Financial reporting implications of COVID-19
October 2020 | TALKINGPOINT | FINANCE & ACCOUNTING
Financier Worldwide Magazine
October 2020 Issue
FW discusses the financial reporting implications of COVID-19 with Neil Parsons, Paul Winrow and Andrew Moyser at MHA MacIntyre Hudson.
FW: In general terms, how would you describe the impact coronavirus (COVID-19) is having on listed companies’ financial and operational outlook?
Parsons: The coronavirus (COVID-19) pandemic has created the highest level of global economic uncertainty since the financial crash of 2008. In terms of GDP decline, many countries have experienced their biggest ever recession. Most governments actively pulled the lever switching off all but essential elements of the economy, and further imposed changes in the behaviours of citizens to stem the spread of the virus. Individuals, all types of consumer and businesses of all sizes have been affected. All related changes need to be factored into forecasts and stress tests of business models. When we look back to annual reporting periods that ended before 31 December 2019 for going concern assessments, the period over which that assessment was made was at least 12 months from the date of approval of the financial statements. Reviewing forecasts for that 12-month period was considered a relatively short-term assessment. In addition to a statement on going concern, in the UK, entities with shares listed on a regulated market are required to produce a formally approved statement of long-term viability in their annual report. This statement discloses how a business model is affected by principal risks and uncertainties, affecting an entity’s ability to settle its liabilities – both prospective and contingent – as they fall due. In terms of viability, periods of assessment often reflect the business cycle of an entity, such as the duration of long-term contracts with customers, the terms of longer-term borrowings and, for property companies, the duration of their lease portfolios. For forecasting purposes, the longer term was often considered by reporting entities as a period commencing after more than one year but with a cut-off point at five years where it was traditionally felt – other than by way of extrapolation – that forecasting was no longer reliable without the existence of significant evidence justifying the process, such as a track record of historical forecast accuracy. The effect of the pandemic is to make the short term feel more like a few weeks and the longer term a period of more than six months. Conditions change rapidly and responses must be quick.
Winrow: Operationally, the short term is about survivability and the medium and longer terms are about strategic focus and adapting the business model. For many entities, the effect of pushing major considerations into the short term means that operational decision-making processes have had to speed up considerably, not only to react to economic change, but also to reappraise the appropriateness of recent decisions. Operational decision making has also involved more intervention by strategic management. Furthermore, in reacting to change, many entities have been forced to jump into the deep end and experiment with the business model on a live basis. If that has not been stressful enough, the speed of dissemination of information via social media has clearly overtaken traditional news outlets. It has therefore never been so important to consider the perceived impact of operational decisions on stakeholders and wider communities. Reputation management remains key. Externally, existing supply chains might take many months to recover from the initial economic lockdown and businesses have had to either stop production or source alternative means of supply. In response to the COVID-19 pandemic, an entity’s internal audit function has a pivotal role to play by providing proactive and predictive support and forward-looking independent challenge to all levels of management, rather than only doing a traditional internal audit review, after the event.
Moyser: Decisions over whether to use government support, such as the furlough scheme or low interest loans or government-backed loans, might seem simple decisions in financial terms, and give welcome financial breathing space, but might be perceived differently by existing stakeholders and the wider community. For some sectors, decisions over whether to retain employees or to reduce headcount are more difficult, as there could be a sudden demand when a period of inactivity had been forecast. Implementing social distancing measures and limiting unnecessary travel has led to most finance professionals and decision makers working from home. This, in turn, has a fundamental impact on an entity’s overall control environment. This impact is felt not only at high level in terms of managing business risk, but also in terms of lower level financial controls and authorisation procedures. To enable such a major increase in remote working, an entity’s IT environment will have undergone rapid evolution. However, given the speed of implementation, have boards considered the potential increase in cyber risk and data protection? Further, the pandemic will have impacted on the effectiveness and role of internal audit teams.
“Clarity of reporting will be key, particularly in narrative reports. Financial statements will need to be consistent from start to finish.”
FW: Against this backdrop, could you outline the key reporting considerations that listed companies need to make?
Winrow: This time around the focus is not just on the numbers but on disclosure. In the past, relatively simple disclosures might have sufficed as relatively little judgement or estimation may have been involved. But we expect more detailed disclosures to support those significant judgements and estimates made, which provide justification to the carrying amounts of assets included in a valuation, or which are subject to an impairment review.
Parsons: For many listed entities, most investors should already be aware of the effect the COVID-19 pandemic has had on financial performance through market announcements, interim reporting, as well as profits warnings. The annual report should bring everything together in one complete and concise story. The next set of annual reports will clearly be event-based. Therefore, the first step in the reporting process should be to establish an achievable reporting timetable, followed by creating a timeline of significant changes, events and transactions affecting the company, to ensure the annual report tells the complete story. Stakeholders, such as employees, customers, suppliers, financiers, shareholders, pension schemes and others, will also be interested to see how they have been taken into account in terms of the decisions made by directors. Although numbers remain the drivers of reporting, I expect investors to focus much more on how the board of directors, and others charged with governance, have performed in steering their company through a very dark period and how their decisions have helped them to survive, adapt and evolve. The next round of annual reports should form a testament to board performance. Financial reporting teams should also ensure they have reviewed, and that financial statements address, specific matters and key topics that regulators have drawn attention to during the pandemic.
Moyser: Clarity of reporting will be key, particularly in narrative reports. Financial statements will need to be consistent from start to finish. Furthermore, there must be clear cohesiveness in terms of the following sections of annual reports. First, the disclosure of principal risks and uncertainties highlighting new risks that have arisen and how they are being mitigated. Second, how the business model and strategy has changed to accommodate new risks. Third, how the longer-term viability of the business model has been assessed and stress tested. Fourth, what new financial and non-financial key performance indicators (KPIs) have arisen and what their purposes are in terms of linking to the strategy and business model. Moreover, there should also be a comprehensive going concern review which clearly lays out the key assumptions and judgements made which justify that the going concern basis is appropriate. Changes to board and composition in light of COVID-19 should be clearly reflected in the corporate governance statement. Clear stakeholder reporting is also required, which should demonstrate the extent to which directors have fulfilled their statutory duties and streamlined their focus and effectiveness.
FW: To what extent has regulatory guidance surrounding financial reporting and other disclosures changed due to COVID-19?
Parsons: Regulatory guidance and support in the UK has been very timely and very supportive. For example, during the pandemic, the Financial Conduct Authority (FCA) issued measures to assist companies to raise new share capital in response to the pandemic, while maintaining an appropriate degree of investor protection. In terms of reporting, the Financial Reporting Council (FRC) has been very helpful in providing support and proactive guidance to help entities trace a safe path through uncertain territory, as well as helping entities apply important changes to IFRS held back by a slow EU endorsement process. Furthermore, the FRC and FCA worked together to extend reporting deadlines and provide relief. As well as regulators, standard setters have played a pivotal role so far. For example, the International Accounting Standards Board (IASB), as well as issuing special guidance on applying IFRS 9, took very fast action to simplify the accounting treatment for leases on the balance sheet by allowing a simplified calculation of modifications of leases due to rent concessions because of COVID-19. In addition, the FRC has issued guidance in several areas, which should be reviewed by auditors and preparers as part of the reporting season. First, detailed guidance for auditors on modified opinions, and general guidance on many audit procedures and specific audit issues. Second, advice on the disclosures of risk emerging from COVID-19 in the context of auditors and companies. Third, advice on annual general meeting (AGM) arrangements. Fourth, thematic reviews of financial reporting. Finally, guidance on risk reporting, going concern and viability in the context of COVID-19, as well as resources for action.
Winrow: Globally, bodies such as the International Organization of Securities Commissions (IOSCO), the International Auditing and Assurance Standards Board (IAASB) and the International Federation of Accountants (IFAC) have each issued guidance, in addition to a plethora of local guidance from professional bodies and others.
Moyser: There is a wealth of guidance to help all companies across the globe, so we are all relatively well equipped in comparison to the 2008 financial crisis. It is essential to act now and ensure that entities have identified the relevant guidance and the issues that are critical to them.
FW: What issues do directors and officers (D&Os) need to consider when assessing their company’s ability to continue as a going concern, and whether the going concern assumption is appropriate?
Parsons: In the simplest terms, an entity is not a going concern where its directors intend to cease trading or have no other realistic alternative other than to cease trading. In the going concern assessment, even where a material uncertainty exists but the directors of a company are of the view that the going concern basis is appropriate, financial statements are prepared on a going concern basis. However, the basis of preparation, and specific front-end statements, must reflect the important judgements made by directors when concluding that the going concern basis is appropriate. It is important to remember that a group can be a going concern even where it contains distressed entities that are not a going concern but are not material to group survival. Such operations might be classified as discontinued and held for disposal.
Moyser: Boards need to undertake a deep and honest assessment and engage with the auditor at the earliest possible stage, so that uncertainties can be understood at the audit planning stage and addressed during the audit field work stage, with any changes in assessments made on a live basis. Leaving the subject of going concern assessments to the end of the audit will no longer suffice and could cause delay and unnecessary stress.
Winrow: Preparers must ensure that there is good quality disclosure around going concern. Going concern disclosures should be distinct and convey clearly and concisely key assumptions and judgements applied, highlighting what uncertainties remain and whether these are material. Furthermore, disclosures should state the duration of the future period over which the going concern assessment has been made. Where material uncertainties exist and the auditor agrees with the disclosures made by directors in respect of going concern, the threshold has been met for the auditor to draw further attention to the matter of going concern, and the disclosures made, without qualifying their report. From an audit perspective, it is essential that the forecasts used in the going concern process are consistent with the forecasts used in all other areas of the reporting process. This includes related sensitivity analysis and risk adjustment. For example, detailed forecasts are used in impairment review processes of goodwill, indefinite lived intangible assets and other non-financial assets. Timings and amounts of cashflows for settling liabilities and provisions should be consistent with the forecasts used for the going concern assessment and should all be formally approved by the board.
“It is crystal clear that regulators around the world will not be lowering their guard or taking a more lenient approach.”
FW: How should financial statements be prepared given material uncertainties?
Parsons: Where material uncertainties exist but the going concern basis is appropriate, financial statements are prepared in accordance with the applicable financial reporting framework but with enhanced disclosure. The extent and form of material uncertainties will have an impact on the audit report and can lead to qualification of that report. Where material uncertainties exist to such an extent that preparing financial statements on the going concern basis is not appropriate, the going concern basis will not show a true and fair view. Financial reporting frameworks such as International Financial Reporting Standards (IFRS) do not describe what to do in this situation. Accounts prepared on a so-called ‘break up basis’ might reflect the recoverable amounts of assets, but liabilities continue to be measured and presented on their contractual basis. In all instances, where loan covenants are breached and bankers have not waived that breach by the reporting date, loans would be presented as due on demand.
FW: What key accounting principles, such as valuations and impairments for example, have become more complex and challenging in the COVID-19 era?
Parsons: It is no surprise that the most complex and challenging areas will be ones involving discounted cash flow calculations or that are otherwise reliant on forecasts and estimations of future cash flows. It is fundamental that annual reports reflect the events that have arisen in the period and conditions that exist at the period end, and that future losses are not provided for. Entities must be clear as to which events fall after the end of the reporting period and are therefore disclosed. Adjusting events should already be reflected in financial statements. When reporting events arise after the end of the reporting period, entities should split those disclosures between COVID-19 related events and other more natural types of event. Valuations should reflect current market conditions at the date of measurement. Four reporting areas will present a major challenge. First, valuations of property performed using an ‘income basis’. Second, impairment reviews based on ‘value in use’. Third, valuations of unlisted investments performed on an ‘income basis’ or on a ‘multiple of earnings or revenues’. Finally, calculations of contingent consideration liabilities for recent business combinations, where the future consideration payable is based on the earnings of an acquired entity. Valuations of financial assets and non-financial assets will generally remain possible unless in extreme circumstances. When valuing an entity, valuation experts can utilise accepted valuation techniques which can normalise the impact of exceptional events such as COVID-19.
FW: What potential consequences might companies face if they misstep when it comes to financial reporting?
Moyser: As is the case in normal circumstances, regulators – for example, the FRC in the UK and the European Securities and Markets Authority (ESMA) and its counterparts in the EU – will continue to review the financial statements of listed companies and make written inquiries to chairpersons of listed companies where there is a perceived shortfall in the quality of reporting, unusual accounting policies, transactions lacking good judgement or an omitted material disclosure of an event or transaction.
Winrow: It is crystal clear that regulators around the world will not be lowering their guard or taking a more lenient approach despite the obvious risks and pressures this year on businesses. Indeed, it can be argued that strong regulatory oversight is needed more now than ever.
Parsons: It is possible that an entity’s financial statements might be brought to the attention of a regulator by a disgruntled third party, activists or other pressure groups. An entity which has entered a material transaction, the nature of which is in the public domain, but where the annual report and financial statements do not disclose that transaction, is an easy target for a regulator. Regulators have the power to require entities to restate their reports. Where the level of misstatement is material and in their view of interest to the public, a regulator will make public their findings. In more extreme cases, regulators might launch a specific inquiry into the conduct of the board of directors where there is suspicion of intentionally reported misleading or false information, deliberately improving the results or inflating the financial position of an entity or omitting disclosure of a material event, transaction or condition. The time cost of dealing with an inquiry by a regulator is significant and in the current climate where the time constraints of senior members of the reporting team is a critical resource, a regulatory inquiry in this current climate would be a very stressful experience, which can be mitigated. Therefore, my advice to boards is to read the announcements and guidance issued by regulators and ensure that work plan objectives include meeting the expectations of regulators for the forthcoming reporting season.
FW: To what extent are regulators, investors and shareholders, among others, likely to hold companies and their D&Os to account for erroneous or misleading disclosures made during the COVID-19 pandemic?
Parsons: Under laws in most jurisdictions, stakeholders are entitled to expect directors to act in good faith and to produce financial statements which are true and fair or are fairly presented and are free from material error, whether or not caused by fraud. Auditing standards point out that the primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. An auditor conducting an audit in accordance with International Standards on Auditing (ISA) is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. However, auditing standards point out that due to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the financial statements may not be detected. COVID-19 has not changed any of this.
Moyser: Errors can involve mathematical mistakes, a misinterpretation of accounting standards or law, or an oversight or a misinterpretation of facts. Material errors in respect of prior periods are adjusted by retrospective restatement and disclosure of the nature and effect of the error. Some financial reporting frameworks, such as IFRS, require an entity to present a third statement of financial position where a retrospective restatement has affected the beginning of the earliest comparative period presented. The need to make a restatement due to the correction of a material error is not uncommon, and although a genuine error can attract unwelcome publicity and a review by regulators, correction is necessary to ensure financial markets contain reliable information. Genuine errors might only be identified because of a regulatory inquiry. Such inquiries can lead to formal press notices, the requirement to disclose the involvement of the regulator in those financial statements which correct the error – or where there is suspicion of professional malpractice – and individuals being referred to their professional body. At the very extreme end, errors might have arisen because of a fraud.
Winrow: In times of financial crisis, the risk of fraud increases, not only at transaction level but at the financial statements level. In the context of the fraud triangle, for entities under very heavy pressure to, for example, meet their banking covenants or trading expectations, there could be a motive to manipulate financial information in order to create a favourable picture. Therefore, pressure might exist to manipulate an entity’s financial performance and financial position. Through changes in an entity’s control environment and with the ability for strategic management to override processes, the opportunity for fraud clearly arises. Where business survival is at stake, a sense of panic might arise and in terms of human behaviour those committing the fraud might rationalise in their mind that it was necessary to save the business and to keep employees in jobs.
“It is no surprise that the most complex and challenging areas will be ones involving discounted cash flow calculations or that are otherwise reliant on forecasts and estimations of future cash flows.”
FW: Given the demanding nature of the current reporting environment, how should companies go about communicating their current position and future strategies as clearly, effectively and convincingly as possible to key stakeholders and other interested parties?
Winrow: It is critical for communications to be clear and concise. This principle applies not only to disclosures in annual reports, but also to interim reports and announcements and press releases. In terms of effectiveness, tabular formats can be more helpful than pages of text. This year, entities might wish to streamline narrative reporting and alter its focus, while complying with the legal requirements. Regarding the communication of important events and transactions and profits warnings, listed companies must follow the rules of their stock exchange, which includes disseminating information in a timely manner, without delay.
Moyser: From a legal perspective, the disclosure and transparency rules in the EU require the directors of companies with share capital listed on an European Economic Area (EEA) regulated market to make a specific statement in their annual reports that financial statements – prepared in accordance with the applicable set of accounting standards – give a true and fair view of assets, liabilities, financial position and profit or loss of the entity and the undertakings included in the consolidation taken as a whole. A management report should also include a fair review of the development and performance of the business and undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face. Investors and markets do not welcome boilerplate disclosures which are generally unhelpful, and which reduce overall report quality. Events such as COVID-19 create opportunities in financial reporting to copy information seen in example financial statements or other entities’ accounts.
Parsons: The demanding nature of the current environment has not changed the responsibilities of directors under law regarding the preparation of financial statements. Regulators will still expect good quality financial reporting and compliance with the law, accounting standards and the relevant listing rules. Financial statements should tell the true story: an entity’s financial autobiography for the year, classified as non-fiction. They should not require any additional procedures or gloss to make them more convincing. Reporting the good news and the bad news with equal prominence adds credibility to reporting. Due to the current environment and in terms of performance reporting, listed companies might feel encouraged to place greater reliance on so-called alternative performance measures (APMs), which are measures derived from generally accepted accounting principles (GAAP). On the darker side, APMs can be used in a way to engineer bad news presented by the GAAP line items of financial statements into a measure that might be perceived as more palatable, but instead is unhelpful or misleading. For example, entities might report an adjusted version of earnings before interest, taxes, depreciation and amortisation (EBITDA) which strips out the costs of COVID-19 and various other costs, to reflect an underlying profitability which does not reflect economic reality. Regulators will challenge entities which report misleading APMs. Guidance issued by ESMA on APMs and COVID-19 is crucial reading.
FW: How important is it to properly coordinate disclosures to the market? What kinds of processes and oversight mechanisms need to be in place?
Winrow: Regarding the communication of important events and transactions and profits warnings, listed companies must follow the rules of their stock exchange. Stock exchanges around the globe generally include in their rules specific requirements for how and when to disseminate information to the market, usually in a timely manner, without delay. This includes all required announcements, including profits warnings.
Moyser: COVID-19 has provided listed companies the opportunity to review all processes. Underpinned by strong and effective internal communications, boards should be on top of any important information that needs to be disclosed. Boards should also consider the use of any available reporting extensions up front and manage market expectations and investors accordingly, with the auditor being made aware of changes to reporting deadlines as soon as possible.
Parsons: The strong coordination of the release of market information is critical to the efficient operation of markets. All boards and listed entities have clear responsibilities and, when things are not so clear, ready access to professional advice. Events like COVID-19 demand great discipline in this area. Both the exchanges and their regulator will have made many important announcements setting out clear guidelines and expectations in these uncertain times. In general, listed entities are expected to have basic processes and oversight mechanisms in place, as well as advisers on board, such as brokers or nominated advisers, who assist them in managing their relationship with the stock exchange.
FW: Looking ahead, what medium- and long-term changes to financial reporting processes, obligations and frameworks might we expect to see stemming from the COVID-19 crisis?
Winrow: I expect that many changes that have been made to financial reporting and audit processes caused by responding to the impact of COVID-19, such as better sharing of information in electronic form, will continue into the future and will further evolve. Along with getting more digital, the future will entail a greater emphasis on all forms of internal controls, and the ability to react rapidly to changes in control environments. Personally, I would not want to see full remote auditing continue for too long, but I concede that some routine aspects of the audit process no longer need to be undertaken at a client premises, and thus audit work may involve much less travel.
Parsons: The European Single Electronic Format (ESEF) will apply to many EU and UK-listed entities for accounting periods commencing on or after 1 January 2020. However, this is subject to possible delay. This is the first time that listed companies will be mandated to produce financial statements in a machine-readable format based on a form of Inline eXtensible Business Reporting Language (iXBRL), in addition to current methods, including paper and PDF. This means that for the first-time computers can compare the financial reports of listed companies in a way that has never been possible. This is only the beginning. As a direct consequence, I expect to see a rapid acceleration of electronic reporting for companies of all sizes and the demise of paper accounts.
Moyser: COVID-19 has transported us into an age of ‘think digital first’ much faster than anticipated. The path is clear for even more sophisticated IT processes to replace traditional reporting methods, for example the use of deeper business analytics, artificial intelligence and machine learning. However, this evolution must be fully controlled. At the simplest level, the ability to have meetings via applications such as Zoom and Microsoft Teams on a short notice or more regular basis has enhanced team and client engagement and has improved the timeliness of communications and decision making. Meetings to discuss accounts and financial information are so much easier and productive and it is possible to drill right into information. Such practices should clearly continue. Hopefully though, and sooner rather than later, physical meetings should return at least to cover critical issues and for finalising processes. Human contact remains an essential part of business.
Neil Parsons joined MHA MacIntyre Hudson in April 2020 as director and head of financial reporting advisory and company law. He is responsible for client facing financial reporting project work and company law matters in respect of companies of all sizes, including issues relating to large listed companies and banks. He helps his clients cut through the complexities of financial reporting and provides technically sound and commercial solutions which are easily understandable. He can be contacted on +44 (0)20 8126 6786 or by email: neil.parsons@mhllp.co.uk.
Paul Winrow recently joined MHA Macintyre Hudson from his role as director of professional standards at Baker Tilly International. He is the firm’s technical partner leading the technical function and responsible for driving audit quality and compliance with professional standards. He has over 25 years’ experience of audit in big four and larger mid-tier firms and has spent the last 10 years in technical roles in larger mid-tier firms and global networks. He can be contacted on +44 (0)7377 338724 or by email: paul.winrow@mhllp.co.uk.
Andrew Moyser is a partner at MHA MacIntyre Hudson, head of audit and leads its audit policy group in the UK. He has significant experience in audit and assurance and covers all high profile or complex audits for the UK. He advises other professional accountants on complex auditing and accounting issues, IFRS and UK GAAP conversions and reconciliations, data analytics and auditing innovation technology, professional ethics and dealing with regulators. He can be contacted on +44 (0)1234 227 004 or by email: andrew.moyser@mhllp.co.uk.
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