FINANCIAL REPORTING AND AUDITING CONSIDERATIONS ON ACCOUNT OF COVID-19

Most countries, businesses and
companies are expected to be impacted by the Covid-19 pandemic and the
increased economic uncertainty may have major financial reporting consequences.
Supply-chains,distribution-chains, cash-flows, demand, price variations,
facility access, workforce availability, debt obligations, contract
cancellations, are experiencing turbulence. 
Such a holistic and cumulative impact on different spheres of business
operations carries a definite, and acute consequence on the financial reporting
by the entity.

The role of preparers of
financial statements, audit committees, auditors and regulators become critical
in this situation. Distilling the impact through the requirements of existing
accounting and auditing requirements frameworks and communicating it
effectively will enable financial markets to base their decisions on such
robust and dependable inputs.

Auditors’ role will require
special attention in relation to appropriate treatment of the financial impacts
and disclosures thereof. The Institute of Chartered Accountants of India has
issued an ‘Accounting & Auditing Advisory on Impact of Coronavirus on
Financial Reporting and the Auditors Consideration’ to help its members in
effectively discharging their obligations.

There will be issues to consider
for this year’s reporting as well as in future years. Every entity would need
to consider the financial impact on itself and the areas of the financial
statements that will be affected along with determining the required
disclosures. Financial reporting areas that are likely to require close
consideration include the following:

(1)  Impairment of assets

Impairment of assets becomes the
foremost financial reporting consideration, given that testing of impairment is
predominantly based on the earnings realisation from a group of assets.

The assumptions such as
the fall in demand, impact of lockdown, fall in commodity prices, decrease in
market interest rates, manufacturing plant shutdowns, shop closures, reduced
selling prices for goods and services, cost of capital, etc. may have a
meaningful impact on the impairment testing performed by entities. Whilst most
entities would perform impairment testing on an annual basis, the current
Covid-19 situation would qualify for being an ‘indicator’, thereby requiring
entities to test for impairment even in the interim.

(2)  Going concern

Financial statements are prepared
on a going concern basis unless management intends either to liquidate the
entity or to cease trading, or has no realistic alternative but to do so.

With business models being
challenged especially in the travel, hospitality, leisure and entertainment
segments, companies may need to consider the implications on the assessment of
going concern and whether these circumstances will result in prolonged
operational disruption which will significantly erode the financial position of
the entity or otherwise result in failure.

It is the
responsibility of management to make an assessment as to whether the entity is
a going concern or otherwise. The unprecedented and uncertain nature of the
pandemic makes it imperative for an entity to evaluate various scenarios that
are possible and assess their impact on the assumption of going concern.
Inability to satisfy the assumptions of going concern would lead to deviation
from historical cost-based accounting and other impacts.

Management should also expect an informed
and sometimes contrarian dialogue with auditors on the aspect of going concern.

(3)  Valuation of inventory

With social distancing norms in
place, entities may not have been able to carry out their annual physical
inventory count fully or even partially on the cut off date. Due to the
lockdowns, auditors and companies may need to rely on additional alternate
procedures to gain comfort on the position and valuation as on 31^st March,
2020.

Companies would need to assess
whether, on their reporting date, an adjustment is required to the carrying
value of their inventory to bring them to their net realisable value in
accordance with the principles of Ind AS 2 –Inventories and AS 2 – Valuation
of Inventories.

Given the pandemic, net
realisable value calculation will likely require more detailed methods and
assumptions, e.g. write-down of stock due to lesser expected price realisation,
reduced movement in inventory, expiry of perishable products, lower commodity
prices, or inventory obsolescence. The usability of raw materials and work in
progress may also require close consideration.

A typical question arises in
relation to allocation of overheads to the valuation of inventory. If an entity
ceases production or reduces production for a period of time, significant
portions of unallocated fixed production overheads (e.g., rent, depreciation of
assets, some fixed labour, etc.) will need to be expensed rather than
capitalised, even if some reduced quantity of inventory continues to be
produced.

(4)  Lease and onerous contracts

The implications of force
majeure provisions on contracts and leases remain to be tested. It is
possible that there may be changes in the terms of lease arrangements or
lessors may grant concession to lessees with respect to lease payments,
rent-free holidays, additional days in subsequent period, etc. Such revised
terms or concessions shall be considered while accounting for leases which may
lead to the application of accounting relating to the modification of leases.
However, generally anticipated revisions are not taken into account.

Some entities may encounter
situations wherein certain contracts may become onerous to perform. Ind AS 27
defines an onerous contract as a contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic benefits
expected to be received under it. Price erosions, long-term commitment, salvage
discount, commitment of additional performance are certain triggers to evaluate
whether a contract has turned onerous. As soon as a contract is assessed to be
onerous, a company applying Ind AS 37 records a provision in its financial
statements for the loss it expects to make on the contract.

(5)  Expected credit loss (ECL)

ECL is an expectation-based
probability weighted amount determined by evaluating a range of possible
outcomes. It enables entities to make adequate provisions for non-realisation
of financial assets including trade receivables.

Ind AS 109 – Financial
Instruments requires an entity, amongst other matters, to also evaluate the
likelihood of the occurrence of an event if this would significantly affect the
estimation of expected losses of financial assets. In assessing the expected
credit loss, management should consider reasonable and supportable information
at the reporting date. Covid-19 impact would require to be factored in the ECL
probability model of entities.

Expected credit losses may
increase due to an increase in the probability of default for financial assets.
Additionally, the effects of the coronavirus may trigger a significant increase
in credit risk, and therefore the recognition of a lifetime ECL provision on
many financial assets.

Event-based provisioning in
relation to specific instances, like a customer turning insolvent or a specific
financial investment getting affected, would continue to be factored in
irrespective of the ECL.

(6)  Revenue recognition and borrowing costs

Ind AS 15 – Revenue from
Contracts with Customers often requires a company to make estimates and
judgements determining the timing and amount of revenue to be recognised.
Covid-19 may result in a likely increase in sales returns, decrease in volume
discounts, higher price discounts, etc. Entities may need to account for
returns and refund liabilities towards the customers whilst recognising the
revenue.

Ind AS 115 requires an entity to
defer a component of revenue to be recognised when the contract includes
variable consideration. This may result in some entities recognising a contract
liability rather than revenue, if significant uncertainty exists surrounding
whether the entity will realise the entire consideration.

Separately, the guidance on
borrowing costs requires an entity to suspend the capitalisation of borrowing
costs to an asset under construction for such extended periods that the actual
construction of the asset is suspended.

(7)  Government grant

Governments may support entities
with monetary and non-monetary measures, but such benefits may be one-time
events or spread over time.

Entities may need to establish an
accounting policy regarding government assistance which needs to be appropriate
and in line with the requirements of Ind AS 20 – Accounting for Government
Grants and Disclosure of Government Assistance. It is essential to distinguish
between government assistance and government grants and ensure that grants are
recognised only when the recognition criterion in Ind AS 20 is met. Some of the
government assistance may involve deferral of tax payments or other tax
allowances. The accounting treatment of tax allowances may need to be accounted
for under Ind AS 12 –  Income Taxes
rather than Ind AS 20.

The current relaxation by the
Reserve Bank of India allowing a moratorium on loan instalments may not qualify
as a government grant.

(8)  Deferred tax

Ind AS 12 – Income Taxes
requires that the measurement of deferred tax liabilities and deferred tax
assets shall reflect the tax consequences that would follow from the manner in
which the entity expects, at the end of the reporting period, to recover or
settle the carrying amount of its assets and liabilities.

Covid-19 could affect future
profits and / or may also reduce the amount of deferred tax assets or create
additional deductible temporary differences due to various factors (e.g. asset
impairment, non-utilisation of available losses, change in projections).
Entities having deferred tax assets on account of accumulated tax losses would
need to reassess their measurement with a newer set of business projections.

Entities may have considered the
assumption of ‘indefinite reinvestment’ and not recognised deferred tax on
accumulated undistributed earnings of subsidiaries. Such assumptions may need
to be revisited to determine if they remain appropriate given the entity’s
current cash flow projections.

(9)  Fair value and hedge accounting

Ind AS 113 – Fair Value
Measurement recognises the fact that observable inputs being considered for
deriving fair value may be either of (i) observable market price (quoted price
in an active market – Level 1) or (ii) application of valuation techniques
(Level 2 and Level 3).

With 1,500 companies trading at
their 52-week low on the Bombay Stock Exchange, the fair value measurement
considered by entities may need a re-look across all three methods of observable
inputs.

While volatility in the financial
markets may suggest that the prices are aberrations and do not reflect fair
value, it would not be appropriate for an entity to disregard market prices at
the measurement date, unless those prices are from transactions that are not
orderly.

The financial assumptions in a
valuation model like discounting rate, weighted average cost of capital, etc.
that are considered in a Level-3 valuation would need a reassessment.

Hedge effectiveness assessment is
required to be performed at the inception and on an on-going basis at each
reporting date or in case of a significant change in circumstances, whichever
occurs first. The current volatility in the markets may result in an entity
requiring to either re-balance the hedge where applicable, or discontinuing
hedge accounting if an economic relationship no longer exists, or the
relationship is dominated by credit risk. Certain opportunistic and speculative
transactions may also take place.

When a hedging relationship is
discontinued because a forecast transaction is no longer highly probable, a
company needs to determine whether the transaction is still expected to occur.
If the transaction is:

(i) still expected to occur, then gains or losses on the hedging
instrument previously accumulated in the cash flow reserve would generally
remain there until the future cash flows occur; or

(ii) no longer expected to occur, then the accumulated gains or losses
on the hedging instrument need to be immediately reclassified to profit or
loss.

(10) Disclosures and management guidance

Transparent disclosures should be
made on the effects and risks of this outbreak on the entity. The Securities
and Exchange Commission instructed publicly traded companies to provide
‘robust’ disclosures on the impact of Covid-19 on their operations and results.
Entities would need to disclose the impact of Covid-19 on their performance,
including qualitative aspects of the business.

Difficult times also warrant
accuracy in guidance; in an uncommon move, leading Indian bell-wether companies
like Wipro and Infosys have refrained from giving any annual guidance to
their shareholders for F.Y. 2020-21, citing the uncertain impact of Covid-19.

The relevance of an audit effort
on the financial statements is further emphasised in uncertain times like
these. Some of the common questions that auditors could encounter would
include:

(A) Have the risk considerations relevant to an entity changed, thereby
requiring an amendment to the audit approach?

Standards on auditing require an
auditor to identify and assess the risk of material misstatements and
materiality in planning and performing an audit. This assessment may have been
made during the earlier half of the financial year 2019-20 and the audit
procedures tailored on the basis of such earlier assessment. Due to Covid-19
and its far-reaching implications, the risk considerations relevant to an
entity may change significantly, thereby requiring an auditor to revisit the
audit plan, materiality and the approach to testing.

The perfect storm that Covid-19
offers has the potential to usurp good and healthy business models and push
profitable companies into a survival challenge. It would be important for
auditors to revisit the audit plan and the risk considerations once again given
the exposure an entity would have to Covid-19.

(B) Have the audit procedures been compromised on account of
restrictions, lockdowns and social distancing?

Auditors may face a challenge in
performing routine audit procedures during times of lockdown, social
distancing, travel restrictions, lesser access to management teams, etc.
Typically, audit procedures that have either a physical work-stream or
dependency on a third party are likely to get impacted. These could include
physical verification of inventory, cash on hand reviews, seeking external
balance confirmations, requiring comfort from component auditors, etc.

SA 501 requires the auditor to
observe some physical inventory counts on an alternative date if the attendance
of physical counting cannot be performed at the year-end date, or perform
alternative audit procedures where attendance of physical inventory counts is
impracticable. The standard also requires an auditor to perform roll-back procedures
to derive the desired comfort on inventory level on a reporting date.

Audit procedures should be
simulated to understand the potential impacts on such procedures to be
performed and alternate procedures identified to supplement or otherwise replace
such an audit procedure.

(C) How does an auditor provide comfort on the operating effectiveness
of internal financial controls given the altered way of working, such as work
from home, no wet signatures, cloud dependency, etc.?

Standards on auditing require an
auditor to assess the design and implementation along with the operating
effectiveness of internal controls over financial reporting. The sudden impact
of Covid-19 and the precautionary measures taken by governments across the
world have resulted in newer work models of work from home, no wet signatures,
cloud dependency, etc.

Auditors would need to evaluate
the impact of such differentiated working models on the internal control
framework and the desired reliance by the auditor on their operating
effectiveness. If the level of expected controls reliance changes, it is
important to document this and any other resulting changes to the planned audit
response.

(D) Is Covid-19 an adjusting event or a non-adjusting event?

According to Ind AS 10 – Events
after the reporting date, events occurring after the reporting period are
categorised into two, viz. (a) Adjusting events, i.e. those that require
adjustments to the amounts recognised in the financial statements for the
reporting period, and (b) Non-adjusting events, i.e. those that do not require
adjustments to the amounts recognised in the financial statements for the
reporting period.

Entities and auditors would need
to ascertain the impact of Covid-19 as either an adjusting or non-adjusting
event given the peculiarity that the effects of Covid-19 and lockdown were
prevalent in March, 2020 itself. Entities impacted by the Covid-19 pandemic
will need to assess how these events have, and may in future impact their
operations. Managements will need to consider the facts and apply critical
judgement in assessing what specific events and, more importantly, the timing
of those events, provide evidence of conditions that existed at the end of the
reporting period in order to determine if an adjustment is required. If it is
concluded as non-adjusting, the entity will need to determine if disclosure of
the event is required.

(E) Does Covid-19 require added consideration to emphasis of matter and
in relation to going concern uncertainty?

If the auditor considers it
necessary to draw users’ attention to a matter presented or disclosed in the
financial statements that in the auditor’s judgement is of such importance that
it is fundamental to users’ understanding of the financial statements, the
auditor shall include an ‘Emphasis of Matter’ paragraph in the Auditor’s
Report. SA 706 also cites instances that may warrant an emphasis of matter
observation by the auditor. One such instance is ‘A major catastrophe
that has had, or continues to have, a significant effect on the entity’s
financial position.’ Depending on the circumstances of the entity, the
auditor may consider appropriate reporting as emphasis of matter.

When
preparing financial statements, management is required to make an assessment of
an entity’s ability to continue as a going concern. In line with SA 570
(Revised), the auditor’s responsibilities are to obtain sufficient appropriate
audit evidence regarding, and conclude on, the appropriateness of management’s
use of the going concern basis of accounting in the preparation of the
financial statements, and to conclude, based on the audit evidence obtained,
whether a material uncertainty exists about the entity’s ability to continue as
a going concern.