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Most organisations are being impacted by the coronavirus (COVID-19) pandemic, either directly or indirectly, and the increased economic uncertainty and risks may have significant financial reporting implications.

The domestic and global shutdowns are having significant impacts on the day-to-day operations of some organisations. Some are no longer able to receive goods from their suppliers or deliver goods or services to their customers. This has many flow-on consequences for the operations of the organisation, including requirement for leased assets and managing employees. All of these conditions and issues can give rise to many different accounting considerations.

Clauses in contracts may be invoked and negotiations of terms may occur during this unprecedented period.

Actions for management to take now

  • Consider the contractual rights and obligations of affected arrangements.
  • Consider the impact of any breaches or modifications.

Common financial reporting questions

Jump to:
 
Revenue
Restructuring
Leases
Other

Revenue

How could estimates in accounting for my revenue contracts be impacted by COVID-19?

Determining the timing and amount of revenue to recognise often requires organisations to make estimates and judgements. The following should be considered when assessing how COVID-19 could impact estimates relating to revenue recognition:

  1. Identify variable consideration (e.g. rights of returns, discounts, rebates) as estimates about the amount of consideration to which the organisation will be entitled could change.
    1. Re-assess the highly probable constraint applied to variable consideration as assumptions around the estimates may have changed (e.g. falling demand for volume rebates).
    2. For contractual obligations that have not been fulfilled or will be delayed, determine if penalties will be incurred as they reduce the consideration.
  2. Right of return to be assessed as frequency of returns may have increased.
  3. Consider whether actions taken to respond to the COVID-19 outbreak result in additional variable consideration (e.g. incentives or new concessions offer to customers).
  4. Inputs used to estimate the stand-alone selling price of products and services to be updated and applied to new contracts.
  5. For performance obligations where revenue is recognised over-time, consider whether the estimated progress towards completion (e.g. costs to complete) reflects the latest expectations.

When should an onerous contract provision for a loss-making contract be recognised?

As a result of the COVID-19 outbreak, costs of fulfilling contracts may rise (e.g. company needs to find an alternative supplier) or benefits received from contracts may be lower than expected (e.g. fall in demand). These changes could turn previously profitable contracts into loss-making contracts.

When a contract becomes onerous (loss-making), a provision is recognised when the unavoidable costs of meeting the obligations in the contract exceed the economic benefits to be received under the contract. Unavoidable costs are the lower of the net costs of fulfilling the contract and the cost of terminating it. When assessing the unavoidable costs, organisations should consider the contract terms carefully, including termination and force majeure clauses.

In calculating the provision, the assumptions used for projecting the benefits and costs to fulfil the contract should be consistent with those used for recoverability assessments (e.g. impairment of non-financial assets) and updated each reporting period.

For assets dedicated to a contract, an organisation tests and recognises any impairment loss on those assets before including them in the calculation of the onerous contract provision.

A provision is recognised only for an existing present obligation – not for future operating losses.

What is the impact on revenue when a right of return period on sales is extended?

If the consideration promised in a sale contract includes a variable amount (e.g. rights of return), then the organisation estimates the amount of consideration to which it will be entitled in exchange for transferring the goods or services to the customer.

The organisation should reassess the amount of consideration (and revenue) they expect to be entitled with the change in return policy. An extension in the right of return period may increase the amount of goods customers are expected to return, which will result in a reduction of revenue and an increase in a refund liability.

Where an organisation extends the right of return period for sales retrospectively and changes its expectations of returns these are accounted for as contract modifications. The modification is accounted for as a cumulative catch up adjustment on the date of modification.

For sales made after the change in policy, organisations will need to determine whether extended returns periods will increase the likelihood of returns and reduce the revenue it recognises when control of the goods are transferred to the customer. At each reporting period, organisations will need to update their assessment of the amount of returns and adjust revenue and the refund liability account accordingly.

What is the impact on revenue from pre-paid membership fees (e.g theme park, zoo, airline lounge access) when the business is temporarily closed and the membership period is extended for the expected closure period for no additional fee?

No services (including alternative services) were provided to members over the period of closure, then no revenue is recognised over this period as no benefit is transferring to the customer and the entity has not satisfied its performance obligation to provide access. Revenue recognition will recommence once the facilities reopen and members regains access and is recognised over the remainder of the period including the extension period.

Restructuring

When is the right time to recognise a restructuring provision?

Companies may restructure their operations to respond to the current economic uncertainty.

An organisation recognises a restructuring provision when it has a formal plan with sufficient detail of the restructuring and has raised a valid expectation in those affected by the plan (i.e. the plan has been implemented or the organisation has announced the main features to those affected by it).

Restructuring provisions include only direct costs arising from the restructuring (e.g. contract termination costs, and consulting fees related to restructuring). Costs associated with ongoing activities are not included in the restructuring provision (e.g. relocating employees, investment in a new system).

Termination benefits for employees made redundant are subject to a different recognition criteria.

How are redundancy payments (termination benefits) in a restructuring accounted for?

An organisation recognises a liability and an expense for termination benefits at the earlier of:

  • when it recognises costs for a restructuring that include the payment of termination benefits; and
  • can no longer withdraw the offer of those benefits.

Consequently, if an organisation implements a restructuring plan that includes employee redundancies, then the provision for termination benefits is recognised to coincide with the recognition of the restructuring provision.

Leases

When is a lessee eligible to apply the practical expedient under the COVID-19-related amendment to AASB 16 Leases?

Rent concessions often meet the definition of a ‘lease modification’ under AASB 16 Leases. The accounting for lease modifications can be complex. For example, the lessee may be required to recalculate lease assets and liabilities using a revised discount rate.

Given the unprecedented impact of COVID-19, many lessees are seeking rent concessions from lessors. In response to the various challenges faced by lessees, the International Accounting Standards Board has granted a practical expedient for lessees where under certain conditions, lessees do not have to apply lease modifications accounting.

Rent concessions are eligible for the practical expedient if they occur as a direct consequence of the COVID-19 pandemic and if all of the following criteria are met:

  • the change in lease payments results in revised consideration for the lease that is substantially the same as, or less than, the consideration for the lease immediately preceding the change;
  • any reduction in lease payments affects only payments originally due on or before 30 June 2021; and
  • there is no substantive change to other terms and conditions of the lease.

Refer to Leases – Rent concessions for more guidance on accounting for rent concessions in the current environment.

What does a lessee need to consider when applying the practical expedient for rent concessions?

The lessee needs to consider whether the rent concession is conditional. An example of a conditional rent concession is when it is agreed on 1 June 2020 that the lessee will receive a rent concession of a 30% reduction in the monthly lease payments for June to December 2020 if the social distancing rule of “4 square meter per person” is in place at the end of each month. Another example is where it is agreed on 1 June 2020 that the monthly lease payments for June to December 2020 is based on a percentage of the monthly turnover.

A rent concession is not conditional if, for example, the landlord agrees that the lease payments for the next 12 months will be reduced by a fixed amount.

Refer to Leases – Rent concessions for more guidance on accounting for rent concessions in the current environment.

How does a lessee account for conditional rent concessions in the form of waivers/forgiveness of payments under the practical expedient for rent concessions?

An example of conditional rent concessions is an agreement signed on 1 June 2020 where the lessee will receive a rent concession of a 30% reduction in the monthly lease payments for June to December 2020 if the social distancing rule of “4 square meter per person” is in place at the end of each month. Another example is where it is agreed on 1 June 2020 that the monthly lease payments for June to December 2020 is based on a percentage of the monthly turnover.

Where the rent concession is conditional on the occurrence of future events, the tenant does not remeasure the lease liabilities at the date when the terms are agreed under the practical expedient. Instead, the tenant:

  • recognises the rent concession as a gain in the profit and loss and a reduction in the lease liability on the date the trigger for the conditional rent concession occurs, for example, at the end of each month when the condition is met. The concession is treated as a negative variable lease payment;
  • continues to accrue interest on the lease liability at the unchanged discount rate; and
  • continues to depreciate the right of use asset (ROUA) and assess whether the ROUA is impaired in accordance with AASB 136 Impairment of Assets.

Refer to Leases – Rent concessions for more guidance on accounting for rent concessions in the current environment.

How does a lessee account for unconditional rent concessions in the form of waivers/forgiveness of payments under the practical expedient for rent concessions?

An unconditional rent concession is when the concession is fixed at the date of change, for example, it is agreed on 1 June 2020 that lease payments for the months of June to December 2020 are reduced by a fixed amount. When the rent concession is not conditional upon the occurrence of other events, the tenant remeasures the lease liabilities at the date when the terms are agreed by discounting the lease payments at the original discount rate. That is, the tenant:

  • recognises the present value of the rent concession as a gain in the profit and loss on the date when the change in terms is agreed. The concession is recognised immediately as a negative variable lease payment as the trigger for the concession has already occurred;
  • continues to accrue interest on the lease liability at the original discount rate; and
  • continues to depreciate the right of use asset (ROUA) and assess whether the ROUA is impaired in accordance with AASB 136 Impairment of Assets.

Refer to Leases – Rent concessions for more guidance on accounting for rent concessions in the current environment.

How should a lessee account for unconditional rent concessions in the form of a deferral of lease payments “interest free” under the practical expedient for rent concessions?

In our view, there is an accounting policy choice. The lessee can choose to either remeasure the lease liability using the original discount rate and recognise the impact of the interest free deferral as a gain in profit and loss when the concession is granted, or not remeasure the lease liability and instead continue to recognise interest expense based on the original amortisation schedule. Under this second approach, the benefit of the deferral is not recognised in the income statement – that is, interest continues to be recognised as if there has been no change in the timing of the cash flows.

Under both approaches, the lessee continues to depreciate the right of use asset (ROUA) and assess whether the ROUA is impaired in accordance with AASB 136 Impairment of Assets.

Refer to Leases – Rent concessions for more guidance on accounting for rent concessions in the current environment.

Other 

When can an organisation recognise expected insurance proceeds for the reimbursement of penalties incurred due its inability to fulfil legal or contractual obligations?

As a result of the COVID-19 outbreak, some organisations may struggle to fulfil their legal or contractual obligations and may incur penalties that give rise to a provision. Insurance proceeds may reimburse some or all of the expenditure necessary to settle the provision.

Reimbursements are recognised when it is virtually certain that they will be received. The reimbursement is recognised as a separate asset (with related income) and should not exceed the related provision for the penalty.

In our view, if the only uncertainty related to recovery of an insured loss is the amount of the recovery, then the reimbursement amount will often qualify to be recognised as an asset. The organisation uses its best estimate of the reimbursement, not exceeding the amount of the provision, to measure the reimbursement asset and presents it as an asset separate to the provision.

Organisations should carefully review their insurance policies, involving legal advisers where necessary to determine eligibility to claim under insurance contracts for losses caused by the COVID-19 outbreak. Given the nature of the outbreak, it may be difficult to assert prior to the settlement of the claim that the only uncertainty related to recovery is the amount of the recovery.

When can an organisation recognise insurance proceeds to compensate for business interruption, e.g. lost profits?

An organisation recognises insurance proceeds to compensate for business interruption losses when it has an unconditional right to receive the compensation. An unconditional contractual right to receive compensation exists if:

  • it has an insurance contract under which it can make a claim for compensation; and
  • the loss event that creates a right for the organisation to assert a claim at the reporting date has occurred and the claim is not disputed by the insurer.

Any compensation receivable is measured based on the amount and timing of the expected cash flows discounted at a rate that reflects the credit risk of the insurer.

Organisations should carefully review their insurance policies, involving legal advisers where necessary to determine eligibility to claim under insurance contracts for business interruption losses caused by the COVID-19 outbreak.

What are force majeure clauses in contracts?

Many commercial contracts contain force majeure clauses, which typically allow one of the parties to cancel or delay delivery on a contract without penalty when unforeseeable circumstances prevent them from fulfilling their obligations. The events covered by a force majeure clause, and the rights and obligations of each of the parties when the clause is triggered, is contract specific. For example, the declaration of COVID-19 as a pandemic by the WHO may trigger the force majeure clause in some contracts.

When an entity invokes a force majeure clause, it should obtain confirmation that the counterparty has accepted the claim and agreed with the consequences. This mitigates dispute risk.

What are some of the potential financial reporting implications when a force majeure clause is invoked in a take or pay contract?

Entities must ensure that the flow-on impacts when a force majeure clause is operative are reflected consistently across the various estimates and judgements. The following are examples:

  • If an organisation was waiting to receive parts needed to fulfil its obligations in a revenue contract and the supplier has now invoked force majeure, is the revenue contract now onerous as the entity is no longer able to fulfil its obligations?
  • If a customer has invoked the clause in a supply contract, what is the impact on the net realisable value of inventories?
  • Hedging (for derivatives accounting) – If an organisation was hedging the highly probable forecast transaction (either purchase or sale) which is now no longer expected to occur, has hedge accounting been discontinued? This includes assessing the treatment of any amount in the cash flow hedge reserve.
  • Forecasting – Force majeure clause often exists in significant contracts. Therefore, when invoked, consideration needs to be given to the flow-on impacts on cash flows more broadly across the organisation, including forecasted cash flows used in impairment testing etc.

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