COVID-19: Implications for financial reporting and audits
This article was last updated on 22 May at 11:45.
The coronavirus (COVID-19) pandemic has quickly become both a global health and economic emergency with deep impacts on the economy and restrictions to daily life. Entities with 2019 and early 2020 year-ends must consider its effects on their activities and how these are reflected in their financial statements. The impacts must also be considered for the practicalities of the reporting and auditing process and planned for accordingly.
Financial reporting impacts include:
- Going concern assessment and disclosures: All companies must assess the appropriateness of the going concern basis of accounting when preparing their financial statements.
Entities are required to adopt the going concern basis of accounting, except in circumstances where the directors determine at the date of approval of the financial statements either that they intend to liquidate the entity or to cease trading, or have no realistic alternative to liquidation or cessation of operations. Under the going concern basis of accounting, an entity will be assumed to continue in business for the foreseeable future without the intention or need to liquidate, cease trading or seek protection from its creditors. As a result, assets and liabilities will be recorded assuming that they will be traded or settled in the normal course of business.
Many entities will be impacted by the COVID-19 pandemic and its resultant economic effects and uncertainty. The impact on the entity should be assessed by management and included in their going concern assessments. Given the unprecedented nature of the crisis and the unique nature of the likely recession this assessment will be far from straight forward. Management must make their best estimates of factors such as future sales levels, impacts on supply factors, future costs, access to finance etc and be able to justify these estimates and assumptions to auditors.
The ICAEW and ICAS have jointly issued guidance for directors of SME businesses which can be found here and is a useful guide to the factors to be considered.
The FRC has recently updated guidance for companies on Corporate Governance and Reporting (including Interim Reports) here. This guidance covers a number of areas including strategic report, going concern assessments and reporting, and reporting on significant judgements and estimation uncertainty.
- Assessment of the date of impact on an entity: Under UK GAAP and IFRS, the broad principle is that the balance sheet reflects the position of the entity at its reporting date. Consideration should be given to the impact of the virus on an entity at its reporting date.
At 31 December 2019 the incidence of the virus was limited to a small number of cases of a then unknown virus in a localised region of China. For entities with a 31 December 2019 year end, the emergence and spread of the virus in 2020 is a non-adjusting event (although as above, it must be included in forward looking going concern assessments).
Although a non-adjusting event companies will need to focus on the importance of the conditions at the balance sheet date – does the event highlight conditions in existence at the year end or did conditions change after the reporting date? If the judgement had a significant effect on the amounts in the financial statements, then this judgement should be disclosed and explained.
If an event is considered to be non-adjusting, then the nature of the event should be disclosed. Where an estimate of the financial effect on the company can be made, then this should be disclosed. Otherwise the fact that the financial effect cannot be estimated should be disclosed. The estimate does not need to be exact – a range of estimated effects is better than no quantitative information at all. In the absence of any quantitative estimate, a qualitative description should be provided.
For entities with reporting dates in early 2020, a more precise assessment is required given the particular circumstances and operational scope of the entity. For example, entities with 28 February 2020 year ends may consider the spread of the virus from localised regions of China to be an adjusting event where they have material operations in areas affected in February 2020.
For those with 31 March 2020 year ends, the timing of impacts will be more certain and far more likely to require adjustment and recognition in the year end financial statements.
- Impacts on reported results and position: The impacts of the economic crisis, operational restrictions and uncertainty associated with the pandemic will vary by entity to entity.
- Financial statement areas which may be affected include:
- Asset impairment – Fixed Assets, Intangible Assets, Fixed Asset Investments in subsidiaries and associates are all at increased risk of impairment.
- Asset valuation – the fair value of assets held at fair value may be more complicated or impossible to value reliably. Valuation reports received from external valuers may contain an uncertainty or qualifying clause in relation to certain aspects of the valuation. For example, the uncertainty may relate to the lack of empirical data upon which to determine a quantitative estimate for a key input. Management may in these circumstances might opt to prepare their own valuations by may not have sufficient expertise or appropriate data to draw upon.
- Stock impairment – stock may be perishable, bespoke, or face reduced demand, any of which may increase the risk of impairment.
- Receivables impairment – shocks to the economy increase the risk of bad debts from third parties and also group entities. For those preparing accounts under IFRS 9, this may further complicate ECL provision calculations. The risks of other debtors, including deferred tax assets being recoverable may also be increased.
- Business interruption, downsizing and closures may increase the risk of leases becoming onerous.
- Lessors and lessees might renegotiate the terms of a lease because of COVID-19 or the lessee might be offered a concession in regard of payments such as a rent holiday. Under FRS 102 simple concessions are likely to create a rent creditor but the renegotiation of the lease with new incentives (such as rent free periods) will require reassessment. Under IFRS 16, both lessor and lessee will need to consider whether the concession should be accounted for as a lease modification and spread over the remaining period of the lease. As discussed here the ISAB is currently consulting on an emergency amendment to IFRS 16 to simplify entities account for COVID-19 related concessions.
- Governments around the world have moved quickly to offer support to entities affected. The accounting for these schemes will require careful consideration, and some schemes will constitute government grants – an area of accounting hitherto of little relevance to many corporate entities. Guidance on how to account for the most significant UK schemes is available here.
- Foreign exchange rates have fluctuated significantly and large gains/losses on re-translation at 31 March 2020 should now be expected and recognised. Similarly, larger gains/losses on the fair value of forex derivatives will be expected.
- Fluctuation of prices and rates in the markets will impact the valuation of assets and liabilities that are dependent on these variables. These will vary according to circumstances, for example the impacts on defined benefit pension obligation calculations following falls in stock markets are likely to be significant.
- Disclosures about the use of judgements and estimation uncertainty in financial statements can be complex and have been criticised in recent years by regulators. These may be more complex this year but also more important than before so it is important that those preparing financial statements are aware of the requirements.
- Financial statement areas which may be affected include:
- Directors and Strategic Reports, and Trustee Reports
In its role promoting transparency and integrity in financial reporting, the Financial Reporting Council (FRC) has provided advice on coronavirus risk disclosures to companies preparing financial statements here.
Since then the impact of the virus has spread from China, Asia, to Europe, the UK and across the globe. Accordingly, most entities will be affected either through shocks to demand for their product, supply of their products or operationally and are likely to require some disclosure in these reports where required. When mitigating actions can be taken, these should also be reported alongside the description of the risk itself.
Small companies are exempt from the requirement to prepare a strategic report and, therefore, the requirement to report on principal risks and uncertainties. Small companies are also exempt from the requirement in the directors’ report to provide particulars of important events affecting the company which have occurred since the end of the financial year and an indication of likely future developments in the business of the company.
However, the directors’ report represents an opportunity for the directors to communicate how the board is taking account of any challenges it faces. In some circumstances it may be useful to provide information above the minimum required by law which may be of interest to other stakeholders such as customers, lenders or suppliers.
FRC guidance on the preparation of the Strategic Report and other relevant guidance is available here.
- Extended filing deadlines
The difficulties preparing financial statements created by the virus have been acknowledged by Companies House and the FCA.
The FCA have announced a temporary extension to listed company filing deadlines. This temporary relief will permit listed companies which need the extra time to complete their audited financial statements an additional 2 months in which publish them. Currently, under the Transparency Directive, companies have 4 months from their financial year end in which to publish audited financial statements. Further detail is available on the FCA website here.
Companies House are allowing all private companies to apply (the extension is not automatic) for a three month extension for their accounts filing deadline. Companies House are also temporarily pausing the strike off process for companies unable to file or update records and have undertaken to treat appeals against late filing penalties sympathetically where COVID-19 is the reason for the delay. Further detail is available on the Companies House website here.
While management focus on operational matters some auditing impacts may have implications for the financial reporting process. These include:
- Audit quality & revised timetables
The FRC has published guidance on audit issues arising from the pandemic. In this guidance they acknowledge the difficulties that the virus and associated restrictions create for companies and auditors, but state that they are "concerned that the current situation should not undermine the delivery of high-quality audits. Audits should continue to comply fully with required standards".
They point out that "In current circumstances, additional time may be required to complete audits and it is important that this is taken, even at the risk of delaying company reporting".
Therefore, while many firms can work remotely, there may be compelling and well documented reasons for auditors and management to liaise with one another to consider delaying reporting if audit or financial reporting quality may be compromised. Management should also engage with key stakeholders including lenders to organise revised reporting deadlines if solutions cannot be found to avoid issues and delays in the audit and reporting process.
- Group audits
Auditing standards and associated guidance place significant requirements on group auditors to closely direct, understand and review the work of auditors of overseas subsidiaries ('component auditors'). Often the process will require close liaison with the component auditors and visits overseas to review audit working papers. While auditors may find technological solutions to meet these requirements, for some jurisdictions there are limitations on what can be shared electronically, while the complexity of some subsidiary audits may necessitate unavoidable face to face review meetings. Where these examples exist, auditors and management will need to consider the impact on the reporting timeline and consider delays as noted above.
- Audit reports and additional work
While logistical challenges in the provision and review of sufficient appropriate audit evidence may be overcome by the benefits of remote working and cloud-based IT systems, or alternative audit procedures, the rapid spread and financial impact of the virus will have many implications for the recognition of balances and transactions in the financial statements as noted above and complicate the audit process. These will affect the risk assessments of auditors and may require additional time to make relevant judgements, consider or to obtain audit evidence and will have implications for the form and content of the audit report. These matters will all take time for management and auditors to resolve, and again will require careful co-operation and the need to assess the appropriateness of the reporting timetable.
If you wish to discuss the implications for financial reporting and audits and/or any other COVID-19 related initiatives, please contact your usual haysmacintyre contact or email CV19@haysmacintyre.com.