The Covid 19 outbreak has already had a significant effect on the economy of India and most other countries. As companies in India prepare for their year-end reporting, there is an urgent need to evaluate the impact of this outbreak on accounting and financial reporting. Companies need to carefully consider these unique circumstances [including the ‘work from home’ (WFH) which was almost forced overnight], increased risk exposures and its’ the impact on financial reporting. Auditors of these companies also face several challenges to issue audit reports.
Most regulators across the world including Securities and Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) have already extended the dates for filing the quarterly / yearly financial results for 31st March 2020 by at least 30-45 days. Relaxations have also been given so as to enable companies to hold virtual meetings of the board of directors and shareholders.
In-spite of these trying situations, as on date of publication of this journal, several prominent companies have already finalised their financial statements and auditors have issued reports thereon.
The following paragraphs discuss some of the key accounting and financial reporting considerations for companies. The role of auditors is also discussed simultaneously since without the report of the auditors, the financial results may not be relied upon by the lenders, investors and analysts. The Institute of Chartered Accountants of India (ICAI) has also come out with several announcements to guide its members (i.e. those who would be auditing these companies) for conduct of audit and reporting in this situation.
For manufacturing companies this is a very important item in financial statements. In accordance with Ind AS 2 ‘Inventories’ and AS 2 ‘Valuation of Inventories’, cost of inventories shall comprise of all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location. As per the above definition, all additional costs incurred by the Company to bring the inventories to their present location needs to be a component of the cost of inventory. In COVID 19 scenario, companies may incur incremental costs like:
Storage/ warehouse costs as the goods were not removed from the warehouse;
Transportation costs incurred to get the goods delivered at the required location;
Abnormal amounts of wastage materials as the goods would be of perishable nature;
Further, inventories are usually written down to net realisable value item by item. The cost of inventories, including the additional costs, as discussed above, may not be recoverable if those inventories are damaged or, if they have become wholly or partially obsolete, or their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs to be incurred to sell have increased. The practice of writing off inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use.
Further, there would be fixed production overheads or indirect costs of production that remain relatively constant regardless of the volume of production (like depreciation, maintenance of factory buildings / equipment, factory overheads). These are normally based on the normal capacity of the production facilities. However, amid the COVID crisis, a Company may need to review its production capacity depending upon on the availability of raw materials or on account of low production due to idle capacity resulting from lower demand. These unallocated overheads may need to be expensed in the statement of profit and loss in the year they are incurred.
Regarding role of auditors, in accordance with Standards on Auditing 501, ‘Audit Evidence – Specific Considerations for Selected Items’ when inventory is material to the financial statements, the auditor has to obtain sufficient and appropriate audit evidence regarding the evidence and condition by:
Attendance at physical inventory counting (observe the performance of management count procedures, inspect the inventory, perform test counts, etc);
Performing audit procedures over the entity’s final inventory records to determine whether they accurately reflect actual inventory count results.
If the physical verification is done at a date other than the date of reporting, the auditor needs to perform additional procedures to obtain audit evidence that whether the changes in inventory between the count date and the reporting date of the financial statements are properly recorded.
Due to government-imposed lockdowns, it would have been impracticable in almost all companies (except maybe some companies in the essential services sector like pharma) to perform a physical inventory counting. In such cases, the auditor is required to perform alternative audit procedures to obtain sufficient and appropriate audit evidence. In absence of the same, the auditor shall use its judgement upon whether his report should be modified under SA 705 or whether an Emphasis of Matter (EoM) is needed. Further, the auditor is also required to use his judgement on the estimates used by the management as discussed above in ‘Management’s Role’. In this context, ICAI has come out with specific guidance on ‘Key Audit Considerations amid Covid 19 for physical inventory verification’.
Property, Plant and Equipment
Ind AS 16 ‘Property, plant and equipment’ and AS 10 ‘Property, plant and equipment’ defines property, plant and equipment as tangible items that are held for use in the production and supply of goods and services, for rental to others, or for administrative purposes and are expected to be used for periods more than one year (or twelve months). However, in these pandemic conditions, Companies need to use its judgement as to whether it can be extended to fifteen months. Further, management estimates will be needed for evaluation of the useful lives of the assets as the assets have remained idle during the lockdown period.
It is important for the Company to charge depreciation even for the period the plant has remained idle. In case a Company is following the useful lives mentioned in Schedule II to the Companies Act, 2013, the management will have to use judgement as to whether it should use the same or different rates – esp. in case of continuous process plants.
The auditor will have to obtain sufficient and appropriate audit evidence regarding the physical verification of property, plant and equipment at the reporting date. Further, the auditor needs to review the capital work in progress for the projects which have started in the lockdown period. In case of such assets, the auditor will need to decide whether additional costs due to the delay in commissioning of the assets can be capitalised or need to be expensed. Further, an impairment testing may also be required particularly for the capital work in progress assets.
Ind AS 23 ‘Borrowing costs’ and AS 16 ‘Borrowing costs’, requires the Company to suspend the capitalisation of interest when the development/ capitalisation of the asset is suspended. Hence, a Company needs to consider whether this lock down period attracts the conditions for suspension of capitalisation of borrowing costs in which case the same would need to be expensed for this period.
The auditor is required to use its judgement with respect to the suspension of activities for assets under construction or erection. Also, the auditor is required to obtain sufficient and appropriate audit evidence with regard to the availment of any moratorium for its borrowings. If appropriate audit evidence is not obtained and there has been a delay in the repayment of loans, auditor will have to consider whether he should report in the main audit report or in CARO.
Impairment of Non-financial assets:
Ind AS 36 ‘Impairment of Non-financial assets’ and AS 28 ‘Impairment of Assets’ requires impairment testing for all non-financial assets. For the same, recoverable value of the asset or a group of assets (called Cash generating Unit or CGU) needs to be computed. The recoverable value of any asset is the higher of ‘value in use’ or ‘value on sale’ for which extensive management estimates and judgements are required. In the current situation, where there is likelihood of factory shut-downs, reduction of prices, reduction in demand etc., such estimations and judgements can become difficult. Also, to calculate ‘value in use’, assumptions for DCF like discounting rates, dependence of imports, projections, production capacity etc., can become challenging. Further, due to COVID – 19, there might be significant changes having adverse effect (and hence impairment) in operations of a CGU to which goodwill has been allocated in the past.
In cases where Goodwill or other Intangible assets (like software development costs, product development costs, etc.) are recognised in the financial statements, the need for impairment testing for such assets would be even more required since the future economic benefits from utilisation of these assets and the period over which they can accrue can be very different than the earlier estimates.
Auditor will have to use his judgement in evaluating the management estimates and the assumptions for the same. It will have to ensure that same are in line with the industry. Further the auditor needs to ensure by performing analytical procedures that these assumptions are forward looking based on the current scenario. These assumptions or cash flows should not be confined to next twelve months but also consider the long-term prospects. Auditor will also have to perform additional audit procedures to have reasonable assurance upon the impairment valuation.
Provisions, Contingent Liabilities and Contingent Assets
Besides the normal year-end provisioning, management will have to consider whether any of its contracts have become onerous in the current scenario. Onerous contracts are those contracts where the unavoidable costs are more than the economic benefits. In such cases, the unavoidable costs in the contract may need to be provided upfront for the entire contract period. Further, there could be penalty clauses embedded in the contracts, which could have been triggered due the lock-down situation. Unless the management can invoke the ‘force majeure’ clause in such agreements, provision may be necessary for all such penalties. If there are on-going negotiations in these contracts and provision is not warranted, the possible liability may need to be disclosed as a contingent liability. The management will, thus, have to review all its major contracts for the above. In case of delays in payments to vendors esp. those in the MSME sector, provision for interest on delayed payments may also need to be looked into.
Coupled with the above, the Company will also have to review its insurance policies as to whether any insurance claims are receivable due to loss of profits due to business disruptions. If the Company has a policy, management may need to estimate the probability of receiving such amounts.
Auditor will have to obtain sufficient and appropriate audit evidence that all provisions on account of onerous contracts / penalties imposed / interest for delayed payments for all open contracts or outstanding payments are provided or disclosed as contingent liabilities.
All companies following Ind AS need to fair value their investments on Mark-to-market (MTM) basis and the resultant profit / loss taken to Statement of profit and loss or Other Comprehensive Income depending on the classification of the investment as “Fair Value though Profit and Loss” or “Fair Value through Other Comprehensive Income”. In the current scenario where all investments have suffered a massive erosion in their market values, management needs to consider whether the same truly represents ‘fair value’ or some other basis can be followed.
Also, for all trade and loan receivables companies need to do provisioning using the Expected Credit Loss (ECL) model as laid down in Ind AS 109. There can be a possibility that in this pandemic situation, some of its performing assets would have become under-performing assets or non-performing assets. In all such cases, management will need to revisit all assumptions to decide the likelihood of the recoverability or the delay in such recoverability. Further, adequate disclosure of all the methods followed, assumptions and information used in determining the revised ECL needs to be disclosed. Under certain circumstances, if management was not able to obtain sufficient information (which is possible in current scenario), the fact should also be disclosed in the financial statements.
The auditor, in all the above cases, will have to obtain sufficient and appropriate audit evidence regarding the assumptions and estimates for the revised ECL model. The auditor will have to ensure the same is done by taking the industry practice and the information is forward looking. The auditor will have to obtain reasonable assurance that the provisioning done by the Company is reflecting the true and fair picture of the financial assets held by the Company and is not unduly optimistic but is based on most realistic scenarios. The disclosures in case of both how investments are fair valued and the ECL model is followed will also need to be carefully evaluated by the auditor to ensure that it not only meets the requirements of Ind AS 109, but also captures the reality of the situation and how the management has dealt with the same.
Impairment for Investments
For companies who do not need to follow Ind AS, AS 13 is the relevant standard. The Company will have to assess provision for diminution of assets for its long-term investments. Management will also have to consider the impact on determination of market value for its short-term (or current) investments. In both cases, careful evaluation needs to be done whether the sudden fall in value of the investments really reflect the fair value of the investments.
Auditor will have to use its judgement whether the provision for diminution of value in case of investments (both long-term and current) can be of considered temporary in nature. If so, no provision for fall in value or MTM is warranted. Also, he will have to obtain a reasonable assurance that the data used for determining the fair value measurement is reliable and does, in fact, reflect the fair value.
Many companies are looking to review the lease terms in the period of lockdown and subsequently. This review will in most cases, be effective from 1st April 2020. For companies following Ind AS, where FY 2019-20 is the first year for implementing the new Ind AS 116 on ‘Leases’, such modifications in lease terms can result in complex adjustments to be done in the recognition of the “Right of Use” (ROU) asset and the corresponding liability. Besides this, estimates of the discount rate may also need to be reviewed.
For companies not following Ind AS, a similar exercise will also be necessary to determine adjustments that maybe necessary for recognition and measurement of finance leases and lease payment liability for Operating leases.
In both the above cases, the auditor will have to review lease agreements in order to obtain sufficient and appropriate audit evidence that no lease contract has become an onerous contract. Further, he will have to re-confirm lease liability recognised in the financial statements and assumptions used by the management for the discounting rates and the concessions.
For companies following Ind AS, there are several challenges for revenue recognition. The management will have to consider impact of likelihood of increased sales returns, discounts, estimate changes for contracts with variable consideration or target based incentives, warranty or AMC periods, etc. In many cases, customers may invoke the ‘force majeure’ clause to avoid taking delivery of goods, etc. For subscription-based revenue models, the subscription periods or AMC periods may also be extended. In all such cases, significant estimate assumptions will need to be considered by the management and can impact revenue recognition – as noticed in several FMCG companies that have declared their results. For companies in real estate and construction sector, these challenges could be still more as in most cases the contract terms will get re-negotiated or in some there could be terminations. Ind AS 115, the relevant standard for revenue, also requires extensive disclosures for all of the above.
For companies not following Ind AS (i.e. following AS 7 / AS 9), though the accounting complexities in measurement and disclosures could be lesser, nonetheless, the recognition issues as described above would remain.
For auditors, ensuring accurate revenue recognition by the companies is one of the most important verification areas. In this uncertain situation, they can face challenges in evaluating the assumptions and estimates adopted by management for changes in revenue recognition. Several contracts and changes thereto will need to be reviewed to make sure that the management is not reporting inaccurate revenue amounts. Reconciliation of these revenue figures with other regulatory filings like GST, with bankers, etc. will also become very important. In the WFH scenario, carrying out verification (even on sampling basis) can also prove very difficult.
For income tax provisioning (including for deferred tax), Companies will face many challenges. The following issues would need to be addressed:
Companies who have opted for the lower tax rates as per the September amendment, may need to reassess the same as they may anticipate losses in the current year and in future also;
For various provisions for liabilities and MTM for investments or other financial assets to be mandatorily done as per the applicable standards, application of the ICDS to ascertain their allowability;
As per the Covid-19 related concessions given, deduction is available in the FY 2019-20 for donations (esp. for Covid19 related and CSR related) made in the period 1st April 2020 to 30th June 2020 – impact of the same on the financial statements for FY 2019-20 would need to be ascertained;
Those companies who intended to take benefit of the“Vivad se Vishwas”scheme may need to re-evaluate the same – this has a corresponding impact on the financial statements;
For companies having unabsorbed losses and MAT credit, recognising the corresponding deferred tax assets for the same would need to be re-evaluated based on revised estimates of future profitability.
Auditors will have to carefully evaluate the assumptions based on which the provision for tax (including the rate applied) is done by the company. Further, auditor will have to obtain sufficient and appropriate audit evidence with respect to the virtual certainty (AS 22) / probable certainty (Ind AS 12) for the recognition of deferred tax assets in the books of accounts. A good checkpoint in such cases is to reconcile the effective tax rate (i.e. current tax plus deferred tax) with that of the earlier year.
Employee Benefits and Costs
Companies will have to decide on its revisions for increments, pay cuts, leave policies, work from home policies and its other related costs for and after the lock-down period. The same would need to be incorporated in the actuarial valuation reports. Year-end provisions like bonus and performance incentives would need to be reviewed based on the new policies and estimates made by the Company.
The auditor will have to confirm the actuarial valuations and the revised assumptions. In case of waiver or pay cuts of salaries/ policy, he would need to ascertain whether the same have the appropriate approvals and the same has been properly accounted.
Subsequent events are broadly those events occurring between the date of financial statements and the date of auditor’s report. Management will have to consider the events happening during the lockdown period as the same falls within the definition of subsequent events. In case some of these relate back to the year end and become adjusting events, effect will need to be given in the FY 2019-20 results (e.g. insolvency of a customer, impairment indications, NRV determination for inventory). If, however, the event is a non-adjusting event, the same will need to be specifically disclosed in the financial statements without passing any entries in FY 2019-20.
The auditor in such a scenario will have added responsibility to ensure that all subsequent events are identified by the company and appropriate treatment depending on whether the subsequent events as adjusting or non – adjusting events. For this, he may need to perform additional audit procedures like reviewing minutes for the current financial year with respect to the decisions taken by the management for such events.
The Reserve Bank of India and the central / state governments have announced several concessions to industry to mitigate the adverse impact of Covid19. Some of these measures like direct contribution by government to employees’ provident fund can trigger the definition of government grants. If so, companies will have to consider accounting for the same at either cost or fair value as per the relevant standards (Ind AS 20 or AS 20) and as per the previously adopted policy, if any, by the company for such grants.
The auditors would also need to understand the nature of the concessions applicable to the auditee company and whether accounting for the same as government grant needs to be done for the same.
If any item/s of the Statement of profit and loss are one-time, non-recurring and can provide additional information for understanding of the financial statements, the accounting standards and the ICAI Guidance Note on format of financial statements for companies provide that such items can be classified as “Exceptional” with adequate disclosure of why the same is so considered. In this scenario, many companies have considered items like inventory losses, impairment, etc. which have pre-dominantly arisen due to the Covid19 impact and the lockdown as ‘exceptional’ and have disclosed them accordingly.
Auditors will have to evaluate whether, if a company, wants to consider a particular item as ‘exceptional’ does it really meet the definition as per the applicable standards.
Normally, the financial statements are prepared on a going concern basis. This means that the company is likely and intends to continue its activities in the near foreseeable future. In the Covid19 situation and the drastic fall in economic activities, it is likely that survival of many companies may become questionable. This would be especially true for company which have high borrowings or are highly leveraged. The management needs to evaluate all factors like industry, likely demand revival and other factors to decide whether the company can continue into the future and meet all its liabilities as and when they fall due. This assumption is not only limited for the next twelve months, but even beyond that to continue as a going concern. There are several industries which are likely to be severely impacted by Covid19 – viz., airlines, hospitality, film exhibition, etc.
From the auditors’ point of view, he has to understand the business continuity plan of the company, how it plans to meet the future liabilities as and when they fall due, demonstratable support available from promoters to the company, etc. If the auditor is not comfortable with the above as represented by the management, he may well need to modify his report and include remarks under the para “material uncertainty about going concern”. ICAI has also come with specific guidance for auditors to deal with the going concern aspect in situation of Covid19.
Audit and reporting considerations
In the current Covid19 scenario with start of normal activities still months away, auditors face several challenges both for his own office functioning as well as conducting audits and issuing reports. Auditors will need to be very cautious and evaluate all facts and circumstances, including scope limitations due to the extended lockdown, before opining on the financial statements. In case, he does not agree with the management assessment of the estimates and assumptions, he may very well modify his audit report and include qualifications, or ’Emphasis of matter’ paragraphs. He can also include some of the limitations in the ‘Key Audit Matters’ or KAM for large companies.
Compliance with the Standards of Auditing (SAs) esp. on audit planning in WFH scenario, risk assessment, audit evidence, materiality and documentation also assume added significance for FY 2019-20. Auditors may well need to spend more time in ensuring adequate compliance with these and other SAs.
Though concessions have been given by the regulators and governments for taxation related compliances, no such concessions have been given (or seem likely) for financial reporting or auditing. These are, therefore, difficult and testing times for both, companies and auditors. Only time (or hindsight) will tell whether the companies and auditors have been able to appropriately capture the current uncertainties in the financial statements and reports. Besides, the additional procedures and WFH challenges, auditors may also face the stark reality that in many cases, the auditees may ask for reduction in fees or delayed payment thereof.
Note: A compilation by the same author of disclosures related to Covid19 by companies and auditors reporting thereon for some companies who have declared their results till mid-May 2020 can be referred in the BCA Journal June 2020 issue.