the COVID1-19 outbreak and stock markets losses, the possibility of goodwill impairment is higher than ever and entities should place a higher emphasis on this matter.

O. As per IAS 36 Impairment of Assets, intangible assets which are not yet available for use should be tested for impairment at least annually. Energy and chemical industries are expected to have intangibles under development for new products and innovative solutions. Both industries mentioned might defer or reconsider the completion of those intangibles due to change in management intent to complete the development, ability to use or sell the intangible, or availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset. Other industries are less likely to have intangibles under development.

P. As per IAS 37 Provisions, Contingent Liabilities and Contingent Assets, onerous contracts are ones in which the unavoidable costs to be incurred by a vendor to meet the obligations might exceed the economic benefits expected to be received under it. If an entity has a contract which is onerous, the present obligation under the contract should be recognized and measured as a provision. Entities most affected by this accounting issue are the ones which entered in a commitment to supply a certain quantity of goods before the outbreak, without fixing the price. Therefore, with the decrease in aggregate demand and general persistent decline in market prices for many goods, the transaction price to deliver the goods might be lower than the costs. On the other hand, the costs to deliver a product might increase due to supply chain interruptions, paid leaves of workers, and delays resulting from imposed lockdowns, which lead to contracts being onerous. Energy and real estate industries are expected to be the most highly impacted by this accounting issue. Consumer durables, chemicals, and building materials are expected to have a medium impact from losses on onerous contracts while FMCG retail online and FMCG brick-and-mortar are expected to have a low impact.

Q. Many entities are expected to undergo restructuring activities during or post the outbreak. Examples of events include sale or termination of a line or a business, closure or relocation of a business, and changes of management or operational structure. Once the restructuring criteria are met, the entity should recognize a provision. All industries are expected to consider restructuring plans, except for the FMCG retail online entities.

R. Some entities purchase “business interruption insurance” which covers the loss of income that a business suffers after a disaster or economic crisis. While this is not a common practice for most industries, as they believe that a full business interruption is highly unlikely, energy and chemical manufacturing entities might have that insurance. Following the political unrest and multiple attacks that those entities endured during the past couple of years, many opted to purchase such insurance. The entity must consider the recognition and/or disclosure for a separate asset for the expected reimbursement when reimbursement is virtually certain.

S. For entities which offer equity-settled to counterparties, the grant of equity instruments might be conditional upon satisfying specified vesting conditions. For example, a grant of shares or share options to an employee is typically conditional on the employee remaining in the entity’s employ for a specified period. There might be performance conditions that must be satisfied such as the entity achieving a specified growth in profit or a specified increase in the entity’s share price. Such employees share option plans and share bonuses exist in the consumer durables, energy, chemical and real estate industries. Given the slowdown faced by entities, it will be more challenging for the vesting conditions to be satisfied and/or for employees to complete the vesting period. Therefore, the entity must reconsider the adequacy of the amounts recorded.

As for cash-settled share-based payments offered by entities to counterparties, the entity must monitor closely the fair value of the equity instruments granted, which will impact the liability measured.

T. IFRS 7 Financial Instruments: Disclosures requires entities to make certain disclosures about the entity’s ability to meet obligations associated with financial liabilities that are settled by delivering cash or another financial assets. Entities might revert to specific measures to manage liquidity during this crisis such as liquidation of long-term investments, factoring of receivables, restructuring of current liabilities, or reverse factoring. Any entity will be highly impacted by these measures and will be required to provide adequate quantitative and qualitative disclosures.

Group 3: IFRS 7 to IFRS 17

A more detailed explanation of accounting considerations and impact by industry for group 3 is provided below:

U. IFRS 7 Financial Instruments: Disclosures requires entities to make certain disclosures that enable users to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed to at the end of reporting period. Credit risk is the risk that one party to financial instruments will fail to discharge an obligation and cause the other party to incur a financial loss. Quantitative and qualitative disclosures are required so that users understand the effect of credit risk on the amount, timing, and uncertainty of future cash flows. Since the crisis has resulted in an increase of credit risk exposure for most entities, an entity should consider how it will disclose its exposure to credit risk on its bank balances, investments in financial instruments, trade receivables and receivables from related parties. Moreover, the entity should disclose the risk management practices it has in place to identify and manage credit risk. Examples of such disclosures would cover the concentration of trade receivables due from customers affected by the outbreak (e.g. chemicals company with major customer base in China or Italy) and possible credit rating downgrades for investments in financial assets held by the entity as of the end of a reporting period.

V. Entities should consider the impact of COVID-19 on their expected credit loss calculations. As a start, an entity must assess whether there have been significant increases in credit risk on financial instruments since initial recognition. For financial instruments with a significant increase in credit risk over the remaining life of the instrument in comparison with the credit risk on initial recognition, the entity should start calculating the expected credit loss (ECL) based on the lifetime ECL rather than 12-month ECL. Moreover, due to the pandemic’s severe effect on debtors’ creditworthiness, entities should also assess whether an objective evidence of impairment exists at the reporting date for certain financial instruments to move quickly from stage 1 to stage 3. Except for FMCG retail online and FMCG brick-and-mortar industries, most industries will be most likely affected by this accounting issue since one or more of their customers would be facing profitability, liquidity, and possibly solvency challenges during the crisis. The FMCG retail online and FMCG brick-and-mortar industries will experience a lower impact given cash-basis sales that those businesses follow. Therefore, low receivable balances on their balance sheets.

W. Continuing on point “V” above, the amount at risk might increase since some vendors will keep on supplying goods to their existing customers despite their financial difficulties, in an attempt to preserve the relationship and show goodwill. Industries that are expected to continue on supplying their goods are the energy, chemicals, and real estate (real estate developers are motivated to continue the development of properties in order to meet the set milestones and delivery dates promised to their customers, which would increase the receivable balance from customers with the increase of percentage of completion). The increase of amount at risk is least likely for the consumer durables and building material industries which will try to limit their exposure of receivables from customers to the balances already due. Healthcare is expected to have an increase in the amount at risk due to the accumulation of receivable balances from insurance entities. The FMCG retail online and FMCG brick-and-mortar industries will experience a lower impact given cash-basis sales that those businesses follow.

X. Continuing on points “V” and “W” above, the loss given default would be impacted. For measuring ECL, the estimate of expected cash shortfalls should reflect the cash flows expected from collateral and other credit enhancements that are part of the contractual terms and are not recognized separately by the entity. Since the value of collaterals provided by debtors might decrease due to a drop in market values, the loss given default might consequently increase.

Y. The coronavirus outbreak disrupted operations and supply chains which will ultimately affect the probability of hedged forecasted transactions occurring during the time period designated at the inception of a hedge. Entities that have hedging transactions will need to determine whether they can still apply hedge accounting to the forecasted transaction or a proportion of it (e.g. if the hedged future cash flows are no longer expected to occur, amount that has been accumulated in the cash flow hedge reserve shall be immediately reclassified from the cash flow hedge reserve to profit or loss as a reclassification adjustment). FMCG retail online, consumer durables, energy, chemicals, and building material industries are more likely to have ongoing hedging contracts to cover highly probable forecasted transactions, such as forecasted purchase of commodities, forecasted sales of goods, and forecasted foreign currency exposure.

Z. IFRS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. It should also reflect market participant views and assumptions used when pricing the asset or liability. The impact of this crisis on fair values will be reflected in calculations related to long-lived assets revaluations, impairment testing, government grants, financial instruments measured at fair value, discontinued operations, and others. Therefore, the calculation should take into consideration the current market conditions and market participants view.

AA. For some customer contracts, the amount receivable by a vendor may be impacted by a wide range of variable considerations such as discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. IFRS 15 Revenue from Contracts with Customers requires that the estimated amount of variable consideration is recognized only to the extent that it is highly probable that a significant reversal in the amount of revenues recognized will not occur when the uncertainty is resolved. Entities are required to reconsider their estimates of variable consideration and whether they expect a reversal to revenue will occur considering the current crisis. For example, real estate entities should assess the probability of penalties on late delivery of projects, consumer durables, energy, chemicals, and building materials should reassess the probability of price concessions and discounts for customers to encourage higher purchases, and the probability that their customers will achieve their target purchases to receive quantity rebates or discounts. All industries are affected by this accounting issue, with lower impact on FMCG retail online and FMCG brick-and-mortar industries given cash-basis sales that those businesses follow.

BB. One of the criteria for entities to recognize revenues as per IFRS 15 Revenue from Contracts with Customers is that it is probable that the consideration for the exchange of goods or services that the vendor is entitled to will be collected. For the purposes of this criterion, only the customer’s ability and intention to pay amounts when they become due are considered. Since this crisis has affected the ability of customers to settle the transaction price when it falls due, entities should reconsider if revenues should be recognized for certain customers and transactions. All industries are affected by this accounting issue, with lower impact for the FMCG retail online and FMCG brick-and-mortar industries given cash basis sales that those businesses follow.

CC. To support lessees during this crisis, lessors and lessees might change the scope of a lease or revise the conditions of existing lease agreements. This might include concessions on the amount and/or timing of payments, free rent periods, or other incentives. Lessees and lessors need to assess whether these revisions constitute a lease modification as per IFRS 16 Leases. These modifications are not expected to be accounted for as a separate lease at the effective date of the lease modification. Both lessor and lessee accounting for a lease as a finance lease should reallocate the consideration in the modified contract, determine the lease term of the modified lease, and remeasure the lease liability/receivable by discounting the revised lease payments using a revised discount rate. For operating leases by lessors, the lessor shall account for a modification to an operating lease as a new lease from the effective date of the modification. Since all industries are involved in lease transactions, all industries are affected by the lease issue.

DD. Insurers and reinsurers who issue insurance contracts will have to consider requirements of IFRS 17 Insurance Contracts to recognize insurance obligations in relation to insurance contracts. This is not an issue to be considered in this paper.

Note: This material has been prepared by the author for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice.