Audit Partner at RSM Poland
In the previous article, I focused on asset measurement at fair value in the times of economic recession, uncertain future of companies and limited information exchange in the context of IFRS 13 assumptions. What about the measurement of assets to which IFRS 13 does not apply? Contrary to what you may think, there are quite a few of them.
Guidelines for the accounting treatment of inventories can be found in IAS 2. This standard requires inventories to be measured at the lower between cost and the net realisable value. The latter is the NRV, something young auditors are very well familiar with. NRV is the estimated selling price in the ordinary course of business, less the estimated cost of completion and the estimated costs necessary to sell inventories. During the “NRV test”, young auditors will certainly check whether the selling price was not higher than the value of inventories disclosed in the balance sheet at the balance sheet date…
What do you need to keep an eye on when making the measurement in a reality dominated by COVID-19 and downturn?
You certainly have to be aware of the downward trend in prices for similar goods/finished products on the market, as well as of a smaller demand for goods, often being the primary cause of falling prices. In addition, you should take a look at the allocation of indirect costs: it may be difficult to allocate them to units of produced inventory, in particular as regards variable indirect costs. It is also a good idea to analyse the activation of fixed overheads: in this case, when capacities are not being used at the normal level, these costs should initially be recognised in the profit and loss account. The Accounting Act provides so; yet, many companies tend to forget about this. For the sake of clarification, a normal level of capacities is the average production volume for a given number of periods or seasons, as expected under typical conditions and with due consideration for planned modernisations.
Assets held for sale
When discussing assets held for sale in the normal course of business, I must mention non-current assets held for sale, and most of all: property, plant and equipment. During an economic downturn, businesses often face the necessity to dispose of more or less useless assets; therefore, they must remember to follow IFRS 5: Non-current Assets Held for Sale and Discontinued Operations and valuation guidelines provided there.
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Impairment of assets
As regards assets the entity is not clearly planning to sell, it seems essential to analyse any evidence of impairment of this asset. This is a potential impairment test. A separate standard is dedicated to the impairment test, i.e. IAS 36 – Impairment of Assets. The economic slowdown itself may suffice to justify a test, in which you compare the carrying amount of an asset with its recoverable value, being the higher of fair value less selling costs and value-in-use, the estimated present value of future cash flows expected from further use of this asset or cash-generating unit. You will not avoid dilemmas related to interest rate volatility, the probability of cash flows or the choice of valuation technique for fair value measurement, as discussed in my previous article. What is more, testing the impairment of goodwill or intangible assets may become problematic due to difficult access to inputs for analysis.
In the case of other intangible assets, the economic recession may require some additional procedures or affect testing for future benefits. Let us look at activated development costs, for example. As you know, development costs (not to be confused with research, the costs of which are always recognised initially in the income statement) may be capitalised. However, both the Accounting Act and IAS 38 provide a number of conditions that must be met for development costs to be capitalised. In line with IAS 38, development costs may be activated and then charged to expense through amortisation, provided that the entity is able to prove, among others, that:
- the entity is able, from the technical point of view, to complete the intangible asset so that it is feasible for use or sale;
- the entity can reliably determine the expenditure incurred during development works or
- there are technical, financial and other resources available to complete development works and use or sell the intangible asset.
In a state of epidemic, some problems may emerge here, e.g. how to financially secure the investment, or it may turn out that it is not possible to receive the technical means necessary to complete works, etc. Therefore, as I have mentioned in Part 1 of my discussion on asset measurement in a state of epidemic, the volatility of the market or demand may prove crucial in the measurement of intangible assets, as well.
Continuing on the topic of measurement during an economic downturn, I would also like to note that in the light of significant increase in credit risk (SICR), entities are required to recognise a write-down in the amount of expected credit losses over the life of the financial instrument (including receivables). IASB and local bank supervisors issued guidelines on how qualitative criteria should be taken into account in order to assess SICR in the event of loan deferral, breach of covenants and other assistance provided by lenders to borrowers in the current COVID-19 environment. COVID-19 and economic downturn also require relevant disclosures, including a revision of SICR, disclosures of potential government assistance packages (and their impact) and long-term macroeconomic indicators. Indeed, there are many things to figure out and write about.
Concluding the topic of asset measurement in the times of COVID-19 and the resulting economic slowdown, I want to take a closer look at leased fixed assets.
Leased fixed assets
As we have pointed out in a series of articles on IFRS 16, leased assets are initially measured at the amount of lease liability, with due consideration for:
- any initial lease payment made at or prior to the commencement of the agreement, less any incentives received;
- any initial costs incurred by the Lessee;
- estimated values of future restoration costs borne by the Lessee in connection with the asset covered by the lease and aimed at restoring the location of the asset.
In turn, the value of liability should include all the fixed elements (payments) the Lessee is required to pay. If the user is also obliged to pay the price of a purchase option (purchase option), it should be included in the measurement. In addition, you have to take the variable fees based on an index or a rate into account. Clearly, the value of liability thus calculated shall be subject to a discount, whose rate (as I have noted earlier) will be more difficult to determine in the times of recession.
What if lease contracts are amended: payments are deferred, contract terms are shortened and part of the leased asset is reduced? Remember that any change of the interest rate, being the basis for calculation of interests for the Lessee, or any change of index (e.g. inflation rate), being the basis for calculation of lease payments, are included in variable payments, and I am not going to discuss them any further. If they change, you need to adjust liabilities remaining to be paid and right-of-use assets. However, if the agreed terms and conditions are amended, according to IFRS 16 lessees must consider contract modification in respect of:
- a possible separate lease contract;
- changes in the accounting treatment of an existing lease.
COVID-19 and lease amendments
In the times of coronavirus, some doubts have emerged whether a deferral of revenues or any other contractual amendment is a modification that requires an adjustment of right-of-use assets and lease liabilities? The International Accounting Standards Board, which has received many enquiries and reports of practical difficulties in adjusting the terms of lease agreements and adjusting the value of liabilities and right-of-use assets resulting from agreement modification, has issued a draft of ED/2020/2 Covid-19-Related Rent Concessions (Proposed amendment to IFRS 16), and then an amendment of IFRS indicating that Lessees shall be exempted from contractual amendments resulting from COVID-19 as “contract modifying” amendments imposing an obligation to make appropriate accounting adjustments of the value of lease liability and the right-of-use assets. In other words, contract amendments pertaining to e.g. the suspension of payments resulting from the COVID-19 situation would not be, as a rule of thumb, contract modifying changes in the light of IFRS 16. You will soon read more on this on RSM Poland blog.
As you can see for yourselves, the current time is not easy, not only for sales people, logisticians, managing directors of larger entities, but also for the people who are involved in daily financial reporting. They are going to face quite a challenge. While it may be a matter of time before IFRS can “technically” be worked out, it can very often be difficult or even impossible, in practice, to obtain relevant inputs for different standards. Time will tell, and we are going to provide insight regarding any doubts as well as offer our hints and suggestions.
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