Why Investors are Paying More Attention to Financial Statements
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- April 8, 2022
Since December 2019 when the first COVID-19 case was reported, the globe has oscillated from seasons of low incidences to high incidences. To date, the World Health Organisation (WHO) has reported various variants such as Alpha, Beta, Gamma, Delta, and Omicron, each with different levels of transmissibility and manifestation.
This has led to various forms of lockdowns and restrictions with some governments implementing stringent measures ranging from suspension of international flights, mandatory quarantines, night curfews, closure of businesses, schools, and international borders.
Some of these actions to mitigate the spread of the virus have impacted supply chains and reduced economic activities across the globe. Recently, we have noted increases in interest rates while inflation is becoming a concern in many countries, causing investors to rethink their investment strategies and asset allocations.
The arrival of vaccines brought about the much-needed relief from the adverse effects of the pandemic, however, the rollout has not been without its challenges especially their availability in developing countries.
This seesaw nature of the pandemic has increased the level of uncertainty in the environment and made the process of applying judgment related to estimates about the future more complex. This has in turn increased the potential of material adjustments to the carrying amounts of assets and liabilities in the financial statements. Users of the financial statements are therefore focusing more on disclosures that affect an entity’s future cash flows, particularly their timing and certainty.
IAS 1, Presentation of Financial Statements, is the accounting standard that provides guidance on the disclosure requirements for the assumptions an entity makes about the future and the sources of estimation uncertainty. In the current environment, users of financial statements are also paying more attention to the cashflows, liquidity and resilience of the balance sheet as the pandemic unfolds.
For instance, liquidity risk heightens where new variants of the virus result in further restrictions, thereby affecting the levels of cash inflows from operations. Information about the expected credit losses (ECL) including the judgements and assumptions in estimating the expected future cash flows is vital. New and emerging risks could be captured within ECL by adding scenarios, updating weightings, and revisiting customer segmentation.
Additionally, information about loan covenants that might have not been a focus pre-covid will become critical now. Users of the financial statements will seek to understand the impact of the current environment on the covenant breaches, and the likelihood of potential breaches or near-breaches of those covenants. Such breaches impact the classification of the loans, especially where no waivers have been obtained from the lenders before year-end.
Furthermore, as this pandemic poses a risk to the existing business model and the survival of the businesses, users of financial statements will seek information about the sensitivity analysis of the various estimates applied in financial reporting. Information on the future scenarios applied like what the base scenario, and upside or downside scenarios look like is vital.
The scenario analysis should provide insights on whether the entity will remain a going concern if there are changes to the current scenario and assumptions applied by management. Given the significant economic downturn, revenues and profitability could decline, including other factors that could cast doubt on the entity’s ability to continue as a going concern, these uncertainties should also be disclosed in the financial statements.
Therefore, management should take full advantage of the provisions in IAS 1 in estimating and disclosing these uncertainties. Paragraph 129 of IAS 1 requires entities to disclose information about the nature of assumptions, the sensitivity of carrying amounts to the methods, assumptions and estimates underlying their calculation, the expected resolution of uncertainty and the range of reasonably possible outcomes including changes made to previous assumptions.
Incorporating assumptions about the pandemic and its effects can be complex and subjective as the variables affecting possible future outcomes keep changing as the pandemic moves through different phases.
While management is provided with the opportunity to make assumptions and estimations, IAS 1 requires disclosure of the uncertainty in these estimations and the sensitivity of those assumptions. Even though estimates are developed with a level of uncertainty, these should not be purely opinions but rather factual and documented with a process in place to monitor and update the data inputs. They should also be consistent from one period to the next and in principle, there should be no use of hindsight.
Finally, although the entity may still be a going concern, the pandemic has heightened the business risks entities face. Sometimes it may be a ‘close call’ to conclude that an entity is a going concern thus additional disclosures on the judgements and material uncertainties including which scenarios and forward-looking information have been included in the going concern assessment will be required. The correct application of these disclosures yields significant benefits to the users of an entity’s financial statements; therefore, management should make a conscious effort to ensure that information provided to users is relevant.
