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The implications of COVID-19 on Treasury Accounting

The implications of COVID-19 on Treasury Accounting

Operational challenges for corporate treasury

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Ralph Schilling

Partner, Finance Advisory, Head of Finance and Treasury Management

KPMG AG Wirtschaftsprüfungsgesellschaft

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COVID 19 - Treasury

Alongside the undisputedly major operational challenges for corporate treasury, the particularities of how financial instruments are recognized in the balance sheet are now also becoming apparent for the reporting of 31 March 2020 at the latest. This also applies to interim reporting in accordance with IAS 34 and, of course, to annual or consolidated financial statements for financial years ending on 31 March 2020.

The Institute of Auditors in Germany e.V. (IDW) has presented the effects of COVID-19 on accounting in a multi-part expert opinion. Below, we would like to address the key issues from this for corporate treasury and show how these were addressed in consulting and audit jobs handled by us.

Impact on hedging and hedge accounting

The global pandemic has led to the disruption of both manufacturing and supply chains in almost all industrialized countries due to the far-reaching restrictions on public life. This has had an immediate effect on the sales and market prices of goods and commodities. These, in turn, have often had an enormous indirect influence on the hedging activities of corporations, so that existing hedges, for example, have had to be rolled over or even liquidated.

Accordingly, the negative effects mentioned by the IDW are now increasingly observable in the presentation of hedge accounting in the balance sheet. A number of factors are now even more important than before, especially when it comes to hedging foreign currency and price risks from planned transactions. The basic requirement of forecasting highly probable cash flows for the use of hedge accounting in accordance with IFRS 9 now seems more important than ever. Only if the previously planned incoming and outgoing payments remain highly likely even in the present pandemic scenario will it be possible to continue to use hedge accounting at all. Should cash flows become entirely improbable because previously planned sales cannot occur, e.g. due to a trading halt or production stops, the hedging relationship must be cancelled completely and the hedge results recognized in other provisions must be reclassified to current income through profit or loss. 

In principle, it cannot be argued that a lower planned cash flow will be recovered in later periods. As a result, it is generally not allowed to roll forward a planning into the future by referring to subsequent catch-up effects  even in a pandemic. Nevertheless, there are different cases and scenarios in which this seems possible to deviate from the general rule:

  • In the case of distinctly identifiable individual transactions, such as in made-to-order production or customized orders, a postponement may be justified with reference to the specific ongoing planning. In this case, however, it must be substantiated in each individual case that the postponement is made for a reasonable period of time and is based on plausible assumptions. The postponement should also be mentioned in the hedging transactions entered into for the transaction and must be taken into account accordingly in the hedge documentation1
  • On the other hand, a delay is rarely possible in the case of goods that are sold in bulk. In this case, a postponement can only take place to a very limited extent and with reference to the COVID-19 pandemic as an unforeseeable event. The catch-up effect must occur within a reasonable period of time and must be substantiated sufficiently with plausible planning, which also considers the existing hedge ratios. The period and scope of the necessary evidence depend heavily on the industry, products and markets, so that it is difficult to define absolute guidelines. In any event, it must be ensured that the postponement does not conflict with already hedged future underlying transactions, resulting in a de facto over-collateralization in later periods. Another aspect to consider is that despite the impact of COVID-19, a continuous roll-forward of hedges may not be allowed, despite the hedging relationship generally providing for a roll-forward strategy. Rather, companies, and in particular Corporate Treasury, are expected to provide a reliable and crisis-adjusted planning. Although it is possible for companies to adjust their accounting hedges to the effects of COVID-19, there will be ineffectiveness from a shift in cash flows. Consequently, such ineffectiveness will have a direct impact on the profit or loss for the period in these cases as well.

Of course, there are also effects on balance sheet hedging relationships designated for recognized underlying transactions, such as receivables in foreign currency. Here, it is particularly important to what extent these hedging relationships are at risk of default, thus coming to an end prematurely.

The explanations above relate primarily to external accounting in accordance with the International Financial Reporting Standards (IFRS), but in principle also apply to the accounting of valuation units under the German Commercial Code. In this regard, however, we would also like to refer to the above-mentioned IDW expert opinion on the effects of COVID-19 on accounting under Commercial Law.

Determining fair values and probabilities of default for financial assets

Corporate Treasury often acts as a center of expertise within the company for market data and fair value determination. COVID-19 causes two additional significant aspects of IFRS accounting that currently need to be considered in this regard.

The first is the determination of fair values under IFRS 13. The three-step concept ranges from directly observable market data (level 1) to derived market data (level 2) all the way to in-house model data (level 3). While the calculations in levels 1 and 2 may be subject to significant changes at the moment, such as those observed in the price of crude oil at the end of March / beginning of April, level 3 models will be subject to manual adjustments. In doing so, it is important to comply with the requirements of IFRS 13, since there may be no contradiction between these and the markets even the market data is unobservable. This can result in complex adjustments to forecasts and models for valuations as at the end of March. It should also be noted in this context that IFRS require a number of disclosures relating to forecast changes and sensitivities for level 3 models.

The second aspect pertains to calculating probabilities of default for valuation purposes. On the one hand, these are the credit/debit value adjustments required under IFRS 13, but under the new IFRS 9 impairment model, these now also include the probabilities of creditor default. Depending on the exact model used and the external and internal sources of the default probabilities, substantial adjustments may be necessary. The IFRS 9 impairment model requires, for example, that debtor-specific factors and macroeconomic conditions, including an assessment of current and future developments, be taken into account. If external data is sourced from third-party providers, Corporate Treasury must ensure that these comply with these requirements. But also internal data, such as historical default probabilities, must also take into account current developments.

Modifications and covenants in respect to COVID-19

Another relevant factor for corporate treasury at this point may be crisis-related modifications to the contractual terms of financial assets and liabilities. 

In accordance with IFRS 9, financial assets that are contractually modified during their maturity must be assessed as to whether these modifications will lead to a derecognition in the balance sheet or only an adjustment. Depending on the qualitative and quantitative analysis of this issue, there may be implications for the profit or loss for the period.

For financial liabilities, it must also be assessed whether all covenants can be fulfilled in the current phase of the pandemic. If the contractual terms are adjusted in this context, it must also be reviewed whether the liability must be modified. A non-compliance with covenants may, however, also have other consequences for the reporting of financial liabilities. In particular, this could have repercussions on the allocation of non-current and current liabilities, which can ultimately have further consequences for key figures and the financing situation of companies.

It should be noted that an external report on COVID-19-induced changes is mandatory in the (interim) financial statements, so that the above-mentioned issues will arise at this point at the latest.

We are in daily contact with our clients but also with regulators regarding the effects of the current situation on corporate treasury. Needless to say that we will be happy to keep you informed about new developments regarding the effects on accounting.

Source: KPMG Corporate Treasury News, Edition 101, May 2020

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cf. IDW RS HFA 48 Tz. 346

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