A New Dawn – Reporting Challenges Continue

Financial Reporting Brief: March 2022

Download our January Quarterly Financial Reporting Brief here

Two years ago we were plunged into the abyss of the COVID-19 pandemic. In the early days, our expectation was that we would return to normal office life within weeks, and then months, and now after two years, is it really over, or when will it be?

With restrictions almost fully removed, social engagement back at reasonably normal levels and economic forecasts being positive, it is probably fair to consider that we are just about there. Inflation has reared its ugly head again and will be a challenge for some time to come. The Russia/Ukraine crisis is a situation of great concern with the impact of sanctions posing a real threat for all. While new uncertainties emerge, COVID-19 continues and other regions of the world have not been quite so fortunate, with vaccination programmes not as generally available.

Our Financial Reporting Brief (FRB) series continues to comment on developments as they emerge. As we entered the pandemic, our minds had been overwhelmed by it and the only topic to write about was the pervasive impact of COVID-19 on financial reporting, governance processes and related areas with our April 2020 article being ‘COVID-19 – the ‘new normal’.

Some balance was regained during April with the realisation that no matter how disastrous the pandemic appeared, the threat of climate change remained a dominant force. Interestingly, many of the measures attached to climate risk improved in the early months of the pandemic. While bringing much of the world to a near standstill had benefit for our welfare, mental and otherwise, it clearly did not offer a lasting solution. Our May 2020 article ‘A Tale of Two Crises’ considered the interaction between the two main risks of COVID-19 and climate change.

These two primary risks continue to have pervasive impact on our economic and social environment. From a reporting perspective, they are now in two somewhat different places for most Irish entities.

With the worst impacts of the pandemic in the rear-view mirror for most entities, the reporting challenge now has more to do with measuring any remaining uncertainties, taking a balanced approach to forecasting and maintaining neutrality in presenting the upside, rather than the downside which dominated a couple of years ago.

Climate change, and other sustainability factors, have not lost any of their threat nor their place in dominating much of the recent and ongoing developments on the reporting landscape. There is a need for significant enhancement of sustainability reporting and action is being taken to achieve this, both at the overall global level and at the European level. FRB shall return to considering these developments very soon.

Resilience – Lessons Learned

Are there lessons to be learned from the pandemic? Yes, there are, and perhaps most of all it has heightened the focus of entities regarding crisis management and business continuity. Entities that have survived, with some prospering, have demonstrated their resilience in meeting the challenges.

The International Organisation of Securities Coordinators (IOSCO) has recently published a consultation paper ‘Operational resilience of trading venues and market intermediaries during the COVID-19 pandemic’. IOSCO sets out observations and lessons learned from the pandemic to help inform regulated entities’ future operational resilience arrangements. The paper comments on a number of different areas, including:

Operational resilience means more than just technological solutions, it also depends on the regulated entity’s processes, premises and personnel;
Dependencies and interconnectivity should be considered before and after a disruption to adequately assess potential risks and changes to controls, especially for service providers and off-shore services;
Review, update and test business continuity plans to ensure they reflect lessons learned from the pandemic, such as the prolonged nature of the crisis and its impact on multiple locations, as well as the implication of remote/hybrid working;
An effective governance framework facilitates and supports operational resilience during novel or unexpected situations;
Compliance and supervisory processes with greater automation and less dependence on physical documents and manual processes may better accommodate a remote workforce. A review of monitoring and supervision arrangements by regulated entities for remote workforces may be appropriate to help ensure continued effectiveness in a remote or hybrid environment; and
Information security risk – decentralized and remote work may increase the importance of monitoring processes to help ensure information security and prevent cyber-attacks.

Operational resilience is fundamental to maintaining the governance and control frameworks essential to the management and stewardship of entities. This includes the ability to produce reliable and transparent financial reporting which is key to the trust and confidence entities must maintain with investors and other stakeholders. The demand for equivalent standards of sustainability reporting will also continue to challenge entities.

Financial Reporting – Judgements, Estimates and Disclosure

Judgements and estimates are key elements of financial statements, and in a majority of entities have a material bearing on the results and financial position presented in the financial statements. The impact of COVID-19, together with climate change and other factors, have increased the difficulties associated with the decision-making process in relation to both. Factors including supply chain disruptions, labour shortages, commodity prices and general inflationary pressures have all contributed to the difficulties. All of these, and other similar factors, introduce volatility and uncertainty to expectations of an entity’s future cash flows and business performance. They influence the ability to form judgements and impact accounting estimates required for several areas of reporting. Disclosure of judgements made, and for estimates, disclosure of the underlying assumptions and information bases, together with sensitivity to other possible outcomes become of vital importance.

Key questions for preparers of financial statements include:

Do the disclosures in the financial statements distinguish clearly between:
- judgments, apart from those involving estimations, made in the process of applying accounting policies with the most significant effect on the amounts recognised in the financial statements; and
- assumptions and other sources of estimation uncertainty affecting the future?
Do disclosures explain clearly the specific judgements made and their impact on the financial statements?
Are the areas of estimation uncertainty identified, where a significant risk of material adjustment to the carrying amounts of assets or liabilities in the next year arises from changes to assumptions or other sources of estimation uncertainty?
Has the carrying amounts of assets or liabilities identified as being subject to key sources of estimation uncertainty been stated?
Do the disclosures explain the key sources of estimation uncertainty for each area identified?
Do the disclosures include sensitivities or ranges of outcomes, so that users of the financial statements can fully understand the potential effect of estimates made?
Do the disclosures avoid mere repetition of accounting policies and generic statements without quantification and focus on how particular decisions or assumptions might affect the entity’s results and financial position?

If the judgements management make have a significant impact on the financial statements, they need to be disclosed under IAS 1. One of the best ways to explain the need for disclosures is provided in IAS 1: “management considers whether disclosure would assist users in understanding how transactions, other events and conditions are reflected in reported financial performance and financial position. Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity.”

An entity should also consider whether to provide additional disclosures when compliance with the specific requirements in IFRS is insufficient to enable users of financial statements to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance.

In relation to estimates, situations could arise, for example, when:

reasonably possible different assumptions could have led to measurement at a materially different amount;
an uncertain factor could cause the carrying amount of an asset or liability to change materially in the next year; or
a reasonably possible change in an assumption could occur, with a consequential material impact on the amounts recognised.

In our February article, we commented on financial instruments including expected loss provisions. Other areas which may require particular consideration now that we are emerging from the pandemic include impairment of non-financial assets, deferred tax assets and onerous contractual commitments – this is not an exhaustive list. Each of them requires the exercise of judgement and the measurement of estimates in uncertain conditions. It should also be borne in mind that it may not be just a matter of undoing the accounting measures adopted when entering the pandemic in 2020. Some deeper thinking may be necessary – for example, reversal of impairment losses can only arise when there is a positive change in cash flows which must be supported by a detailed review of the underlying bases and assumptions and appropriate disclosure.

Future Prospects

While many entities can look to continuing recovery and a positive future, there are those still suffering from the impact of the pandemic while still others have specific difficulties with supply chain disruption, labour shortages or other such factors. The challenge of maintaining operating capability looms large for some, and the question of going concern remains. Compliance with banking covenants and arrangements is fundamental, which magnifies the focus on cash flow forecasting and the ability to maintain sufficient ‘head room’ to continue. The reasonableness of the bases and assumptions used in the forecasts is critical to maintaining the confidence of investors and other stakeholders.

Information that is likely to be relevant to users of the financial statements includes:

inputs that have been subject to stress tests and an explanation of how these stress tests have affected the going concern conclusions;
any mitigating actions management is able to take to improve liquidity;
any post balance sheet changes to liquidity, specifically the arrangement of new lending facilities, the extension of existing facilities or the renegotiation of debt instruments or facilities or waiving of loan covenants;
the level of drawn and undrawn finance facilities in place;
the covenants in place and whether there is concern that they may be breached; and
the need for structural changes in order for the entity to continue to operate as a going concern.

Some or all of this information should be considered for disclosure even if an entity concludes that there is no material uncertainty regarding its ability to continue as a going concern.

Conclusion

There will continue to be challenges to financial reporting, in good times and not so good times. While it appears we are in recovery from the worst impacts of COVID-19, uncertainty continues with inflationary pressures and the potential consequences of the Russia/Ukraine situation. Climate change and other sustainability risks are continuing threats.

The importance of reliable and comprehensive disclosure is magnified in periods of substantial uncertainty.

Maintaining the trust and confidence of investors and other stakeholders is the ultimate goal.