30 Nov 2022
The recent sharp deterioration in economic conditions coupled with increasing interest rates is having a far-reaching impact across businesses in the UK and globally. Businesses must continue to consider the direct and indirect impact of these conditions and forecast weaker economic outlooks on their financial reporting. In this article, we provide you with the latest technical insight into the key areas for consideration.
1. Going concern assessments
The current economic environment is putting an additional strain on companies, many of which are still struggling after the Covid-19 pandemic. Management must take into account all available information about the future prospects of the business together with wider economic assumptions around inflation and interest rates when completing their going concern review and provide robust disclosures in their financial statements to explain their conclusions regarding the going concern status of the entity.
In light of changing circumstances and the difficulty in predicting the impact of the current uncertainties, it may be appropriate for the entity to perform reverse stress testing rather than performing multiple sensitivities. This should take into account the point at which covenants are breached as well as when liquidity is exhausted.
It’s important for management to consider whether their plans are able to mitigate the negative impact on their business and disclose the key judgements in their going concern assessment.
2. Impairment of assets
Entities are required to make an assessment at each reporting date whether there is an indication that an asset may be impaired under both UK GAAP and IFRS. Given that two of the impairment indicators include a significant adverse change in the economic environment and an increase in the market rate of interest, it is likely entities will need to undertake an impairment review for investments, including in group entities, property plant and equipment, and intangible assets. Entities will need to ensure clear and concise disclosures including the assumptions used, and any changes in their assumptions from previous periods.
3. Post Balance Sheet Events
Financial statements must reflect the conditions which exist at the balance sheet date. In an evolving economic climate, it is harder for entities to determine what conditions existed at the balance sheet date, and therefore whether a post-balance sheet event is adjusting or non-adjusting. Companies will need to pay particular attention to their disclosures. Material non-adjusting events will need to be disclosed along with an estimate of the financial impact.
4. Judgements and estimates
Given the economic uncertainty, the judgements and estimates required by management are more difficult to make. Management will need to review all areas of their financial subject to judgements and estimation uncertainty and ensure concise disclosure in the financial statements.
Stock provisioning will need to take into account the impact of rising costs of material, fuel, and labour on its net realisable value. The economic conditions are likely to impact the demand for certain products so entities will need to determine whether their stock is still recoverable or whether it’s obsolete.
For receivables, FRS 102 reporters will need to determine whether there is evidence at the balance sheet date that debtors are recoverable. FRS 101 and IFRS reporters will need to modify their expected credit loss assessment and associated model.
The current economic conditions mean that more long-term or fixed price revenue contracts are likely to become onerous if the cost of servicing the contract cannot be passed onto the customer. Companies should review their customer contracts and consider the impact of increased costs on their contracts and recognise provisions as appropriate.
5. Narrative reporting and distributable profits
It is crucial that both the front-end narrative reporting and the annual accounts use the same assumptions when considering the risks and uncertainties facing the business. In particular, the Strategic Report should include the risks (such as the economic and climate change risks) facing the business and mitigation strategies adopted. Linkages between the information presented within the strategic report, such as strategy and business model, and the disclosures and assumptions used in the accounts should be highlighted and explained, and care should be taken to ensure these are consistent. In a further observation on linkages, the FRC annual review highlighted its expectations to see the Strategic Report explain “significant movements in the statements of financial position and cash flows, and not be limited to an explanation of financial performance.”
Finally, compliance with “specific legal requirements around distributions, including the requirement to file interim accounts to support distributions in excess of distributable profits shown in the relevant accounts (usually the most recent audited accounts).” Whilst middle market businesses might not be required to file interim accounts, they are still required to prepare management accounts to support a dividend where this is not supported by the relevant accounts. It is also important that care is taken before any assets are moved around a group as this can result in a deemed distribution which could be unlawful if there are insufficient or negative reserves.
Other sources of information
The FRC’s annual review of corporate reporting includes a number of reminders, in addition to those outlined above, and we have summarised their findings in this article.
For further information, please get in touch with Lou Ward, or your usual RSM contact.