04 May 2020
For entities that apply the FRS 102 provisions in full, coronavirus is likely to have a major effect on a number of financial instruments.
This article does not consider the impact on entities that have chosen to apply the recognition and measurement principles of IAS 39 or IFRS 9.
What does FRS 102 say?
Impairment analysis of financial assets held at cost or amortised cost
FRS 102 (paragraph 11.21) requires that “at the end of each reporting period, an entity shall assess whether there is objective evidence of impairment of any financial assets that are measured at cost or amortised cost. If there is objective evidence of impairment, the entity shall recognise an impairment loss in profit or loss immediately.”
FRS 102 (paragraph 11.23) states that “Other factors may also be evidence of impairment, including significant changes with an adverse effect that have taken place in the technological, market, economic or legal environment in which the issuer operates.”
Most financial assets are measured at amortised cost and for these assets, assuming the going concern assumption remains appropriate, the impairment “is the difference between the asset’s carrying amount and the present value of estimated cash flows discounted at the asset’s original effective interest rate.”
Valuation of financial instruments held at fair value
FRS 102 (paragraph 2A.1(c)) states that “If the market for the asset is not active and any binding sale agreements or recent transactions for an identical asset (or similar asset) on their own are not a good estimate of fair value, an entity estimates the fair value by using another valuation technique.”
The valuation technique would be expected to arrive at a reliable estimate of the fair value if:
- it reasonably reflects how the market could be expected to price the asset; and
- the inputs to the valuation technique reasonably represent market expectations and measures of the risk return factors inherent in the asset.
If it is difficult to ‘reasonably represent market expectations’ at the reporting date, meaning that the fair value is no longer ‘reliably measurable’, then the financial instrument’s “carrying amount at the last date the asset was reliably measurable” becomes its new cost. The entity shall measure the asset at this cost amount less impairment, if any, until a reliable measure of fair value becomes available.
The last reporting date is not likely to be ‘the last date the asset was reliably measurable’ and management are likely to need to document carefully when they feel the last reliable estimate could be made, and their assumptions and judgements underlying that conclusion. If the asset or liability is particularly material, it may be appropriate to include disclosure in the financial statements relating to key judgements.
Deferral of payment terms
If an entity gives, or is in receipt of, extended credit terms then the arrangement constitutes, in effect, a financing transaction which should be discounted at a market rate of interest for a similar debt instrument.
Even if the value of the interest imputed in this calculation is not large the definition of materiality principally depends on whether the economic decisions of the users of the financial statements would be influenced by omissions or misstatements. If a business extends its usual credit terms for a key customer, that indicates there may be an increased vulnerability to cash flow risks which will affect users’ judgements on the financial statements.
Should financial assets and liabilities be shown as current or non-current?
Financial assets - Regardless of the contractual payment terms, a financial asset should be classified as current or non-current based on management’s assessment at the reporting date of the likely inflow of cash. This can produce some accounting inconsistencies, as a financial instrument may be disclosed as a long-term debtor for one party and a short-term creditor for the other (particularly common for intra-group balances).
Financial liabilities - FRS 102 requires that “an entity shall classify a creditor as due within one year when the entity does not have an unconditional right, at the end of the reporting period, to defer settlement of the creditor for at least 12 months after the reporting date.”
If an entity is in breach of a covenant at the year end and the bank agrees to waive or modify the covenant but only confirms this after the year end, the liability should be shown as a current liability because at the reporting date the entity was in default. The modification should be disclosed (but not adjusted for) in the financial statements.
Practical impact and interpretation for preparers
- Due to worldwide uncertainty the estimate of impairment will be more important, and material, than ever.
- Management will need to carefully consider whether the impairment should be recognised in the current period ie if it’s an adjusting event in accordance with section 32, or whether it only requires disclosure.
- Valuation of financial instruments held at fair value:
- Obtaining third-party evidence (from an active market or third-party sale of a similar instrument), at the reporting date could be incredibly difficult. This is likely to result in high variability in the range of reasonable fair value estimates, meaning that the fair value is no longer ‘reliably measurable’.
- Deferral of payment terms:
- In the past the value of the interest imputed for extended credit may have been deemed immaterial. However, where extended credit terms have been provided principally because of coronavirus, it is possible that these items will now be considered material by nature, even where values are small.
- The calculation of interest for extended credit is likely to also include some risk as it would involve a risk assessment of the creditor which will be extremely difficult.
- Classification of financial assets and liabilities
- Any covenant breaches which occur due to coronavirus at the year-end should be shown as current liabilities. If the bank waives the covenant after the year-end this should be disclosed (but not adjusted for) in the financial statements.
- Management’s assessment of how a financial asset should be classified as current or non-current becomes more important because the users’ assessments of cash recoverability in the current economic climate will be more sensitive than ever.
- Allow time before authorising the financial statements. Financial instruments will require more thought from both the preparers of financial statements and the auditors and are likely to involve the exercise of management judgement. You will need to evaluate the assumptions made against real evidence.
- You may not be able to adjust the recognised values for information received after the reporting date, but you can make the disclosures surrounding those values more useful to the users of the financial statements.
- Fully document the assumptions, estimates and judgements made in this area and the reasons those were made as these are likely to be key risks.