The disclosure of judgements and estimates is the most frequently raised topic by the Financial Reporting Council (FRC) in their correspondence with companies in the last three consecutive years. As the global COVID-19 pandemic persists, entities are faced with the challenge of reporting meaningful information in an unprecedented period of uncertainty. In the 2020/21 reporting cycle, the FRC’s attention is set to focus on the “disclosures addressing risk, judgement and uncertainty in the face of the ongoing economic and social impact of Covid-19”. Such disclosures will be subject to increased scrutiny from auditors and will continue to attract the attention of investors, who will be searching for insight into the impact of management’s judgements and estimates on current and future reporting. Are you planning to include sufficiently detailed explanations and sensitivities to satisfy the users of your financial statements?
The FRC recently released a thematic review discussing the financial reporting effects of COVID 19. In this article, we discuss three key areas of the financial statements where we expect that the impact of COVID-19 on disclosure of the critical judgements and estimates will be particularly challenging.
1. Expected credit loss (ECL) estimates
In the current climate, ECLs may become a major source of estimation uncertainty for more entities. Entities must include disclosures which will enable users to understand their exposure to credit risk, including significant changes as a result of COVID-19. As part of this, significant judgements and assumptions about the forward-looking information which is incorporated into ECL estimates must be clearly explained. For example, entities could disclose the specific assumptions about micro and macro- economic factors (such as currency fluctuations, interest rates, GDP growth rate and industry outlook) made in determining the expected credit losses. Whilst the FRC strongly discourages the arbitrary allocation of total ECLs between COVID-19 and non-COVID-19 impacts, management are expected to explain in the rationale for the causes of the overall increase in ECLs (where material) and the specific impacts from COVID-19 that have contributed to this increase.
In addition to this, the quantitative impact of assumptions made should be sufficiently illustrated by means of scenario or sensitivity analysis. This is to show users of the accounts the range of possible outcomes if the assumptions were to change.
Intercompany loans and receivables must also be assessed to determine whether there has been a significant increase in credit risk as a result of the pandemic. It may be helpful to provide clear and specific explanation of any conclusion on whether or not there has been a significant increase in credit risk. For example, if long-term intercompany loans are assessed not to have a material ECL provision despite the impacts of COVID 19, the reasons for this conclusion may be disclosed along with any relevant sensitivity analysis.
2. Impairment of non-financial assets
Specific assumptions about future cash flows, growth rates and discount rates are typically required for the estimation of the recoverable amount (value-in-use) of non-financial assets. The determination of these critical forward-looking assumptions in the 2020/21 financial statements is expected to involve a higher degree of estimation of uncertainty due to the current economic circumstances.
Therefore, entities should provide specific explanation that will help users to understand the assumptions made about the impact of COVID-19 in forecasts, plans and budgets used as a basis for impairment testing. As part of this, sensitivity disclosures should be provided where a reasonably possible change in a key assumption would eliminate any impairment headroom. This disclosure is not new but is expected to be more prevalent this reporting season.
3. Inventory provisioning
IAS 2 requires inventory to be measured at the lower of cost and net realisable value. However, the determination of net realisable value in a COVID-19 climate is likely to require significantly greater judgement than for a typical year end reporting cycle. Consistent with the disclosures of judgements and estimates outlined above, entities will need to explain the critical assumptions that were applied in the measurement of inventory and the impact of these assumptions, as well as the disclosure of scenarios that illustrate how sensitive the assumptions are to changes in expectations.
The 2020/21 reporting season will be challenging for all entities, for many different reasons. When preparing the financial statement disclosures, we encourage entities to consider carefully the judgements and estimates made for all material balances. The FRC will be expecting that sufficient explanation is provided for the impact of the current unprecedented levels of uncertainty.
It should be noted that there are other areas where COVID 19 will present challenges such as the going concern assessment, presentation of alternative performance measurements, fair value measurements etc. For more information on the financial reporting impacts of COVID-19, please check our resource centre here.