(Second of two parts)
In last week’s article, we discussed the challenges of assessing an entity’s status as a going concern, accounting for financial instruments, impairment of non-financial assets and revenue recognition. This week’s article will provide brief discussions on inventory costing and valuation, addressing onerous contracts and assessing whether events surrounding the pandemic and the resulting developments are adjusting or non-adjusting events.
INVENTORY COSTING AND VALUATION
Inventories are required to be accounted for at the lower of their cost or net realizable value (NRV). The pandemic and resulting government measures have caused certain entities to reduce their usual production volume, with some completely stopping production during the second quarter. These entities may need to revisit the cost of their inventories. This is particularly true for those manufacturers that allocate fixed production overheads based on normal production capacity. If the production volume of these entities are lower than what was determined to be “normal capacity,” the fixed production overhead should not be allocated to the units produced as this will unduly inflate their costs. Rather, any unallocated fixed production overhead will need to be expensed as incurred.
Determining the NRV (or the selling price less cost to sell and/or cost to complete) is another matter as this entails estimation on the part of management. The pandemic may have resulted in reduced demand for the entities’ goods, which in turn will cause the entities to decrease their prices. In such a case, entities will have to determine whether they need to write down the cost of their inventories to NRV. In other cases, entities with goods that are perishable may even find themselves disposing of their products that they are unable to sell, thus resulting in the write off of these inventories.
In all of the above, entities will need to also consider making additional disclosures to further describe the impact of the pandemic in their inventory costing and valuation.
ONEROUS CONTRACTS
Onerous contracts are defined under PAS 37, Provisions, Contingent Liabilities and Contingent Assets, as contracts where the “unavoidable costs of meeting the obligations… exceed the economic benefits expected to be received.” If a contract is found to be onerous, PFRSs require the entity to recognize a provision for such a contract and even possibly recognize an impairment on the related asset or assets.
With the disruption in supply chains brought about by the pandemic, entities will need to consider whether their contracts are onerous and if there is any need to quantify and recognize any compensation or penalties from these contracts. For example, a manufacturing entity has to shut down its facilities as required under ECQ. The entity, however, has contracts to sell goods at a fixed price, which may force the entity to procure the goods from another party at a significantly higher cost. The entity will need to review its contracts to determine if there are any compensation or penalties if the entity is unable to fulfill its obligations. The entity will also need to check if there are any special terms that may relieve the entity from its obligations (e.g., force majeure). If the entity can cancel the contract without paying any compensation or penalty to the other entity, the contract is not onerous. Thus, the entity will not need to recognize any provision or impairment losses under the contract.
EVENTS AFTER REPORTING DATE
Events after the reporting period (or balance sheet date) are favorable or unfavorable events that “occur between the end of the reporting period and the date when the financial statements are authorized for issue.” Such events may be adjusting events (i.e., they have an impact on the financial statements) or non-adjusting events (i.e., they have no impact on the financial statements but may have an impact in terms of the disclosures). Events after the reporting date are adjusting events if they “provide evidence of conditions that existed at the end of the reporting period.”
Management needs to exercise critical judgment in order to assess if the events surrounding COVID-19 are adjusting or non-adjusting events. If the events are adjusting events, the entity will need to make the necessary changes (e.g., recognize provisions for court cases existing at the end of the reporting period but were subsequently settled, recognize impairment loss on receivables for customers that declared bankruptcy after the balance sheet date, etc.) in the amounts recognized in the financial statements. If the events are non-adjusting events, the entities will then need to assess if the impact is material. If such is the case, they must make the necessary disclosures in their financial statements.
DISCLOSURES (FOR INTERIM REPORTING PURPOSES)
The abovementioned implications carry with them the corresponding disclosures required by the relevant standards. However, entities that are required to prepare interim financial statements will also need to consider the required disclosures under PAS 34, Interim Financial Reporting. Under this standard, an entity should disclose events or transactions that have significant impact on its balances since the end of the last annual reporting period. Some examples of these events and transactions are those that impact the valuation of financial assets, such as equity or debt instruments, any loan default or breach of a loan agreement.
Since the disclosures under PAS 34 are basically updates of the disclosures or information presented in the most recent annual reporting period (i.e., Dec. 31, 2019), entities should also consider the extent of information they presented in the annual financial statements. However, since the local impact of the pandemic was felt only in the latter part of the first quarter of 2020, it is possible that this information may not have been included in the 2019 annual financial statements. Entities will then need to include more comprehensive disclosures in their interim financial statements.
ACCOUNTING CHALLENGES FROM COVID-19
This article briefly touches on some of the challenges COVID–19 poses in preparing financial statements. These challenges may differ from entity to entity and as developments surrounding the outbreak continue to evolve, but there can be no denial that all entities will feel the pandemic’s repercussions on people’s lives and the economy. Entities will thus need to be constantly alert to the implications of the outbreak on their financial statements.
This two-part article is the first of a series covering the accounting impact of the coronavirus outbreak. Other articles that will follow will provide more in-depth discussion on certain areas such as impairment and revenue recognition.
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.
