(First of two parts)
The COVID-19 pandemic has resulted in challenges and difficulties previously unknown to economies and businesses worldwide. Travel bans, quarantines and lockdowns have become standard measures implemented by governments. Most businesses, regardless of industry, are losing revenue, experiencing disrupted supply chains and even possibly facing permanent closure. Economies are severely impacted with recession looming large on the horizon.
The Philippines has not been immune to the havoc caused by the pandemic, with substantial parts of the country placed under varying levels of community quarantine for extended periods. Even as quarantine conditions ease in most parts of the country, we are all looking at a “new normal” in going about our lives, with no guarantee when we can return to the way things were before COVID-19.
As the situation evolves, entities may find themselves hard-pressed to assess the full impact of the pandemic not only on their business operations but also on their financials. Consequently, entities may face certain challenges in the process of closing the books and their preparation of interim and annual Philippine Financial Reporting Standards (PFRSs) financial statements.
LEASES
One of the key items for consideration is lessor and lessee accounting under PFRS 16, the standard on leases. With the lease concessions and temporary closures experienced during the past three months, both lessor and lessee need to take a step back and assess how such events will impact their lease accounting moving forward. Our two-part publication, “Consensus in lease concessions due to COVID-19,” which was issued on June 8 and 15, provides a more detailed discussion on Leases.
GOING CONCERN
One such challenge is the assessment of whether an entity will continue to be a going concern (i.e., will continue to operate). The management, regardless of the entity’s size or business, is required by PFRSs (particularly, Philippine Accounting Standards or PAS 1, Presentation of Financial Statements) to assess the appropriateness of the going concern assumption when they prepare financial statements. Disclosures must be made if such an assumption is no longer valid or if there is significant doubt that the entity will continue as a going concern in the future.
However, if management assesses that such an assumption is no longer valid, the disclosures are not the only ones affected; the financial statements (as a whole) should no longer be prepared on a going-concern basis and the basis for measuring assets and recognizing liabilities will change. The assets will have to be written down to their recoverable amounts. For liabilities, provisions should be measured and recognized only when there is a present obligation, in accordance with PAS 37, Provisions, Contingent Liabilities and Contingent Assets. The assessment should be performed until the financial statements are approved for issuance, and all facts and circumstances should be considered.
Although the pandemic has affected all entities, the extent and manner are not the same. Thus, the degree of consideration and the conclusions reached will differ from entity to entity. Given the uncertainties involved and the evolving implications of COVID-19, management must exercise significant judgment and continuously update its assessment until the date of the issuance of the financial statements.
FINANCIAL INSTRUMENTS
The accounting for financial instruments is another area greatly challenged by our current situation. Entities that have identified increasing concentrations of risk in areas and industries affected by the pandemic should consider whether they need to make any disclosure on such risk concentrations, including the amount of the exposure. The entities’ liquidity risk will also need to be assessed if such is increasing under the current environment. If this is the case, PFRS 9, Financial Instruments, requires these entities to make the necessary disclosures not readily evident from existing risk disclosures.
Another aspect to consider is if there are any liquidity issues faced by the entities’ customers, as well as any potential deterioration in the credit quality of the trade receivables of these entities. These issues will have an impact on the expected credit loss (ECL or bad debts) of the entity as a supplier or lender. Entities will need to consider all available information regarding not only the current conditions or events brought about by COVID-19, but also forecasts of future economic conditions when they apply judgment and estimation on the ECL calculation. Entities also need to consider additional disclosures on the financial statements on the judgments and estimates applied to incorporate the effects of the pandemic in measuring the ECL.
IMPAIRMENT
PAS 36, Impairment of Assets, requires entities to assess if there are any indicators of impairment on non-financial assets every reporting period. If there are, it requires them to perform impairment testing. The assessment of any indicators of impairment entails looking at both external and internal sources of information. With recent developments, current information such as the volatility of financial markets, declining market interest rates, shutdowns or even closures of businesses and declining demand and supply may indicate that an asset is impaired.
Although these indicators do not necessarily mean that entities will recognize impairment losses, entities need to exercise care and significant judgment to ensure that the assumptions (such as discount rate, future cash flows, terminal values, etc.) made in performing impairment testing are reasonable and valid under conditions existing as of the reporting date. As most of these assumptions are subject to significant uncertainties, entities will also need to consider providing more detailed disclosures in the financial statements on these assumptions and the sensitivities involved.
REVENUE RECOGNITION
The situation can affect the estimation process in existing customer contracts that are within the scope of PFRS 15, Revenue from Contracts with Customers. If ongoing customer contracts have variable considerations (e.g., discounts, rebates, price concessions, bonuses and penalties), entities will need to estimate the variable considerations and their effect on the transaction price (i.e., amount of revenue to be recognized) and to assess whether to constrain these variable considerations. Entities are required to update such estimations throughout the life of the contract.
These requirements may prove to be a challenge to certain entities as they will need to consider the impact of the pandemic and the uncertainties involved in their estimation process. The pandemic may also result in entities modifying their contracts with customers by amending the scope and/or the price of the contract. Entities will have to assess the impact of such modifications in their revenue accounting and the related disclosures.
In the second part of this article, we will briefly discuss additional challenges in estimating the pandemic’s business impact on the preparation of financial statements, namely inventory costing and valuation, the recognition of compensation or penalties from potentially onerous contracts, and the assessment of adjusting or non-adjusting events after the reporting period.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Ma. Emilita L. Villanueva is a Partner from the Assurance Service Line of SGV & Co.
