COVID-19 Financial reporting: Financial instruments COVID-19 Financial reporting: Financial instruments COVID-19 Financial reporting: Financial instruments

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FINANCIAL RESILIENCE

Most organisations are being impacted by the coronavirus (COVID-19) pandemic, either directly or indirectly, and the increased economic uncertainty and risks may have significant financial reporting implications.

During periods of economic uncertainty, volatile asset prices and currency exchange rates along with declining long-term interest rates, the impact on financial instruments accounting can be significant and broad-ranging. The valuation of financial instruments along with expected credit losses, application of hedge accounting, modifications to debt arrangements and the current/ non-current classification of debt could all be impacted.

• On classification of debt, review projected covenant compliance in different scenarios and ensure any negotiations with financiers are finalised before reporting date.
• On provision for doubtful debts, analyse how COVID-19 impacts the risk profile of its customer base and consider whether the customer base should be segregated into different portfolios. Assess the recoverability based on management forecasts of different possible outcomes.
• For derivatives, update forecasts of purchases and sales and consider impact on hedge accounting such as whether the hedged volumes or timing will be negatively impacted.
• On fair valuing unlisted assets, ensure there is a process for updating inputs and sensitivities into the methodology, taking into account the risk factors identified and the different possible outcomes.

• How does COVID-19 impact the use of historical data to estimate Expected Credit Losses?
  
• What are examples of indicators that the collectability of receivables has deteriorated?
  
• How will COVID-19 impact the segmentation of an organisation’s receivables portfolio for expected credit loss calculations?
  
• How will COVID-19 impact an organisation’s write-off policy for receivables?

• What should an organisation consider if it has significant losses accumulated in its cash flow hedge reserve?
  
• What are the impacts of changes in expectations of future sales and purchases on derivative contracts designated into hedge relationships?
  
• What is the impact of credit risk on hedge accounting?

• What do we need to consider in accounting for a new funding arrangement that is in the form of derivatives?
  
• I am planning to negotiate the terms of my financing arrangements – what are some of the accounting implications?
  
• I have drawn down on a margin lending facility, how does this impact my cash flows forecast?
• Is the capitalisation of borrowing costs impacted when construction and development projects (e.g. property plant and equipment, inventory) are interrupted due to the COVID-19 outbreak?
  

• What are the accounting considerations if invoice payment terms for customers are extended in response to COVID-19?
• Current market prices are very volatile, should current observable market prices be used as inputs to fair value estimates?
  
• What are lenders’ financial reporting considerations for loans provided under the Coronavirus SME Guarantee Scheme?
  
• What are the financial reporting considerations for lenders under the Reserve Bank of Australia’s Term Funding Facility?
  

Impairment of financial assets

Many organisations use historical collection patterns to estimate expected credit losses (ECLs) - commonly known as provision for doubtful debts. ECLs are an unbiased, probability-weighted amount, estimated using reasonable and supportable information that is available without undue cost or effort at the reporting date. This includes information about past events, current conditions and forecasts of future economic conditions.

Given the unprecedented impact COVID-19 is having on various industries, historical collection patterns (past events) may no longer be a reliable indicator of the recoverability of an organisation’s receivables portfolio.

While historical loss information could be used as a starting point for estimating ECLs, organisations will need to assess whether, and by how much, they expect the COVID-19 pandemic to impact recoverability of their debtor balances based on the available information as at reporting date and adjust their ECLs accordingly.

Refer to COVID-19 how expected is that ECL? for more guidance on calculating ECLs in the current environment.

Many non-lending organisations have typically focussed on assessing the recoverability of significantly aged debtors (for example, 120+ days). However given the impact of COVID-19 is unprecedented and the severity of the impact differs across various industries, organisations may need to analyse whether the recoverability of their debtors has deteriorated regardless of days past due. This requires a detailed understanding of the impact across its customer base.

Some indicators of a deterioration in collectability may include:

• Has there been a material increase in the receivables balance from prior year? If so, why did it increase, for example, is this because of an increase in sales or because of delays in receipts?
• Are customers still paying on time, started paying late or stopped paying altogether? Have debtor days relative to payment terms increased from the prior year?
• Have debtor days increased between February¹ (pre-COVID-19) and June (during COVID-19)?
• Have there been any defaults on amounts due from customers since the beginning of March?
• Have certain customers stopped making payments and have not made any additional orders?
• Are more customers being offered extended payment terms?
• Are aged debtors (e.g. 120+ days) approaching their customer limits? Has it been necessary to cut off credit offered to customers?

Where there are indicators that the recoverability of the asset portfolio has deteriorated, organisations need to consider how they will incorporate new information about the impact of COVID-19 into their determination of the expected credit losses.

Refer to COVID-19 how expected is that ECL? for more guidance on calculating ECLs in the current environment.

_{1. Note: February was prior to any significant impacts emerging in Australia. However, depending on a debtor’s industry, you may need to consider an earlier time i.e. if sell into China, overseas travel related etc.)}

Organisations can measure ECLs on a collective group basis, so long as the receivables are segmented based on shared credit risk characteristics.

Organisations may have segmented their portfolio to capture the historical credit loss experience for different types of customers in prior periods. However, as the impact of COVID-19 on different industries is unprecedented, the segmentation applied in previous periods may no longer be appropriate and may require changes.

Understanding a customer’s credit risk is a multifaceted process. For example, the credit risk of a customer may depend on a combination of the following:

• Customer type and size – an entity vs an individual, multinational corporations vs small to medium businesses
• Industry – hospitality and the arts versus supermarkets and health
• Geographic region – tourism-based economy versus manufacturing or in a different jurisdiction subject to its own lockdown laws
• The impact on the supply chain due to border restrictions and the flow-on implications on the operations of the customer; and/or
• Occupation and employment status – Where the customer base comprises individuals, for example, casual employees in the retail sector versus permanent employees in the healthcare sector.

In other cases, the extent of how critical the entity is to its customer’s supply chain may differentiate the risk profile. The more crucial an entity’s product is to their customer’s operations, the more likely invoices outstanding at the reporting date will be collected compared to another customer who has multiple revenue streams and the entity is supplying to one of its smaller revenue streams.

Refer to COVID-19 how expected is that ECL? for more guidance on calculating ECLs in the current environment.

Many organisations apply a blanket write off policy for portfolios of assets with small balances and similar risk profiles.

As a result of COVID-19, organisations may segment their portfolios into different sub-groups taking into consideration how COVID-19 has impacted their customer base across the various industries. Organisations may now apply a specific write-off policy to each sub-group of receivables. For example, the likelihood of a swift recovery for a manufacturing company whose operation is impacted by supply chain interruption may be lower than another manufacturing company not dependent on parts from overseas.

Take another example where an entity that provides a 90 days payment term had a blanket policy of writing off receivables when they reach 180 days past due. Due to COVID-19, it is now offering extended payment terms of 180 days to eligible customers.

In this scenario, the organisation’s blanket write-off policy may not be appropriate as invoices that are 180 days past the extended due date would have previously been considered to be 270 days past due. Management may need to consider the collectability of receivables of this group separately.

Refer to COVID-19 how expected is that ECL? for more guidance on calculating ECLs in the current environment.

Hedging

Where an organisation has accumulated losses in the cash flow hedge reserve, it needs to consider whether those losses are going to be recoverable in a future period. The losses from the cash flow hedge reserve must be recognised immediately in the income statement if management does not expect the losses will be recoverable.

In the current environment, an example of where this may apply is where an organisation is hedging purchases of future inventory. If the anticipated future sales price of the inventory is not expected to be able to absorb the losses on the associated hedging instruments, then these losses will need to be recognised in profit and loss immediately.

Many organisations enter into derivative contracts to manage the foreign exchange or price risk of future sales and purchases. They generally are designated into hedge relationships in accordance with AASB 9 Financial Instruments.

Given the significant global economic contraction as a result of the COVID-19 situation, many organisations are experiencing a significant reduction or delay in sales and purchases.

AASB 9 requires a reassessment of hedge relationships when the hedged item has either been reduced or delayed or if it is no longer highly probable to occur. This would generally give rise to ineffectiveness and in certain circumstances, the change in fair value of the derivatives, including the amount recognised in the cash flow hedge reserve may have to be recognised in the profit or loss statement.

The impact of credit risk on hedge accounting is two-fold. Firstly, the fair value of a derivative includes the credit risk of the organisation and the counterparty. For most non-bank organisations, the counterparty is typically a bank.

With COVID-19, the organisation’s credit risk may have increased, for example, if it has to cease its operation. This in turn will impact the fair value of the derivative which may give rise to ineffectiveness being recognised in the profit or loss. Secondly, if the impact of credit risk now dominates the hedge relationship, this could trigger discontinuation of hedge accounting.

Financing/Re-financing

In the current economic environment, many organisations are looking for new ways to secure funding. Given the movement in the AUD/USD exchange rates, many organisations that have raised debt in USD and entered into cross currency swaps (CCS) to convert the US funding to AUD, are finding that the CCS is now in a significant asset position. Financial institutions are offering funding arrangements linking the amount of funding to the value of this derivative. In addition, the structure of the new funding arrangement takes the form of derivatives, for example, as a pair of forward contracts or CCSs without closing out the original swap derivative.

The accounting implications will depend on the specific terms and conditions of the arrangements. However if the two new derivatives being entered into reference each other and the terms are interdependent, it is likely that this will result in the two derivatives being considered a single contractual arrangement for accounting purposes, that is, it may be reflected as an amortised cost debt on the balance sheet rather than derivatives measured at fair value through the income statement.

Many organisations are currently negotiating with their financiers to modify the terms of their financing arrangements, for example, to change the debt covenant requirements, increase their facilities or extend the term of the arrangement. Classification of debt as current or non-current is based on the contractual terms as at reporting date. A change in the terms may result in an immediate profit and loss impact. Entities considering modifying their facilities should discuss with their lenders in advance of reporting date. Any change to the terms subsequent to reporting date are non-adjusting events.

Some entities have arrangements where the financier can call on them to make a margin payment when certain triggers are met. An example of which could be when there is a significant decline in the fair value of certain assets. Current market volatility may trigger such margin calls which may result in significant outlays of cash to settle the calls.

Entities should incorporate the potential cash outflows in their cash flows forecast including those supporting their going concern assessment. Entities may need to consider whether they have sufficient funding to meet potential calls or whether they should start engaging with their counterparties to modify these arrangements.

The economic turbulence resulting from the COVID-19 pandemic might lead to the suspension of projects due to legal restrictions on working or shortages of labour and/or supplies. These suspensions can impact whether borrowing costs can continue to be capitalised.

Borrowing costs are capitalised when they are directly attributable to the acquisition, construction or production of a qualifying asset (i.e. one that necessarily takes a substantial period of time to get ready for its intended use or sale).

If an organisation suspends active development of a qualifying asset for an extended period, then it also suspends capitalisation of the borrowing costs for that asset. An organisation continues to capitalise borrowing costs if:

• the interruption is for only a short duration;
• it continues to perform substantial administrative or technical work on the project; or
• it can demonstrate that the interruption is due to an external but common event or an interruption that is a typical part of the process. 

In evaluating whether it should suspend capitalisation of borrowing costs as a result of COVID 19 restrictions, an organisation may need to apply judgement considering both the expected length and the nature of the suspension.

Other

If the payment extension is a change from the original contract and under the extended payment terms, payment is still required to be made in 12 months or less (for example, payment term has extended from 30 days to 120 days), it is likely to be a non-substantial modification with no impact on the balance sheet and the income statement (subject to doubtful debt consideration).

However, there may be an impact to the profit or loss if payment terms are extended beyond 12 months and/or there are other complexities (for example, 24-month payment plan for an outstanding bill, or customers are charged interest over the extension period).

Organisations will also need to consider whether there is a change in the credit risk profile of customers who are on extended payment terms. Provision for doubtful debt (expected credit losses) will increase if customers, for example, are expected to continue to have longer term liquidity constraints beyond the payment terms.

Fair value is a market-based measurement – it is measured using assumptions that market participants would use, reflecting market conditions at the measurement date. Current quoted prices in an active market provide the most reliable evidence of fair value as they reflect the risks inherent in an economic environment impacted by COVID-19. Entities should use the current market prices as inputs to the fair value estimates at reporting date.

The Coronavirus SME Guarantee Scheme is one of the Government’s COVID-19 initiatives to support the flow of credit for small to medium enterprises (SMEs).

A lender recognises only the loan receivable from the SME as the guarantee is an integral part of the loan. Loans provided under the scheme are granted in accordance with the lender’s normal credit approval process, and priced at a market interest rate that considers the benefit derived from the guarantee.

The lender should disclose the credit enhancement on the loans, such as the nature, extent and duration of the guarantee, the volume of loans covered by the guarantee and how the guarantee impacts the estimation of expected credit losses.

Phase 1 of the Scheme commenced on 23 March 2020 and ceased for loans on 30 September 2020. It supported unsecured working capital loans for up to $250,000 for terms of up to three years, including a repayment holiday for the first six months.   

Phase 2 of the Scheme commenced on 1 October 2020 and ceased for loans on 30 June 2021. It supported secured and unsecured loans for up to $1 million for terms of up to five years with a cap on interest rates.

The RBA’s Term Funding Facility (TFF) provides authorised deposit-taking institutions (ADIs) with access to low-cost funding at a fixed rate of 0.25% for 3 years. There are no substantive conditions attached to the ongoing use of the TFF and it is not linked to the provision of specific loans to customers.

The fixed rate on the TFF may not be reflective of a market rate for the lender, regardless, the cost of borrowings for this funding will reflect the contractual rate of 0.25%.

An ADI should disclose the nature of the facility, the extent it has been drawn upon and how it has been recognised in the financial statements. The payment profile is included in the maturity analysis for liabilities.

The Term Funding Facility closed to new drawdowns of funding on 30 June 2021. The last possible maturity date for Term Funding Facility funds is 30 June 2024.