Accounting implications of the effects of coronavirus: PwC In depth INT2020-02

Publication date: 03 Apr 2020

adobe_pdf_file_icon_32x32Accounting implications of the effects of coronavirus - PwC In depth

At a glance

This In depth considers the impact of the new coronavirus (‘COVID-19’ or ‘the virus’) on the financial statements for periods ending after 31 December 2019 of entities whose business is affected by the virus.

Contents

  1. Background
  2. Non-financial assets

2.1 - Impairment of non-financial assets
2.2 - Impairment disclosures 
2.3 - Associates and joint ventures
2.4 - Inventories
2.5 - Property, plant and equipment
2.6 - Fair value measurement of non-financial assets and liabilities

  1. Financial instruments

3.1 - Classification and measurement of financial assets under IFRS 9
3.2 - Impairment under IFRS 9
3.3 - Hedge accounting under IFRS 9
3.4 - Hedge accounting under IAS 39
3.5 - Borrowings and other financial liabilities under IFRS 9
3.6 - ‘Own use’ under IFRS 9
3.7 - Disclosures under IFRS 7
3.8 - Fair value of financial assets and liabilities
3.9 - Subsidiaries, associates and joint ventures measured at fair value
3.10 - Classification and measurement of financial assets under IAS 39
3.11 - Impairment of financial assets under IAS 39
3.12 - Borrowings and other financial liabilities under IAS 39

  1. Leases
  2. Cash and cash equivalents
  3. Revenue recognition and government grants

6.1 - Revenue
6.2 - Government assistance

  1. Non-financial obligations

7.1 - Provisions
7.2 - Onerous contracts
7.3 - Contingent assets
7.4 - Employee benefits and share-based payments
7.5 - Income taxes

  1. Going concern and events after the reporting period

8.1 - Going concern
8.2 - Events after the reporting period

  1. Presentation and disclosure

9.1 - Presentation of financial statements
9.2 - Breach of covenants
9.3 - General disclosures
9.4 - Financial risks
9.5 - Disclosure outside the financial statements

  1. Interim financial statements.

Refer here for frequently asked questions related to the accounting implications of the effects of COVID-19.

1. Background

Publication date: 16 Mar 2020

The COVID-19 outbreak has developed rapidly in 2020, with a significant number of infections. Measures taken to contain the virus have affected economic activity, which in turn have implications for financial reporting.

Measures to prevent transmission of the virus include limiting the movement of people, restricting flights and other travel, temporarily closing businesses and schools, and cancelling events. This will have an immediate impact on businesses such as tourism, transport, retail and entertainment. It will also begin to affect supply chains and the production of goods throughout the world, and lower economic activity is likely to result in reduced demand for many goods and services. Financial services entities (such as banks that lend to affected entities, insurers that provide protection to affected individuals and businesses, and funds or other investors that invest in affected entities) are also likely to be affected.

Management should carefully consider the impact of COVID-19 on both interim and annual financial statements. The impact could be significant for many businesses.

The implications for financial statements include not only the measurement of assets and liabilities but also disclosure and possibly an entity’s ability to continue as a going concern. The implications, including the indirect effects from lower economic activity, should be considered by all entities, not just those in the territories most significantly affected.  

2. Non-financial assets

Publication date: 22 Jul 2020

2.1 Impairment under IAS 36, Impairment of assets

Many businesses will have to consider the potential impairment of non-financial assets. IAS 36 requires goodwill and indefinite-lived intangible assets to be tested for impairment at a minimum every year, and other non-financial assets whenever there is an indicator those assets might be impaired. Temporarily ceasing operations or suffering an immediate decline in demand or prices and profitability are clearly events that might indicate impairment. However, reduced economic activity and lower revenues are likely to affect almost any entity and might also indicate impairment.

Management should consider whether:

  • COVID-19 and the measures taken to control it are likely to reduce future cash inflows, or increase operating and other costs, for the reasons described above;
  • these events (including, for example, a fall in an entity’s share price such that market capitalisation is lower than carry value) are an indicator of impairment requiring goodwill and indefinite-lived intangible assets to be tested outside the annual cycle or other assets to be tested;
  • the assumptions and cash flow forecasts used to test for impairment should be updated to reflect the potential impact of COVID-19;
  • budgets, forecasts and other assumptions from an earlier impairment testing date, that were used to determine the recoverable amount of an asset, should be revised to reflect the economic conditions at the balance sheet date, specifically to address increased risk and uncertainty;
  • an expected cash flow approach (multiple probability-weighted scenarios) might be a better way to estimate recoverable amount than a single predicted outcome, to capture the increased risk and uncertainty. The potential impact of measures taken to control the spread of the virus could be included as additional scenarios in an expected cash flow approach. There might be a range of potential outcomes considering different scenarios;
  • the factors used to determine the discount rate, however the recoverable amount is determined, should be revised to reflect the impact of the virus and the measures taken to control it (for example, the risk-free rate, country risk and asset risk). The discount rate used in a single predicted outcome approach should be adjusted to incorporate the risk associated with COVID-19. Management should ensure that appropriate risk is reflected in either the cash flows or the discount rate.

Whichever approach management chooses to reflect the expectations about possible variations in the expected future cash flows, the outcome should reflect the expected present value of the future cash flows. Where fair value is used to determine the recoverable amount, the assumptions made should reflect market participant assumptions.

FAQ 2.1.1 - Is the coronavirus (COVID-19) pandemic an impairment indicator?
FAQ 2.1.2 - Should the business plan prepared by management be revised to incorporate the impacts of COVID-19?
FAQ 2.1.3 – How can impairment tests that incorporate cash flow forecasts be more reliably performed in periods of uncertainty?
FAQ 2.1.4 – What are the consequences of the COVID-19 pandemic on the discount rate?
FAQ 2.1.5 – Level at which impairment testing is performed
FAQ 2.1.6 – Does an entity incorporate cash flows from government assistance or grants when determining the value in use of a cash-generating unit?
FAQ 2.1.7 - Is an entity permitted to change the timing of its annual impairment test of goodwill, in the light of COVID-19 if the test was not historically performed at year end?

2.2 Impairment Disclosures

The disclosure requirements in IAS 36 are extensive. Management should consider specifically the requirements to disclose assumptions and sensitivities in the context of testing goodwill and indefinite-lived intangible assets.

Management should also consider the requirements in IAS 1, ‘Presentation of financial statements’,to disclose the major sources of estimation uncertainty that have a significant risk of resulting in a material adjustment to the financial statements in a subsequent period.

FAQ 2.2.1 - Which Impairment disclosures will be of particular interest to users of financial statements this year?

2.3 Associates and joint ventures accounted for using the equity method

Interests in joint ventures and associates accounted for under the equity method are tested for impairment in accordance with IAS 28 Investments in Associates and Joint Ventures. Management should consider whether the impact of COVID-19 and the measures taken to control it are an indicator that an associate or joint venture is impaired.

Interests in joint ventures and associates that are within the scope of IFRS 9, ‘Financial instruments’,are subject to that standard’s impairment guidance.

FAQ 2.3.1 – Is COVID-19 a significant event for associates with different period ends from the entity?

2.4 Inventories

It might be necessary to write-down inventories to net realisable value. These write-downs could be due to reduced movement in inventory, lower commodity prices, or inventory obsolescence due to lower than expected sales.

IAS 2 Inventories requires fixed production overheads to be included in the cost of inventory based on normal production capacity. Reduced production might affect the extent to which overheads can be included in the cost of inventory.

Entities should assess the significance of any write-downs and whether they require disclosure in accordance with IAS 2.

FAQ 2.4.1 – How is overhead cost allocated to inventory where the number of units produced reduces due to COVID-19?

2.5 Property, plant and equipment

The virus might mean property, plant and equipment is under-utilised or not utilised for a period, or that capital projects are suspended. IAS 16, ‘Property, plant and equipment’, requires depreciation to continue to be charged in the income statement while an asset is temporarily idle. IAS 23, ‘Borrowing costs’, requires the capitalisation of interest to be suspended when development of an asset is suspended.

FAQ 2.5.1 – Can an entity stop depreciating an asset if it is idle?
FAQ 2.5.2 – Suspending capitalisation of borrowing costs

2.6 Fair value measurement of non-financial assets and liabilities (including investment properties)

Fair values are likely to change significantly as a result of COVID-19.

Valuation best practices support the use of multiple valuation techniques when estimating the fair values. Changing methodologies (for example, from a market multiple approach to a discounted cash flow approach), or changing the weighting where multiple valuation techniques are used, would be appropriate if the change results in a measurement that is equally or more representative of fair value in the circumstances. This change would be considered a change in accounting estimate.

The discount rate used in a discounted cash flow technique includes a number of market inputs, including a risk-free rate and a cost of debt. In most jurisdictions, risk-free rates have declined significantly in 2020, while the cost of debt has declined for some entities and increased for others. This could result, for some entities, in a lower weighted average cost of capital, and thus discount rate. However, entities should remember that the discount rate needs to be calibrated to the risks in the cash flow forecast, including the long-term growth rate.  

Please also refer to fair value measurements of financial instruments under IFRS 13.

FAQ 2.6.1 - Impact of COVID-19 on investment property valuation
FAQ 2.6.2 - Uncertainties in cash flows and change in valuation technique for level 3 fair value measurement
FAQ 2.6.3 – Additional considerations for discount rates used in Level 3 fair value measurements
FAQ 2.6.4 – 'Determining fair value where an entity might be forced to liquidate assets'

3. Financial instruments

Publication date: 28 Jul 2020

3.1 Classification and measurement of financial assets under IFRS 9

Under IFRS 9, the classification of financial assets that are debt instruments depends on both (a) the entity’s business model for managing the financial assets, and (b) whether the contractual cash flows of the financial asset are solely payments of principal and interest. 

Management should consider the impact of COVID-19 on the classification of these assets, in particular whether the entity’s business model for managing financial assets might have changed.

Additionally, the impact of any changes to the terms of a loan agreement, perhaps because of actions taken by local government or the renegotiation of terms between a borrower and a lender, should be assessed. Lenders should apply the guidance in IFRS 9 to determine the impact of the change in terms, including those for determining whether the change to the terms results in derecognition and, if not, for recognising a modification gain or loss.

FAQ 3.1.1 – How will factoring or other sales of trade receivables be impacted by COVID-19?
FAQ 3.1.2 – How should a bank and a borrower account for a loan repayment holiday imposed by law?
FAQ 3.1.3 – What is the accounting treatment of a loan repayment holiday negotiated between a bank and a borrower?
FAQ 3.1.4 – When is a new loan granted to an existing borrower, in substance, a payment holiday on the original loan?
FAQ 3.1.5 – New loans granted to defaulted debtors
FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19
FAQ 3.1.7 – Monetary items forming part of the net investment in a foreign operation
FAQ 3.1.8 - “Accounting for gain or loss on debt modification where borrowing costs are capitalised under IAS 23”

3.2 Impairment under IFRS 9

Where an entity has any financial instruments that are within the scope of IFRS 9’s expected credit loss (ECL) model, management should consider the impact of COVID-19 on the ECL. Instruments to be considered include loans, trade and other receivables, debt instruments not measured at fair value through profit or loss, contract assets, lease receivables, financial guarantees and loan commitments. 

Management should consider the impact of COVID-19 on both of the following:

  • whether the ECL is measured at a 12-month or lifetime ECL. If the credit risk (risk of default) has increased significantly since initial recognition, the ECL is measured at the lifetime ECL rather than the 12-month ECL (except for assets subject to the simplified approach, such as short-term receivables and contract assets, which are always measured using lifetime ECL); and
  • the estimate of ECL itself. This will include all of:
    • the credit risk (risk of default); for example, this might increase if the debtor’s business is adversely impacted by COVID-19;
    • the amount at risk if the debtor defaults (exposure at default); for example, debtors affected by COVID-19 might draw down on existing unused borrowing facilities, or cease making discretionary over-payments, or take longer than normal to pay, resulting in a greater amount at risk; and
    • the estimated loss as a result of default (loss given default); for example, this might increase if COVID-19 results in a decrease in the fair value of a non-financial asset pledged as collateral.

Where contractual payment dates are extended or amounts are expected to be received later than when contractually due, this may give rise to an ECL unless either additional compensation is received for the lost time value of money, or the EIR is 0%.

IFRS 9 requires forward-looking information (including macro-economic information) to be considered both when assessing whether there has been a significant increase in credit risk and when measuring ECL. Forward-looking information might include additional downside scenarios related to the spread of COVID-19. This might be achieved by adding one or more additional scenarios to the entity’s existing scenarios, amending one or more of the existing scenarios (for example, to reflect a more severe downside(s) and/or to increase their weighting), or using an ‘overlay’ if the impact is not included in the entity’s main ECL model.

Certain governments might ask local banks to support borrowers affected by COVID-19. This could be in the form of payment holidays on existing loans or reduced fees and interest rates on new loans. Entities giving such support should consider the impact on their financial statements, including whether:

  • payment holidays indicate that the affected loans have suffered a significant increase in credit risk or default, and therefore moved to stage 2 or stage 3 of the ECL model; and
  • reduced fees or interest rates on new loans indicate that the loans are not made at a market rate.

Management should consider the need to disclose the impact of the virus on the impairment of financial assets. For example, disclosures required by IFRS 7, ‘Financial instruments: Disclosures’,that might be affected include how the impact of forward-looking information has been incorporated into the ECL estimate, details of significant changes in assumptions made in the reporting period, and changes in the ECL that result from assets moving from stage 1 to stage 2.

FAQ 3.2.1 - Impact of COVID-19 payment holidays on ECL staging
FAQ 3.2.2 - How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model?
FAQ 3.2.3 – In the context of COVID-19 and ECL, what information is ‘reasonable and supportable’?
FAQ 3.2.4 – Example of a provision matrix for corporates in a COVID-19 environment
FAQ 3.2.5 – Impact of price concessions on expected credit losses of trade receivables
FAQ 3.2.6 – Cash collateral held for trade receivables or lease receivables: recognition and impact on measurement of ECL
FAQ 3.2.7 - To what extent should additional COVID-19 related information after the reporting date be included in the ECL estimate?
FAQ 3.2.8 – Aligning the definition of default: Regulatory versus Accounting
FAQ 3.2.9 - Possible revisions to ECL estimates required in a downturn
FAQ 3.2.10 – How should an entity account for changes to the cash flows on a debt instrument measured at amortised cost or fair value through other comprehensive income (FVOCI)?
FAQ 3.2.11 – Impact of prepayments on lifetime probability of default for SICR assessments
FAQ 3.2.12 – Inclusion of cash flows expected from the sale on default of a loan in the measurement of expected credit losses (ECL)
FAQ 3.2.13 – Should borrower pre-payment options be taken into account when determining the period over which to measure expected credit losses (ECL)
FAQ 3.2.14 – What discount rate should be used when measuring ECL for credit cards and other similar products?
FAQ 3.2.15 – Factors to consider in relation to ‘days past due’ for IFRS 9 ECL where a loan has been granted a payment holiday
FAQ 3.2.16 – Staging of loans where a significant increase in credit risk has occurred that cannot be identified individually or that is based on shared credit risk characteristics
FAQ 3.2.17 – In the context of COVID-19, what are relevant considerations when determining if a financial instrument is credit impaired based on qualitative factors?

3.3 Hedge accounting under IFRS 9

Management should consider the impact of COVID-19 on its existing hedges, in particular whether the hedges continue to meet the criteria for hedge accounting. For example, if a hedged forecast transaction is no longer highly probable to occur, hedge accounting is discontinued. For similar reasons, management should also consider the impact of COVID-19 on its ability to designate new hedges.

FAQ 3.3.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting?
FAQ 3.3.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19?
FAQ 3.3.3 – Hedge accounting and payment holidays
FAQ 3.3.4 – Recoverability test for hedging reserves
FAQ 3.3.5 – Fair value hedge accounting and debt modifications (IFRS 9)

3.4 Hedge accounting under IAS 39, ‘Financial instruments’

Management should consider the impact of COVID-19 on its existing hedges, in particular whether hedges continue to meet the criteria for hedge accounting. For example, if a hedged forecast transaction is no longer highly probable to occur or no longer highly effective, hedge accounting is discontinued. For similar reasons, management should also consider the impact of COVID-19 on its ability to designate new hedges.

FAQ 3.1.5 – New loans granted to defaulted debtors
FAQ 3.4.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting?
FAQ 3.4.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19?
FAQ 3.4.3 – Hedge accounting and payment holidays (IAS 39)
FAQ 3.4.4 – Fair value hedge accounting and debt modifications (IAS 39)

3.5 Borrowings and other financial liabilities under IFRS 9

The impact of any changes to the terms of a loan agreement, perhaps because of actions taken by local government or the renegotiation of terms with the lender, should be assessed. Borrowers should apply the guidance in IFRS 9 to determine the impact of the change in terms, including those for determining whether the change to the terms results in derecognition and, if not, for recognising a modification gain or loss.

FAQ 3.1.2 – How should a bank and a borrower account for a loan repayment holiday imposed by law?
FAQ 3.1.4 – When is a new loan granted to an existing borrower, in substance, a payment holiday on the original loan?
FAQ 3.1.5 – New loans granted to defaulted debtors
FAQ 3.1.3 – What is the accounting treatment of a loan repayment holiday negotiated between a bank and a borrower?
FAQ 3.5.1 – How is the accounting for supplier finance arrangements impacted by COVID-19?

3.6 ‘Own use’ under IFRS 9

Under IFRS 9, contracts to buy or sell a non-financial item that can be settled net in cash are within the scope of the standards (with the result that they are typically accounted for as derivatives), unless the contracts were entered into and continue to be held for the purpose of receipt or delivery of non-financial items to meet the entity’s expected purchase, sale or usage requirements. COVID-19 might impact whether some contracts meet these ‘own use’ requirements. For example, disruption to an entity’s supply chain due to COVID-19 might have the effect that certain commodity contracts will be settled net in cash rather than by physical delivery.  

3.7 Disclosures under IFRS 7

Additional disclosures might be required. IFRS 7 requires, amongst other things, disclosure of defaults and breaches of loans payable, of gains and losses arising from derecognition or modification, and of any reclassification from the cash flow hedge reserve that results from hedged future cash flows no longer being expected to occur.

3.8 Fair value of financial assets and liabilities

The fair value of an asset or liability at the reporting date should be determined in accordance with the applicable IFRS standards. Where fair value is based on an observable market price, the quoted price at the reporting date should be used. The fair value of an asset reflects a hypothetical exit transaction at the reporting date. Changes in market prices after the reporting date are therefore not reflected in asset valuation.

The volatility of prices on various markets has increased as a result of the spread of COVID-19. This affects the fair value measurement either directly – if fair value is determined based on market prices (for example, in the case of shares or debt securities traded on an active market) – or indirectly (for example, if a valuation technique is based on inputs that are derived from volatile markets).

Counterparty credit risk and the credit spread that is used to determine fair value might also increase. However, the impact of actions taken by governments to stimulate the economy might reduce risk-free interest rates.

A change in the fair value measurement affects the disclosures required by IFRS 13, ‘Fair value measurement’, which requires entities to disclose the valuation techniques and the inputs used in the fair value measurement, as well as the sensitivity of the valuation to changes in assumptions. It might also affect the sensitivity analysis required for recurring fair value measurements categorised within level 3 of the fair value hierarchy. The number of instruments classified as level 3 might increase.

FAQ 3.8.1 – Determining whether a market is still active in a period of market disruption
FAQ 3.8.2 – Assessing prices in inactive markets
FAQ 3.8.3 – Determining whether transactions are orderly
FAQ 3.8.4 – Adjustments to the quoted price in an active market
FAQ 3.8.5 – Delays in the availability of information
FAQ 3.8.6 – Post market closure events
FAQ 3.8.7 – Uncertainties in cash flow fair value measurement of financial instruments
FAQ 3.8.8 – Should possible future modifications be considered when determining the fair value of a debt instrument?
FAQ 3.8.9 –Consideration of fair value where an entity has breached a debt covenant

3.9 Subsidiaries, associates and joint ventures measured at fair value

The fair values of investments in subsidiaries, associates and joint ventures might be affected by equity market volatility. The starting point for valuations of listed companies is the market prices at the reporting date.

Entities are required to disclose changes in business or economic circumstances that affect the fair value of investment entities or investments in associates and joint ventures carried at fair value under IFRS 9.

3.10 Classification and measurement of financial assets under IAS 39 (applicable to insurers applying the temporary exemption from IFRS 9)

Financial assets are classified in one of four categories under IAS 39. Reclassifications between categories could be considered by management as a result of COVID-19. The guidance in IAS 39 should be followed to determine whether reclassification is permitted or required.

FAQ 3.10.1 - Is COVID-19 a ‘rare circumstance’ for insurers?

3.11 Impairment of financial assets under IAS 39 (applicable to insurers applying the temporary exemption from IFRS 9)

Impairment charges will likely increase as a result of COVID-19. Under IAS 39, a financial asset is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the asset’s initial recognition (a ‘loss event’). For investments in equity securities, a ‘significant’ or ‘prolonged’ decline in the fair value below cost is one example of objective evidence of impairment.

FAQ 3.11.1 – What is a ‘significant’ or ‘prolonged’ decline in fair value below cost?

3.12 Borrowings and other financial liabilities under IAS 39 (applicable to insurers applying the temporary exemption from IFRS 9)

The contractual terms of an entity’s borrowings or other payables could be amended as a result of COVID-19. Management should determine whether the change in terms results in derecognition or is accounted for as a modification.

4. Leases

Publication date: 03 Aug 2020

A lessor and a lessee might renegotiate the terms of a lease as a result of COVID-19, or a lessor might grant a lessee a concession of some sort in connection with lease payments. In some cases, a lessor might receive compensation from local government as an incentive to offer such concessions. Both lessors and lessees should consider the requirements of IFRS 16, ‘Leases’, and whether the concession should be accounted for as a lease modification and spread over the remaining period of the lease. Lessors and lessees should also consider whether incentives received from local government are government grants.  

FAQ 4.1 – How should lease concessions related to COVID-19 be accounted for?
FAQ 4.2 – What are the accounting implications of a force majeure clause in a lease contract in the context of COVID-19?
FAQ 4.3 – Impairment of lease receivables
FAQ 4.4 – Should lease terms be reassessed as a result of COVID-19?
FAQ 4.5 – Should a lessor in an operating lease continue to recognise lease income when its collectability is uncertain due to COVID-19?
FAQ 4.6 – COVID-19-related modifications to operating leases: lessor perspective
FAQ 4.7 – Accounting by lessees for voluntary forgiveness by the lessor of lease payments when the practical expedient in IFRS 16 is not applied
FAQ 4.8 – Accounting by operating lessors for voluntary forgiveness of amounts contractually due for past rent
FAQ 4.9 – Lessor accounting for initial direct costs where an operating lease is modified
FAQ 4.10 – What does ‘proportionally’ mean in the context of ‘consideration for a lease’, as described in the IASB’s educational material?
FAQ 4.11 – Is it appropriate for a lessor in an operating lease to change the pattern of income recognition in light of COVID-19?

On May 28th, 2020, the IASB issued an amendment to IFRS 16 related to Covid-19 related rent concessions. As a practical expedient, a lessee may elect not to assess whether a rent concession related to COVID-19 is a lease modification. A lessee that makes this election should account for any change in lease payments resulting from the rent concession the same way it would account for it if it were not a lease modification. This practical expedient is only applicable to lessees. For more details see In brief INT2020-09 and In depth INT2020-05.

5. Cash and cash equivalents

Publication date: 16 Mar 2020

IAS 7 defines cash equivalents as short-term highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. COVID-19 has resulted in the value of some money market and other funds declining more than insignificantly. Furthermore, some money market funds include clauses which allow the fund manager to restrict redemption in unlikely events, one of which might be the result of COVID-19. Management should consider whether investments previously classified as cash equivalents continue to meet the definition in light of these declines in value and/or restrictions on redemption. Investments might need to be re-classified out of cash equivalents. 

6. Revenue recognition and government grants

Publication date: 01 Jul 2020

6.1 Revenue

An entity’s sales and revenue might decline as a result of the reduced economic activity following the steps taken to control the virus. This is accounted for when it happens.

However, there could also be an effect on the assumptions made by management in measuring the revenue from goods or services already delivered and, in particular, on the measurement of variable consideration. For example, reduced demand could lead to an increase in expected returns, additional price concessions, reduced volume discounts, penalties for late delivery or a reduction in the prices that can be obtained by a customer. All of these could affect the measurement of variable consideration. IFRS 15, ‘Revenue from contracts with customers’, requires variable consideration to be recognised only when it is highly probable that amounts recognised will not be reversed when the uncertainty is resolved.

Management should reconsider both its estimate of variable consideration and whether the recognition threshold is met.

IFRS 15 is applied only to those contracts where management expects a customer to meet its obligations as they fall due. Management might choose to continue to supply a customer even where it is aware that the customer might not be able to pay for some or all of the goods being supplied. Revenue is recognised in these circumstances only where it is probable that the customer will pay the transaction price when it is due, net of any price concession.

IFRS 15 requires an entity to disclose information that allows users to understand the nature, amount, timing and uncertainty of cash flows arising from revenue. This might require, for example, information about how an entity has applied its policies, taking into account the uncertainty that arises from the virus, the significant judgements applied (for example, whether a customer is able to pay) and the significant estimates made (for example, in connection with variable consideration).

FAQ 6.1.1 – Can government grants for lost income be presented as revenue from contracts with customers or lease income where the entity is the principal of the grant?
FAQ 6.1.2 – Negative revenue: revision of a ‘highly probable’ variable transaction price due to COVID-19
FAQ 6.1.3 – Service provider shutdown due to COVID-19
FAQ 6.1.4 – For entities using the cost-to-cost input method for revenue recognition, would additional costs arising from COVID-19 be included in the measure of progress?
FAQ 3.2.5 – Impact of price concessions on expected credit losses of trade receivables

6.2 Government assistance

Governments around the world have reacted to the impact of COVID-19 with a variety of measures, including tax rebates and holidays and, in some cases, specific support for businesses, in order that those businesses are able to support their customers. Management should consider whether this type of assistance received from a government meets the definition of a government grant in IAS 20, ‘Government grants’. The guidance in IAS 20 should be applied to a government grant.

FAQ 6.2.1 – Six-step framework to account for the receipt of government grants
FAQ 6.2.2 – Identifying the party that receives a government grant
FAQ 6.2.3 – Determining whether a relief or measure is a government grant within the scope of IAS 20
FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19

7. Non financial obligations

Publication date: 12 Jun 2020

7.1 Provisions

IAS 37, ‘Provisions, contingent liabilities and contingent assets’, requires a provision to be recognised only where: an entity has a present obligation; it is probable that an outflow of resources is required to settle the obligation; and a reliable estimate can be made. Management’s actions in relation to the virus should be accounted for as a provision only to the extent that there is a present obligation for which the outflow of economic benefits is probable and can be reliably estimated. For example, a provision for restructuring should be recognised only where there is a detailed formal plan for the restructuring, and management has raised a valid expectation in those affected that the plan will be implemented.

IAS 37 does not permit provisions for future operating costs or future business recovery costs.

IAS 37 requires an entity to disclose the nature of the obligation and the expected timing of the outflow of economic benefits.

7.2 Onerous contracts

Onerous contracts are those contracts for which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. Unavoidable costs under a contract are the least net cost of exiting the contract (that is, the lower of the cost to exit or breach the contract and the cost of fulfilling it). Such contracts might include, for example, supply contracts that the entity is unable to fulfil because of the virus. Management should consider whether any of its contracts have become onerous.

7.3 Contingent assets

One of the steps taken to control the spread of the virus is to require some businesses to close temporarily. An entity might have business continuity insurance and be able to recover some or all of the costs of closing. Management should consider whether the losses arising from COVID-19 are covered by its insurance policies. The benefit of such insurance is recognised when the recovery is virtually certain. This is typically when the insurer has accepted that there is a valid claim and management is satisfied that the insurer can meet its obligations. The benefit of insurance is often recognised later than the costs for which it compensates.

7.4 Employee benefits and share-based payments

Management should consider whether any of the assumptions used to measure employee benefits and share-based payments should be revised. For example, the yield on high-quality bonds or the risk-free interest rate in a particular currency might have changed as a result of recent developments, or the probability of an employee meeting the vesting conditions for bonuses or share-based payments might have changed.

Management should consider the impact of any changes made to the terms of, for example, a share-based payment plan, to address the changes in the economic environment and the likelihood that performance conditions will be met. To the extent that such changes are beneficial to the employee, they would be accounted for as a modification and an additional expense would be recognised. Management should be aware that cancelling a share-based payment award, even if the vesting conditions are unlikely to be satisfied, results in immediate recognition of the remaining expense. 

Management should also consider whether it has a legal or constructive obligation to its employees in connection with the virus (for example, sick pay or payments to employees that self-isolate) for which a liability should be recognised in accordance with the guidance in IAS 19, ‘Employee benefits’.

Management might be considering reducing its workforce as a result of the virus. IAS 19 requires a liability for employee termination to be recognised only when the entity can no longer withdraw the offer of those benefits, or the costs of a related restructuring are recognised in accordance with IAS 37.

IFRS 2, ‘Share-based payment’,requires entities to explain modifications to share-based payments, the incremental fair value granted, as well as information about how the incremental fair value was determined.

IAS 19 requires extensive disclosure of the assumptions used to estimate employee benefit liabilities, together with sensitivities and changes in those assumptions.

FAQ 7.4.1 – What are the implications of the COVID-19 crisis for the net defined benefit liability when reporting under IAS 34?
FAQ 7.4.2 – What are the implications of the COVID-19 crisis for the pension expense when reporting under IAS 34?

7.5 Income taxes

The virus could affect future profits as a result of direct and indirect factors (including effect on customers, suppliers and service providers). Asset impairment could also reduce the amount of deferred tax liabilities and/or create additional deductible temporary differences. Entities with deferred tax assets should reassess forecast profits and the recoverability of deferred tax assets in accordance with IAS 12, ‘Income taxes’,taking into account the additional uncertainty arising from the virus and the steps taken to control it.

Management might also consider whether the impact of the virus affects its plans to distribute profits from subsidiaries and, therefore, whether it needs to reconsider the recognition of any deferred tax liability in connection with undistributed profits.

Management should disclose any significant judgements and estimates made in assessing the recoverability of deferred tax assets, in accordance with IAS 1.

8. Going concern and events after the reporting period

Publication date: 30 Apr 2020

8.1 Going concern

Management should consider the potential implications of COVID-19 and the measures taken to control it when assessing the entity’s ability to continue as a going concern. An entity is no longer a going concern if management intends either to liquidate the entity or to cease trading, or it has no realistic alternative but to do so. Management should consider the impact of measures taken by governments and local banks in its assessment of going concern. Management should also remember that events after the reporting date that indicate that an entity is no longer a going concern are always adjusting events.

Material uncertainties that might cast significant doubt on an entity’s ability to continue as a going concern should be disclosed in accordance with IAS 1.

FAQ 8.1.1 – How does an entity prepare financial statements on a non-going concern basis?

8.2 Events after the reporting period

The global situation is evolving rapidly. Management should therefore consider the requirements of IAS 10, ‘Events after the reporting period’, and in particular whether the latest developments provide more information about the circumstances that existed at the reporting date. Events that provide more information about the spread of the virus and the related costs might be adjusting events. Clear disclosure of adjustments made and events that are considered to be non-adjusting is required where this is material to the financial statements.

FAQ 8.2.1 – Should the effects of COVID-19 impact the measurement of assets and liabilities for entities with a reporting date in the first quarter of 2020?
FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value
FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value

9. Presentation and disclosures including financial risk

Publication date: 15 Apr 2014

9.1 Presentation

An entity might consider several presentation alternatives within the financial statements to provide useful information in relation to COVID-19.  Entities should ensure that any presentation alternative complies with IAS 1’s requirements. In some cases, it might be more helpful to provide narrative explanations of the impact within the notes.

FAQ 9.1.1 – Presentation of the COVID-19 impact in the income statement
FAQ 9.1.2 – Classification of inventory costs, during closure, in an income statement presented by function

9.2 Breach of covenants

The financial impact of the virus might cause some entities to breach covenants on borrowings, or it might trigger material adverse change clauses. This could result in loan repayment terms changing and some loans becoming repayable on demand. Management should consider whether the classification of loans and other financing liabilities between non-current and current is affected and, in extreme situations, whether the entity remains a going concern. Management should consider particularly the impact of any cross-default clauses. Management should also consider the effect of any changes in the terms of borrowings as a result of the circumstances described above, and it should treat waivers obtained after the reporting date as non-adjusting events.

9.3 General disclosures

Management should consider the specific requirements in IAS 1 to disclose significant accounting policies, the most significant judgements made in applying those accounting policies, and the estimates that are most likely to result in an adjustment to profits in future periods. All these disclosures might be different as a result of the impact of the virus. The extent of disclosures regarding estimation uncertainty might need to be increased. For example, the carrying amount of more items might be subject to a material change within the next year.

There might be individually significant financial effects of the virus – for example, individually material expenses such as an impairment or a modification adjustment. In addition to the disclosure requirements of individual standards, IAS 1 requires an entity to disclose separately on the face of the income statement, or in the notes to the financial statements, material items of income or expense. An entity might also disclose additional line items or sub-totals on the face of the income statement where this is necessary for an understanding of performance. Management should consider the specific requirements of IAS 1 if it discloses additional sub-totals. There is also a requirement in IAS 1 to disclose information relevant to an understanding of the financial statements that is not otherwise disclosed.

9.4 Financial risks

Entities will need to disclose any changes in their financial risks (such as credit risk, liquidity risk, currency risk and other price risk) or in their objectives, policies and processes for managing those risks. In particular, additional disclosures about liquidity risk might be needed where the virus has affected an entity's normal levels of cash inflows from operations or its ability to access cash in other ways, such as from factoring receivables or supplier finance.

9.5 Disclosure outside the financial statements

An entity’s stakeholders will be interested in the impact of the virus and the measures taken to contain its spread. Some of these stakeholders’ needs might be met more appropriately by disclosure outside the financial statements. Management might consider updating its analysis of the principal risks and uncertainties. Management should also consider any specific local disclosure requirements, such as those issued by a local securities regulator. For example, the European Securities and Markets Authority has recently stated that “issuers should provide transparency on the actual and potential impacts of COVID-19, to the extent possible based on both a qualitative and quantitative assessment on their business activities, financial situation and economic performance in their 2019 year-end financial report if these have not yet been finalised or otherwise in their interim financial reporting disclosures”.

10. Interim financial statements

Publication date: 03 Jul 2020

Many entities might first report the impact of the virus in interim financial statements. The recognition and measurement guidance described above applies equally to interim financial statements. There are typically no recognition or measurement exceptions for interim reporting, although management might have to consider whether the impact of the virus is a discrete event for the purposes of calculating the expected effective tax rate. IAS 34, ‘Interim financial statements’, states that there might be greater use of estimates in interim financial statements, but it requires the information to be reliable and all relevant information to be disclosed. 

Interim financial information usually updates the information in the annual financial statements. However, IAS 34 requires an entity to include in its interim financial report an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period. This implies that additional disclosure should be given to reflect the financial impact of the virus and the measures taken to contain it. This disclosure should be entity-specific and should reflect each entity’s circumstances.

Where significant, the disclosures required by paragraph 15B of IAS 34 should be included, together with:

  • the impact on the results, balance sheet and cash flows of the virus and the steps taken to control the spread;
  • significant judgements that were not required previously (for example, in connection with expected credit losses);
  • updates to the disclosures of significant estimates; and
  • events since the end of the interim period.

 

FAQ 10.1 – Implications of goodwill impairment in interim financial statements
FAQ 10.2 – What is the impact on impairment testing of providing financial information (such as a Q1 trading update) during the year but not in accordance with IAS 34?
FAQ 10.3 – How should an entity estimate the weighted average annual effective income tax rate?

Authored by:

Tony Debell
Partner: United Kingdom
Email: tony.debell@pwc.com

Vikash Kalidas
Senior manager - United Kingdom
Email: vikash.x.kalidas@pwc.com

Illustrative text

Publication date: 12 Aug 2020

These illustrative examples demonstrate the practical application of the principles of this guidance.

Click here for an index of FAQs by accounting standard

FAQ Reference
Non-financial assets
FAQ 2.1.1 - Is the coronavirus (COVID-19) pandemic an impairment indicator? IAS 36
FAQ 2.1.2 - Should the business plan prepared by management be revised to incorporate the impacts of COVID-19? IAS 36
FAQ 2.1.3 – How can impairment tests that incorporate cash flow forecasts be more reliably performed in periods of uncertainty? IAS 36
FAQ 2.1.4 – What are the consequences of the COVID-19 pandemic on the discount rate? IAS 36
FAQ 2.1.5 – Level at which impairment testing is performed IAS 36
FAQ 2.1.6 – Does an entity incorporate cash flows from government assistance or grants when determining the value in use of a cash-generating unit? IAS 36
FAQ 2.1.7 - Is an entity permitted to change the timing of its annual impairment test of goodwill, in the light of COVID-19 if the test was not historically performed at year end? IAS 36
FAQ 2.2.1 - Which impairment disclosures will be of particular interest to users of financial statements this year? IAS 36
FAQ 2.3.1 – Is COVID-19 a significant event for associates with different period ends from the entity? IAS 36
FAQ 2.4.1 – How is overhead cost allocated to inventory where the number of units produced reduces due to COVID-19? IAS 2
FAQ 2.4.2 – What factors should be considered in determining the normal capacity and abnormal costs for inventory capitalisation as a result of COVID-19? IAS 2
FAQ 2.5.1 – Can an entity stop depreciating an asset if it is idle? IAS 16
FAQ 2.5.2 – Suspending capitalisation of borrowing costs IAS 23
FAQ 2.5.3 – Considerations of cost capitalisation for property, plant and equipment and investment property in the COVID-19 environment IAS 23
FAQ 2.6.1 - Impact of COVID-19 on investment property valuation IFRS 13, IAS 40
FAQ 2.6.2 - Uncertainties in cash flows and change in valuation technique for level 3 fair value measurement IFRS 13
FAQ 2.6.3 – Additional considerations for discount rates used in Level 3 fair value measurements IFRS 13
FAQ 2.6.4 – 'Determining fair value where an entity might be forced to liquidate assets' IFRS 13
   
Financial instruments
FAQ 3.1.1 – How will factoring or other sales of trade receivables be impacted by COVID-19? IFRS 9
FAQ 3.1.2 – How should a bank and a borrower account for a loan repayment holiday imposed by law? IFRS 9
FAQ 3.1.3 – What is the accounting treatment of a loan repayment holiday negotiated between a bank and a borrower? IFRS 9
FAQ 3.1.4 – When is a new loan granted to an existing borrower, in substance, a payment holiday on the original loan? IFRS 9
FAQ 3.1.5 – New loans granted to defaulted debtors IFRS 9
FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19 IFRS 9
FAQ 3.1.7 – Monetary items forming part of the net investment in a foreign operation IFRS 9
FAQ 3.2.1 - Impact of COVID-19 payment holidays on ECL staging IFRS 9
FAQ 3.2.2 - How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model? IFRS 9
FAQ 3.2.3 – In the context of COVID-19 and ECL, what information is ‘reasonable and supportable’? IFRS 9
FAQ 3.2.4 – Example of a provision matrix for corporates in a COVID-19 environment IFRS 9
FAQ 3.2.5 – Impact of price concessions on expected credit losses of trade receivables IFRS 9
FAQ 3.2.6 – Cash collateral held for trade receivables or lease receivables: recognition and impact on measurement of ECL IFRS 9
FAQ 3.2.7 - To what extent should additional COVID-19 related information after the reporting date be included in the ECL estimate? IFRS 9
FAQ 3.2.8 – Aligning the definition of default: Regulatory versus Accounting IFRS 9
FAQ 3.2.9 - Possible revisions to ECL estimates required in a downturn IFRS 9
FAQ 3.2.10 – How should an entity account for changes to the cash flows on a debt instrument measured at amortised cost or fair value through other comprehensive income (FVOCI)? IFRS 9
FAQ 3.2.11 – Impact of prepayments on lifetime probability of default for SICR assessments IFRS 9
FAQ 3.2.12 – Inclusion of cash flows expected from the sale on default of a loan in the measurement of expected credit losses (ECL) IFRS 9
FAQ 3.2.13 – Should borrower pre-payment options be taken into account when determining the period over which to measure expected credit losses (ECL) IFRS 9
FAQ 3.2.14 – What discount rate should be used when measuring ECL for credit cards and other similar products? IFRS 9
FAQ 3.2.15 – Factors to consider in relation to ‘days past due’ for IFRS 9 ECL where a loan has been granted a payment holiday IFRS 9
FAQ 3.2.16 – Staging of loans where a significant increase in credit risk has occurred that cannot be identified individually or that is based on shared credit risk characteristics IFRS 9
FAQ 3.3.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IFRS 9)? IFRS 9
FAQ 3.3.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IFRS 9)? IFRS 9
FAQ 3.3.3 – Hedge accounting and payment holidays IFRS 9
FAQ 3.3.4 – Recoverability test for hedging reserves IFRS 9
FAQ 3.3.5 – Fair value hedge accounting and debt modifications (IFRS 9) IFRS 9
FAQ 3.4.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IAS 39)? IAS 39
FAQ 3.4.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IAS 39)? IAS 39
FAQ 3.4.3 – Hedge accounting and payment holidays (IAS 39) IAS 39
FAQ 3.4.4 – Fair value hedge accounting and debt modifications (IAS 39) IAS 39
FAQ 3.5.1 – How is the accounting for supplier finance arrangements impacted by COVID-19? IFRS 9
FAQ 3.8.1 – Determining whether a market is still active in a period of market disruption IFRS 13
FAQ 3.8.2 – Assessing prices in inactive markets IFRS 13
FAQ 3.8.3 – Determining whether transactions are orderly IFRS 13
FAQ 3.8.4 – Adjustments to the quoted price in an active market IFRS 13
FAQ 3.8.5 – Delays in the availability of information IFRS 13
FAQ 3.8.6 – Post market closure events IFRS 13
FAQ 3.8.7 – Uncertainties in cash flow fair value measurement of financial instruments IFRS 13
FAQ 3.8.8 – Should possible future modifications be considered when determining the fair value of a debt instrument? IFRS 13
FAQ 3.8.9 – Consideration of fair value where an entity has breached a debt covenant IFRS 13
FAQ 3.10.1 - Is COVID-19 a ‘rare circumstance’ for insurers? IAS 39
FAQ 3.11.1 – What is a ‘significant’ or ‘prolonged’ decline in fair value below cost? IAS 39
   
Leases
FAQ 4.1 – How should lease concessions related to COVID-19 be accounted for? IFRS 16
FAQ 4.2 – What are the accounting implications of a force majeure clause in a lease contract in the context of COVID-19? IFRS 16
FAQ 4.3 – Impairment of lease receivables IFRS 16, IFRS 9
FAQ 4.4 – Should lease terms be reassessed as a result of COVID-19? IFRS 16
FAQ 4.5 – Should a lessor in an operating lease continue to recognise lease income when its collectability is uncertain due to COVID-19? IFRS 16, IFRS 9
FAQ 4.6 – COVID-19-related modifications to operating leases: lessor perspective IFRS 16
FAQ 4.7 – Accounting by lessees for voluntary forgiveness by the lessor of lease payments when the practical expedient in IFRS 16 is not applied IFRS 16
FAQ 4.8 – Accounting by operating lessors for voluntary forgiveness of amounts contractually due for past rent IFRS 16
FAQ 4.9 – Lessor accounting for initial direct costs where an operating lease is modified IFRS 16
FAQ 4.10 – What does ‘proportionally’ mean in the context of ‘consideration for a lease’, as described in the IASB’s educational material? IFRS 16
FAQ 4.11 – Is it appropriate for a lessor in an operating lease to change the pattern of income recognition in light of COVID-19? IFRS 16
   
Revenue Recognition and Government Grants
FAQ 6.1.1 – Can government grants for lost income be presented as revenue from contracts with customers or lease income where the entity is the principal of the grant? IAS 20
FAQ 6.1.2 – Negative revenue: revision of a ‘highly probable’ variable transaction price due to COVID-19 IFRS 15
FAQ 6.1.3 – Service provider shutdown due to COVID-19 IFRS 15
FAQ 6.1.4 – For entities using the cost-to-cost input method for revenue recognition, would additional costs arising from COVID-19 be included in the measure of progress? IFRS 15
FAQ 6.2.1 – Six-step framework to account for the receipt of government grants IAS 20
FAQ 6.2.2 – Identifying the party that receives a government grant IAS 20
FAQ 6.2.3 – Determining whether a relief or measure is a government grant within the scope of IAS 20 IAS 20
   
Non financial obligations
FAQ 7.4.1 – What are the implications of the COVID-19 crisis for the net defined benefit liability when reporting under IAS 34? IAS 34
FAQ 7.4.2 – What are the implications of the COVID-19 crisis for the pension expense when reporting under IAS 34? IAS 34
   
Going concern and events after the reporting period
FAQ 8.1 – How does an entity prepare financial statements on a non-going concern basis? IAS 1
FAQ 8.2.1 – Should the effects of COVID-19 impact the measurement of assets and liabilities for entities with a reporting date in the first quarter of 2020? IAS 10
FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value IAS 10, IAS 36
FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value IAS 10, IAS 36, IFRS 13
   
Presentation and disclosure
FAQ 9.1.1 – Presentation of the COVID-19 impact in the income statement IAS 1
FAQ 9.1.2 – Classification of inventory costs, during closure, in an income statement presented by function IAS 1
   
Interim financial statements
FAQ 10.1 – Implications of goodwill impairment in interim financial statements IAS 34, IFRIC 10
FAQ 10.2 – What is the impact on impairment testing of providing financial information (such as a Q1 trading update) during the year but not in accordance with IAS 34? IAS 34, IFRIC 10
FAQ 10.3 – How should an entity estimate the weighted average annual effective income tax rate? IAS 34

Illustrative text - Non-financial assets - FAQ 2.1.1 - Is the coronavirus (COVID-19) pandemic an impairment indicator?

Publication date: 20 Apr 2020

Many businesses will be impacted to some degree by the COVID-19 pandemic. IAS 36, ‘Impairment of assets’, requires that management consider at each report date whether there is any indication that an asset may be impaired. IAS 36 includes both internal and external indicators to identify if an impairment review is required. 

The following impairment indicators might be particularly relevant in the current economic climate:

  • actual financial performance is significantly lower than the original budget;
  • cash flow is significantly lower than earlier forecasts;
  • material changes in mid-term and/or long-term growth rates as compared to the previous estimates;
  • market capitalisation less than book value of net assets;
  • announced change in business model, restructuring, discontinued operations, etc;
  • restrictions on operations such as inability to import, export, or travel;
  • increase in the entity’s cost of capital;
  • change of market interest rates or other market rates of return;
  • fluctuations in the foreign exchange rates or commodity prices that impact the entity’s cash flows;
  • deferral of investment projects; and
  • significant or prolonged decrease in the entity’s stock price.

This list is not comprehensive and other indicators might present themselves. The indicators above and in the standard are examples only.

Illustrative text - Non-financial assets - FAQ 2.1.2 - Should the business plan prepared by management be revised to incorporate the impacts of COVID-19?

Publication date: 20 Apr 2020

Yes. Cash flows used for impairment testing should be based on a business plan that reflects the expected and most current impacts of COVID-19. It is expected that all entities will be updating forecasts and plans in response to current conditions. When measuring value in use, an entity should base cash flow projections on the most recent financial budgets/forecasts approved by management. Reliance on a previously approved forecast might  not be appropriate in the current market conditions. There should be consistency of assumptions and forecasts applying to impairment tests of different assets required by this and other standards.

The assumptions used in determining a recoverable amount (value in use or fair value less costs of disposal) need to be reasonable and supportable. In the current context of uncertainty:

  • Management assumptions should be consistent with market evidence such as independent macroeconomic forecasts, industry commentators or analysts, brokers’ analysis and other third party experts. Greater weight should be given to credible external evidence that is available. 
  • Any differences between the business plan’s underlying assumptions and market evidence should be analysed and understood. Management might find it helpful to explain these differences in the financial statement disclosures or other material accompanying the financial statements. 
  • Management should understand any differences between fair value less costs of disposal and value in use, and it should ensure that they are supportable.

Illustrative text - Non-financial assets - FAQ 2.1.3 – How can impairment tests that incorporate cash flow forecasts be more reliably performed in periods of uncertainty?

Publication date: 23 Apr 2020

Two approaches to constructing the cash flow model supporting an asset or cash-generating unit (‘CGU’) can be considered:

  • The ‘traditional’ approach, which consists of using a ‘single set of estimated cash flows and a single discount rate’ taking into account the ‘appropriate’ discount rate (para A4 of IAS 36). Uncertainties are reflected through the risk premium included in the discount rate.
  • The ‘expected cash flow’ approach, which consists of using ‘all expectations about possible cash flows instead of the most likely cash flow’ (para A7 of IAS 36). Uncertainties are reflected through probability-weighted cash flow scenarios.

A basic assumption in calculating discount rates is that the expected cash flows fully reflect the uncertainties related to the current economic environment. Theoretically, the above two approaches should provide the same result. However, this relies on a degree of precision in the estimates under the ‘traditional’ approach that might be difficult to achieve.

Management should consider probability-weighting different scenarios to estimate the expected cash flows. This should enable an understanding of the range of potential outcomes for an asset or a CGU and its attached risks – for example, a ‘business as usual’ scenario, a scenario with short-/medium-term disruption, and a scenario with a broader and longer period of negative impact.

The ‘expected cash flow’ approach has, among others, the following advantages in an environment of higher uncertainty:

  • The sensitivity of the recoverable amount to uncertainties is explicit in the measurement, compared to the ‘traditional’ approach where it is factored into the discount rate.
  • It enables management to assess the uncertain assumptions that might have the most significant impacts on the recoverable amount.
  • It calculates a range of expected cash flows instead of only considering the most likely case.
  • It might be more aligned with the way in which management prepares forecasts for the purposes of responding to the pandemic.
  • It lessens the impact of the judgemental exercise inherent in adding a single specific risk premium to the discount rate, which might be difficult to quantify and support in documentation.

Management might seek to apply the ‘traditional’ approach in response to an unexpected change in circumstances in a short space of time, which means that they cannot rigorously adjust cash flows in a timely fashion. In these situations, additional analysis might need to be performed to consider and assess the reasonableness of the cash flow impacts implied by the risk premium.

For these reasons, we recommend that discount rate adjustments to correct for optimistic cash flow scenarios are not best practice; this is because, without additional analysis, the concluded risk premium might under or over state the correction.

See also FAQ 2.6.2 on uncertainties in cash flows and change in valuation technique for Level 3 fair value measurement.

Illustrative text - Non-financial assets - FAQ 2.1.4 – What are the consequences of the COVID-19 pandemic on the discount rate?

Publication date: 23 Apr 2020

The discount rate should reflect the current market assessments of time value of money for the periods until the end of the useful life of the asset/cash-generating unit (‘CGU’), market risks, country risks, and any other risks specific to the asset/CGU for which the future cash flow estimates have not been adjusted, as well as other factors that market participants would reflect in pricing the expected future cash flows. As a starting point in calculating such a rate, management might use the weighted average cost of capital.

Despite the uncertainties in the current economic environment, the established methods for calculating the cost of capital should continue to be used. However, a re-assessment of each input into the calculation and assessment of the overall result is needed. In the current environment, certain observable inputs that go into the calculation of the cost of capital (such as risk-free rate) have declined. For many companies, the cost of debt will have increased, but this needs to be considered on a company-by-company basis. Companies with the highest credit ratings might, by contrast, have seen a decline in their cost of debt in line with sovereign debt. At the same time, increased volatility and other indicators point to an increase in the cost of equity. In addition, the heightened focus on liquidity might, for some industries, result in an optimal capital structure that is more weighted towards equity than in the past. Taken together, this means that, for most companies and sectors, the cost of capital is presently higher than it was in 2019. Companies should consider this when completing impairment assessments in 2020.

The discount rate does not, however, simply result from the application of a formula. It requires the exercise of judgement based on the overall valuation exercise. In particular, if the cash flows are not believed to incorporate a sufficient level of risks (for instance, by probability-weighting different scenarios to estimate the expected cash flows) and therefore cannot be considered as the expected cash flows, the discount rate might need to be adjusted upwards. However, management should first attempt to adjust the cash flows prior to making any adjustments to the discount rate, because it is generally difficult to estimate and support the amount by which the discount rate should be adjusted (see FAQ 2.1.3). To the extent that uncertainties are not reflected in cash flows (for example, through probability-weighting), they might have to be reflected as an additional specific risk premium in the discount rate. The premium needs to be calibrated to the nature and amount of uncertainty not fully captured in the forecast.

Illustrative text - Non-financial assets - FAQ 2.1.5 – Level at which impairment testing is performed

Publication date: 18 Jun 2020

As a consequence of COVID-19, entities might have impairment indicators for assets, cash-generating units (CGUs) and groups of CGUs. The assets and CGUs will then be tested for impairment under IAS 36, ‘Impairment of Assets’. These CGUs might include goodwill, or they might be part of a larger group of CGUs that include goodwill. A question arises as to which level an entity tests first for impairment: goodwill and then the underlying CGUs (that is, ‘top down’); or the CGUs and then related goodwill (that is, ‘bottom up’).

IAS 36 requires a ‘bottom up’ approach to impairment testing. The impairment test is a two-step process:

Step 1: Test the individual asset, or related CGU if the recoverable amount for the individual asset cannot be determined. Any impairment should be recognised at this step, to reduce the carrying amount to the recoverable amount. Testing performed at the CGU level would include goodwill to the extent that goodwill is monitored at this level.

Step 2: Test the CGU or group of CGUs including goodwill. This second stage is a comparison of the recoverable amount with the restated carrying amount after the step 1 impairment test.

The two-stage approach ensures that, where there are indicators of impairment, assets and CGUs within a group of CGUs are tested separately for impairment first, with any impairment recognised before the larger group including goodwill is tested. [IAS 36 para 98].

Due to the different levels of impairment testing required, it is important that CGUs are correctly identified as the smallest group of assets that generate cash inflows that are largely independent of each other. Impairments should not be masked by incorporating additional assets and cash flows from the same operating segment.

The ‘bottom up’ approach can be summarised by way of the following diagram:

corona_faq_215

The following is an illustrative example:

An entity acquired a group of entities some years ago. At the current period end, due to the economic consequences of COVID-19 in the territory within which one subsidiary, entity A, is located, there is an indicator that entity A might be impaired. Entity A is a CGU. Value in use is higher than fair value less costs of disposal, and so it is taken as the recoverable amount.

Scenario A – Recognition of impairment where goodwill has been allocated to the CGU

The carrying value of entity A and its recoverable amount are compared, as follows, to determine the impairment loss:

Cash-generating unit A
  C’m
Net assets attributable to CGU 220
Goodwill (allocated to and monitored at CGU A level) 40
   
Total net assets attributable to CGU 260
Value in use of CGU 200
   
Impairment 60
   

Where goodwill from a business combination is allocated to the individual CGU, there is an impairment loss of C60 million in entity A, reducing the carrying value of its net assets and goodwill to C200 million. C40 million of the impairment loss is attributed to the full write-off of goodwill, and C20 million is then attributed to other assets on a pro rata basis.

The carrying values, after recognising the impairment loss, are as follows:

Carrying value after impairment A
  C’m
Net assets attributable to CGU 200
Goodwill
   
Total net assets attributable to CGU 200
   

Scenario B – Recognition of impairment where goodwill has been allocated to a group of CGUs

In this scenario, goodwill is monitored at a group of CGUs that include entity A. The entity first calculates impairment loss (if any), based on entity A’s net assets excluding goodwill, and it then tests goodwill against the group of CGUs.

Cash-generating unit A
  C’m
Net assets 220
Value in use of CGU 200
   
Impairment 20
   

Entity A’s net assets are reduced, by the impairment loss, to C200 million (allocation of the impairment loss is on a pro rata basis).

In order to test goodwill, the entity then tests the group of CGUs that includes entity A and to which goodwill has been allocated. The group of CGUs consists of the operations of entities A and B combined. (The impairment test of this group of CGUs should be done at the same time annually, and at any reporting date where there is an indication of impairment such as COVID-19, because it contains goodwill.) The calculation of the impairment loss is then as follows:


Cash-generating unit
A B Goodwill Aggregated CGUs
  C’m C’m C’m C’m
Net assets (based on first step of impairment testing) 200 110 80 390
Value in use 200 180   380
   
Impairment 10 10
   
Carrying values after impairment A B Goodwill Larger CGU
  C’m C’m C’m C’m
Net assets 200 110 70 380
   

The total impairment charge is thus C30 million, being C20 million from the first stage and C10 million from the second stage. This is the difference between the carrying amount of entity A’s assets of C220 million and their revised carrying amount of C200 million, plus the difference between the carrying amount of goodwill of C80 million and its revised carrying amount of C70 million.

If goodwill had incorrectly been tested first, all of the impairment (C30m) would have been allocated to goodwill (reducing goodwill to C50m), and the assets of entity A would not have been impaired. However, because there is an indicator of impairment in entity A, the subsequent test of entity A would reveal a C20 million impairment based on its value in use of C200 million, resulting in total impairments of C50 million and net assets of C360 million (C200m + C110m + C50m) when total value in use cash flows are C380 million.

Illustrative text - Non-financial assets - FAQ 2.1.6 – Does an entity incorporate cash flows from government assistance or grants when determining the value in use of a cash-generating unit?

Publication date: 18 May 2020

Governments around the world have reacted to the impact of COVID-19 with a variety of measures to support businesses. IAS 36 does not contain specific guidance on whether, or how, government assistance or grants are reflected in the value in use (‘VIU’) of a cash-generating unit (‘CGU’). 

The following principles might be useful in determining whether cash flows from government assistance or grants are incorporated into the measurement of VIU of a CGU:

  • VIU reflects ‘an estimate of the future cash flows the entity expects to derive’ from the asset or CGU.
  • In measuring VIU, an entity should ‘base cash flow projections on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the remaining useful life of the asset’.
  • Incorporating government assistance or grants that change existing cash flows in a VIU model is likely to be appropriate, whereas government assistance or grants that do not affect existing VIU cash flows should be excluded.
  • Ensure consistency between the cash flows included in the VIU calculation and the carrying amount being considered for recoverability. For example, if a government grant has not yet been received and there is a recognised grant receivable, the entity should include this grant receivable in the carrying amount if the related cash flows are included in the VIU calculation.

Entities should analyse the government assistance and grants available to them. If, based on that analysis, management determines that the government assistance or grants represent future cash inflows or a reduction in cash outflows derived from a CGU, they are included in the VIU. Examples might include a government grant towards employee costs within a CGU or a reduction in the local authority rates payable for a building that is included in the CGU. Management should ensure that the cash flows related to government reliefs included in a CGU’s VIU are based on reasonable and supportable assumptions and are appropriate based on the terms and conditions of the various reliefs. Examples of government assistance that would be excluded from VIU include favourable income tax or financing arrangements, because these cash flows are not part of a VIU assessment.

Where an entity has recognised a receivable related to a government grant, management should determine whether that asset should be included within the CGU being tested for impairment. [IAS 36 para 79]. If, for practical reasons, the cash inflow associated with the receivable is included in the VIU, the carrying amount of the receivable should be included in the carrying amount of the CGU.

The following examples illustrate the above principles to different grant scenarios which might arise.

Example 1: Background

Entity A is a hotel, and it prepares IFRS financial statements for a 30 June year-end. Government regulations mean that the hotel will be closed for the period from 1 May to 31 August. The carrying amount of the hotel, which is a single CGU, is C50 million. The initial VIU, calculated before any government assistance or government grant, is C50 million.

Example 1A:- Monthly grant received

On the last day of each month that it is closed, entity A is entitled to a government grant of C500,000 towards employee costs paid in the month. Entity A has included a cash outflow of C1 million for employee costs in July and August in its initial VIU of C50 million. 

Entity A has concluded, based on the government grant received to date, that it is reasonable and supportable to include a cash inflow of C1 million for the expected grant in July and August in its VIU, and so the VIU after grant is C51 million. VIU therefore exceeds the carrying amount by C1 million.

Example 1B: Total government grant received upfront

Before year-end, entity A received a government grant of C2 million towards employee costs for the period from 1 May to 31 August. At 30 June, entity A has recognised a government grant of C1 million in its income statement related to employee costs in May and June, and it has a deferred income liability of C1 million related to future employee costs to be incurred in July and August. 

Since entity A has received the cash for the government grant upfront, there are no future grant cash inflows to be included in the VIU, and so the VIU is C50 million. However, in accordance with paragraphs 75 and 76 of IAS 36, it is appropriate to include the deferred income liability of C1 million in the carrying amount of the hotel CGU, because the recoverable amount cannot be determined without consideration of this liability. The carrying amount of the hotel CGU is therefore C49 million. VIU therefore exceeds the carrying amount by C1 million.

Illustrative text - Non-financial assets - FAQ 2.1.7 - Is an entity permitted to change the timing of its annual impairment test of goodwill, in the light of COVID-19 if the test was not historically performed at year end?

Publication date: 03 Apr 2020

Many businesses will be required to test for impairment as a result of the COVID-19 pandemic.The annual impairment test for (groups of) CGUs to which goodwill belongs can be performed at any time during the year, provided that the test is performed at the same time every year [IAS 36 para 96]. An entity might choose to perform its impairment test at a less busy time of the year, (for example, not at year end). 

Entities might expect that the impact of COVID-19 will have reduced by their period end, and they might want to delay their normal goodwill impairment testing process to take account of this.

Example

Company A has historically performed its annual goodwill impairment test at 31 October rather than at its 31 December year end. The company does not prepare IAS 34 compliant interim reports. Given the economic circumstances and the impact of COVID-19, the company identifies an impairment of goodwill when performing the annual impairment test.

Late in December 2020, significant progress has been made in identifying a reliable vaccine and, looking forward, the impact of COVID-19 on the company has materially reduced.

Is the company permitted to change the timing of the impairment test of goodwill, and consequent recognition of any impairment to year end, to reflect the year end recoverable amount? 

No. It is not acceptable to extend the period between annual tests beyond 12 months. Company A should not defer the test because it believes that the impact of COVID-19 will have reduced by year end. Company A is required  to perform its annual testing at the same time every year and so cannot avoid the 31 October test and it must book any impairment loss identified. [IAS 36 para 96]. Company A would not be able to reverse any goodwill impairments recognised at the annual goodwill test date, but it might be able to reverse any non-goodwill impairments (such as property, plant and equipment) at future reporting dates  (see FAQ 10.1).

When performing the annual test, company A assesses the available information regarding the impact of COVID-19 and incorporates this in its impairment testing. For both ‘value in use’ and ‘fair value less costs of disposal’ tests, this requires judgement and an analysis of the facts and circumstances. When considering what information to incorporate FAQs 8.2.2 and 8.2.3 might provide additional guidance.

Company A might be required to test again at year end if additional indicators of impairment (or impairment reversal) arose in the intervening period. 

Note that if an entity had already performed an impairment test for previous IAS 34 interim reporting during the year, the annual goodwill impairment test must still be performed.

Illustrative text - Non-financial assets - FAQ 2.2.1 - Which impairment disclosures will be of particular interest to users of financial statements this year?

Publication date: 20 Apr 2020

Users such as investors, financial analysts and regulators are focusing on obtaining detailed and current information in this period of market turbulence. IAS 36, ‘Impairment of assets’, IAS 1, ‘Presentation of financial statements’, IAS 10, ‘Events after the balance sheet date’ and IAS 34, ‘Interim financial reporting’ all prescribe relevant disclosures. Also, there are often specific requirements of regulators that should be incorporated in the financial statements to the extent that they provide meaningful information to the readers of the financial statements and reflect management’s views and judgements when assessing recoverable amounts.

The critical disclosures for upcoming interim and annual reporting cycles will be related to sensitivity analyses (that is, key assumptions that have a significant risk of causing a material adjustment to the carrying amount of assets, including goodwill). These key assumptions should not be restricted to discount rates or growth rates, but they might also include expected profit margins and other highly sensitive assumptions that could have a significant impact on future cash flows. Other disclosures that are relevant, where a reasonably possible change in assumptions would lead to an heightened risk of impairment, include:

  • a description of the asset/cash-generating unit (‘CGU’) being tested;
  • the amount by which the recoverable amount exceeds the carrying value;
  • the values assigned to the key assumptions used in the sensitivity analysis;
  • the amount by which the key assumptions would have to change where the change would result in the recoverable amount equalling the carrying amount (for example, an entity might disclose that a 1% increase in the pre-tax discount rate would reduce its recoverable amount to equal its carrying amount); and 
  • the aggregate carrying amount of goodwill allocated to the CGU(s) and the aggregate carrying amount of intangible assets with indefinite useful lives allocated to the CGU(s).

IAS 34 generally requires relatively less disclosure than would be required in an annual set of financial statements. However, the principle in IAS 34 is to provide an explanation of the events and changes that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period. In view of the significant developments as a result of COVID-19, an entity's interim financial statements would likely be more detailed than in previous years.

Illustrative text - Non-financial assets - FAQ 2.3.1 – Is COVID-19 a significant event for associates with different period ends from the entity?

Publication date: 22 Jul 2020

Due to COVID-19, many entities are experiencing adverse trading conditions, and financial results are being impacted. For entities that have equity-accounted investments, this could have accounting implications – these could include a decline in operational results, impairment and other related impacts for their associates.

Where an investor has an equity-accounted investment in an investee which has a different reporting period from the investor, IAS 28 requires the investor to adjust the earnings of the investee for significant transactions or events that occur between the date of the associate’s or joint venture’s year end and that of the investor. [IAS 28 paras 33, 34].

The difference in reporting periods between the investor and the associate or joint venture is often referred to as the ‘lag period’. As a result of COVID-19, an investee’s results during the lag period might have been affected.

Question

Should an investor make adjustments to its equity-accounted earnings for changes to its investee’s earnings during the lag period?

Solution

It depends. If the transactions or events in the lag period are significant, the investor should make adjustments during the lag period. Judgement will be required to determine whether the transactions or events in the lag period are significant.

This does not necessarily mean that distinct accounting entries must be recorded in the investee's accounts, in terms of IFRS, for the transaction or event to be deemed significant for adjustment in the investor's accounts. However, there does need to be a significant event in order for paragraph 34 of IAS 28 to apply. Determining whether there has been a significant event is a matter of judgement. It is not sufficient to consider only relatively poor trading results as a result of the macroeconomic impact of COVID-19 as a significant event. An indicator that there has been a significant event, for which an adjustment should be made, would be the ability of the investor to measure reliably the impact of only that event on the earnings in the lag period.

The illustration below sets out examples of how COVID-19 might impact reporting for entities that have associates with non-coterminous year ends.

Illustration

Entity A prepares annual financial statements at 31 March 2020 each year. One of entity A’s associates, entity Y, prepares annual financial statements at 31 December 2019.

Due to COVID-19, entity Y saw a decline in operational results during the period from 31 December 2019 to 31 March 2020.

Example 1 – The investee recognised a significant impairment during the lag period

There has been a significant event – namely, a material impairment in one of the investee’s cash-generating units during the lag period. The investor should make an adjustment to the lag period accounting if this is material to the investor.

Example 2 – The investee has seen a decline in results as a consequence of the general economic decline due to COVID-19

There has not been a significant event during the lag period. Relatively poor trading results in the lag period would not, on their own, indicate the existence of a significant event that requires adjustment during the lag period.

Example 3 – The investee was forced by government decree to shut down its stores due to COVID-19, but no impairment or provision has been recognised by the investee; the entity can reliably measure the impact of the shutdown on its results

There has been a significant event. The requirement for the investee to shut down its stores as a result of COVID-19 is a specific and significant event. Therefore, the investor should make an adjustment to the lag period accounting if the amount is material to the investor’s accounts.

The above guidance would apply equally to an improvement in operational results.

If the assessment of whether COVID-19 was considered a significant event required significant judgement and was material, the disclosure as required by paragraph 122 of IAS 1 should be provided.

Illustrative text - Non-financial assets - FAQ 2.4.1 – How is overhead cost allocated to inventory where the number of units produced reduces due to COVID-19?

Publication date: 29 Apr 2020

COVID-19 is impacting entities in many different ways. Some manufacturing sites are being closed or run at a lower capacity, due to lockdown measures or changes in consumer behaviour and demand. These changes could impact the number of inventory units produced.

IAS 2 requires fixed production overheads to be included in the cost of inventory based on normal production capacity. The amount of fixed overhead allocated to inventory is not increased as a result of low production. Consequently, reduced production will result in unabsorbed fixed overheads which will be charged to the income statement in the period in which they are incurred.

The following example illustrates how to allocate overhead cost to inventory:

The following is relevant information for entity A:

  • Normal capacity is 7,500 labour hours per quarter.
  • Actual labour hours for Q1 are 3,000 hours, because the factory was closed part way through Q1 due to government lockdown.
  • Total fixed production overhead is C1,500.
  • Total variable production overhead is C2,700.
  • Total units produced in the quarter are 3,000 units, because the factory was run at reduced capacity.

Management should allocate overhead costs to units produced at a rate of:

  • fixed production overhead (fixed production overhead/labour hours for normal capacity) C1,500/7,500 = C0.2 per hour; and
  • variable production overhead (variable production overhead/actual hours) C2,700/3,000 = C0.9 per hour respectively.

Therefore, fixed production overhead allocated to 3,000 units produced during the quarter (one unit per hour) = 3,000 × C0.2 = C600. The remaining C900 (C1,500 – 600) of overhead incurred that remains unallocated is recognised as an expense.

Illustrative text - Non-financial assets - FAQ 2.4.2 – What factors should be considered in determining the normal capacity and abnormal costs for inventory capitalisation as a result of COVID-19?

Publication date: 12 Aug 2020

Due to COVID-19, many territories’ governments have imposed restrictions on entities’ operations for a period of time. As a result of these restrictions, some entities might operate under lower revised capacity and/or incur additional costs to change their business practices. It is unknown when these restrictions will be lifted.

IAS 2 requires fixed production overheads to be allocated to the costs of conversion, based on the normal capacity of the production facilities. [IAS 2 para 13]. Abnormal amounts of wasted materials, labour or other production costs are recognised as expenses in the period in which they are incurred. [IAS 2 para 16]. Therefore, the costs of unused capacity and additional costs which represent wasted materials, labour or other production costs should be written off to the profit or loss in the period in which they occur.

However, IAS 2 does not contain any specific factors to be considered in determining what might be the ‘new normal’ capacity and abnormal costs.

Abnormal amounts of wastage

When considering new costs, entities should assess the nature of costs incurred, the territory in which they operate, and comparison to other entities, to determine whether these costs represent abnormal wastage while impacted by COVID-19. Entities might also consider whether they have revised their selling prices to incorporate the additional costs incurred under the new restrictions for new contracts.

Normal capacity

Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. [IAS 2 para 13]. Entities should consider the nature of any constraints on production, the territory in which they operate, and comparison to other entities, to determine whether any capacity constraints represent normal capacity while impacted by COVID-19. When considering capacity, entities should exercise caution in determining any ‘new normal’ capacity. This is because reductions in production due to reduced demand should not affect normal capacity. Many entities with automated production facilities might have limited production constraints as a result of COVID-19. Therefore, we believe that it would be a high hurdle for entities to consider changing their normal capacity as a result of COVID-19.

Management should disclose any significant judgements and estimates made in assessing whether the overhead absorption rates should be revised or whether the additional costs should be capitalised or expensed in the profit and loss, in accordance with IAS 1. Entities should also consider whether any changes in business practice might be indicators of impairment in cases where assets might become idle, or there might be plans to discontinue or restructure the operation to which an asset belongs (see FAQ 2.1.1, ‘Is the coronavirus (COVID-19) pandemic an impairment indicator?’). [IAS 36 para 12(f)].

The following scenarios illustrate how the above factors might be applied in assessing whether an entity’s changes in business practices might be regarded as the ‘new normal’.

Illustration 1 – Reduced capacity and additional costs incurred to comply with new restrictions

Entity A manufactures food products. As a result of the COVID-19 pandemic, the local government imposed additional measures to maintain the integrity of the food chain so that safe food products were available for consumers. In order to do so, entity A will need to hire additional labour to perform health and safety checks and reduce the operating capacity of its factory to enable safe distancing among employees. The demand for entity A’s food products has not changed, and the revised lower capacity is insufficient to cope with the market demand.

All entities in the industry are subject to the same restrictions, and they will need to incur similar additional costs and they will have reduced allowable capacity. Management’s long-term budgets indicate that the entity intends to pass on much of this incremental cost to its customers.

#Entity A could capitalise these additional labour costs if they meet the definition of costs under IAS 2. [IAS 2 para 10]. It might also revise its fixed production overhead allocation rate to reflect the reduced allowable capacity during this period. This would result in higher fixed costs capitalised in the cost of inventory. Entity A should assess whether the inventories might need to be written down to net realisable value, especially if the selling prices of the products have yet to be adjusted for the increase in production costs.

Illustration 2 – Reduced production due to lower demand

Entity B manufactures business attire. Because of COVID-19, the demand for its products are significantly decreased. As such, entity B is projecting to operate at 50% of its manufacturing capacity for the next 12 months, and to resume full capacity thereafter. This is consistent with most other business attire manufacturers in the territory in which entity B operates.

Entity B was unable to reduce its fixed production overheads for the next 12 months, and it was also unable to increase the selling price of its products to compensate for the higher fixed production costs per unit produced.

Even though entity B expects that it will operate at a reduced capacity for the next 12 months, the normal production capacity of its manufacturing facility and the long-term plan in operating the manufacturing facility has not changed. The fact that most other business attire manufacturers have also decided to reduce production due to reduced demand does not impact this either.

Accordingly, the amount of fixed overhead allocated to each unit of production should not increase because of low production or idle capacity. Unallocated overheads are recognised as an expense in the period in which they are incurred (see FAQ 2.4.1, ‘How is overhead cost allocated to inventory where the number of units produced reduces due to COVID-19?’).

Illustrative text - Non-financial assets - FAQ 2.5.1 – Can an entity stop depreciating an asset if it is idle?

Publication date: 03 May 2020

Many governments have imposed lockdown restrictions to minimise the spread of COVID-19. This has resulted in a number of assets becoming idle; for example, shops, offices and manufacturing sites have been closed and aeroplanes have been grounded. 

Question

Can an entity stop depreciating an asset if it is idle?

Solution

No, depreciation does not cease when an asset is idle. [IAS 16 para 55]. If an asset is depreciated using a units of production method, the depreciation charge can be zero while there is no production.

Some entities might consider changing their depreciation method to units of production during a lockdown period. 

Can an entity change to a 'units of production method' for calculating depreciation?

An entity selects a method of depreciation that most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. [IAS 16 para 60]. 

The depreciation method applied to an asset should be reviewed at least at each financial year end. However, the depreciation method is applied consistently from period to period, unless there is a change in the expected pattern of consumption of the future economic benefits. [IAS 16 para 62]. Where an entity is using the straight-line method of depreciation, it has determined that the economic benefits of the asset are consumed as a result of the passage of time (that is, on a straight line). An entity would need to demonstrate that an asset is no longer consumed over time in order to change to a production method, which would be rare. 

If an entity changes its depreciation method, this change is accounted for as a change in an accounting estimate in accordance with IAS 8. If an entity does change depreciation method, it would be rare to change back to the original depreciation method in a subsequent period, because this would be acceptable only if it was accompanied by a change in the expected pattern of consumption. 

Example A

Entity A owns and operates a local airline. The aircraft engine can fly 5,000 flight hours before it must be replaced. The entity plans to fully utilise the 5,000 hours inherent in the engine before replacement. The aircraft flies a consistent number of miles year on year. Entity B determines that depreciating the engine on flight hours (production method) most appropriately reflects how the economic benefits are consumed. However, entity A uses straight-line depreciation as a proxy for flight hours, because the hours are materially consistent year on year.

During Q1 of 2020, entity A’s fleet of planes is grounded due to travel restrictions imposed to reduce the spread of COVID-19. It is unknown when these restrictions will be lifted. Entity A reassesses the method of depreciation at the end of Q1 and determines that the straight-line method is now not a reasonable proxy for a production method. In addition, entity A determines that a straight-line method no longer reflects the consumption of economic benefits embodied in the asset. Management therefore changes its depreciation method to units of production, and it follows the requirements for a change in estimate in IAS 8.

Once the lockdown is over, it is unlikely that entity A would be able to change its depreciation method back to the straight-line method for these assets. This is because units of production would continue to reflect the expected pattern of consumption of the economic benefits embodied in the engine. 

Example B

Entity B owns and operates a local airline. The aircraft engine can fly 5,000 flight hours before it must be replaced, which would cover seven years of flight paths. However, the entity has a policy to replace its engines every five years, irrespective of the number of flight hours. Entity B therefore determines that the engine’s economic benefits are limited by time, and straight-line depreciation is the most appropriate depreciation method. 

During Q1 of 2020, entity B’s fleet of planes is grounded due to travel restrictions imposed to reduce the spread of COVID-19. It is unknown when these restrictions will be lifted. Entity B still considers the useful life of the engine to be five years, following its policy to replace its engines at this time. Given that entity B has determined that the economic benefits of the engine are limited by time, it would be inappropriate to change to a units of production method of depreciation. Entity B should continue to depreciate during the time when the aircraft are grounded.  

Example C

As a result of COVID-19, the government imposes a lockdown, and so lessee C cannot open its leased store. In addition, access to the store is very limited, and lessee C is not permitted to do any renovation work in the store or use the store as a warehouse for online sales; however, lessee C’s goods remain stored in the premises. Lessee C depreciates its ‘right of use’ asset on a straight-line basis over the lease term, because that is the method that most closely reflects the expected pattern of consumption of the future economic benefits embodied in the lease asset; for this ‘right of use’ asset, the predominant limiting factor is the period of time for which the lessee has contractual rights to use the underlying asset over the lease term.   

During the period of the lockdown, it would not be appropriate for lessee C to stop depreciating the asset or to change its method of depreciation. This is because depreciation does not cease when the asset becomes idle or is retired from active use under the straight-line method of depreciation. [IAS 16 para 55].  

Illustrative text - Non-financial assets - FAQ 2.5.2 – Suspending capitalisation of borrowing costs

Publication date: 02 Jul 2020

Question:

What is considered to be an ‘extended period’ for the purpose of suspending capitalisation of borrowing costs in terms of IAS 23?

Solution:

Borrowing costs that are attributable to the acquisition, construction or production of a qualifying asset are capitalised as part of the cost of that asset. [IAS 23 para 8].

In many countries, lockdowns or other restrictions have been implemented to curb the spread of COVID-19. These lockdowns and/or restrictions vary in duration and industry impact. For example, certain lockdown restrictions prohibit the performance of non-essential services, such as construction. In other situations, entities are working at reduced capacity or have temporarily placed certain capital projects on hold, thereby affecting development / construction activities on qualifying assets.

An entity should suspend capitalisation of borrowing costs during extended periods in which it suspends active development of a qualifying asset. [IAS 23 para 20]. IAS 23 does not provide guidance regarding what it envisages to be an ‘extended period’. 

Where construction activities are interrupted, but the cessation is a necessary and foreseeable part of the process, capitalisation of borrowing costs can continue, as set out in paragraph 21 of IAS 23.

The COVID-19 conditions and associated lockdowns and/or restrictions are not considered to be a necessary part of the process of getting an asset ready for its intended use or sale. Nor is the COVID-19-related cessation of activities considered necessary during the construction period of an asset. However, the term ‘activities’ does encompass more than physical construction of the asset. Where substantial technical and administrative work is carried out, capitalisation of borrowing costs should continue, even if physical construction has ceased. [IAS 23 para 21].

The assessment of whether or not the lockdowns and/or restrictions result in an extended period in which active development on a qualifying asset has ceased is a matter of judgement. 

The following factors might be taken into account when making the judgement (not an exhaustive list):

  • Although the lockdown or restrictions might be the initial reason why the activities have ceased, management might take into account updated budgets and revised business plans which might cause the activities to be delayed for longer than just the lockdown period.
  • The total period of suspension, not only the period of government-imposed lockdown or restrictions, will need to be considered. Further to this, if a reporting date falls within a period in which activities have ceased, management might need to estimate when activities are likely to resume again, which might only be during the next reporting period. The period from the start of the suspension to the estimate of when the activities are expected to resume will need to be considered. Caution should be exercised in forecasting the projected length of delay. Management should consider the requirements of IAS 10, ‘Events after the reporting period’, and, in particular, whether the latest developments provide more information about the circumstances that existed at the reporting date. See FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value.
  • The nature of the activities that are still being performed during the lockdown and/or restrictions – that is, if substantial technical and administrative work continues during the lockdown and/or restrictions, borrowing costs would likely continue to be capitalised, even though physical construction might have been suspended. [IAS 23 para 21].
  • The projected length of the delay relative to the time period ordinarily expected for the construction of the specific asset. The shorter the projected length of delay relative to the project as whole, the more likely it is that borrowing costs should continue to be capitalised.
  • The possibility of the lockdown and/or restriction period being extended or the implementation of a phased approach that might allow some construction to be performed. A phased approach to lifting the lockdown and/or restrictions might mean that activities to prepare the asset could resume sooner than waiting for the lockdown and/or restrictions to be lifted in their entirety.

Illustrative text - Non-financial assets - FAQ 2.5.3 – Considerations of cost capitalisation for property, plant and equipment and investment property in the COVID-19 environment

Publication date: 12 Jul 2020

As a result of COVID-19, many territories have imposed restrictions on operations, including a restriction on the construction of property, plant and equipment (‘PP&E’) and investment property. Entities might continue to incur costs in relation to the construction, even though construction might be limited or suspended. Entities might continue construction and incur additional costs due to restrictions and/or health and safety compliance. These costs might be incurred internally (for example, salaries of project managers) and/or externally (for example, on-charge by contractors as allowed by the construction contract).

Question

How should entities account for costs incurred in relation to PP&E and investment property in the COVID-19 environment?

Solution:

Paragraph 16 of IAS 16 and paragraph 21 of IAS 40 discuss the cost elements of PP&E and investment property, respectively. Both standards require entities to capitalise purchase price and expenditure that is directly attributable to the acquisition/construction of assets. Entities should assess the nature of costs incurred while impacted by COVID-19, to determine whether these costs are directly attributable to the assets.

Paragraph 22 of IAS 16 and paragraph 23 of IAS 40 further require entities to expense, as incurred, abnormal amounts of wasted materials and labour or other resources. IFRS does not contain any specific definition of ‘abnormal’. Entities should assess the nature of costs incurred, the territory in which they operate, and comparison to other entities, to determine whether these costs are abnormal while impacted by COVID-19. The assessment of whether additional costs incurred are abnormal might be judgemental, especially for labour and overhead costs. For costs paid to third party constructors, the assessment is generally less judgemental. This is because these costs are likely to be negotiated and agreed between parties on an arm's length basis and, consequently, are less likely to represent wasted materials for which the customer would be prepared to pay.

Applying these principles to both acquired and self-constructed assets, entities might capitalise the following costs, among others:

  1. certain project management costs relating to originally planned activities that are not impacted by the lockdown if they remain directly attributable to the asset being constructed; and
  2. additional labour costs incurred to complete the construction that are required to comply with ongoing health and safety requirements in that territory.

Entities should not capitalise the following costs, among others:

  1. errors (such as design errors);
  2. storage and leasing costs of certain equipment located at construction sites that continue to be incurred during the lockdown period while construction is paused, since they are no longer directly attributable; and
  3. additional indirect labour costs incurred to comply with ongoing health and safety requirements where management concludes that these costs are not specifically related to the asset construction but are instead part of the cost of doing business (that is, administration or other general overhead costs).

See FAQ 2.5.2 for details of considerations of borrowing cost capitalisation.

The following three examples indicate further how the above principles might be applied:

Example 1 – Idle workers retained by entity

An entity is in the process of a construction project for a new head office. As a result of COVID-19, the entity is legally allowed to have only a restricted number of workers on site, which is less than the number before the pandemic. This has resulted in some workers being idle. The entity has decided not to terminate the idle workers’ employment, in anticipation of a relaxing of the requirements in the near future.

In this case, the labour costs for the idle workers would be expensed as incurred, since the costs do not meet the ‘directly attributable’ criterion.

Example 2 – Outsourced construction project

An entity has a third party constructing a new head office building on its behalf. As a result of COVID-19, the third party construction company is legally only allowed to have a restricted number of workers on site, which is less than the number before the pandemic. The total cost of the construction project has increased, because it is expected to take longer than initially anticipated.

The costs due to the additional time taken to construct the office should be capitalised, since they are directly attributable, and not abnormal, based on the nature of the expenses.

Example 3 – Additional health and safety-related costs

An entity has an ongoing construction project for its PP&E. The entity operates in a territory where the government has mandated that additional health and safety measures need to be taken as a result of the pandemic. Items including face masks and other personal protective equipment are required for people working on site.

The costs are directly attributable to the construction of the building. The costs are also incurred by any entity in that territory performing a similar construction, and so they are not abnormal. The costs should therefore be capitalised.

Illustrative text - Non-financial assets - FAQ 2.6.1 - Impact of COVID-19 on investment property valuation

Publication date: 20 Apr 2020

Question

In light of the uncertainties related to COVID-19, is it possible for management to determine the fair value of an investment property in accordance with IFRS 13?

Solution

Yes. IFRS 13 addresses the situation where observable inputs are not available. 

The carrying value of investment property held at fair value is often determined by way of engaging an external valuer. In the context of COVID-19, valuation reports received from external valuers may contain an uncertainty or qualifying clause in relation to certain aspects of the valuation. For example, the uncertainty may relate to the lack of empirical data upon which to determine a quantitative estimate for a key input.

Nonetheless, IFRS 13 requires an entity to develop unobservable (Level 3) inputs using the best information available in the circumstances, which might include an entity’s own data. This data should be adjusted if reasonably available information indicates that other market participants would use different data. However, an entity need not undertake exhaustive efforts to obtain information about market participant assumptions. [IFRS 13 para 89].  

While under IFRS 13, an entity should apply valuation techniques consistently, a change in valuation technique or its application is appropriate if the change results in a fair value measurement that is equally or more representative of fair value under the circumstances.  Changes in market conditions is an example of such a change. Further guidance for dealing with uncertain cash flows is included in FAQ 2.6.2 on uncertain cash flows.

Finally, IFRS 13 deals with uncertainty in relation to Level 3 fair value measurements through providing users with appropriate disclosure. For example, including a description of the valuation techniques used, how decisions are made in relation to valuation procedures and the sensitivity of fair value measurements to significant unobservable inputs.

Illustrative text - Non-financial assets - FAQ 2.6.2 - Uncertainties in cash flows and change in valuation technique for level 3 fair value measurement

Publication date: 21 Apr 2020

Question:

How should uncertainties associated with COVID-19 be factored into a level 3 fair value measurement for non-financial assets?

Solution:

For reporting dates in the first half of 2020, COVID-19 has given rise to many significant uncertainties including: the length of time and severity of the impact of COVID-19, how effective measures taken to control the spread of the virus will be, and how quickly activities may return to more normal conditions once the pandemic is over. It might not be possible for companies to factor all of these uncertainties into a single set of cash flow forecasts. Rather, there might be a range of potential outcomes that need to be included as different scenarios with appropriate weightings applied to each. Management would need to document its basis for the factors that have been built into each scenario, including the probability weights applied to each of the scenarios.

When valuing businesses and most non-financial assets, entities in practice use an expected cash flow model. Even if management is not explicitly modeling scenarios, it is implicitly probability weighting the possible scenarios to arrive at a single forecast. Another approach is to use a forecast that is not an expected cash flow forecast, for example, management’s best estimate. IFRS 13 requires the use of a discount rate that is consistent with the risk inherent in the cash flows. This means that the discount rate applied to the expected cash flows and “best estimate” cash flows are not the same. If the cash flow forecasts do not fully reflect multiple scenarios capturing the range of relevant outcomes, an entity may need to add a company-specific risk premium, also known as an alpha, to the discount rate. This will result in a higher discount rate that reflects the risks in the forecast. More guidance on the interplay between the discount rate and cash flow forecast can be found  in the International Valuation Standards issued by the International Valuation Standards Council (specifically in paragraph 50.38). A multiple scenario approach may eliminate the need for the alpha since discount rates should not be adjusted for risks that are already reflected in the cash flows.

If management moves from a single set of cash flows to a probability weighted set of cash flows, this represents a change in accounting estimate in accordance with IAS 8, which should be accounted for as such. However, in accordance with IFRS 13 paragraph 66, the disclosures in IAS 8 for a change in accounting estimate are not required for revisions resulting from a change in a valuation technique or its application. IFRS 13 paragraph 65 cites changing market conditions is an example of a circumstance where a change in valuation technique or its application may be appropriate.

Additionally, IFRS 13 deals with uncertainty in relation to Level 3 fair value measurements through providing users with appropriate disclosure. For example, including a description of the valuation techniques used, how decisions are made in relation to valuation procedures and [for recurring fair value measurements] the sensitivity of fair value measurements to significant unobservable inputs".

Illustrative text - Non-financial assets - FAQ 2.6.3 – Additional considerations for discount rates used in Level 3 fair value measurements

Publication date: 27 Apr 2020

Question:

What other considerations for discount rates are relevant for Level 3 fair value measurements of non-financial assets, such as a business, given the impact of COVID-19 on economic conditions?

Solution:

The considerations for discount rates are two-fold in light of the impact of COVID-19 on economic conditions:

(1)       Systematic risk (beta)

One component of the discount rate is compensation for bearing the systematic risk inherent in the cash flows. The amount of an asset’s systematic risk is measured by its beta, which is measured in relation to the market as a whole. This represents risk that cannot be reduced through diversification, and it is rewarded with a risk premium or higher level of expected return. This risk is derived from external macroeconomic factors that affect all companies in some way, although in different magnitudes. The beta is a component of the cost of equity included in the discount rate and is unrelated to whether (and to what extent) the unsystematic risk (alpha) should be included in the discount rate. As to the specific implications that COVID-19 has on interest rates, see FAQ 2.1.4.

(2)       Unsystematic risk (alpha)

The other component of the discount rate is unsystematic (diversifiable) risk, which is the risk specific to the particular asset. Since this risk can be diversified away, investors do not require to be compensated for it. 

Examples of unsystematic risk include customer concentration risk, keyman risk and regulatory risk. Unsystematic risk might be reflected in the asset’s cash flows (for example, by using different scenarios with appropriate weightings).

IFRS 13 requires the use of a discount rate that is consistent with the risk inherent in the cash flows. This means that the discount rate applied to the expected cash flows (measured using multiple possible scenarios that are probability-weighted) and ‘best estimate’ cash flows (measured at the most likely amount) are not the same. If the cash flow forecasts do not fully reflect multiple scenarios capturing the range of possible outcomes, an entity might need to add a risk premium, also known as an alpha, to the discount rate; however, alpha is not included in the discount rate for aspects other than cash flow projection risk. This will result in a higher discount rate that is commensurate with the risks in the forecast. See FAQ 2.6.2 for further discussion.

Illustrative text - Non-financial assets - FAQ 2.6.4 – 'Determining fair value where an entity might be forced to liquidate assets'

Publication date: 20 May 2020

Solution

For assets carried at fair value in accordance with the requirements of a specific IFRS (or where disclosure of fair value is required), fair value would generally be within the scope of IFRS 13’s measurement requirements.

IFRS 13 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

The requirement to use an orderly transaction basis for valuation is embedded directly into IFRS 13’s concept of fair value. [IFRS 13 para 15]. However, it is possible that some transactions might not be orderly, with examples of circumstances that might indicate that a transaction is not orderly noted in paragraph B43 of IFRS 13; these include that the seller is in or near bankruptcy or receivership (that is, the seller is distressed), and that there was not adequate exposure to the market for a period to allow for marketing activities that are usual and customary for transactions in the asset.

Where there is a clear expectation or other evidence that the sale of an asset will take place in a manner that is not orderly, little if any weight should be placed on the expected disorderly transaction price. [IFRS 13 App B para B44]. Where an entity does not have sufficient information to know if a transaction is to be orderly, the anticipated transaction price should be taken into account, but it will be given less weight than those transactions known to be orderly.

For example, a piece of land to be sold in an orderly transaction might have an estimated value of C10 million; whereas, in a disorderly transaction resulting from a forced sale, it might only be expected to sell for C6 million. In measuring the fair value at the balance sheet date, IFRS 13 requires market participant assumptions to be used for an orderly transaction. Accordingly, the fair value at the balance sheet date would be C10 million, despite the expectation of a forced sale.

Disclosure will be important if assets are carried above the expected proceeds owing to an expectation that they will be liquidated in a disorderly transaction after the balance sheet date.

Illustrative text - Financial instruments - FAQ 3.1.1 – How will factoring or other sales of trade receivables be impacted by COVID-19?

Publication date: 05 May 2020

Solution

Entities factoring or otherwise selling trade receivables apply the requirements in paragraphs 3.2.1–3.2.21 of IFRS 9 to assess whether the arrangement results in the receivables being derecognised. Often, such arrangements are established as a ‘factoring program’ whereby sales are made from time to time as new receivables arise.

Entities need to consider whether the derecognition criteria are met each time a receivable is sold – that is, the analysis of a factoring or similar program is not static and needs to be re-assessed each time a new sale occurs.

This is particularly relevant when applying the ‘risks and rewards test’ in paragraph 3.2.6 of IFRS 9 (that is, in assessing whether an entity has transferred significantly all risks and rewards, has retained significantly all risks and rewards, or falls somewhere in between).

As a result of COVID-19, certain exposures to risks and rewards and the relative size of each kind of risk might have changed. For example, late payment risk and/or credit risk might have become more significant as compared to other risks, and the relative size of the late payment risk as compared to the credit risk might have changed. Historical trends in risk factors might no longer be representative of expected exposure to risks at the time when receivables are factored.

Accordingly, entities should carefully assess how the changes in risk factors might impact the derecognition of trade receivables under factoring programs.

Illustrative text - Financial instruments - FAQ 3.1.2 – How should a bank and a borrower account for a loan repayment holiday imposed by law?

Publication date: 07 May 2020

Question

In response to COVID-19, a new law is enacted that imposes a moratorium on borrowers making loan principal and interest payments for a specified period of time. Under the law, the payments are deferred rather than forgiven, but interest is not accrued in full on the deferred payments. The deferred loan repayments are imposed on all banks operating in the country, and they apply automatically without any amendments being made to loan agreements, although individual borrowers can voluntarily opt out of the resulting payment holidays. The original loans are at a fixed rate of interest, and they are measured at amortised cost by both the bank and the borrower. Assume that the loans are not derecognised as a result of the moratorium.

How should the bank and the borrower account for the rescheduled loan principal and interest payments?

NB This FAQ does not address other IFRS accounting considerations that might arise from such loan repayment holidays, such as the impact on expected credit losses (‘ECL’). See, in particular, FAQ 3.2.1 ‘Impact of COVID-19 payment holidays on ECL staging’.

Solution

Since no amendment is made to the loan agreement, it might be questioned whether or not this is a modification for the purposes of IFRS 9, and this could depend on the specific facts and circumstances. However, the measurement impact will be the same, regardless of whether the payment holiday is accounted for as a modification such that paragraphs 5.4.3 and BC4.253 of IFRS 9 are applied, or as a change to the estimated cash flows under the original loan such that paragraph B5.4.6 is applied. In either case, both the borrower and the bank will recalculate the gross carrying amount of the loan by discounting the rescheduled payments at the loan’s original effective interest rate (sometimes referred to as the ‘cumulative catch-up’ method).

In terms of timing of recognition, where the payment holiday is accounted for as a modification by applying paragraphs 5.4.3 and BC4.253 of IFRS 9, the resulting gain (for the borrower) or loss (for the lender) should be recognised immediately in profit or loss on the occurrence of the modification. Where the payment holiday is accounted for as a change to the estimated cash flows by applying paragraph B5.4.6, the estimated future cash flows should be revised (for the bank, taking into account the number of borrowers expected not to opt out of the payment holiday) as and when those estimates change as a result of the progress of the new law. The resulting gain (for the borrower) or loss (for the lender) is recognised immediately in profit or loss. The exact time when the estimated future cash flows change might depend on facts and circumstances (such as when details of the eventual law become known and any uncertainties in the enactment process), but they must be revised no later than when the law has been enacted. Subsequently, interest will continue to be recognised on the loan using the effective interest method, so that interest is still recognised during the period of the repayment holiday.

The gain or loss is not ‘spread forward’ and recognised over the remaining life of the loan by adjusting the effective interest rate under paragraph B5.4.5 of IFRS 9. Paragraph B5.4.5 only applies to periodic re-estimation of cash flows to reflect movements in market rates of interest, which is not the case for these changes.

Whilst payments (or changes to payments) arising solely as a result of legislation are disregarded for the specific purpose of the ‘solely payments of principal and interest’ or SPPI assessment they are not disregarded when measuring a loan, and so they should be reflected in the measurement.

IFRS does not prescribe the income statement line item(s) in which such gains / losses should be reported, so an entity should disclose the accounting policy that it has applied, where material. However, for the bank, to the extent that the loss does not relate to credit risk it would not be appropriate to classify that loss within ECL impairment expense. Furthermore, where relevant to an understanding of the entity’s financial performance, an additional line item (or disaggregation of a line item) reporting the gains / losses should be presented in the income statement in accordance with paragraph 85 of IAS 1.

Paragraph 35J of IFRS 7 requires disclosures about modifications of contractual cash flows on financial assets, including the gain or loss recognised. It does not apply to modifications of contractual cash flows on financial liabilities or to gains and losses arising from changes in estimates of expected cash flows, although disclosure of these would be required under paragraph 39 of IAS 8 and paragraph 20(a)(v) and (vi) of IFRS 7. 

Instead of borrowers having to ‘opt out’ of the payment holiday as described in the illustration above, a new law might require borrowers to ‘opt in’ to the payment holiday, by notifying the bank that they wish to exercise their new right to a payment holiday. In such a case, the remeasurement gain / loss would still need to be recognised in the income statement no later than when the law is enacted, based on the estimated number of customers who will subsequently ‘opt in’. That is because the definition of effective interest rate in Appendix A to IFRS 9 requires the estimation of future cash flows to take into account prepayment, extension and similar options. Hence, changes resulting from permitted payment holidays at the borrower’s option should be included, even where a borrower has not yet notified the bank of its intention to exercise its right to the holiday. It would not be appropriate to recognise a remeasurement gain / loss only at a later date, when a borrower requests that their individual loan be granted the payment holiday.

Illustrative text - Financial instruments - FAQ 3.1.3 – What is the accounting treatment of a loan repayment holiday negotiated between a bank and a borrower?

Publication date: 12 May 2020

Question A borrower has a loan at a fixed rate of interest from a bank, which both parties measure at amortised cost. In response to COVID-19, and sometimes at the recommendation or encouragement of a government or regulator, a borrower approaches the bank and applies for deferral of one or more instalments on the loan repayment for a specified period of time (a ‘repayment holiday’). The original loan agreement does not allow for any deferral of repayments. The bank accepts the application, and it also agrees to apply to the deferred instalment a contractual interest rate that is lower than the loan’s original effective interest rate. Assume that the modification does not result in derecognition of the original loan

How should the bank and the borrower account for the deferral of the loan instalment?

NB This FAQ does not address other IFRS accounting considerations that might arise from such loan repayment holidays, such as the impact on expected credit losses (‘ECL’). See, in particular, FAQ 3.2.1 ‘Impact of COVID-19 payment holidays on ECL staging’.

Solution

Paragraphs 5.4.3 and BC4.253 of IFRS 9 apply to modifications that do not result in derecognition. These require both the bank and the borrower to recalculate the gross carrying amount by discounting the revised expected cash flows at the loan’s original effective interest rate. The resulting modification gain (for the borrower) or loss (for the bank) is recognised immediately in profit or loss on the occurrence of the modification.

IFRS does not prescribe the income statement line item(s) in which such a modification gain / loss should be reported, so an entity should disclose the accounting policy that it has applied, where material. However, for the bank, to the extent that the loss does not relate to credit risk  it would not be appropriate to classify that loss within ECL impairment expense. Furthermore, where relevant to an understanding of the entity’s financial performance, an additional line item (or disaggregation of a line item) reporting the gains / losses should be presented in the income statement in accordance with paragraph 85 of IAS 1.

For the bank, paragraph 35J of IFRS 7 requires disclosures about modifications of contractual cash flows on financial assets, including the gain or loss recognised. For the borrower, disclosure of the gain on modification is required by paragraph 20(a)(v) of IFRS 7.

Illustrative text - Financial instruments - FAQ 3.1.4 – When is a new loan granted to an existing borrower, in substance, a payment holiday on the original loan?

Publication date: 12 May 2020

Question

A new loan is granted by a bank to an existing borrower who is not in default. The new loan is documented in a separate contract to the original loan contract. The original loan contract continues to exist and no changes are made to it. When should the new loan be accounted for as a modification of the original loan – because, in substance, it represents a payment holiday on the original loan – rather than as a separate transaction?

NB If the borrower is in default, see FAQ 3.1.5 'New loans granted to defaulted debtors'.

Solution

Judgement should be applied to determine the substance of the arrangement in the specific facts and circumstances.

Section B.6 of the Guidance on implementing IFRS 9 provides examples of indicators of when two separate contracts should be aggregated and treated for accounting purposes as a single ‘unit of account’, rather than being accounted for separately, as would normally be the case. Those indicators are as follows:

  • they are entered into at the same time and in contemplation of one another;
  • they have the same counterparty;
  • they relate to the same risk; and
  • there is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.

The first indicator does not apply in this situation, since the question is whether or not the new loan should be considered a modification of the original loan part way through its life, not whether the two contracts should be aggregated at inception. The second indicator applies and, in this situation, the lender and borrower are the same for both loans. The conclusion will therefore depend on the assessment of the last two indicators, where judgement should be applied. To illustrate this, consider the following two scenarios.

Scenario 1

  • The interest rate of the new loan is less than or equal to the rate of interest on the original loan and is not a current market interest rate for the borrower at the date when the new loan is agreed;
  • the proceeds of the new loan are paid to the borrower in instalments, whose amounts and dates are substantially the same as the scheduled repayments on the original loan;
  • the proceeds of the new loan are used by the borrower to pay the scheduled repayments due on the original loan;
  • the maturity date of the new loan is substantially the same as the original loan; and
  • other key terms and conditions of the new loan copy those of the original loan.

Considering the third indicator, both the new loan and the original loan are exposed to credit risk and to interest rate risk. Considering the fourth indicator, given the similarities between the old and new loans, there is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished by modifying the terms and conditions of the original loan. Therefore, although the new loan is documented in a separate contract, all of the applicable indicators show that it is, in substance, a modification of the original loan. Both the bank and the borrower should therefore account for the new loan as if it were a modification of the original loan.

Scenario 2

  • The interest rate of the new loan is a current market interest rate for the borrower at the date when the new loan is agreed;
  • the proceeds of the new loan are paid to the borrower in full at the start of the new loan;
  • the proceeds of the new loan are not used by the borrower to repay the original loan;
  • the maturity date of the new loan is substantially different from that of the original loan; and
  • the other key terms and conditions of the new loan are the bank’s current terms and conditions for a loan of this type (for example, relating to maturity and collateral), which differ from those of the original loan.

Considering the third indicator, both the new loan and the original loan are exposed to credit risk and to interest rate risk. However, considering the fourth indicator, given the substantial differences between the old and new loans, there is an economic need and substantive business purpose for structuring the transactions separately. Therefore, in this scenario the applicable indicators do not show that the new loan is, in substance, a modification of the original loan. Both the bank and the borrower should therefore account for the new loan as a separate transaction.

Illustrative text - Financial instruments - FAQ 3.1.5 – New loans granted to defaulted debtors

Publication date: 12 May 2020

Question:

A bank makes a loan to a customer. The customer subsequently enters into financial difficulties and goes into default. The bank assesses that the loan is credit-impaired (stage 3). To maximise its overall recovery, the bank restructures the loan and also enters into a separate loan commitment to lend more money to the customer, which is drawn down shortly afterwards.

Does the new loan that results from the draw-down of the loan commitment meet the definition of a purchased or originated credit-impaired financial asset?

Solution:

Not necessarily. 

Although the new loan is in a separate contract, it was entered into by the bank as part of the restructuring of the existing loan that is in default, to maximise its overall recovery. In substance, therefore, in this case the new loan represents part of the modification of the existing loan (that is, it is an increase of the existing loan). The bank should determine if the modification of the existing loan, including the new loan, meets the requirements for derecognition of the existing loan (further guidance is given in chapter 44). If not, the new loan is treated as the continuation of the existing loan and hence is not a purchased or originated credit-impaired loan (because the existing loan was not credit-impaired when first recognised). In this case, the bank should recognise a modification gain or loss in accordance with paragraph 5.4.3 of IFRS 9. The bank should also assess whether the modified loan has significantly increased in credit risk since initial recognition of the original loan and/or continues to be credit-impaired at the reporting date and measure and disclose the expected credit loss accordingly.

In the less likely circumstance that the modified arrangement is considered to result in the derecognition of the existing loan, the restructured arrangement (both the existing loan and the new loan) are recognised as new loan(s), initially recognised at fair value. The bank should assess whether the new loan(s) are credit-impaired on origination and hence meets the definition of an originated credit-impaired loan in Appendix A of IFRS 9: whether or not this is the case will depend on the specific facts and circumstances.

Illustrative text - Financial instruments - FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19

Publication date: 12 May 2020

Question

What are the accounting implications of financial support arrangements put in place by central banks in response to COVID-19?

Illustration

In response to COVID-19, some central banks have developed programmes to provide economic support to the economy. Some of these programmes are implemented through the commercial banking system, and such programmes vary by jurisdiction. For example, central banks might provide funding to commercial banks at potentially favourable rates or terms, with the expectation that the banks will then lend the funds on to their customers at similarly favourable rates. Central bank support could also take the form of loans provided directly to qualifying entities (such as small businesses, or businesses in certain sectors), financial guarantees of a bank’s customer loans, purchases of securities by commercial banks from money market funds with funds borrowed from a central bank, or swaps or repurchase transactions with a central bank.

Solution

In order to determine the appropriate accounting treatment, it will be important to understand the provisions of each particular arrangement. The analysis should focus on the following key considerations:

  • Is the arrangement provided on market terms?
  • If the arrangement is not provided on market terms, is there an element of government grant?
  • If so, who is the beneficiary of the government grant?
  • What is the accounting by the beneficiary of the government grant?
  • What is the accounting if the transaction is not provided on market terms but there is no government grant?

The following analysis focuses primarily on funding schemes and guarantee arrangements, to illustrate the application of the principles to the most common types of transaction. However, similar considerations would apply to other arrangements, such as swaps or repurchase arrangements. Additionally, while this FAQ refers to central banks, a similar analysis would apply if the scheme is provided directly by the government.

Is the arrangement provided on market terms?

Funding schemes

For funding arrangements provided by a central bank to a commercial bank, the assessment will depend in part on whether the funding from the central bank is considered to be ‘on market’ (that is, whether the funding is entered into at a prevailing market rate in the current environment).

Determining the market rate is judgemental and will depend on the specific facts and circumstances. In making this assessment, entities should consider the rate for a similar instrument (that is, similar as to currency, maturity, type of interest, collateral, credit rating and other terms). [IFRS 9 para B5.1.1]. In some cases, it might be judged that the central bank is establishing a market rate for funding on the particular specified terms, separate from other sources of funding (such as other types of central bank programme, or other borrowings).

If the entity concludes that the funding is not provided on market terms, it should consider whether the difference between the market rate and the rate on the funding is a government grant within the scope of IAS 20.

Guarantees

Where guarantees of new or existing loans are received by a commercial bank from a central bank, the entity will need to assess whether the premium paid for the guarantee is ‘on market’. If the entity concludes that the premium paid for the guarantee is not on market, the entity will similarly need to consider whether the difference is a government grant under IAS 20.

If the arrangement is not provided on market terms, is there an element of government grant?

Paragraph 3 of IAS 20 defines ‘Government’ as “government, government agencies and similar bodies whether local, national or international”. A central bank therefore falls within the definition of a government entity.

A government grant is defined as “assistance from the government that takes the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity”.

Where funding or guarantees provided in response to COVID-19 are on terms that are not on market, then in the absence of other factors (such as the provision of a separate good or service), there is likely a government grant.

To determine the accounting implications of a government grant, entities must first determine who the beneficiary is.

Who is the beneficiary of the government grant?

The transfer of resources from a government to an entity can take different forms and means of execution. As a result, different parties might benefit from the government grant. Nonetheless, it will be key to identify the beneficiary of the grant in order to properly apply the government grant accounting model.

Funding arrangements

For example, a commercial bank might receive funding from a central bank at favourable rates, with the understanding that it will on-lend at similarly favourable rates to its end customers. In some cases, the commercial bank might have significant discretion over how the funding is on-lent to its customers. The discretion covers the following aspects:

  • Who (which customers the commercial bank lends to)?
  • What terms (the amount of the loan, the interest rates, repayment terms and/or collateral)?
  • When (the timing of issuance of the loans to the customers, as compared to receipt of the funding from the central bank)?

In such a scenario, the commercial bank might be viewed as the beneficiary of the grant, even though ultimately its end customers will also benefit from the favourable funding.

In other cases, a central bank might make some of the payments due on loans made to eligible end customers (for example, interest payments due for the first 12 months). 

In that scenario, the ultimate party who benefits from the grant might be viewed as the customer, who is relieved from its obligation to pay interest for the first 12 months on the loan that it entered into with the commercial bank (that is, the customer is the one who benefits from the funding of interest payments). The commercial bank is only collecting the interest to which it is entitled under the loan from the borrower.

Financial guarantees

Where a government provides a guarantee to a commercial bank of its loans to customers, a similar analysis would need to be performed.

Depending on the facts and circumstances, the borrower might be identified as the beneficiary of the grant in the form of a lower rate of interest (for example, where the guarantee is provided at the same time as and in conjunction with the loan and where, absent the government guarantee, the borrower would pay a higher rate of interest). This might be the case if the guarantee is viewed as integral to the loan (that is, the loan and the guarantee are viewed as one unit of account). 

Alternatively, the commercial bank might be identified as the beneficiary of the government grant in the form of a guarantee on ‘off-market’ terms – for example, if the fee paid by the commercial bank for the guarantee is not based on market terms (that is, it is zero). This might be the case if the guarantee is not integral to the loan (for example, if it has been added after the origination of the loan).

What is the accounting by the beneficiary of the government grant?

Funding

A government grant is not recognised until there is reasonable assurance that the entity will comply with the conditions attached to it and that the grant will be received. [IAS 20 para 7]. Receipt of a grant does not, of itself, provide conclusive evidence that the conditions attaching to the grant have been or will be fulfilled.

Therefore, if funding provided in response to COVID-19 contains an element of government grant, the beneficiary would need to determine whether there is ‘reasonable assurance’ that the grant will be received, taking account of factors such as:

  • Which aspects of the funding remain uncertain, and how critical are they? What are the conditions that the entity must comply with?
  • Will the central bank be able to deliver the programme, considering practical challenges as well as its ability to pay?

If there is the required reasonable assurance, the government grant is recognised separately from the loan. The loan is initially recognised at its fair value plus or minus any transaction costs. [IFRS 9 para 5.1.1]. The grant is measured as the difference between the initial carrying value of the loan and the amount lent. [IAS 20 para 10A].

In subsequent periods, the government grant is recognised in profit or loss, on a systematic basis, over the period(s) in which the entity recognises as expenses the related costs for which the grant is intended to compensate. [IAS 20 para 12]. Depending on the facts and circumstances, the benefit of the grant might therefore be recognised as a one-time gain or spread over time. For example, if the grant compensates for a modification loss that a commercial bank recognises for modifying existing customer loans, it would be recognised at the time when the modification loss is recognised by the commercial bank. On the other hand, if the grant compensates for lower interest income or higher interest expense on new loans, it would be recognised over time as interest income or expense is recognised.

Where IAS 20 is applied, the specific disclosures required by IAS 20 should be provided. These include the nature and extent of government grants recognised in the financial statements. [IAS 20 para 39].

Guarantees

If the commercial bank concludes that a financial guarantee received from the government contains an element of government grant, it should first assess whether the recognition criteria in paragraph 7 of IAS 20 are met, in the same way as for funding arrangements. If the recognition criteria are met, the bank could present the grant on a gross basis by setting up a ‘pre-paid’ guarantee premium asset and a deferred income liability, or on a net basis of zero by offsetting the pre-paid premium and deferred income accounts [IAS 20 para 24].

Subsequent to initial measurement, the pre-paid asset and deferred income liability (if gross presentation is followed) will be amortised into profit or loss over the life of the loan covered by the guarantee.

What is the accounting if the transaction is ‘off market’ but there is no government grant?

There might be circumstances where the commercial bank is not the beneficiary of a government grant and/or the transaction might otherwise not be on market terms.

For example, a central bank might provide a guarantee to a commercial bank based on market terms, but the loans from the commercial bank to its customers might not be provided on market terms (after taking into account the government guarantee). This could be the case where the terms are mandated by the government as part of an industry-wide scheme to provide financial support to the economy. The loans to customers might therefore be ‘off market’.

While, under IFRS 9, the fair value of a financial instrument (such as a loan) at initial recognition is normally the transaction price (that is, the fair value of the consideration given or received – see para B5.1.2A of IFRS 9 and IFRS 13), in some cases, part of the consideration given might be for something other than the financial instrument. In that case, any additional amount lent would be an expense (unless it qualifies for recognition as some other type of asset). This could be the case if, at the time when the commercial bank enters into the loans with its customers, it expects that there will be an overall loss on them (that is, the margin does not cover the expected losses). The additional amount lent in this case might be a concession granted to the customer under a government-mandated programme to support the economy.

However, if the consideration is only for the financial instrument (that is, there is no overall concession being granted) and the entity determines that the fair value differs from the transaction price, the difference between the fair value and the transaction price should only be recognised as a gain or loss if the fair value is evidenced by a quoted price in an active market for an identical asset (that is, a Level 1 input) or based on a valuation technique that uses only data from observable markets. Where the fair value depends on one or more unobservable inputs, the day one ‘loss’ would not be recognised upfront, but it would be recognised after initial recognition only to the extent that it arises from a change in factors that market participants would take into account when pricing the asset. [IFRS 9 para B5.1.2A]. Therefore, total interest income or expense recognised (including the amortisation of the day one gain or loss) might not be materially different from the interest income or expense recognised if the transaction is considered to be on market terms.

Illustrative text - Financial instruments - FAQ 3.1.7 – Monetary items forming part of the net investment in a foreign operation

Publication date: 03 Jun 2020

Question

Some entities have made loans to their foreign operations (subsidiaries, associates or joint ventures) that are part of the net investment in those foreign operations. These are loans or receivables for which settlement is neither planned nor likely to occur in the foreseeable future (see para 15 of IAS 21).

What are the implications when circumstances regarding loans for which the settlement was neither planned nor likely to occur in the foreseeable future have changed (for example as a result of COVID-19)?

Solution

Management’s expectations and plans for repatriating cash from its foreign operations might change in the light of COVID-19. Such changes are events that would cause an entity to reconsider whether the settlement of loans or receivables is neither planned nor likely to occur in the foreseeable future. If the settlement is now either planned or likely to occur, the entity can no longer record future exchange differences arising on translation of the loans in other comprehensive income. These exchange differences should be recorded in profit or loss on a prospective basis from the date when management's expectations or plans changed.

Additionally, where a loan that was previously classified as part of the net investment is repaid, management needs to consider whether some of the amounts previously accumulated in the currency translation adjustment (CTA) reserve should be reclassified to profit or loss. 

Whether to reclassify any CTA to profit and loss will depend on the entity's chosen accounting policy for repayment of loans that form part of its net investment where there is no change in the parent’s proportionate shareholding, and on its interpretation of the ownership interest concept in IAS 21. If the entity’s policy is to interpret ownership interest as proportionate interest, none of the amounts in the CTA reserve should be reclassified. However, if the entity’s policy is to interpret ownership interest as absolute interest, a pro rata share of the CTA reserve should be reclassified. 

Loans might no longer be classified as part of the net investment because of a change in the likelihood of repayment, but they might not be immediately repaid. Where an entity’s chosen policy would result in reclassification of some CTA on repayment of the loan, the timing of recycling also needs to be considered.  

There is no explicit guidance in IAS 21 about the timing of reclassification and so, in these circumstances, a second accounting policy choice can be made to apply the reclassification either when the loan is no longer considered to form part of the net investment in the foreign operation, or when the loan is actually repaid.

Plans to distribute profits from subsidiaries might also impact the need to recognise a deferred tax liability in connection with undistributed profits and other outside basis differences (see section 7.5 of this In depth publication).

Illustrative text - Financial instruments - FAQ 3.1.8 - “Accounting for gain or loss on debt modification where borrowing costs are capitalised under IAS 23”

Publication date: 07 Jul 2020

Question:

An entity has a specific borrowing to finance a qualifying asset. The borrowing cost is capitalised in accordance with IAS 23. The specific borrowing is modified in such a way that this does not result in derecognition. In accordance with IFRS 9, the entity recalculates the borrowing’s carrying amount by discounting the new modified cash flows at the original effective interest rate.

Should management capitalise the modification gain or loss under IAS 23?

Solution:

Management has an accounting policy choice. There are two valid views on how to account for the modification gain or loss on a specific borrowing relating to a qualifying asset under IAS 23:

No capitalisation: paragraph 6 of IAS 23 specifically refers to ‘borrowing costs’ including ‘interest expense calculated using the effective interest method as described in IFRS 9’. This can be interpreted narrowly to exclude a modification gain or loss, with the result that such a gain or loss should be recognised in profit or loss.

Capitalisation: the alternative view is that a modification gain or loss is the result of cash flows discounted using the original effective interest rate and is therefore part of applying the effective interest rate method. Also, the list of possible borrowing costs in paragraph 6 of IAS 23 is not exhaustive, and so the modification gain/loss can be included under borrowing costs as an 'other cost an entity incurs in connection with the borrowing of funds' in accordance with paragraph 5 of IAS 23. Where this view is applied, only the portion that relates to the acquisition, construction or production period is capitalised, with the remainder recognised in profit or loss.

Both views are acceptable, and so an accounting policy choice should be made. The chosen policy should be applied consistently to all modification gains or losses on specific borrowings to finance qualifying assets, and it should be disclosed.

Illustrative text - Financial instruments - FAQ 3.2.1 - Impact of COVID-19 payment holidays, including subsequent extensions to such holidays, on ECL staging

Publication date: 10 Jul 2020

Background

Prior to the COVID-19 pandemic, payment holidays or ‘forbearance’ were typically initiated by a borrower known to be in financial difficulty. The lender obtained detailed financial information from the borrower that the lender used on a case-by-case basis to assess the financial position of the borrower and tailor the payment holiday to their individual circumstances. In those circumstances, the exposure was classified either as stage 2 as a minimum, or stage 3 (refer to FAQ 3.2.2 ‘How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model?’).

Following the COVID-19 pandemic, the circumstances in which payment holidays are typically granted have changed significantly. They have been initiated both by borrowers but also governments as blanket measures, with very little, if any, financial information provided by individual borrowers. That has typically resulted in standardised payment holidays being offered to all customers in a class (for example all home mortgages) without a borrower-level assessment. In addition, the initial payment holiday granted may also subsequently be extended and only high level information obtained from the borrower as part of the process to grant the extension.

As highlighted by the IASB in its document issued on 27 March 2020, in these changed circumstances it is not appropriate to apply previously established approaches to assessing significant increase in credit risk (‘SICR’) for payment holidays in a mechanistic manner.

Question

What factors should be considered in assessing whether a loan granted a payment holiday related to COVID-19 should be classified in stage 1, stage 2 or stage 3?

Answer

There are a wide range of factors that may be relevant in making this assessment when a payment holiday is first granted. The relevance of each factor will depend upon the particular facts and circumstances, as well as the materiality of the possible impact. Key factors to consider are discussed below.

Subsequent extensions to payment holidays

The factors set out in this FAQ would also be expected to be relevant in assessing how a loan should be classified when an extension to the original payment holiday period is granted, when the lender does not have detailed, up-to-date financial information on the borrower. However, if an extension is granted, then the following factors should be considered in addition to those in the rest of this FAQ:

  • Likelihood of SICR: Generally, the likelihood of an SICR will be greater when a payment holiday is extended than when it was first granted. That is because with the passage of time it will become less and less likely the payment holiday is necessitated only by short term liquidity difficulties.  However, this will be dependent on specific facts and circumstances. For example:
    • where an extension is requested by the borrower despite ‘lockdown’ being eased in the relevant territory, with more normal economic activity having resumed so that other borrowers are able to resume normal repayments, there would be a strong presumption an SICR has occurred;
    • where the original payment holiday was for a longer period of time, for example 3 months, an extension would be more indicative of an SICR (rather than just short term liquidity difficulties) than if the original payment holiday was for a shorter period of time such as 1 month; and
    • where extensions are granted as a ‘blanket’ measure that does not discriminate between borrowers, that would not provide relevant information to staging at the individual loan level (refer to ‘Blanket’ vs customer-initiated below).
  • Indebtedness: When the terms of the extension do not change the maturity date of the loan, the periodic repayment obligation after payments resume will be higher than before the extension.  In isolation, this would be expected to increase the borrower’s probability of default and the likelihood of the loan moving to stage 2.
  • Higher risk loans: For higher risk loans already in stage 2 with a higher expectation of default, there might not yet be sufficient information to identify which of those loans are credit impaired on an individual basis, and so are required to be moved to stage 3 (refer to ‘Credit impaired or stage 3 below). However, as per paragraph B5.5.5 of IFRS 9, such loans should not be grouped with less risky loans for recognition of a loss allowance on a collective basis when this obscures their heightened risk and introduces bias by under-estimating ECL.
  • Data gathering: When granting an extension, banks may have had more time to build processes and greater opportunity to gather customer data with which to classify borrowers more accurately, compared to when payment holidays were first granted (refer to ‘Forward planning’ below). That is because when payment holidays were initially granted, due to the importance of borrowers quickly accessing relief schemes and the speed with which banks had to put in place new processes, very little, if any, current financial information was generally requested from individual borrowers.  This additional data should be considered when assessing in which stage to classify affected loans.
  • ‘Double count’: As more information becomes available over time, care should be taken to avoid any ‘double counting’. This could arise where exposures are moved to stage 2 due to payment holiday extensions, but the underlying risk necessitating the extension has already been appropriately reflected in the SICR assessment via other inputs to the ECL estimate. This risk is greatest where collective approaches have been applied elsewhere in the ECL estimation, such as via overlays or in the application of multiple economic scenarios. As discussed below under ‘Practical considerations’, it might therefore be preferable to first apply updated macroeconomic scenarios and weightings to reflect the change in economic outlook and then focus only on those loans with payment holiday extensions that would remain in stage 1.

When the lender does have detailed, up-to-date financial information on the borrower that shows they are in financial difficulty. Similarly, then the guidance in FAQ 3.2.2 referred to above should be applied instead of this guidance where a borrower requests an extension but the bank declines the extension because it determines that the borrower would not be able to service the loan even with a further deferral of payments, that would indicate the borrower is in financial difficulty and the loan should be classified in stage 2 as a minimum.

IFRS technical considerations

  • ‘Blanket’ vs customer-initiated: As highlighted in the IASB document, where a payment holiday is granted to an entire class of financial instruments, that alone should not automatically result in all those financial instruments moving to stage 2. That is because if the ‘blanket’ nature of the holiday does not discriminate between borrowers, it does not provide relevant information to staging at the individual loan level. An example would be a government requiring that payment holidays are granted to an entire class of loans (for example all home mortgages) without regard to the borrower’s individual financial circumstances. However, affected loans would still need to be assessed for other indicators of SICR and where the blanket payment holiday is motivated by the deterioration in the economic outlook, a portion of those loans would generally be expected to move to stage 2.
  • Collective assessment: Due to the common absence of detailed information from borrowers regarding the individual cause of their payment holiday request and their broader financial circumstances, it is highly likely that initially a collective approach will be needed to determine which loans with payment holidays should be moved to stage 2.
  • Short-term liquidity issue vs SICR: Where a borrower is only experiencing short-term liquidity difficulties and those difficulties will be mitigated by the payment holiday, perhaps in conjunction with other government reliefs that reduce the risk of default, the loan may not experience a significant increase in the risk of default and validly remain in stage 1. In addition, where the application process asks only very high-level questions, some borrowers granted payment holidays may be pre-emptively maximising their cash and not currently experiencing liquidity issues or a significant increase in the risk of default. But other borrowers will not be experiencing only short-term liquidity difficulties, for example where they are in a sector likely to suffer longer-term difficulties, they will not benefit from government reliefs or reliefs will not reduce their risk of default (for example, a guarantee that only reduces the lender’s loss given a default). For that reason, assuming all loans granted a payment holiday remain in stage 1 is not appropriate.
  • Modification vs existing clause: Some loans may contain pre-existing clauses permitting the borrower a payment holiday, so no modification to the original loan contract is needed to allow this. This guidance on payment holidays obtained via contractual modifications is likely to similarly apply to these cases.
  • Credit impaired or stage 3: A loan that is granted a payment holiday will only move to stage 3 when the loan is identified as credit impaired on an individual basis. This is because the IFRS 9 definition of credit impaired does not include assets assessed only on a collective basis where the impact cannot yet be identified for individual assets. 
  • Regulatory vs accounting: Where the regulatory treatment or regulatory reporting of payment holidays is changed, this will not automatically affect the accounting analysis under IFRS 9. The impact of such changes, if any, on IFRS 9 accounting would need to be separately analysed and assessed.

Practical considerations

Significant judgement may be needed in applying the above technical considerations and determining which loans should move to stage 2, where a bank has limited data on customers’ specific circumstances. The availability of that information will also vary by bank, by territory and over time. However, as more information naturally becomes available, the approach taken should be updated appropriately. The following considerations may be relevant:

  • Impact of Multiple Economic Scenarios (MES): Practically, when assessing which loans with payment holidays move to stage 2, a lender might first apply updated macroeconomic scenarios and weightings to reflect the change in economic outlook. Attention can then be focused on those loans with payment holidays that would remain in stage 1.
  • Relevant risk factors: When assessing loans with payment holidays to determine which / what portion should move to stage 2, the following risk factors may be relevant to the extent data is available:
    • Industries and sectors: Dependent on the territory, borrowers in some industries or sectors, such as a nurse or a company in the health sector, might have significantly stronger future prospects than borrowers in others, such as the tourism sector.
    • ‘Headroom’: Loans that prior to COVID-19 had credit risk (for example. a probability of default or ‘PD’) closer to the threshold for moving to stage 2, or other risk indicators such as recent payment arrears, are more likely to have had a significant increase in credit risk since initial recognition once the additional factor of the payment holiday is also taken into account.
    • Indebtedness: Even where a borrower’s income returns to its pre-COVID-19 level, their level of indebtedness might continue to grow during the payment holiday and so increase their future debt servicing costs and risk of default. This might be the case where the borrower cannot access government reliefs, where the relief only provides short-term liquidity that needs to be repaid, or where that relief does not fully address their income shortfall (for example, as enhanced government unemployment benefit is capped so borrowers with income levels significantly in excess of the cap will see their level of indebtedness increase more significantly during COVID-19 disruption).
    • Other products: Where a borrower has other financial products with the lender, such as investments, revolving credit facilities etc, where that information is not already incorporated into the SICR criteria, information about those other products may be helpful in evaluating the risk of the borrower. 
  • Forward planning: Lenders might consider how the situation will evolve over time and what data will become available when. That may help identify additional data, or more granularity on existing data, that can be gathered to improve identification and support of riskier customers, provide more accurate estimation of the effect on staging and ECL, and manage expectations of both internal and external stakeholders. Examples might include:
    • Adding additional questions, such as the industry a retail customer works / worked in, to those that new applicants are required to answer;
    • Contacting a sample of customers to better understand their circumstances and how they have changed since the payment holiday was initially granted; or 
    • Gathering existing unstructured data (for example, the precise nature of the customer’s employment on their paper application form) so it can be analysed. 

Other considerations

Given the extent of judgement involved, at least in the shorter term, the staging approach adopted for customers with payment holidays is likely to be the subject of significant scrutiny by users of financial reports. Clear disclosure will therefore be essential. The nature and extent of that disclosure will vary dependent on the reporting (for example, annual vs interim, IAS 34 interim vs other types of interim reporting) but regardless, the following will likely be key:

  • A clear description of the approach taken to the staging of loans with payment holidays. 
  • The key assumptions and judgements that have been made.
  • Explanation of the potential impact if different judgements had been made. 
  • Analysis of the credit risk concentration of loans granted payment holidays, for example by PD banding or Loan To Value (LTV) ratio for secured exposures, as well as by stage. 
  • Explanation of any changes made to previously applied SICR criteria (also refer to the publication ‘Spotlight: Changes to SICR criteria’).
  • Any expectations of the timescale over which the uncertainties might be resolved.

Illustrative text - Financial instruments - FAQ 3.2.2 - How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model?

Publication date: 02 May 2020

Question:

When a borrower is in financial difficulty, to maximise recovery of the contractual cash flows of a loan, a bank might offer to modify the contractual terms. For example, the borrower might be offered a payment holiday. This is done with the objective of helping the borrower during their period of financial difficulty but still maximising recovery by the bank of the loan’s contractual cash flows. For loans such as retail mortgages, this also helps to avoid the need to repossess the borrower’s home. Such modifications are sometimes referred to as ‘forbearance’, although definitions of this term might differ between banks, between different regulatory regimes and over time if definitions evolve.

When a bank grants a modification to a borrower due to their financial difficulty and this does not result in derecognition, in which ‘stage’ of the IFRS 9 ECL impairment model (that is, stage 1: ‘performing’; stage 2: ‘underperforming’; or stage 3: ‘credit-impaired’) should the loan be classified i) at the time of modification, and ii) subsequently? The loan was not purchased or originated credit-impaired.

NB This FAQ assumes that the borrower is in financial difficulty. Refer to the separate FAQ 3.2.1 for discussion of the ‘Impact of COVID-19 payment holidays on ECL staging’.

Solution:

i) At the time of modification

The appropriate classification of the loan will depend on the specific facts and circumstances of the modification granted to the customer. The definition of a ‘credit-impaired financial asset’ (that is, stage 3) in Appendix A to IFRS 9 states that:

“A financial asset is credit-impaired when one or more events that have a detrimental impact on the estimated future cash flows of that financial asset have occurred. Evidence that a financial asset is credit-impaired include observable data about the following events: …

(c) the lender(s) of the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty, having granted to the borrower a concession(s) that the lender(s) would not otherwise consider; …”

Considering each of the three possible stages:

  • Stage 3 – In many cases, the loan will meet the definition of ‘credit-impaired (stage 3), because the forbearance concession has only been granted due to the borrower’s financial difficulty, the lender would not otherwise grant such a concession, and the concession has a detrimental effect on the estimated future cash flows (for example, a portion of the interest or principal payments are waived).
  • Stage 2 – Where the loan does not meet the definition of ‘credit-impaired’, it should be classified in stage 2. This might be the case, for example, where a customer is not in significant financial difficulty and:
    • a short-term payment holiday is granted where payments are only deferred (rather than waived) and interest accrues on the unpaid deferred amounts, with the result that there is not a detrimental impact on the estimated future cash flows of the loan.
    • a loan covenant is amended or waived, which is not considered to have a detrimental impact on the estimated cash flows.
  • Stage 1 – At the time of granting a modification to a borrower that is a concession due to their financial difficulty, it would not be appropriate to classify the loan in ‘stage 1’.

As well as considering the ECL implications of the modification, paragraph 5.4.3 of IFRS 9 requires the gross carrying amount of the loan to be recalculated, and a corresponding modification gain/loss to be recognised in profit or loss when the contractual cash flows of a loan asset are renegotiated or otherwise modified and this does not result in derecognition of the loan.

ii) Subsequent classification

As described in paragraph B5.5.27 of IFRS 9, following such a modification, a loan is not automatically considered to have lower credit risk. Typically, a borrower would need to demonstrate consistently good payment behaviour over a period of time before the credit risk is considered to have decreased and the loan moves from stage 3 to stage 2, or from stage 2 to stage 1. A history of missed or incomplete payments would not typically be erased by simply making one payment on time.

The stage classification under IFRS 9 is a separate matter from whether or not a loan still meets a definition of ‘forbearance’, because the latter could reflect a regulatory definition which requires a different ‘probation’ period. That is, it should not be assumed that a regulatory ‘probation’ period can be used as the period of good payment behaviour needed to move an asset from stage 3 to stage 2, or from stage 2 to stage 1, for IFRS 9 purposes.

Disclosure

Appropriate disclosure should also be given in accordance with IFRS that describes how an entity determines whether:

  • the credit risk of financial instruments has increased significantly since initial recognition (para 35F(a) of IFRS 7);
  • financial assets are credit-impaired (para 35F(a), (d) of IFRS 7); and
  • modified financial asset moves from stage 3 to stage 2, and from stage 2 to stage 1 (para 35F(f) of IFRS 7).

Illustrative text - Financial instruments - FAQ 3.2.3 – In the context of COVID-19 and ECL, what information is ‘reasonable and supportable’?

Publication date: 01 May 2020

Question

When estimating expected credit losses (‘ECL’), IFRS 9 references the requirement to use ‘reasonable and supportable information’ in both of the two key elements of the estimation:

  • staging (stage 1 versus stage 2 or 3) – the standard requires the use of reasonable and supportable information that is indicative of a significant increase in credit risk (‘SICR’) (IFRS 9 paras 5.5.4, 5.5.9 and 5.5.11); and
  • measurement – the standard requires the measurement of ECL to reflect reasonable and supportable information that is available at the reporting date about past events, current conditions and forecasts of future economic conditions. [IFRS 9 para 5.5.17].

In the context of COVID-19, what information is ‘reasonable and supportable’?

Solution

COVID-19 is a significant worldwide event that, by 31 March 2020, was having a significant negative economic impact. This information in itself should be considered ‘reasonable and supportable’ and so reflected in the estimation of ECL, albeit with a significant level of judgement, as at 31 March 2020 and later reporting dates1. It would therefore not be reasonable and supportable to disregard the effects of COVID-19 when estimating ECL at these reporting dates. This applies both when determining if there has been an SICR and when measuring the ECL.

In terms of more detailed considerations, in September 2015 the Transition Resource Group for Impairment of Financial Instruments (‘ITG’) considered a question relating to 'reasonable and supportable' information in the context of an emerging uncertain future event. That discussion provides helpful insight into factors to consider in the context of COVID-19 when assessing whether information should be excluded on the basis of it not being ‘reasonable and supportable’. These insights are summarised below in five key points for consideration, relating to:

  • judgement required;
  • second-order effects;
  • collective versus individual approaches;
  • low likelihood and uncertainty; and
  • disclosures.

NB: Paragraph references below in respect of the ITG are references to the published ‘Meeting Summary–16 September 2015’. All other paragraph references are to IFRS 9, unless stated otherwise.

1 Judgement required

In the context of an emerging uncertain event, there will likely be a range of forward-looking information that is available, some of which will be reasonable and supportable and some of which will not. Determining which information is reasonable and supportable, and its effects on the measurement of ECL, will require a high level of judgement. Whilst, as referenced in paragraph B5.5.51, entities are not required to undertake an exhaustive search for information, they do need to consider all of the information that is available to them and to form a judgement whether it is reasonable and supportable. The extent of corroboration that is available in respect of that information will be a factor in determining how supportable that information is. In particular, multiple sources indicating a similar trend will be indicative of reasonable and supportable information. 

Whilst the higher level of judgement required in assessing what information is reasonable and supportable in the context of COVID-19 makes this area difficult for entities, it is not impossible, and the need for judgement does not mean that there is no information that is reasonable and supportable. This is supported by paragraph 46 of the ITG summary, which states that “an entity should make an effort in good faith to estimate the impact of uncertain future events, including second-order effects, on the credit risk of financial instruments and the measurement of expected credit losses”.

It is therefore expected that there will be some forward-looking information related to COVID-19 that can, and should, be judged as reasonable and supportable and therefore included in the assessment of both staging/SICR and measurement of ECL. Practical examples might include credit rating agency downgrades and economists’ forecasts.

2 Second-order effects

When considering an uncertain future event, it might be helpful to break this down for ECL purposes into two elements: firstly, the uncertainty around the event itself; and, secondly, the cash flow consequences of that event (and thus the ECL) on a particular instrument if the event occurs (so-called ‘second-order effects’). Determining the second-order effects might pose particular challenges.

In considering what information is reasonable and supportable for measuring these second-order effects, paragraph 46(c) of the ITG summary states that “information does not necessarily need to flow through a statistical model or credit rating process in order to determine whether it is reasonable and supportable”. Paragraph B5.5.52 refers to ECL being “directionally consistent with changes in observable data … such as … unemployment rates, ...commodity prices”. Hence, currently available observable data around, for example, falling oil prices, falling stock market prices and increased unemployment data should be incorporated into ECL estimation as reasonable and supportable information, in measuring second-order effects, to the extent that it is relevant to the assets under consideration. In addition, the second-order effect of government support schemes should be incorporated when estimating economic impacts and resulting ECL if this information is reasonable and supportable, because to do otherwise would be excluding information that could introduce bias and would be contrary to the requirements of IFRS 9.

3 Collective versus individual approaches

Reasonable and supportable information might not always be available at an individual instrument level, and so it might be necessary for economic effects to be incorporated into ECL measurement through the use of overlays to a base model or on a collective basis. This is supported by paragraph B5.5.4 which notes that, where information is not available at an individual instrument level, ECL should be measured on a collective basis, considering ‘comprehensive credit risk information’ which incorporates ‘all relevant credit information, including forward-looking macroeconomic information’. As a result, an absence of granular information at an individual instrument level is not a reason to exclude the impact of relevant macroeconomic information from the estimation of ECL.

Within Example 5 of the Implementation Guidance to IFRS 9, paragraphs IE 38 and IE 39 (summarised and expanded on in FAQ 45.42.1) provide useful illustrations of applying collective approaches in the context of portfolios of loans. The FAQ illustrates the use of either a ‘bottom up’ or a ‘top down’ approach to applying a collective overlay to an existing model, depending on the extent of the information available.

As noted in paragraph 49 of the ITG summary, caution should be applied to avoid double counting of impacts. For example, if a rise in unemployment is expected as a result of COVID-19, before incorporating that impact as an overlay it must be ensured that there is no double counting of unemployment assumptions that might already be incorporated in the base model.

4 Low likelihood and uncertainty

A key requirement of IFRS 9 when measuring ECL is to reflect probability-weighted outcomes. Accordingly, paragraph 45 of the ITG summary states that “information should not be excluded from the assessment of expected credit losses simply because (a) the event has a low or remote likelihood of occurring or (b) the effect of that event on the credit risk or the amount of expected credit losses is uncertain”.

Paragraph 5.5.18 also requires an entity, when measuring ECL, to reflect the possibility of a loss occurring and the possibility of no loss occurring, even where the probability is very low. Therefore the probability of an event occurring being low is not sufficient for the event to be excluded from the ECL estimate as not ‘reasonable and supportable’. Similarly, where the impact of COVID-19 results in a significant range of possible outcomes, this does not mean that the information is not ‘reasonable and supportable’. Rather, this can be dealt with by assigning appropriate weightings to different scenarios that reflect that range.

5 Disclosures

Given the significant uncertainty about the impacts of COVID-19, high levels of judgement might be involved in assessing which information is reasonable and supportable and in using this information to measure second-order effects. As a result, in some instances, following an assessment of the information, it might not be possible to conclude that certain information is reasonable and supportable. However, where this is the case, it is important that entities make relevant disclosures so that users of the financial statements can understand the extent of limitations on the measurement of the ECL. Examples might include:

  • disclosing where an entity would ordinarily measure ECL at the individual instrument level but has applied a collective approach or an overlay, because ‘reasonable and supportable’ information was not available at the individual instrument level; or
  • disclosing where an entity has been unable to incorporate a particular risk or event into the assessment of SICR or the measurement of ECL, because no ‘reasonable and supportable' information was considered available.

1 For 2020 reporting dates earlier than 31 March, see FAQ 8.2.1.

Illustrative text - Financial instruments - FAQ 3.2.4 – Example of a provision matrix for corporates in a COVID-19 environment

Publication date: 23 Jun 2020

IFRS 9’s impairment model is an ‘expected credit loss’ (ECL) approach.

Given the complexity of implementing an expected loss model, IFRS 9 mandates a simplified approach for trade receivables without a significant financing component (and permits entities to use the same simplified approach for trade receivables with a significant financing component). Generally, normal trade receivables with terms of one year or less would not have a significant financing component. The simplification requires an entity to use lifetime ECL to measure its impairment provision against such receivables.

IFRS 9 allows a provision matrix to be used to determine the ECL for trade receivables. IFRS 9 is not prescriptive about how to develop a provision matrix. One approach is illustrated below. However, other approaches might also be appropriate, provided that they are consistent with the principles in IFRS 9. 

The impact of COVID-19 on the provision matrix approach is highlighted for each step in the boxes below.

COVID-19 impact – Overall
  • COVID-19 has had a significant impact on economies and has caused disruptions to many companies’ operations. The economic environment has changed dramatically, and the impact on ECLs cannot be ignored.
  • As a result, assumptions and simplifications used previously in provision matrices might no longer hold in a COVID-19 environment, and they might need to be revisited.
  • The key pre-COVID-19 assumptions that need to be revisited include the following:
    • groupings of receivables that share similar credit risk characteristics; and
    • the inclusion of forward-looking information into the loss rates and use of multiple scenarios.

How does a provision matrix work?

A provision matrix uses past data and forward-looking information to calculate the ECL. A provision matrix essentially applies an expected loss rate to every ageing category of receivables, including the current category. Illustrative Example 12 in IFRS 9 provides the following simple example:

 

Current

1–30 days past due

31–60 days past due

61–90 days past due

More than 90 days past due

Expected loss rate

0.3%

1.6%

3.6%

6.6%

10.6%



 

Gross carrying amount of receivable

Lifetime expected credit loss allowance (Gross carrying amount × lifetime expected credit loss rate)

Current & accrued unbilled receivables

CU15,000,000

CU45,000

1–30 days past due

CU7,500,000

CU120,000

31–60 days past due

CU4,000,000

CU144,000

61–90 days past due

CU2,500,000

CU165,000

More than 90 days past due

CU1,000,000

CU106,000

Total

CU30,000,000

CU580,000


ECL rates are developed for each ageing category, and they are applied to the outstanding balances to determine the ECLs and, ultimately, the ECL provision to be recognised.

It is important to note that each ageing category, including those receivables that are not past due, have an ECL rate. This is because, even for sales that have just occurred, there is a possibility that the debtor will not pay for credit reasons.

The term ‘expected’ is often used in everyday parlance to mean ‘more likely than not to occur’. However, in the context of ECL, ‘expected’ is used to refer to a probability-weighted amount calculated by multiplying various possible outcomes by the likelihood that each outcome will occur, and then adding up all of those values.

The outcome of the model looks very simple, but determining the ECL rate to apply often requires significant judgements to be made. We discuss some of the key considerations in establishing a provision matrix below, and we highlight the impact of COVID-19 on them.

What data and information are required to produce a provision matrix?

In its simplest form, a provision matrix requires history of past sales, the time from sale until payment receipt, and the amounts written off for the equivalent period.

COVID-19 impact – Data

IFRS 9 versus IFRS 15

Only those losses that are due to credit risk are within the scope of the ECL. This could include the losses from credit notes issued to debtors who do not have the ability to pay. 

Other pricing adjustments or concessions (for example, due to disputes / discounts / inefficiencies) are subject to guidance in IFRS 15, ‘Revenue from contracts with customers’. The guidance in IFRS 15 should be applied prior to determining the amount of the credit loss allowance under IFRS 9.

As a result of COVID-19, a company might expect to give customers a discount, because goods or services could not be completed in the manner that was initially agreed in the contract. Such discounts would not be considered credit losses, and so they should not be incorporated into the estimates of ECL, as discussed further in FAQ 3.2.5. However, the entity would need to determine how such estimated discounts impact the amount of revenue recognised for such contracts.

Internal versus external

Depending on the availability of internal data, management might have to supplement the internal data with external data and analysis to the extent necessary. For example, data regarding the impact of COVID-19 on the expected default rates of companies in particular industries or geographies might be available from credit rating agencies or other market information providers.


Step 1: Define the portfolio

  • Depending on the diversity of its customer base, the entity should use different provision matrices for different groups of receivables on the basis of shared credit risk characteristics. This would be the case if historical and/or forecast credit loss experience shows significantly different loss patterns for different customer segments. For example, receivables could be grouped by:
    • the relevant industry sector of the debtor;
    • the geographical location of the debtor;
    • whether the receivables are guaranteed or credit insured;
    • what, if any, government reliefs have been provided that affect the receivable;
    • whether payment terms have been extended in the light of COVID-19;
    • the nature of the receivable, which might affect whether the debtor will repay it only after settling other claims (such as salaries and rents, that are more essential to its continued operation); or
    • what, if any, actions have been taken to limit credit losses (for example, obtaining enhanced collateral).

COVID-19 impact – Groupings of trade receivables

  • It is important to understand the drivers of credit risk for the underlying receivables and how these might have been impacted by COVID-19. In some cases, the driver of credit risk might be geographic, while in others it might be based on the nature of the customer, the industry that it operates in, and/or the nature of the goods/services. In a complex business, there will likely be multiple matrices – for example, product A in region B being sold to customer type C.
  • For example, consider an entity that sells to large restaurant chains and grocery stores. Historically, the company might have found that the loss rates experienced in both customer bases were similar enough to justify a single provision matrix. However, the entity might now consider that restaurant chains which were closed due to social distancing were more significantly impacted by COVID-19 than grocery stores, which remained open during the pandemic. Accordingly, the entity might group the receivables from restaurants and grocery chains separately into different provision matrices.
  • The groupings should be done in a way that facilitates the incorporation of forward-looking information, since customers that historically had relatively consistent patterns of losses might no longer be expected to have similar loss patterns in the future.
  • The analysis might also need to go down to the individual customer level in some cases. For example, where a particular customer is known to be in financial difficulty as a result of COVID-19, it might require an increased provision compared to historical averages over all ageing categories. It is important to consider and avoid any double counting of losses, so a balance that is provided for specifically should not also be included in the wider general loss rate for that customer type.
  • The level of grouping required is often a matter of significant judgement and, in developing groupings, an entity should consider where further disaggregation would be expected to lead to material changes.

Step 2: Define the period of sales and bad debts related to those sales

For each group of receivables, the entity will have defined an historical period of sales and determined how much of the receivables in respect of those sales resulted in cash losses. The period of sales used should have been such that, pre-COVID-19, the historical losses arising were a valid representation of loss patterns. The most recent historical losses might be appropriate in the period soon after the pandemic had an impact, because the entity might not have a history of a period for which historical losses arising were a valid representation of loss patterns. Lockdowns, social distancing and widespread government relief programmes are measures that have, for the most part, not been seen before. Alternative starting points could be a previous recession, if it had (more) similar effects to COVID-19, and the entity has (or can obtain) data for receivables that are similar to its current receivables. However, in either case, as time passes and the entity has actual historical data in a COVID-19 environment, it might be more suitable to use that as the starting point.

Additionally, where the entity is a newly established one, or it is entering into a new market, it might not have had sufficient historical data of its own, in which case it might need to rely on external data such as industry loss ratios.

Therefore, in this FAQ, for illustrative purposes only, a period of one year, based on the most recent historical period, is used. Management has determined this to be appropriate as a starting point, prior to any adjustments for forward-looking information (considered in step 4 below). However, the period to be used in practice would depend on the facts and circumstances of each case. In that year, CU10,000 of sales were made on credit (that is, trade receivables recognised), and cash losses of CU300 were incurred in relation to those sales.

Step 3: Calculate the historical payment profile of the trade receivables

To determine the historical default rate for each time bucket of receivables, the payment profile for the receivables arising in the historical period of sales must be determined.

In this FAQ, of the total sales of CU10,000, customers paid CU2,000 within 30 days of the sale date. Therefore, CU8,000 of the sales were still outstanding after 30 days. Customers paid an additional CU3,500 within the next 30 days, resulting in CU4,500 sales that were not paid within 60 days. This analysis continues, as shown below, until ultimately the remaining unpaid receivables of CU300 are written off as losses by the entity:

Total sales (CU):

10,000

Total paid:

Ageing profile of sales (step 3):

Paid in 30 days:

(2,000)

(2,000)

8,000

Paid between 30 and 60 days:

(3,500)

(5,500)

4,500

Paid between 60 and 90 days:

(3,000)

(8,500)

1,500

Paid after 90 days:

(1,200)

(9,700)

300 [loss]



COVID-19 impact – Payment profiles

In light of COVID-19, another factor to consider is whether the historical ageing profile of sales should be adjusted to incorporate changes in expectations of delays in future payments. There could be general trends for some types of customer to pay later than in the past, and other information (such as customer requests/notifications and payment patterns to date) that indicates a change in the ageing profile of receivables. An adjustment would then be made to the historical payment profile.

An example of this is illustrated further in step 4 below.


Step 4: Calculate the historical loss rate

This step calculates the historical loss rate for each time bucket of receivables. From the CU10,000 sales made in the period, there were losses of CU300. Therefore, these CU300 of receivables are included within the amount outstanding in each of the time buckets (because the cash was never received), even though the amount outstanding reduces for each subsequent period. For each time bucket, the historical loss rate can be determined by dividing the ultimate loss (of CU300) by the amounts outstanding in that time bucket, as illustrated below:


Current sales

Payments outstanding after 30 days

Payments outstanding after 60 days

Payments outstanding after 90 days

Historical ageing profile of sales: [1]

CU10,000

CU8,000

CU4,500

CU1,500

Historical loss: [2]

CU300

CU300

CU300

CU300

Historical loss rate:
[2] / [1]

3%

3.75%

6.67%

20%

Step 5: Adjust the loss rate for current and forward-looking information

The historical loss rate should be adjusted to reflect current and forward-looking information that might affect the ability of customers to settle the receivables. Such information should be reasonable and supportable, and it should be available without undue cost or effort.

Consideration should be given to the impact of expected changes in the economic, regulatory and technological environment (such as industry outlook, GDP, employment and politics), and external market indicators.

When determining which forward-looking information to include, management should consider which forward-looking information most impacts each of the groupings determined in step 1. These could be general trends and changes in the economy, such as inflation/growth rates or unemployment rates. In addition, there could be further industry- or geography-specific indicators that might have a significant impact on loss levels. These indicators might differ for each group of receivables, depending on the factors considered in step 1.

One approach might be for an entity to look for historical correlation between macroeconomic factors (such as unemployment rates) and the loss rates experienced. If there is such a correlation, and that factor (that is, unemployment) is forecast to be higher or lower than the historical average over the period during which losses have been observed, an adjustment would then be made to the historical amounts (for example, expected higher unemployment might mean that the provision applied to current receivables needs to be increased).

IFRS 9 also requires companies to consider alternative scenarios, to develop a probability-weighted outcome. Therefore, in some cases, an entity might use scenario analysis, reflecting different possible future outcomes for the correlated variable(s), calculate the ECL for each scenario, and then probability-weight them to arrive at the ECL to be recognised in the financial statements. For example, different default rates could be weighted by base case, downside case and upside case for each time bucket. Alternative forward-looking scenarios would be particularly relevant for longer-dated receivables and for periods of greater uncertainty.

COVID-19 impact – Forward-looking information
  • Given the substantial uncertainties arising from COVID-19, determining how to quantify the impact of forward-looking information in a COVID-19 environment can be challenging and judgemental. There is no ‘one size fits all’ answer, and entities will need to consider the key drivers of credit risk for each grouping that was identified in step 1.
  • As a starting point, management might look to historical information, such as behaviour of customers during previous recessions, to establish economic data (such as GDP, unemployment rates) that correlates with losses. Any such data should be consistent with that used for other purposes (such as impairment of non-financial assets, recoverability of deferred tax assets or assessing going concern). Management might then use current forecasts of such data to estimate the effect of future economic conditions on the ECL. 
  • For example, consider an entity that sells to companies producing a particular commodity. In the past, a key driver of credit loss changes for the entity has been the commodity price. The entity might consider historical correlation of losses with changes in the commodity price. For example, a regression analysis using a long period of historical data might show that, for each CU0 decline in the commodity price which persists for three months, the loss rate increases by 1%. Assuming that forecast commodity prices have declined and that the decline is expected to persist for 12 months, management might use that historical information to develop its estimate of how its current receivables might be impacted.
  • Other receivables might have a different driver of credit risk. For example, an entity might be selling a product to individual homeowners. The key driver of credit risk for the resulting receivables might be unemployment rates. Accordingly, the entity might be able to develop a model to estimate the impact of expected unemployment rates on its current receivables. However, an additional overlay might be required for other factors, such as government assistance or similar reliefs provided to the homeowners (such as exceptional unemployment benefits and mortgage repayment holidays).
  • Sometimes, there might be insufficient historical data on the entity’s own receivables to develop a meaningful analysis. For example, a company selling to the restaurant industry might have no historical precedent for restaurants being closed due to a pandemic. In this case, further industry research might help. For example, what are industry analysts forecasting that the impact on restaurants will be, and are there any studies considering expected loss rates?
  • In establishing a link to economic data, further complexities might arise due to ‘lag’. Consider an electricity provider, for example. A rise in unemployment might not trigger an immediate increase in defaults, because customers prioritise paying electricity bills over other discretionary expenditures. The increase in unemployment might only trigger a rise in loss rates if, for example, it is sustained for a six-month period. This ‘lag’ is another variable to consider in historical analysis with economic variables.
  • Entities will need to use their best efforts to understand what is the most meaningful forward-looking information to incorporate into the analysis and how a reasonable estimate of the impact can be made. As noted above, to the extent that management is not able to fully reflect the impact of COVID-19 in its models, additional adjustments (or ‘overlays’) will need to be considered.

After taking into account this forward-looking information, the expected loss rates are recalculated. In this FAQ, it is assumed that, based on an analysis as set out above, management determines that this expected loss rate is CU400. This CU400 amount includes forward-looking information that reflects COVID-19. 

Additionally, this FAQ assumes that, based on customer requests/notifications and payment patterns to date, payments for 10% of sales are expected to be delayed by a further 30–60 days. The historical payments for 10% of sales are therefore also moved from the current bucket to later time buckets. These are shown in the table below as expected payments (see the COVID-19 box for step 3 above).

Total sales (CU):

10,000

Total paid:

Ageing profile of sales (step 3):

Expected to be paid in 30 days:

(1,000)

(1,000)

9,000

Expected to be paid between 30 and 60 days:

(4,000)

(5,000)

5,000

Expected to be paid between 60 and 90 days:

(3,200)

(8,200)

1,800

Expected to be paid after 90 days, and expected loss:

(1,400)

(9,600)

400 [Loss]

The expected loss is then applied to the expected ageing profile calculated above, to determine the expected loss rate. Please note that the expected loss of CU400 has been applied across all of the time buckets, because it is assumed that this average CU400 is representative of the losses expected in each and every time bucket. Adjustments would have to be considered if that were not the case.


Current sales

Payments outstanding after 30 days

Payments outstanding after 60 days

Payments outstanding after 90 days

Expected ageing profile of sales: [1]

CU10,000

CU9,000

CU5,000

CU1,800

Expected loss: [2]

CU400

CU400

CU400

CU400

Expected loss rate:
[2] / [1]

4.00%

4.44%

8.00%

22.22%

Step 6: Calculate the ECL using the expected loss rates

The final step is to apply the expected loss rates to the ageing profile of the receivables at the reporting date to determine the total ECL, as illustrated below. The illustration assumes that the ageing used does not yet reflect the migration between buckets triggered by COVID-19. If the ageing were already reflective of that migration, one would have to ensure that there is no double counting, since (as illustrated in step 5) the historical ageing was adjusted to reflect expectations of migration between ageing categories.


Total receivables

Current

30–60 days

60–90 days

After 90 days

Trade receivable balances at reporting date: [1]

CU140

CU50

CU40

CU30

CU20

Expected loss rate: [2]

 

4%

4.44%

8.00%

22.22%

Expected credit loss:
[1] × [2]

CU10.6

CU2

CU1.8

CU2.4

CU4.4

The above process would be repeated for each separate grouping of receivables, or for large individual customers.

Disclosures

For entities applying the provision matrix approach, IFRS 7 allows the disclosures about credit risk-rating grades to be based on provision matrix data. However, both this and the other disclosures required by IFRS 7 should not be ‘boilerplate’, but they should tell the story of how the impacts of COVID-19 have been incorporated.

COVID-19 impact – Disclosures

Areas to focus on as a result of COVID-19:

  • how COVID-19 has been reflected in the inputs and assumptions used to measure ECL (including forward-looking information and any additional adjustments or ‘overlays’);
  • credit risk concentrations and whether these are sufficiently granular, taking into account the different effects of COVID-19 on different receivables;
  • the carrying amount of receivables that are credit impaired at the reporting date (such as receivables from debtors that are in significant financial difficulty, or receivables that are more than 90 days past due);
  • credit risk management practices and how these have changed due to COVID-19 (including payment holidays, extended payment terms or other reliefs granted to affected borrowers); and
  • critical estimate disclosures. These could include disclosures about forward-looking information, how receivables have been grouped, or the determination of credit adjustments versus price concessions.

Illustrative text - Financial instruments - FAQ 3.2.5 – Impact of price concessions on expected credit losses of trade receivables

Publication date: 23 Jun 2020

Question

As a result of COVID-19, an entity might provide price concessions to its customers on goods or services for which revenue within the scope of IFRS 15 had previously been recognised. How do such price concessions impact provisions for expected credit losses (ECLs) required by IFRS 9?

Solution

Only those losses that are due to credit risk are within the scope of the IFRS 9 ECL provision. Pricing adjustments or concessions – where the resulting loss relates to factors such as customer disputes, inefficiencies by the entity or sales incentives in difficult trading conditions, rather than being credit losses related to the debtor’s credit risk – are subject to guidance in IFRS 15, which needs to be applied prior to IFRS 9. Conversely, losses from credit notes issued to debtors who do not have the ability to pay are included in the measurement of ECL. 

For example, as a result of COVID-19, an entity might have given customers a discount on goods or services that could not be completed in the manner or timing that was initially agreed in the contract. Such discounts would not be considered a credit loss, and so they should not be incorporated into forward-looking estimates of ECL. The entity needs to consider these discounts when measuring the amount of revenue recognised for such contracts.

The discounts measured under IFRS 15 will directly impact the ‘revenue’ line in the income statement. The IFRS 9 ECL provision, on the other hand, will be presented in an expense line such as ‘provision for bad debts’ and will not impact the amount of revenue recognised.

Additionally, where loss rates are used as a basis for estimating the IFRS 9 ECL provision, these may be indirectly impacted by changes to contract prices.

For example, consider an entity that had recorded revenue and a related receivable of CU1,000 for the rendering of a service. The entity determines that the required provision for lifetime ECL is 2% of the receivable and, accordingly, at the end of the period in which the revenue was recognised, it had recognised a provision for CU20. In the next period, the entity voluntarily agrees to grant a discount of CU100 due to quality issues with the service, as a result of COVID-19, which had not been anticipated in the period in which the revenue had initially been recognised. The retrospective price discount will result in a CU100 reduction to revenue in the period in which the discount is recognised in accordance with IFRS 15. After the reduction in revenue, the carrying amount of the account receivable is CU900, and the required ECL provision is CU18 (assuming that the ECL rate applied remains at 2% for illustration purposes). Accordingly, the impact is a reduction of revenue of CU100 and a reversal of the ECL provision of CU2.

The impact of such concessions on the data used to develop loss rates to be applied to other similar receivables in a provision matrix should also be considered, as discussed in FAQ 3.2.4.

Distinguishing between a price concession and the entity’s exposure to the customer’s credit risk might require judgement, particularly where the concession is given to a client with poor credit risk. Where there are significant judgements or estimates related to the accounting for price concessions, entities should consider the disclosure requirements required for significant accounting judgements and estimates in IFRS 15 and IAS 1. An entity should also consider the more general disclosure requirements within IFRS 15 related to price concessions granted.

Illustrative text - Financial instruments - FAQ 3.2.6 – Cash collateral held for trade receivables or lease receivables: recognition and impact on measurement of ECL

Publication date: 24 Jun 2020

Question

As a result of the impact of COVID-19, suppliers might require customers to provide cash collateral before goods or services are provided. The cash collateral might be held indefinitely by the supplier and only returned once the customer no longer procures goods or services from them. Similarly, some lessors might require lessees to provide cash collateral that is only returned after the lease term has ended. This FAQ assumes that management has determined that the cash collateral does not represent a pre-payment for goods or services or lease rentals.

How should the supplier or lessor recognise such cash collateral, and how should it reflect the collateral when measuring the expected credit loss (‘ECL’) for trade or lease receivables?

Solution

[NB The solution below focuses on trade receivables, but the same principles apply to cash collateral on lease receivables, except where stated.]

Management should first consider whether the cash collateral results in derecognition of any trade receivable balances in accordance with paragraph 3.2.3 of IFRS 9, or whether it should be offset against them in accordance with paragraph 42 of IAS 32. In most cases, it is unlikely that the receipt of cash collateral would result in settlement of the trade receivables and hence in their derecognition. The offsetting criteria are also unlikely to be met, since there is generally no intention to settle net (and some of the other conditions for offsetting might also not be met). This is because the collateral would generally remain with the supplier for future procurement of goods and services, rather than being used to settle specific trade receivables. As such, cash collateral should be recognised as a financial liability to the customer when it is received.

When determining the ECL of trade receivables, cash collateral would be considered a credit enhancement in terms of paragraph B5.5.55 of IFRS 9, since the collateral will reduce the amount of loss in the event that the debtor defaults. As such, the collateral will be reflected in the measurement of the ECL. However, the collateral does not affect whether a significant increase in credit risk has occurred (for receivables not measured using the simplified approach), nor whether a receivable is credit-impaired (when giving the disclosures required by para 35M of IFRS 7). [IFRS 9 App B para B5.5.12]. 

For entities that use a provisions matrix in calculating the ECL on trade receivables, the cash collateral might have the following impacts:

  • Grouping of trade receivable balances: It is unlikely that customers providing cash collateral and those not providing cash collateral will be similar in nature and have similar credit risk. As such, it would be expected that trade receivables that are subject to cash collateral would be grouped and analysed separately from trade receivables that are not.
  • Calculating the loss rate: In determining appropriate loss rates, the cash collateral would reduce the loss on a default, and so it should be considered. 

The following disclosures should be provided in accordance with IFRS 7:

  • the effect of collateral on the amounts arising from ECLs (para 35K of IFRS 7); and
  • where there is a legal right to offset the collateral against trade receivables, the offsetting disclosures in paragraphs 13A–13E of IFRS 7. Please note that these disclosures apply regardless of whether, on the balance sheet, the collateral is offset against the trade receivables where they are subject to a master netting arrangement or similar agreement.

The considerations above for recognition, ECL and disclosures would apply equally to cash collateral held for lease receivables. However, whilst lessors are required to provide quantitative information about collateral held, they are not required to provide a narrative description of such collateral. [IFRS 7 para 35A].

Illustrative text - Financial instruments - FAQ 3.2.7 - To what extent should additional COVID-19 related information after the reporting date be included in the ECL estimate?

Publication date: 30 Jun 2020

Question:

IAS 10 requires an entity to evaluate information available after the reporting date to determine if such information constitutes an adjusting event which provides evidence of conditions that existed at the end of the reporting period, for which an entity shall adjust the amounts recognised in the financial statements . A non-adjusting event, which is indicative of conditions that arose after the reporting period, only requires disclosure.

To what extent should COVID-19 related events after the reporting date, but before the financial statements are authorised for issue, be incorporated into the determination of IFRS 9 ECL provisions?

Solution:   

Paragraph 5.5.17 of IFRS 9 requires ECL to be measured in a way that reflects information available at the reporting date about past events, current conditions and forecasts of future economic conditions. However, the example given in paragraph 9(b)(i) of IAS 10 demonstrates that additional information that becomes available to management after the reporting date should be taken into account in ECL, if it reflects conditions that existed at the reporting date.  The example given in IAS 10 is of the bankruptcy of a customer that occurs after the reporting period, confirming that the customer was credit-impaired at the end of the reporting period. In this way, ECL is treated differently to the assessment of fair value for the purposes of IAS 10, as the receipt of such information after the reporting date, which could not have been known by a market participant at the reporting date, would not be an adjusting event for a fair value estimate (refer to FAQ 8.2.3).

The application of IAS 10 to IFRS 9 ECL is also made more complex by IFRS 9’s specific requirement to determine ECL by evaluating a range of possible outcomes. Consequently, in the specific context of ECL, post reporting date events can fall into 3 categories:

#

Category

Example fact pattern and analysis for ECL

1

Information that becomes available after the reporting date that clearly relates to circumstances or events before or at the reporting date.  This is an adjusting event for the purposes of IAS 10.

The reporting date is 30 June 2020. On 2 July 2020 the unemployment data for May 2020 is published and is significantly worse than expected in the base case scenario.

This gives evidence about conditions at the reporting date and so should be incorporated into an entity’s assessment of ECL at 30 June as an adjusting event.

2

Information that becomes available after the reporting date that clearly relates to circumstances or events after the reporting date and which could not reasonably have been anticipated at the reporting date.  This is not an adjusting event for the purposes of IAS 10, nor does it indicate reasonable and supportable information available at the reporting date which should have been reflected in the ECL estimate under IFRS 9.

The reporting date is 31 December 2019. Rapidly increasing cases of COVID-19 occurred during early 2020, with increasing adverse economic impacts. The situation at 31 December 2019 was that a limited number of cases of an unknown virus had been reported to the World Health Organisation. There was no explicit evidence of human-to-human transmission at that date.

This does not give evidence about conditions at the reporting date and so is a non-adjusting event. Neither does this indicate there was reasonable and supportable information available at 31 December 2019 which should have been reflected in the ECL estimate.

3

Information that becomes available after the reporting date that clearly relates to circumstances or events after the reporting date, but which might have been anticipated as a possible scenario at the reporting date.

Consideration should be given as to whether the event provides greater insight as to the reasonable and supportable information at the reporting date and the range of possible scenarios and probability weightings to be reflected in ECL at that date. If so, this might justify refinements to scenarios and / or weightings at the reporting date, but a 100% weighting should not be given to a particular scenario where there was genuine uncertainty at the reporting date.

The reporting date is 30 June 2020. On 21 July 2020, the government announced a relaxation of ‘lockdown’ to allow some ‘non-essential’ sectors to reopen for business. At 30 June, there were reports that the government would review the lockdown in three weeks time but the outcome was uncertain.  

The government relaxation of ‘lockdown’ does not give evidence of a condition at the reporting date.  However, it does give greater insight into the possible future outcomes beyond the reporting date. The entity should therefore consider whether there was reasonable and supportable information at the reporting date indicating such a scenario was possible.  If so, the entity should consider whether such a development had already been appropriately factored into the scenarios selected and their weightings at the reporting date, and if not then make a suitable adjustment.

Determining whether, and to what extent, information and events after the reporting date reflect information available and circumstances that existed at the reporting date and/or information about expected future scenarios at the reporting date may be judgmental. This may be especially so in the context of COVID-19, due to the fast-pace of events and the potentially high degree of uncertainty over future outcomes. 

In making this assessment of the impact (if any) on ECL, the following considerations will be often be relevant:

  • Significance and impact assessment: Entities should focus on significant post reporting date events and should assess whether these might have a material impact on the estimation of ECL. When assessing if a post reporting date event might have a material impact on ECL, potential indirect or ‘second order’ effects should be considered as well as the direct impact.  For example, whilst worse than expected unemployment figures would be an adverse development, the effect on ECL might be dampened if additional government action would also be expected in response to that worsening trend.  Similarly, there may be a number of post reporting date events that should be looked at in aggregate, not just individually.
  • Whether the outcome was contemplated: When a significant post reporting date event occurs, it will likely be necessary to exercise judgement in determining whether scenarios and weightings at the reporting date were determined with that type of possible outcome in mind, and whether an adjustment is appropriate. This is particularly so when scenarios and weightings are initially selected without a detailed list drawn up of possible future outcomes for which each chosen scenario is considered representative of.
  • Resolution  of uncertainty vs new information: In the context of COVID-19 and the already high degree of uncertainty over future outcomes, in many cases post reporting date events will simply confirm the existence of that uncertainty at the reporting date, rather than indicate that the overall direction of possible future outcomes was materially different to what was originally estimated at the reporting date. In such circumstances adjustment to the reporting date ECL would not generally be needed. 

Illustrative examples

Below are some illustrative examples of possible post reporting date events for a bank with a 30 June 2020 reporting date (i.e. after COVID-19 was declared a pandemic), along with an illustrative analysis of considerations when assessing ECL at that date.

The list is not exhaustive, judgement is required. If individual facts and circumstances are different to those assumed in the illustrative examples and analyses below, then the relevant factors to consider and conclusions reached could also differ.  

 

Post reporting date event

Illustrative analysis

1

On 3 July 2020 the bank regulator announced that banks will be required to grant payment holidays on credit cards, adding to the payment holidays already offered to retail customers on mortgages. Other jurisdictions similarly affected by the pandemic have similar schemes for credit card holders.

Given the fast pace of developments it cannot be assumed that this decision had already been taken at 30 June and that it gives evidence of a condition at that date. However, it does give greater insight into the possible future outcomes beyond the reporting date. Given the pre-30 June policy of providing support that had already resulted in the mortgage payment holidays, and other similar schemes for credit cards in other jurisdictions, there was reasonable and supportable information available at 30 June to demonstrate such a future development could reasonably happen. The bank therefore considers whether such a development had already been appropriately factored into the scenarios selected and their weightings, and if not then would make a suitable adjustment.

This is an example of a ‘category 3’ event.

 (NB. Accounting for the modifications due to the payment holidays on credit cards - as distinct from any ECL impact - will be a non-adjusting event that is only accounted for at the time the modification actually happens. See FAQ 3.2.1 regarding the implications of payment holidays for ECL.)

2

On 5 July 2020 the bank starts to modify contracts with customers to give payment holidays, but this is only putting into effect what was communicated to the bank as a requirement by the government prior to 30 June where requested by customers.

This post reporting date information is confirming the position at the reporting date (for example. it is not providing new information) and the expected implications of the known government policy at the reporting date should be factored into ECL assessments as an adjusting event, similar to a ‘category 1’ event. . 

(NB. Accounting for any amortised cost remeasurements or modifications due to the payment holidays - as distinct from any ECL impact - would need to be considered separately for the purposes of IAS 10. See FAQ 3.2.1 regarding the implications of payment holidays for ECL and FAQs 3.1.2 & 3.1.3 regarding other possible measurement implications.)

3

On 10 July 2020 the government announced a new COVID-19 support scheme for a sector of the economy that had not previously benefited from support (for example, government grants to enable employers to continue paying furloughed staff). At 30 June there were indications that the sector was in financial distress, which the anticipated continuing lockdown would exacerbate further. However, due to the fast pace of developments, the government had not made the decision to support the sector by 30 June.

The government’s announcement of the support scheme does not give evidence this was a certainty at the reporting date. However, it does give greater insight into the possible future outcomes beyond the reporting date in respect of a sector experiencing financial distress under the lockdown. The entity considers government policy at the reporting date. It notes that the government has previously supported other similar sectors in similar difficulties. The entity therefore determines that there was reasonable and supportable information available at 30 June to demonstrate such a future development could reasonably happen. The entity considers whether such a development had already been appropriately factored into the scenarios selected and their weightings at the reporting date, and if not it makes a suitable adjustment. This is an example of a ‘category 3’ event. 

However, if the government policy is ‘out of the blue’ and not reasonably considered possible at the reporting date, the entity may judge that it should not be factored into the ECL assessment at the reporting date. Such a scenario would be a ‘category 2’ event.

4

On 20 July 2020 a major commercial borrower entered bankruptcy / administration.

This is similar to the example in IAS 10 para 9 of the bankruptcy of a customer that occurs after the reporting period usually confirming that the customer was credit-impaired at the end of the reporting period. Similarly, this post reporting date event indicates that the customer was credit-impaired at the reporting date and that the event is a ‘category 1’ adjusting event, unless there was a major event between 1-20 July that triggered a significant deterioration.  The bank may also need to consider any implications for other borrowers in similar industries or circumstances at the reporting date.

5

On 21 July 2020 a major borrower pays their outstanding period-end balance in full in cash.

Subsequent settlement of the balance only confirms one of the possible future outcomes at the reporting date, i.e. payment.  But non-payment was also a possible outcome, as a result of conditions existing at the reporting date or possible events after the reporting date. So this does not confirm a condition at the reporting date and is not an adjusting event. The ECL estimate should therefore not be set to nil.  This is an example of a ‘category 3’ event. However in practice ECL might be negligible in such circumstances.

6

On 23 July 2020 a pharmaceutical company announced it has successfully completed trials of a vaccine for COVID-19 and obtained accelerated regulatory approval such that the vaccine will now go into global production.

There was information available at 30 June that pharmaceutical companies were completing trials and might soon obtain accelerated regulatory approval of a vaccine.

The bank considers whether its forecast macroeconomic scenarios and the weightings as at 30 June appropriately reflected the possibility of this outcome. This is an example of a ‘category 3’ event.

7

On 30 July 2020 the total number of mortgage payment holidays granted post-30 June 2020 reaches 50,000 and shows only initial signs of slowing, continuing the trend seen prior to 30 June.

The bank determines that the number of mortgage payment holidays granted post reporting date confirms the trend seen before 30 June, and that this is already reflected in its period end estimate of ECL. Accordingly no further adjustment to ECL  is needed. This is an example of a ‘category 3’ event.

Illustrative text - Financial instruments - FAQ 3.2.8 – Aligning the definition of default: Regulatory versus Accounting

Publication date: 07 Jul 2020

Background

The definition of default is a key element in the IFRS 9 ECL impairment model , in particular for banks, as:

  1. IFRS 9 requires entities to assess ‘significant increase in credit risk’ using the change of the risk of default occurring over the expected life of the financial instrument. Therefore, the definition of default (‘DoD’) impacts the amount of assets for which lifetime ECL is recognised rather than 12-month ECL;
  2. Generally, banks seek to maximise alignment of the DoD with the definition of credit-impaired; accordingly, assets that meet the definition of default are moved to stage 3; and
  3. The DoD is an input for the calculation of credit risk parameters typically used by banks in the estimation of ECL: probability of default (PD), loss given default (LGD) and exposure at default (EAD).

The definition of default is also typically a key element for banks’ regulatory reporting, and in many territories, the banking regulator has specific requirements for the definition of default. These requirements typically include use of a ‘days past due’ count and ‘Unlikeliness To Pay’ (or ‘UTP’) criteria. In contrast, IFRS 9 lacks operational guidance to define a default, so banks generally try to the extent possible to align the DoD used for IFRS 9 with the DoD used for regulatory purposes. This is also consistent with the requirement of paragraph B5.5.37 of IFRS 9 to apply a default definition that is consistent with the definition used for internal credit risk management purposes and with the Basel Committee recommendation that the definition of default adopted for accounting purposes be guided by the definition used for regulatory purposes[1]. 

NB This FAQ does not address other possible issues arising from interconnections between the IFRS 9 impairment model and regulatory requirements on credit risk, such as the reconciliation of IFRS 9 and regulatory PDs (see FAQs 45.30.1 and 45.30.2), modifications of assets vs regulatory forbearance (see FAQ 45.79.1) and the accounting treatment applied to a change in the DoD (see FAQ 45.24.6).

Question

Should a bank automatically align the definition of default it uses for the purposes of IFRS 9 ECL with the definition used for regulatory reporting purposes, as defined by its banking regulator (the ‘regulator’), when the regulatory DoD changes?

Solution

No. Regulatory requirements are separate from accounting requirements, in part  as they do not have the same objectives. The objective of IFRS 9 ECL is to reflect an unbiased estimate of expected credit losses. Regulatory requirements may consider other objectives which are inconsistent with IFRS 9, such as levels of prudence or harmonisation between banks in the same zone. Therefore, the alignment between the regulatory DoD and the IFRS 9 DoD should not be automatic. In particular, when the regulator changes its DoD, the same change should only be made to the IFRS 9 DoD where, as required by paragraph B5.5.37 of IFRS 9, information becomes available that demonstrates that changed default definition is more appropriate for the particular financial instrument. Significant unexpected events, such as COVID-19, might also prompt such changes by regulators, for example to update ‘Unlikeliness To Pay’ criteria for unexpected events that could not have been reasonably foreseen.

Therefore, where a bank wishes to align the definition of default it uses for the purposes of IFRS 9 ECL with the definition used for regulatory reporting purposes, it should first analyse the regulatory requirements to ensure their consistency with the requirements of IFRS 9.  Set out below are some examples of possible factors to consider when performing this analysis:

Materiality thresholds for exposures more than 90 days past due (‘dpd’): Under IFRS 9, there is a rebuttable presumption that an exposure that is more than 90 dpd is in default. The regulator may define materiality thresholds so that even when an exposure is more than 90 dpd, it will not be considered as defaulted if the past due amount is below a defined threshold. A bank would need to justify such a rebuttal under paragraph B5.5.37 of IFRS 9 using reasonable and supportable information to demonstrate that this more lagging default criterion is more appropriate. Therefore, the regulatory requirement should not be included in the IFRS 9 DoD unless the bank has reasonable and supportable information allowing it to rebut the 90 dpd presumption. This consideration may be particularly relevant to ‘micro’ lenders advancing individually small amounts or to banks operating in low interest rate environments where a small amount could still be the substantial portion of an amount due.

Criteria to exit from default status or ‘probation period’: The regulator’s requirements for the definition of default may contain probation periods, i.e. a minimum period required before a defaulted asset can exit from being treated as defaulted. Those regulatory probation periods may not be consistent with how a bank manages credit risk or with its historic default data. Therefore, the inclusion of any such probation periods in the IFRS 9 DoD should be justified as being more appropriate using available information, as required by paragraph B5.5.37 of IFRS.

Changes due to COVID-19: The information required by paragraph B5.5.37 of IFRS 9 demonstrating that a changed definition of default is more appropriate would normally be expected to include actual historical experience. In the context of COVID-19 and the occurrence of circumstances not previously considered relevant to the DoD, management might appropriately judge that a changed definition is more appropriate without having to wait for historic experience to be accumulated.  However, this would only be the case where there is appropriate alternative information that demonstrates the changed definition is more appropriate and where the change is consistent with the broader principles of IFRS 9. In particular, it would not be appropriate to make a change to the DoD that would introduce bias into the ECL estimate, for example by inappropriately reducing the number of defaulted exposures.

Consistency of DoD: IFRS 9 does not contemplate the use of more than one DoD for a particular financial instrument.  Use of multiple DoD’s in the estimation of ECL (for example, using one DoD in calculating PD but another DoD in calculating LGD and EAD) could also introduce bias into the ECL estimate that would conflict with the requirement of paragraph 5.5.17(a) of IFRS 9. Therefore, where it is concluded that it is appropriate to update the IFRS 9 DoD to align with a changed regulatory DoD, that change should be made consistently to the DoD used in all parts of the IFRS 9 ECL estimate.

Is the regulatory DoD used in credit risk management: Paragraph B5.5.37 of IFRS 9 requires entities to apply a DoD that is consistent with the definition used for internal credit risk management. The DoD used for internal credit risk management will generally correspond to the DoD set up by the regulator. But, in rare cases, the regulatory DoD may be inconsistent with the risk management policy of the bank. This may be the case if the regulator introduces a level of prudence in the DoD which does not reflect how the bank manages its credit risk. In that case, which would typically be rare, the regulatory DoD should not be used for the purposes of IFRS 9 ECL without suitable adjustment if the impact would otherwise be material.

[1] Basel Committee on Banking Supervision – Guidance on credit Risk and accounting for expected credit losses

Illustrative text - Financial instruments - FAQ 3.2.9 - Possible revisions to ECL estimates required in a downturn

Publication date: 28 Jul 2020

Question

Where an entity is in a downturn scenario, customer behaviour might change, and this might require an entity to revise its future estimated cash flows for loans and other instruments measured using the amortised cost model. These changes might arise, for example, from changed expectations of customer use of prepayment or extension options. For the purposes of amortised cost measurement, this is discussed further in FAQ 3.2.10 ‘How should an entity account for changes to the cash flows on a debt instrument measured at amortised cost or fair value through other comprehensive income (FVOCI)?’

For the separate purpose of estimated credit loss (ECL) estimation, what other examples are there of similar revisions that might be necessary in a downturn scenario, as well as related guidance?

Answer

Revisions to all elements of the ECL estimation might be necessary, depending on the facts and circumstances and the ECL methodology adopted. Whilst not exhaustive, set out below are examples of possible revisions that might be needed to the probability of default (PD), the loss given default (LGD), the period of exposure and thus the exposure at default (EAD), and the effective interest rate (EIR) used to discount ECL. References to related guidance are also provided.

  • Impact of prepayment rates on the probability of default (‘PD’)

See FAQ 3.2.11 – Impact of prepayments on lifetime probability of default for SICR assessments, which considers whether a change in prepayment expectations should be incorporated into the assessment of the change in lifetime PD, and it provides a policy choice. Where a policy of incorporating prepayment expectations into PDs has been adopted, historical prepayment rates inherent in historical default data might no longer be representative of future customer behaviour. Judgement will therefore be required to determine how these historical prepayment expectations should be changed and the consequent effect on estimated PDs.

  • Impact of work-out strategy on loss given default (LGD)

See FAQ 3.2.12 – Inclusion of cash flows expected from the sale on default of a loan in the measurement of expected credit losses (ECL), which explains the need to consider both past practice and future expectations, which might differ from past practice, in determining an entity’s expected use of loan sales as a recovery method in a default scenario. In a downturn scenario, past practice in this area might be less relevant, particularly where the market for loan sales has changed or where management anticipates adopting different strategies. Where there has been, or is expected to be, a change, this might require a revision to estimated future cash flows (for example, within the LGD).

  • Impact of prepayment options on expected life

See FAQ 3.2.13 – Should borrower pre-payment options be taken into account when determining the period over which to measure expected credit losses (ECL)? which considers the impact that prepayment, extension, call and similar options might have in determining the expected life of a financial instrument, and subsequently the period over which to measure ECL. During a downturn, changed customer behaviour might result in changes to the likelihood and timing of such options being exercised. Any such changes should be taken into account when determining the period over which to measure ECL.

  • Impact on discount rates used when measuring ECL (EIR)

See FAQ 3.2.14 – What discount rate should be used when measuring ECL for credit cards and other similar products? which considers complexities that might arise when determining the EIR for credit cards and other similar products. In a downturn scenario, revisions might be required to the customer segmentation for the purposes of calculating the EIR. Furthermore, historical customer profiles might no longer be appropriate for new customers, given the changed market circumstances.

Where revisions are made for the purposes of ECL estimation, any impact on estimated contractual cash flows should also be considered as part of the amortised cost measurement.

In addition, where changes are made to estimation techniques or significant assumptions, disclosure should be provided in line with paragraph 35G(c) of IFRS 7. If this gives rise to a significant accounting judgement or a critical accounting estimate, additional disclosures should be provided in line with paragraphs 122 and 125 of IAS 1 respectively.

Illustrative text - Financial instruments - FAQ 3.2.10 – How should an entity account for changes to the cash flows on a debt instrument measured at amortised cost or fair value through other comprehensive income (FVOCI)?

Publication date: 28 Jul 2020

The guidance below addresses the accounting for changes to the cash flows of a debt instrument measured at amortised cost or FVOCI. In certain situations, a financial liability accounted for at amortised cost by the issuer might be accounted for at fair value through profit or loss by the holder. In those scenarios, the guidance below only applies to the issuer.

The cash flows of a financial instrument can change for several different reasons. IFRS 9 provides guidance in paragraphs B5.4.5 (floating-rate instruments/components), B5.4.6 (other instruments/components) and 5.4.3 (modifications) on how to treat changes in cash flows, depending on the nature of the change. The flow chart below can be used to determine which of IFRS 9’s requirements apply.

3_2_10


Note 1 – For loans that are pre-payable at par (or with only an insignificant amount of compensation), careful analysis might be required to determine the substance of a change in cash flows – see the last paragraph of Section 1 for further guidance.

Section 1 – When does a change in cash flows that arises under the terms of a contract fall within paragraph B5.4.5 of IFRS 9 (floating-rate instruments/components)?

Paragraph B5.4.5 of IFRS 9 states that “For floating-rate assets and floating-rate liabilities, periodic re-estimation of cash flows to reflect the movements in the market rates of interest alters the effective interest rate. If a floating-rate financial asset or a floating-rate financial liability is recognised initially at an amount equal to the principal receivable or payable on maturity, re-estimating the future interest payments normally has no significant effect on the carrying amount of the asset or the liability”.

It follows that paragraph B5.4.5 applies to ‘floating-rate’ financial assets and liabilities. A floating-rate instrument is one whose original contractual terms contain a provision such that the cash flows will (or might) be reset to reflect movements in market rates of interest.

Market rates of interest comprise different components, typically: the time value of money as represented by a benchmark rate (such as LIBOR); credit and other spreads; and a profit margin. So, if the contract provides for the cash flows of an instrument to be reset to reflect changes in any or all of these components, paragraph B5.4.5 of IFRS 9 applies to those changes. Examples are: a change in the benchmark rate (such as LIBOR) for a loan whose stated interest rate is LIBOR + 2%; a ‘ratchet loan’ whose credit spread is reset to reflect changes in the credit risk of the borrower; and a loan with a cross-selling clause whose profit margin is adjusted if other loans are taken out by the same borrower.

The frequency of reset, and whether the timing of the reset is in the control of one or other party or at pre-specified intervals/events, does not affect whether paragraph B5.4.5 applies. So a loan whose initial interest rate is first reset after a long specified period (for example, two years), and then resets more frequently (for example, monthly), falls within paragraph B5.4.5, provided that, each time the rate is reset, the rate charged until the next reset date is a market rate for that period. Similarly, loans whose rate is reset at the discretion of the lender, such as credit cards or loans whose stated rate is the lender’s base rate or standard variable rate, fall within paragraph B5.4.5, provided that the rate reflects the time value of money and credit risk of the instrument.

Most commonly, the reset feature in the contract is expressed as a repricing of the coupon. It would be acceptable to apply paragraph B5.4.5 to other contractual terms that have the same effect. An example is a fixed-rate loan pre-payable by the borrower at par (or with only an insignificant amount of compensation) at any time, where the effect of this feature enables the borrower to have the lender agree to reset the cash flows to the then market rate.

For the application of paragraphs B5.4.5 and B5.4.6 to inflation-linked bonds.

Section 2 – When does a change in cash flows that arises under the terms of a contract fall within paragraph B5.4.6 of IFRS 9 (other instruments/components)?

For financial instruments that are not floating-rate financial assets or liabilities subject to paragraph B5.4.5 of IFRS 9 (see Section 1), the requirements in paragraph B5.4.6 apply to changes in the actual or expected cash flows under the original contractual terms. Paragraph B5.4.6 of IFRS 9 states that “The entity recalculates the gross carrying amount of the financial asset or amortised cost of the financial liability as the present value of the estimated future contractual cash flows that are discounted at the financial instrument’s original effective interest rate … The adjustment is recognised in profit or loss as income or expense”.

It follows that paragraph B5.4.6 applies in cases where the contract provides for the cash flows to be reset but the amount of the reset does not reflect movements in market rates of interest. Examples are a profit-participating loan (whose coupon varies with the net profits of the borrower), and a bail-in bond (whose contractual payments are reduced when the borrower breaches a specified regulatory capital ratio).

Section 3 – Modifications of financial assets and liabilities

Paragraph 5.4.3 of IFRS 9 applies to renegotiations and other modifications of the terms of a financial instrument, and requires that “When the contractual cash flows of a financial asset are renegotiated or otherwise modified and the renegotiation or modification does not result in the derecognition of that financial asset in accordance with this Standard, an entity shall recalculate the gross carrying amount of the financial asset and shall recognise a modification gain or loss in profit or loss”. Paragraph BC4.253 of IFRS 9 states that the accounting for modified financial liabilities mirrors that of modified financial assets.

It follows that a change to the terms that results from a renegotiation or other modification is accounted for under paragraph 5.4.3 of IFRS 9, even if that change results in the cash flows being reset to reflect movements in market rates of interest. An example is a loan whose terms are renegotiated to remove or amend a covenant in return for higher coupon payments. Another example is a loan that is renegotiated to reduce the contractual cash flows because the borrower is in financial difficulty.

For the application of paragraphs B5.4.5 and B5.4.6 to inflation-linked bonds.

 

Illustrative text - Financial instruments - FAQ 3.2.11 – Impact of prepayments on lifetime probability of default for SICR assessments

Publication date: 28 Jul 2020

Question:

For financial assets that fall within the scope of IFRS 9’s impairment requirements, IFRS 9 requires entities to assess whether there has been a significant increase in credit risk (SICR) since the asset’s initial recognition. In assessing SICR, many banks apply a quantitative element based on the change in the lifetime probability of default (LPD) of the financial asset.

Should a change in prepayment expectations that does not arise from a deterioration in the intrinsic credit quality of the borrower be incorporated into the assessment of the change in LPD?

Solution:

IFRS 9 provides no explicit guidance on whether or not changes in prepayment expectations should be incorporated into the assessment of the change in LPD. There are two views on this subject.

One view is that, if an entity’s prepayment expectation for a financial instrument changes, such that the financial instrument is expected to remain on an entity’s books for a longer or shorter period than originally expected, this inevitably leads to a change in lifetime default risk or LPD. All other things being equal, the longer a financial instrument remains on an entity’s books, the higher the lifetime default risk. Proponents of this view believe that changes in prepayment expectations should be factored into the assessment of changes in LPD.

The alternative view is that it would be inappropriate to transition a financial asset from stage 1 to stage 2 where there has been no deterioration in the intrinsic credit quality of the borrower (that is, where the borrower’s financial capacity to meet its financial obligations has not changed). In this situation, the marginal default risk of the borrower has not changed, and the only thing that has happened is that the bank expects the financial asset to remain on its books for longer. Proponents of this view believe that such changes in prepayment expectations (where there is no change in marginal default risk) should not be incorporated into the assessment of changes in LPD.

Entities should choose whether or not to incorporate prepayment expectations into the assessment of LPD, and they should apply the chosen approach consistently where the impact of the choice is material.

Regardless of the approach taken for SICR purposes, paragraph B5.5.28 of IFRS 9 requires the measurement of the expected credit losses to incorporate the effect of estimated prepayments over the remaining life of the financial asset.

Illustrative text - Financial instruments - FAQ 3.2.12 – Inclusion of cash flows expected from the sale on default of a loan in the measurement of expected credit losses (ECL)

Publication date: 28 Jul 2020

Question:

IFRS 9 defines credit losses as the difference between all contractual cash flows that are due to the entity in accordance with the contract and the cash flows that the entity expects to receive. In certain circumstances, an entity may choose to sell a defaulted loan to a third party in order to maximise recovery cash flows.

Should the cash flows that are expected to be recovered in this manner be included in the measurement of ECL?

Solution:

Yes, but only to the extent that the entity expects to sell loans after default.

The cash flows that an entity expects to receive on default of a loan may be based on several different scenarios such as: taking no action; keeping the loan and restructuring it to maximise collections; selling the loan; or foreclosing on the loan and collecting the collateral. Accordingly, when measuring ECL, selling the loan may be a relevant scenario when considering the possibility that a credit loss occurs (that is, in a default scenario).

Hence, the cash flows expected from the sale on default of a loan should be included in the measurement of ECL if:

  1. selling the loan is one of the recovery methods that the entity expects to pursue in a default scenario;
  2. the entity is neither legally nor practically prevented from realising the loan using that recovery method; and
  3. the entity has reasonable and supportable information upon which to base its expectations and assumptions.

In order to support an entity’s expectation that loan sales would be used as a recovery method in a default scenario, an entity should consider both its past practice and its future expectations, which may differ from past practice. When determining the amount of recovery proceeds to include in the measurement of ECL, an entity should consider relevant market-related information relating to loan sale prices and should deduct selling costs.

In the circumstances described above, the inclusion of recovery sale proceeds in the measurement of ECL would be appropriate for financial instruments in all of the stages 1, 2 and 3. This is because when measuring expected credit losses, paragraph 5.5.18 of IFRS 9 requires an entity to reflect the possibility that a credit loss occurs (and the possibly that no credit loss occurs) for financial instruments in all impairment stages, even if the possibility of a credit loss occurring is very low.

However, proceeds from possible future sales should not be included in the expected cash flows when considering the possibility that no credit loss occurs (that is, in a performing scenario). For example, if, in the case of a particular loan portfolio, an entity concludes that there is a 10 per cent probability of default occurring, it would only be when considering the outcome of this default scenario that expected sale proceeds would be considered. If, in that default scenario, the entity expects to sell all the defaulted loans and recover 30 per cent of the contractual cash flows of the loan through sale proceeds, but if it did not sell the loan would only expect to recover 25 per cent through continuing to hold the loan, the loss given default for that default scenario would be 70 per cent rather than 75 per cent.

Illustrative text - Financial instruments - FAQ 3.2.13 – Should borrower pre-payment options be taken into account when determining the period over which to measure expected credit losses (ECL)?

Publication date: 28 Jul 2020

Question:

A bank enters into a 10 year loan, which includes a pre-payment option that allows the borrower to pre-pay the loan at year 5. To determine the period over which to measure ECL, should the bank take into account the borrower pre-payment option?

Solution:

Yes. The maximum period over which ECL should be measured is the maximum contractual period over which the entity is exposed to credit risk, which is 10 years in this case. However, the period over which to measure ECL may be shorter than the maximum contractual period for some or all of the possible outcomes or scenarios used and/or the cash flows may be less than the maximum contractual cash flows (for example, a partial pre-payment may occur). This is because the definition of credit loss in IFRS 9 requires an entity to estimate cash flows by considering all contractual terms of the financial instrument, including pre-payment, extension, call and similar options, through the expected life of that financial instrument. Furthermore, paragraph B5.5.51 of IFRS 9 states that the bank is required to consider all reasonable and supportable information relevant to the estimate of ECL, including the effect of pre-payments.

As a simple example, assume, based on an assessment of all relevant and supportable information (including forward-looking information), the bank expects there is a 60% likelihood that the borrower will pre-pay the loan at year 5 and a 40% likelihood that the borrower will repay the loan at maturity (that is, the end of year 10). In such a case, the measurement of ECL will be a probability-weighted amount based on the expected cash flows of the two scenarios using a 5 year period and 10 year period respectively.

At subsequent reporting dates, the period(s) over which to measure ECL should be kept under review and amended if expectations change.

Borrower pre-payments should also be taken into account when measuring ECL for a portfolio of loans. The bank should also consider whether to sub-divide portfolios into groups of loans, by considering pre-payment terms (and the factors that may drive pre-payments) in addition to credit factors.

Illustrative text - Financial instruments - FAQ 3.2.14 – What discount rate should be used when measuring ECL for credit cards and other similar products?

Publication date: 28 Jul 2020

Question:

The contractual interest rate on credit cards and other similar products can be significant, and the discount rate used can have a significant impact on the expected credit loss (ECL) impairment provision recognised under IFRS 9.

What discount rate should be used when measuring ECL for credit cards and other similar products?

Solution:

The definition of credit loss in Appendix A to IFRS 9 states that cash flows should be discounted at the original effective interest rate (EIR), other than for purchased or credit-impaired financial assets.

In practice, determining the original EIR for credit cards and other similar products can be complex and judgemental, particularly since the contractual interest rate can vary significantly from period to period for the same credit card customer. This can occur if, for example, the contractual terms specify that customers (sometimes referred to as ‘transactors’) will incur 0% interest if amounts spent on the card are paid off within a specified period such as one month, but customers (sometimes referred to as ‘revolvers’) will incur a much higher rate of interest, say 20%, if the amount is not paid off within the specified period.

In assessing whether an entity’s approach to calculating the original EIR under IFRS 9 is appropriate, relevant factors to consider include:

  • Internal consistency – the IFRS 9 definition of ECL states that the relevant cash flows should be discounted using the original effective interest rate. Hence, the same EIR should be used for discounting ECL as is used in measuring interest income, in calculating modification gains / losses under paragraph 5.4.3 of IFRS 9, and in any other calculation where the use of original EIR is required. 
  • Segmentation – as discussed in the December 2015 meeting of the IFRS Transition Resource Group for Impairment of Financial Instruments (‘ITG’) in the context of determining the period over which to measure ECL for revolving credit facilities1, portfolios should be appropriately segmented, or grouped on the basis of shared characteristics, when calculating ECL. The segmentation of portfolios should ensure that ECL are measured in a way that is unbiased and does not combine different facilities that do not have suitably similar characteristics. The importance of appropriate segmentation applies equally to EIR as it does to other aspects of the ECL calculation. An entity should therefore assess whether, on the basis of reasonable and supportable information that is available without undue cost or effort, the level of disaggregation and segmentation applied (including differentiation between ‘transactors’ and ‘revolvers’) is appropriate.
  • Monitoring segmentation – an individual customer facility might change from being a transactor incurring 0% interest to a revolver incurring 20% interest, and vice versa, over the life of the facility. If this is the case, and if the credit card is considered to be a floating rate instrument, segmentation should therefore be considered on an ongoing basis and might need to change from one period to another.
  • Stage 2 – where a facility has had a significant increase in credit risk at the reporting date (so is in ‘stage 2’) the ECL must be modelled on the basis that the customer fails to pay off their future balance in some instances (para 5.5.18 of IFRS 9). It follows that, in those instances, there will be an unpaid balance at default on which to incur a credit loss. Since the customer will, at that stage, be incurring 20% interest, use of a 0% EIR is not appropriate for stage 2 facilities.

Additional considerations might arise when an entity transitions from IAS 39 to IFRS 9. The definition of EIR in IFRS 9 is identical to the definition in IAS 39; so, from a technical perspective, no change is required. However, there might nonetheless be a need to make changes from an implementation perspective. One reason is that EIR calculations might have validly been performed at very aggregated levels under IAS 39, where appropriate interest income recognition was the only material consideration. However, such a level of aggregation might no longer be appropriate under IFRS 9, where the original EIR will also be used to discount ECL on specific facilities over potentially long time periods.

1 Refer to paragraph 44 of the IASB summary of the December 2015 ITG meeting.

Illustrative text - Financial instruments - FAQ 3.2.15 – Factors to consider in relation to ‘days past due’ for IFRS 9 ECL where a loan has been granted a payment holiday

Publication date: 14 Aug 2020

Question

The IFRS 9 ECL model contains rebuttable presumptions where contractual payments on a financial instrument are more than 30 or 90 days past due. Where a loan is granted a payment holiday (for example, in connection with COVID-19), what factors should be considered when assessing ‘days past due’ and determining whether the loan has had a significant increase in credit risk (‘SICR’) or is credit impaired?

Solution

Appendix A to IFRS 9 states that “A financial asset is past due when a counterparty has failed to make a payment when that payment was contractually due”. No further guidance is provided in IFRS 9, and so a level of judgement might be required. However, it is important that, regardless of how ‘days past due’ is determined, a recent event of delinquency (that is, non-payment) is not disregarded when determining whether there has been a SICR , even where this has been temporarily rectified through the granting of a payment holiday. Some key factors to consider include:

  • Contractual terms: Given the reference to ‘contractually due’ in the Appendix A definition, the contractual terms of the original loan and effect of the payment holiday should be understood to determine the contractual obligations and the extent (if any) to which a payment is ‘past due’. It might be the case that a previously past due payment is contractually cancelled by the payment holiday and replaced with a new later payment date, in which case the loan will not be ‘past due’ until after this new later payment date.

    It would not be appropriate for the ‘days past due’ count to continue, regardless of the payment holiday, where no amounts are ‘past due’ based on the contractual terms as amended by the payment holiday.
  • Other indicators of a SICR and credit impairment: Whilst the 'days past due' day count is a relevant factor to consider in assessing the appropriate stage for financial instruments in the ECL model, it is only one factor. Entities should therefore ensure that all other relevant indicators of SICR and credit impairment are incorporated into their assessment of ECL staging, using the reasonable and supportable information available without undue cost and effort, and that there is not over-reliance on the current ‘days past due’ count (further guidance is included in FAQ 3.2.1, ‘Impact of COVID-19 payment holidays, including subsequent extensions to such holidays, on ECL staging’). For example, if a payment was five days past due at the time when a payment holiday was granted, this history should not be disregarded when considering whether there has been a SICR. That is because, even though payments might be nil days past due following the granting of the holiday, the past history of missing a contractually due payment would generally be expected to be a relevant factor for assessing credit risk and whether there has been a SICR.
  • Day count is irrespective of reporting dates: If a payment becomes more than 30 or 90 days past due before the end of a reporting period, and a payment holiday is also granted before the end of that same reporting period (that is, so that the payment is never more than 30 or 90 days past due at a reporting date), the intra-period day count cannot be ignored. That is because the day count should be a robust indicator of credit risk and calculated irrespective of the entity’s reporting dates. As soon as a payment becomes more than 30 or 90 days past due, it moves to stage 2 or stage 3, unless the entity rebuts the presumption based on reasonable and supportable information in accordance with paragraphs B5.5.20 and B5.5.37 of IFRS 9 respectively. The move is only reversed subsequently if there is evidence that the loan has no longer suffered a SICR or is no longer credit impaired.
  • Regulatory guidance: Given the lack of guidance in IFRS 9, certain regulated entities (such as banks) might look to available regulatory guidance relating to ‘days past due’ when determining the impact of a payment holiday on the count of ‘days past due’. This might be with the objective of maximising alignment between the measures used for accounting and regulatory purposes. However, any such regulatory guidance should not be applied automatically for IFRS 9 purposes. Instead, it should first be assessed whether it is consistent with the principles of IFRS 9. In particular, it would not be appropriate to determine ‘days past due’ in a way that would introduce bias into the ECL estimate – for example, by inappropriately reducing the number of exposures in stage 2 or stage 3.

Illustrative text - Financial instruments - FAQ 3.2.16 – Staging of loans where a significant increase in credit risk has occurred that cannot be identified individually or that is based on shared credit risk characteristics

Publication date: 14 Aug 2020

Question

A bank has advanced 1,000 loans to individual borrowers which, to date, have been classified in stage 1 for expected credit loss (‘ECL’) purposes. Due to COVID-19, the bank estimates, based on reasonable and supportable information (for example, government information on nationwide economic conditions which can be related to these loans), that 20% of the loans have had a significant increase in credit risk (‘SICR’) at 30 June 2020. However, at its 30 June 2020 reporting date, the bank has only been able to identify 12% of the 1,000 loans that have experienced a SICR , based on analysis that it has performed on individual loans and groups of loans with shared credit risk characteristics (see IE29–IE39 in IFRS 9 for guidance on these approaches). The bank therefore intends to classify only 12% of the 1,000 loans in stage 2 at 30 June 2020 and the remaining 88% in stage 1. Is this approach compliant with IFRS 9?

Solution

No. IFRS 9 requires lifetime ECL to be recognised on all financial instruments for which there has been a SICR since initial recognition. Therefore, where the bank cannot identify the remaining 8% of loans that have had a SICR (either individually or by grouping together loans considered to have had a SICR based on shared credit risk characteristics), paragraph B5.5.6 of IFRS 9 requires the entity to recognise lifetime ECL on a portion of the financial assets for which credit risk is deemed to have increased significantly (that is, on a further 8%, so that 20% in total are classified in stage 2).

IFRS 9 provides no explicit guidance on how an entity should select the portion of financial assets deemed to have had a SICR, so an entity should use its judgement to determine an appropriate basis, dependent on the specific facts and circumstances. Where this is a critical estimate, it should be disclosed in accordance with paragraph 125 of IAS 1.

Illustrative text - Financial instruments - FAQ 3.2.17 – In the context of COVID-19, what are relevant considerations when determining if a financial instrument is credit impaired based on qualitative factors?

Publication date: 12 Nov 2020

Background

As a result of COVID-19, there has been widespread granting of payment holidays, as well as subsequent payment holiday extensions, to borrowers by banks and similar lending institutions. As a result, financial instruments will often hit ‘quantitative’ triggers for credit impairment, based on days past due, much later than would ordinarily be the case. It is therefore important that the other (so-called ‘qualitative’) triggers of credit impairment, in accordance with the definition of ‘credit impaired’ in Appendix A to IFRS 9, are appropriately designed and operated; otherwise, financial instruments might move to credit impaired (often referred to as ‘stage 3’) too late.

Whilst ECL is measured as lifetime ECL for both stages 2 and 3, there are nonetheless a number of possible implications of a financial instrument moving to stage 3, including:

  • a potentially significant increase in the ECL (for example, if the move causes the probability of default to increase to 100%);
  • a reduction in reported interest income and net interest margin, a key metric for many banks; this is because, for an asset in stage 3, interest income is calculated on the lower net carrying value of the asset (that is, after deducting the ECL provision) rather than on the gross amount used in stages 1 and 2; and
  • the use of different scenarios for measuring ECL, or application of different weightings, compared to those used for stage 2 assets. For example, a higher weighting might be given to liquidation of collateral or sales of loans as recovery methods for assets in stage 3.

In addition, there might be indirect impacts beyond the IFRS financial reporting – for example, IFRS 9 transition regulatory capital relief for banks might no longer apply once a financial instrument has moved into stage 3.

Question

In the context of COVID-19, what are relevant considerations when determining if a financial instrument is credit impaired based on qualitative factors?

Answer

COVID-19 has introduced a range of new circumstances that were typically not envisaged when preparers first developed their policy of what constitutes ‘credit impaired’ and operationalised it. Paragraph B5.5.52 of IFRS 9 states that “an entity shall regularly review the methodology and assumptions used for estimating expected credit losses to reduce any differences between estimates and actual credit loss experience”. The IASB also noted in its ‘IFRS 9 and COVID 19’ paper, published on 27 March 2020, that entities should adjust their approach to determining ECL to different circumstances, and that existing methodologies should not continue to be applied mechanistically.

Therefore, whilst there has been no change to the IFRS 9 definition of ‘credit impaired’, entities should reassess their credit impaired indicators to take account of new COVID-related circumstances and new information, and update them where appropriate.

Entities should consider all reasonable and supportable information that is available without undue cost or effort for use in assessing whether a financial instrument is credit impaired. FAQ 3.2.3 – In the context of COVID-19 and ECL, what information is ‘reasonable and supportable’? provides helpful guidance in this area. In particular, entities should consider:

  1. all new types of data that they have obtained (for example, from online platforms used by customers to apply for payment holiday extensions);
  2. additional information that they can obtain without undue cost or effort (for example, from further outreach to customers);
  3. information from past payment deferrals where this is relevant to the loans being considered (that is, the experience is based on similar customers and similar loans in similar economic conditions); and
  4. other relevant information, such as declines in fair value as a result of credit risk.

As discussed in FAQ 3.2.7 - To what extent should additional COVID-19 related information after the reporting date be included in the ECL estimate?, where reasonable and supportable information becomes available after the reporting date, it should also be incorporated into the assessment of whether a financial instrument was credit impaired at the reporting date.

Appendix A to IFRS 9 provides the definition of a credit impaired asset, referring to the occurrence of one or more events that have a ‘detrimental impact on the estimated future cash flows’ of the asset, and stating that evidence of credit impaired status includes ‘observable data’ about such events. Below are specific factors to consider in the context of COVID-19:

‘Observable’ data: The meaning of ‘observable’ in the context of the Appendix A definition is different from that used in IFRS 13, ‘Fair Value Measurement’. In the context of credit impaired, ‘observable data’ includes borrower-specific facts that have been observed (for example, that the borrower has requested an extension to a payment holiday or that the borrower has stated that they are unemployed). Judgement should then be applied in determining the relative weight to be applied to each piece of observable data and its impact on the estimated cash flows.

‘Detrimental’ impact on estimated cash flows: The detrimental impact of the event(s) referred to in the definition are on the estimated cash flows of the financial asset. That is inherently a forward-looking assessment, so it is not necessary for the actual impact to yet be visible (for example, on current contractually due cash flows) for an asset to be credit impaired. For example, where it is assessed that a borrower will be credit impaired when government support ends, and it is known that support will end, the lender should not delay stage 3 classification until the support has actually ended. In addition, there is inherent uncertainty in estimating future cash flows, so there does not need to be certainty over the outcome (for example, that there will definitely be a cash shortfall) in order for a financial instrument to meet the definition of credit impaired.

Forbearance and ‘financial difficulty’: Events where the lender has granted a concession(s) to the borrower, for economic or contractual reasons relating to the borrower’s financial difficulty that the lender would not otherwise consider, are included in the list of examples in the definition of credit impaired. Such concessions are often referred to as ‘forbearance’. In the context of COVID-19, if a borrower is in financial difficulty, such concessions should be treated no differently to how they were prior to COVID-19. FAQ 3.2.2 – How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model? provides specific guidance in this area.

Significant financial difficulty of the borrower: ‘Significant financial difficulty of the borrower’ is included as the first event in the Appendix A definition. This does not require certainty that the borrower will not be able to pay in full, and so judgement will be required. Indeed, the extent and quality of information available might give rise to significant judgement in making this assessment. In particular, in the COVID-19 economic environment, it is often the case that qualitative customer information has been obtained via online platforms or automated processes which capture only a limited amount of information and might not be as comprehensive as customer information obtained in the pre-COVID-19 environment.

For example, consider the situation where a borrower applies for an extension to an initial three-month payment holiday and is required to provide information via an online platform to the lending bank that confirms:

  1. they remain unemployed;
  2. they were previously employed in the hospitality industry (a sector with continuing vulnerability in the relevant territory); and
  3. they do not anticipate being able to resume regular repayments in three months’ time.

All of these pieces of information represent observable data. However, the first two pieces of information alone do not necessarily provide evidence that the borrower is in significant financial difficulty, and judgement will be required. For example, in the context of a request for an extension, if the lending bank already has information about the increased credit risk of the borrower, the additional information from the first two points might be sufficient to assess the exposure as credit impaired. If those first two pieces of information were key to the original decision to lend, they might also be given greater weight. However, the borrower might have other resources for payment (for example, a partner who still has an income, or other assets that can be used to service the loan). In contrast, when taken together with the third piece of information, which addresses the consequences of the borrower’s circumstances, these three pieces of information would generally evidence that the related loan is credit impaired.

Breach of contract: Whilst a breach of contract is an event listed in the definition, not all breaches will be an indicator of credit impairment. Ordinarily, even if being one day past due with a payment is technically a breach of a contract, this alone would not be sufficient to meet the definition of credit impaired. New circumstances might also arise in the context of COVID-19 that require changes to whether breaches trigger credit impairment. For example, if an entity misses the loan covenant deadline for submitting their audited financial statements, but that technical breach of the contract is solely due to logistical challenges faced by the auditor (for example, in gaining physical access to the borrower’s premises due to lockdown restrictions) and not due to any credit-related issues of the borrower, that would not be an indicator that the borrower is credit impaired.

Any change in ECL resulting from using an updated basis for determining credit impaired would be a change in estimate under the definition in IAS 8, and not a change in accounting policy. This is because the credit impaired status is an element of the ECL estimation methodology, and the updated assessment method reflects a change in the circumstances on which the estimate is based.

Where the result of these considerations is that there is not yet sufficient information to identify a loan as credit impaired on an individual basis, but it is nonetheless higher credit risk within stage 2, as per paragraph B5.5.5 of IFRS 9 such loans should not be grouped with less risky loans for recognition of a loss allowance on a collective basis where this would obscure their heightened risk and introduce bias by under-estimating ECL.

Illustrative text - Financial instruments - FAQ 3.3.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IFRS 9)?

Publication date: 02 May 2020

Illustration

Variable-rate loans that are hedged items in a cash flow hedge might contain floors that are triggered due to the low benchmark interest rates that some countries are experiencing in the light of COVID-19. If such a loan is hedged with an interest rate swap that does not contain an equivalent floor, two questions need to be considered:

Question 1: Does the hedge continue to qualify for hedge accounting?

Question 2: Will ineffectiveness be recorded in the income statement?

Solutions

Solution 1

It depends. It is possible to designate (or continue with an existing hedge) despite a mismatch in terms, provided that the effectiveness criteria under IFRS 9 are met.

In a cash flow hedge of interest rate risk that involves a variable-rate asset or liability, the hypothetical derivative would be a swap with the same notional amount and the same re-pricing dates as the hedged item. The index on which the hypothetical swap’s variable rate is based would also match the index on which the asset or liability’s variable rate is based (not the one on which the hedging instrument’s rate is based). Finally, the hypothetical derivative would reflect any caps, floors or any other non-separated embedded derivative features of the hedged item.

If the hedge relates to a long-term debt/swap, and the effects of the floor on the hedged item are expected to be short-lived, the economic relationship criterion is likely to be met. 

However, if the floor is expected to affect the cash flows of the hedged item (that is, the interest on the debt is likely to be fixed at the floored rate) for the majority of the remaining hedging period, it is unlikely that the hedge would continue to qualify for hedge accounting. In such circumstances, further changes in interest rates would affect the hedging instrument but not the hedged item. An example of where this might arise is where the remaining period of the hedge relationship is relatively short.

Solution 2

Even if the hedge continues to qualify for hedge accounting, the mismatch in terms will give rise to ineffectiveness that will be recorded in the income statement (subject to the normal ‘lower of’ test for a cash flow hedge).

Illustrative text - Financial instruments - FAQ 3.3.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IFRS 9)?

Publication date: 02 May 2020

Solution

Entities often hedge risk exposures arising from forecast transactions (that is, anticipated transactions for which there is not yet a firm commitment). To qualify for hedge accounting, IFRS 9 requires, among other things, the forecast transaction to be highly probable.

The IFRS Glossary defines probable as ‘more likely than not’. Therefore, in the context of forecast transactions, the term ‘highly probable’ indicates a much greater likelihood of happening than ‘more likely than not’. This is consistent with the IASB’s use of ‘highly probable’ in IFRS 5, where the term is regarded as implying a significantly higher probability than ‘more likely than not’.

In assessing the likelihood that a transaction will occur in light of COVID-19, there is a range of factors that might be relevant, depending on the particular facts and circumstances. These include, but are not limited to, the following:

  • the financial and operational ability of the entity to carry out the transaction (for example, retailers that have closed stores, or airlines that have curtailed operations);
  • the entity’s revised business plans as a result of COVID-19;
  • the likelihood of disruptions to a particular activity (for example, a manufacturing facility that might need to be repurposed or shut down); and
  • the likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, changing delivery methods for goods or services).

The above list is not exhaustive, and a holistic analysis tailored to the circumstances of the entity should be performed.

The length of time until a forecast transaction is projected to occur is also a factor in determining probability. Usually, the more distant in time a forecast transaction is, the less likely it is that the transaction would be regarded as highly probable, and the stronger the evidence that would be needed to support an assertion that it is highly probable. However, in the current situation, the opposite might be true (that is, certain shorter-term transactions might no longer be highly probable, whereas longer-term transactions might still be highly probable), depending on the entity’s assessment of the forecast duration of disruptions.

Where a forecast transaction is no longer highly probable, hedge accounting must be discontinued. The appropriate treatment of accumulated other comprehensive income related to such discontinued hedges will depend on whether the transaction is still expected to occur.

See the following table for further considerations regarding accounting for discontinuation of a cash flow hedge:


Discontinuance of cash flow hedges  

  Hedging instrument    Hedged item

Hedge termination events Continue mark-to-market accounting De-recognise from the balance sheet Re-classify to P&L Retain amounts in equity
  Note 1     Note 2

Hedging instrument no longer exists (that is, sold, terminated, extinguished, exercised or expired)    
The hedge no longer meets the effectiveness criteria for hedge accounting (although the hedged item is still expected to occur)    
The entity changes its risk management objective    
The hedged future cash flows are no longer highly probable, but are still expected to occur    
The hedged future cash flows are no longer expected to occur    
Variability of cash flow ceases (for example, the forecast transaction becomes a fixed-price firm commitment)    

 

Illustrative text - Financial instruments - FAQ 3.3.3 – Hedge accounting and payment holidays

Publication date: 18 May 2020

Question

How is hedge accounting affected where a payment holiday is granted on a loan that has been hedged for interest rate risk (from either the borrower’s or the lender’s perspective)?

Solution

The effect on hedge accounting will depend on the type of hedge and how the hedged item was documented, as well as the type of payment holiday.

Cash flow hedges

A typical cash flow hedge involves mitigating the variability in cash flows of a variable-rate loan. The hedging instrument is commonly an interest rate swap, with periodic settlements of interest that match the timing of the interest payments/receipts on the loan which gives rise to them.

How the hedged item was documented and the nature of the payment holiday might impact the effect of a payment holiday on such a cash flow hedge.

Example 1: Forgiven payments

Assume that an entity has a floating-rate loan with 60 monthly remaining payments. As a result of COVID-19, the next two months of interest payments are forgiven. The entity determined that the payment holiday should be accounted for as a modification of the loan.

Hedging instrument: Interest rate swap whose critical terms perfectly matched the pre-modification loan and for which the terms remain unchanged.

Hedged item: The entity designated the specific loan or any replacement thereof.

Hedged risk: Cash flow hedge of exposure to variability in cash flows due to changes in benchmark interest rate risk.

Analysis:

The loan now has 58 floating interest cash flows, whereas the hedging instrument continues to have 60 interest cash flows.

The entity considers that the original hedged loan remains outstanding, but that its cash flows no longer perfectly match the hedging instrument.

This mismatch in cash flows would likely not be significant enough to violate the economic relationship effectiveness test, but it would result in some ineffectiveness being recognised (subject to the usual ‘lower of’ test).

One way to measure the ineffectiveness would be to amend any hypothetical derivative, to remove the two cash flows that have been forgiven from the variable leg. The fixed leg used to measure changes in the hedged item might also be recomputed by factoring in the forgiven cash flows in a manner that would have resulted in a fair value of zero at the inception of the hedging relationship.

Example 2: Deferred payments

Assume that an entity has a floating-rate loan with 60 monthly remaining payments. As a result of COVID-19, interest payments calculated at the floating rates for the next two months are deferred for one year. The entity determined that the payment holiday should be accounted for as a modification of the loan.

Hedging instrument: Interest rate swap whose critical terms perfectly matched the pre-modification loan and for which the terms remain unchanged.

Hedged item: The entity designated the specific loan or any replacement thereof.

Hedged risk: Cash flow hedge of exposure to variability in cash flows due to changes in benchmark interest rate risk.

Analysis:

The entity considers that the original hedged loan remains outstanding, but that its cash flows no longer perfectly match the hedging instrument.

The payment holiday results in a mismatch in the timing of cash flows between the hedged item and the hedging instrument. This mismatch in the timing of the cash flows would likely not be significant enough to violate the economic relationship effectiveness test, but it would result in some ineffectiveness being recognised (subject to the usual ‘lower of’ test).

One way to measure the ineffectiveness would be to amend the variable leg of any hypothetical derivative used to measure the changes in the hedged item, to reflect the revised timing of the two cash flows that have been deferred. The fixed leg might also be recomputed by factoring in the deferred cash flows in a manner that would have resulted in a fair value of zero at the inception of the hedging relationship.

The above examples assume that specific loans have been designated. If the hedged item had been documented differently (for example, a series of highly probable floating-rate cash flows not tied to a specific loan), the resulting accounting implications could differ.

For more complex hedging instruments, particularly where the cost of hedging approach under IFRS 9 has been used (for example, options), there would also be other implications to consider (such as alignment of time value).

Fair value hedges

A typical fair value hedge involves entering into a derivative to ‘swap’ the cash flows on a fixed-rate loan to floating rates. The hedging instrument is most commonly an interest rate swap with periodic settlements of interest that match the timing of the interest payments/receipts on the hedged fixed-rate loan.

Generally, the hedged risk is documented as the exposure to changes in the fair value of the loan due to changes in a particular benchmark interest rate.

Payments on the hedged loan might either be forgiven or deferred as a result of COVID-19. This discussion assumes that the entity has determined that the impact is accounted for as a modification of the underlying loan.

Where the hedging instrument remains unchanged, the effect of changes in interest rates on the fair value of the loan will differ from the effect on the fair value of the derivative.

For short-term payment holidays granted in response to COVID-19, the mismatch in the timing or amount of the interest rate cash flows and the settlements under the derivative would likely not be significant enough to violate the economic relationship effectiveness test. However, this mismatch could result in the fair value changes of the hedged loan (and hence the basis adjustment recorded for the hedged risk) differing from the fair value changes in the derivative. In this case, ineffectiveness would be recognised in the income statement as a result of this mismatch.

Illustrative text - Financial instruments - FAQ 3.3.4 – Recoverability test for hedging reserves

Publication date: 05 Jun 2020

Question

COVID-19 has resulted in falls in commodity prices, foreign exchange rates and other market prices. This has led to some entities experiencing significant losses on hedging instruments in cash flow hedges, resulting in debit balances being included in the cash flow hedge reserve. Does IFRS 9 require these debit balances to be tested for recoverability?

Solution

Yes. Paragraph 6.5.11(d)(iii) of IFRS 9 requires recoverability to be considered for losses in cash flow hedging reserves (that is, where the accumulated amounts are in a loss position). Where an entity expects that all or a portion of such losses will not be recovered in one or more future periods, it should immediately reclassify the amount that is not expected to be recovered to profit or loss.

IFRS 9 does not provide specific guidance on how the recoverability test should be applied, and entities should follow their existing accounting policies for the assessment of recoverability of these amounts. In addition, where such debit balances are significant, an entity should consider whether disclosure about the accounting policy – and about significant judgement in the application of that policy – is required in accordance with paragraph 122 of IAS 1.

However, prior to assessing such debit balances for recoverability, the entity should consider whether recycling of such balances is required for other reasons (for example, if a forecast transaction is no longer expected to occur). See FAQ 3.3.2 regarding how COVID might impact the assessment of whether transactions continue to be highly probable, which affects the entity’s ability to continue to apply hedging in future periods and which might impact recognition of hedging reserves.

Illustrative text - Financial instruments - FAQ 3.3.5 – Fair value hedge accounting and debt modifications (IFRS 9)

Publication date: 23 Jun 2020

Question

What is the impact of a payment holiday granted on a loan that has been hedged for interest rate risk in a fair value hedge relationship (from either the borrower’s or the lender’s perspective)?

Illustration

Some years ago, entity A entered into a fixed-rate loan. At the same time, it entered into an interest rate swap to ‘swap’ the fixed interest cash flows on the loan to floating-rate interest cash flows. The critical terms of the swap matched those of the loan, and entity A designated the swap as a hedging instrument in a fair value hedge of interest rate risk.

As a result of COVID-19, the borrower is granted a deferral of payments for three months and an extension of the maturity date by three months. The loan has a remaining maturity of five years as at the date when the deferral is granted. Management has determined that the deferral and extension are appropriately accounted for as a modification of the debt (as opposed to an extinguishment). The terms of the interest rate swap designated as the hedging instrument used are not changed, and the lender has determined that the loan is not credit impaired.

Solution

The modification of the debt (for which the accounting is discussed in FAQ 3.1.3) creates a mismatch in the timing of the cash flows between the hedged item and hedging instrument (as discussed further in FAQ 3.3.3).

As a result, management might consider that entity A’s risk management objective for the hedging relationship is no longer met. For example, the risk management objective might have changed from hedging all of the loan over its entire life to being a partial-term hedge of the portion of the debt that is equivalent to its original maturity (that is, the next five years). Under paragraph B6.5.26 of IFRS 9, hedge accounting is discontinued where a hedging relationship no longer meets the entity’s risk management objective.

Where the modification leads to a discontinuation of the fair value hedging relationship, paragraph 6.5.10 of IFRS 9 requires any adjustment that was made to the hedged item as a result of fair value hedge accounting to be amortised to profit and loss, based on a recalculated effective interest rate. The amortisation should begin as soon as the loan ceases to be adjusted for hedging gains or losses.

An entity can choose to designate the existing derivative in a new fair hedging relationship of the modified debt prospectively from the date of discontinuance of the old hedging relationship.

Illustrative text - Financial instruments - FAQ 3.4.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IAS 39)?

Publication date: 02 May 2020

Illustration

Variable-rate loans that are hedged items in a cash flow hedge might contain floors that are triggered due to the low benchmark interest rates that some countries are experiencing in the light of COVID-19. If such a loan is hedged with an interest rate swap that does not contain an equivalent floor, two questions need to be considered:

Question 1: Does the hedge continue to qualify for hedge accounting?

Question 2: Will ineffectiveness be recorded in the income statement?

Solutions

Solution 1

It depends. It is possible to designate (or continue with an existing hedge) despite a mismatch in terms, provided that the effectiveness criteria under IAS 39 are met.

In a cash flow hedge of interest rate risk that involves a variable-rate asset or liability, the hypothetical derivative would be a swap with the same notional amount and the same re-pricing dates as the hedged item. The index on which the hypothetical swap’s variable rate is based would also match the index on which the asset or liability’s variable rate is based (not the one on which the hedging instrument’s rate is based). Finally, the hypothetical derivative would reflect any caps, floors or any other non-separated embedded derivative features of the hedged item.

If the hedge relates to a long-term debt/swap, and the effects of the floor on the hedged item are expected to be short-lived, the quantitative hedge effectiveness thresholds are likely to be met. 

However, if the floor is expected to affect the cash flows of the hedged item (that is, the interest on the debt is likely to be fixed at the floored rate) for the majority of the remaining hedging period, it is unlikely that the hedge would continue to qualify for hedge accounting. In such circumstances, further changes in interest rates would affect the hedging instrument but not the hedged item. An example of where this might arise is where the remaining period of the hedge relationship is relatively short.

Solution 2

Even if the hedge continues to qualify for hedge accounting, the mismatch in terms will give rise to ineffectiveness that will be recorded in the income statement (subject to the normal ‘lower of’ test for a cash flow hedge).

Illustrative text - Financial instruments - FAQ 3.4.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IAS 39)?

Publication date: 02 May 2020

Solution

Entities often hedge risk exposures arising from forecast transactions (that is, anticipated transactions for which there is not yet a firm commitment). To qualify for hedge accounting, IAS 39 requires, among other things, the forecast transaction to be highly probable.

The IFRS Glossary defines probable as ‘more likely than not’. Therefore, in the context of forecast transactions, the term ‘highly probable’ indicates a much greater likelihood of happening than ‘more likely than not’. This is consistent with the IASB’s use of ‘highly probable’ in IFRS 5, where the term is regarded as implying a significantly higher probability than ‘more likely than not’.

In assessing the likelihood that a transaction will occur in light of COVID-19, there is a range of factors that might be relevant, depending on the particular facts and circumstances. These include, but are not limited to, the following:

  • the financial and operational ability of the entity to carry out the transaction (for example, retailers that have closed stores, or airlines that have curtailed operations);
  • the entity’s revised business plans as a result of COVID-19;
  • The likelihood of disruptions to a particular activity (for example, a manufacturing facility that might need to be repurposed or shut down); and
  • the likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (for example, changing delivery methods for goods or services).

The above list is not exhaustive, and a holistic analysis tailored to the circumstances of the entity should be performed.

The length of time until a forecast transaction is projected to occur is also a factor in determining probability. Usually, the more distant in time a forecast transaction is, the less likely it is that the transaction would be regarded as highly probable, and the stronger the evidence that would be needed to support an assertion that it is highly probable. However, in the current situation, the opposite might be true (that is, certain shorter-term transactions might no longer be highly probable, whereas longer-term transactions might still be highly probable), depending on the entity’s assessment of the forecast duration of disruptions.

Where a forecast transaction is no longer highly probable, hedge accounting must be discontinued. The appropriate treatment of accumulated other comprehensive income related to such discontinued hedges will depend on whether the transaction is still expected to occur.

See the following table for further considerations regarding accounting for discontinuation of a cash flow hedge:

Discontinuance of cash flow hedges
     
  Hedging instrument Amount accumulated in equity
Hedge termination events Continue mark-to-market accounting De-recognise from the balance sheet Reclassify to profit or loss Retain amounts in equity
  Note 1     Note 2
Hedging instrument no longer exists (that is, sold, terminated, extinguished, exercised, or expired)    
The hedge no longer meets the effectiveness criteria for hedge accounting    
The entity revokes the hedge designation    
The forecast transaction is no longer highly probable, but is still expected to occur    
The forecast transaction is no longer expected to occur    
Variability of cash flow ceases (for example, the forecast transaction becomes a fixed price firm commitment)    
         
Note 1 – The hedging instrument will continue to be marked to market, unless it is re-designated as a hedging instrument in a new hedge.
 
Note 2 – The cumulative gain or loss on the hedging instrument previously recognised directly in other comprehensive income from the period when the hedge was effective remains recognised in equity and is reclassified to profit or loss when profit or loss is impacted by the hedged item.

 

Illustrative text - Financial instruments - FAQ 3.4.3 – Hedge accounting and payment holidays (IAS 39)

Publication date: 20 May 2020

Question

How is hedge accounting affected where a payment holiday is granted on a loan that has been hedged for interest rate risk (from either the borrower’s or the lender’s perspective)?

Solution

The effect on hedge accounting will depend on the type of hedge and how the hedged item was documented, as well as the type of payment holiday.

Cash flow hedges

A typical cash flow hedge involves mitigating the variability in cash flows of a variable-rate loan. The hedging instrument is commonly an interest rate swap, with periodic settlements of interest that match the timing of the interest payments/receipts on the loan which gives rise to them.

How the hedged item was documented and the nature of the payment holiday might impact the effect of a payment holiday on such a cash flow hedge.

Example 1: Forgiven payments

Assume that an entity has a floating-rate loan with 60 monthly remaining payments. As a result of COVID-19, the next two months of interest payments are forgiven. The entity determined that the payment holiday should be accounted for as a modification of the loan.

Hedging instrument: Interest rate swap whose critical terms perfectly matched the pre-modification loan and for which the terms remain unchanged.

Hedged item: The entity designated the specific loan or any replacement thereof.

Hedged risk: Cash flow hedge of exposure to variability in cash flows due to changes in benchmark interest rate risk.

Analysis:

The loan now has 58 floating interest cash flows, whereas the hedging instrument continues to have 60 interest cash flows.

The entity considers that the original hedged loan remains outstanding, but that its cash flows no longer perfectly match the hedging instrument.

This mismatch in cash flows would likely not be significant enough to cause the relationship to fail the highly effective (80–125% effectiveness) test, but it would result in some ineffectiveness being recognised (subject to the usual ‘lower of’ test).

One way to measure the ineffectiveness would be to amend any hypothetical derivative, to remove the two cash flows that have been forgiven from the variable leg. The fixed leg used to measure changes in the hedged item might also be recomputed by factoring in the forgiven cash flows in a manner that would have resulted in a fair value of zero at the inception of the hedging relationship.

Example 2: Deferred payments

Assume that an entity has a floating-rate loan with 60 monthly remaining payments. As a result of COVID-19, interest payments calculated at the floating rates for the next two months are deferred for one year. The entity determined that the payment holiday should be accounted for as a modification of the loan.

Hedging instrument: Interest rate swap whose critical terms perfectly matched the pre-modification loan and for which the terms remain unchanged.

Hedged item: The entity designated the specific loan or any replacement thereof.

Hedged risk: Cash flow hedge of exposure to variability in cash flows due to changes in benchmark interest rate risk.

Analysis:

The entity considers that the original hedged loan remains outstanding, but that its cash flows no longer perfectly match the hedging instrument.

The payment holiday results in a mismatch in the timing of cash flows between the hedged item and the hedging instrument. This mismatch in the timing of the cash flows would likely not be significant enough to cause the relationship to fail the highly effective (80–125% effectiveness) test, but it would result in some ineffectiveness being recognised (subject to the usual ‘lower of’ test).

One way to measure the ineffectiveness would be to amend the variable leg of any hypothetical derivative used to measure the changes in the hedged item, to reflect the revised timing of the two cash flows that have been deferred. The fixed leg might also be recomputed by factoring in the deferred cash flows in a manner that would have resulted in a fair value of zero at the inception of the hedging relationship.

The above examples assume that specific loans have been designated. If the hedged item had been documented differently (for example, a series of highly probable floating-rate cash flows not tied to a specific loan), the resulting accounting implications could differ.

Fair value hedges

A typical fair value hedge involves entering into a derivative to ‘swap’ the cash flows on a fixed-rate loan to floating rates. The hedging instrument is most commonly an interest rate swap with periodic settlements of interest that match the timing of the interest payments/receipts on the hedged fixed-rate loan.

Generally, the hedged risk is documented as the exposure to changes in the fair value of the loan due to changes in a particular benchmark interest rate.

Payments on the hedged loan might either be forgiven or deferred as a result of COVID-19. This discussion assumes that the entity has determined that the impact is accounted for as a modification of the underlying loan.

Where the hedging instrument remains unchanged, the effect of changes in interest rates on the fair value of the loan will differ from the effect on the fair value of the derivative.

For short-term payment holidays granted in response to COVID-19, the mismatch in the timing or amount of the interest rate cash flows and the settlements under the derivative would likely not be significant enough to cause the relationship to fail the highly effective (80–125% effectiveness) test. However, this mismatch could result in the fair value changes of the hedged loan (and hence the basis adjustment recorded for the hedged risk) differing from the fair value changes in the derivative. In this case, ineffectiveness would be recognised in the income statement as a result of this mismatch.

Illustrative text - Financial instruments - FAQ 3.4.4 – Fair value hedge accounting and debt modifications (IAS 39)

Publication date: 23 Jun 2020

Question

What is the impact of a payment holiday granted on a loan that has been hedged for interest rate risk in a fair value hedge relationship (from either the borrower’s or the lender’s perspective)?

Illustration

Some years ago, entity A entered into a fixed-rate loan. At the same time, it entered into an interest rate swap to ‘swap’ the fixed interest cash flows on the loan to floating-rate interest cash flows. The critical terms of the swap matched those of the loan, and entity A designated the swap as a hedging instrument in a fair value hedge of interest rate risk.

As a result of COVID-19, the borrower is granted a deferral of payments for three months and an extension of the maturity date by three months. The loan has a remaining maturity of five years as at the date when the deferral is granted. Management has determined that the deferral and extension are appropriately accounted for as a modification of the debt (as opposed to an extinguishment). The terms of the interest rate swap designated as the hedging instrument used are not changed, and the lender has determined that the loan is not credit impaired.

Solution

The modification of the debt (for which the accounting is discussed in FAQ 3.1.3) creates a mismatch in the timing of the cash flows between the hedged item and hedging instrument (as discussed further in FAQ 3.4.3).

As a result of the change to the terms of the hedged item, the entity might choose to voluntarily de-designate the hedging relationship, as permitted by paragraph 91(c) of IAS 39.

Where the hedging relationship is discontinued due to de-designation, paragraph 92 of IAS 39 requires any adjustment that was made to the hedged item as a result of fair value hedge accounting to be amortised to profit and loss, based on a recalculated effective interest rate. The amortisation should begin as soon as the loan ceases to be adjusted for hedging gains or losses.

An entity can choose to designate the existing derivative in a new fair hedging relationship of the modified debt prospectively from the date of discontinuance of the old hedging relationship.

Illustrative text - Financial instruments - FAQ 3.5.1 – How is the accounting for supplier finance arrangements impacted by COVID-19?

Publication date: 06 May 2020

Question

An entity whose payables are included in a supplier finance arrangement (also known as a ‘reverse factoring’ or ‘structured payables’) assesses whether the original trade payables:

  1. are extinguished and a new liability (such as bank financing) should be recognised; or
  2. if modified rather than extinguished, should be presented differently in the balance sheet (for example, in a separate line item).

How does an entity assess changes to these arrangements made in response to the economic conditions triggered by COVID-19?

Solution

The accounting for payables thatare included in a supplier finance arrangement is based on the specific facts and circumstances of each programme. An entity weighs the evidence in order to determine whether the economic substance of the arrangement is that the previous trade payables have been extinguished or, if modified rather than extinguished, should be presented differently in the balance sheet in order to provide a fair presentation, as required by paragraph 15 of IAS 1.

As a result of the economic circumstances triggered by COVID-19, an entity might make changes to its supplier finance arrangements, such as adding a guarantee from a parent (or other group company) or extending payment dates. For those balances subject to the new terms, the entity should reassess whether the original trade payables are extinguished, as well as the appropriate presentation of the payables based on the updated terms. Appropriate disclosures should also be provided (for example, the changes to the terms and, where the conclusion that the outstanding balance remains trade payable is a critical accounting judgement, the disclosures required by para 122 of IAS 1).

Illustrative text - Financial instruments - FAQ 3.8.1 – Determining whether a market is still active in a period of market disruption

Publication date: 07 Apr 2020

Question:

What factors should be considered when determining whether a market is active?

Solution:

Paragraph B37 of IFRS 13 provides a list of factors to consider in determining whether there has been a significant decrease in the volume or level of activity in relation to normal market activity.

The factors that an entity should evaluate include (but are not limited to):

  1. There is a significant decline in the activity of, or there is an absence of, a market for new issues (that is, a primary market) for the asset or liability or similar assets or liabilities.
  2. There are few recent transactions.
  3. Price quotations are not developed using current information.
  4. Price quotations vary substantially, either over time or among market makers (for example, some brokered markets).
  5. Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability.
  6. There is a significant increase in implied liquidity risk premiums, yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entity’s estimate of expected cash flows, taking into account all available market data about credit and other non-performance risk for the asset or liability.
  7. There is a wide bid-ask spread or there are significant increases in the bid-ask spread.
  8. Little information is publicly available (for example, a principal-to-principal market).

If an entity concludes that there has been a significant decrease in the volume or level of activity in the market for an asset or liability, the entity should perform further analysis of the transactions or quoted prices observed in that market. A significant decrease in activity on its own is not indicative that the transaction prices observed do not represent fair value. Nevertheless, further analysis is required, because the transactions or quoted prices might not be determinative of fair value, in which case adjustments might be necessary when using the information in estimating fair value.

Illustrative text - Financial instruments - FAQ 3.8.2 – Assessing prices in inactive markets

Publication date: 07 Apr 2020

Question:

Can a company disregard market prices of financial assets in an inactive market in periods of market volatility when determining the fair value of a financial asset?

Solution:

Paragraph B44 of IFRS 13 provides guidance to be considered in evaluating observable transaction prices under different circumstances:

  • The transaction is not orderly – If the evidence indicates that the transaction is not orderly, an entity is required to place little, if any, weight (compared with other indications of fair value) on that observable transaction price when estimating fair value.
  • The transaction is orderly – If the evidence indicates that the transaction is orderly, an entity is required to consider that transaction price when estimating fair value. The amount of weight placed on that transaction price (when compared with other indications of fair value) will depend on the facts and circumstances of the transactions and the nature and quality of other available inputs.

FAQ 3.8.3 addresses how to determine whether a transaction is orderly. Where a market is considered inactive, pricing inputs for referenced transactions might be less relevant. The determination of whether a transaction is (or is not) orderly is more difficult if there has been a significant decrease in the volume and level of activity for the asset or liability.

If management does not have sufficient information to conclude whether an observed transaction is orderly (or is not orderly), it is required to consider that transaction price when estimating fair value. In those circumstances, that transaction price might not be determinative (that is, the sole or primary basis) for estimating fair value. There might be circumstances in which less weight should be placed on transactions where a reporting entity has insufficient information to conclude whether the transaction is orderly when compared with other transactions that are known to be orderly.

IFRS 13 does not prescribe a methodology for making significant adjustments to transactions or quoted prices when estimating fair value in inactive markets. Instead of applying a prescriptive approach, management should weigh indicators of fair value.

Illustrative text - Financial instruments - FAQ 3.8.3 – Determining whether transactions are orderly

Publication date: 07 Apr 2020

Question:

When are transactions considered orderly?

Solution:

Paragraph B43 of IFRS 13 provides a list of circumstances that might indicate that a transaction is not orderly, including (but not limited to):

  • There was no adequate exposure to the market, for a period before the measurement date, to allow for marketing activities that are usual and customary for transactions involving such an asset or liability.
  • There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant.
  • The seller is in or near bankruptcy or receivership (that is, distressed) or the seller was required to sell to meet regulatory or legal requirements (that is, if the seller was forced). However, not all requirements to divest result in a forced sale, since many requirements to divest are made in circumstances that allow sufficient time and marketing effort to result in an orderly disposal.
  • The transaction price is an outlier when compared with other recent transactions for the same (or a similar) asset or liability.

Although IFRS 13 provides a list of factors to consider that might indicate that a transaction is not orderly, we believe that there is an implicit rebuttable presumption that observable transactions between unrelated parties are orderly. In our experience, such transactions are considered to be orderly in almost all instances. Therefore, the evidence necessary to conclude that an observable transaction between unrelated parties is not orderly should be incontrovertible.

Illustrative text - Financial instruments - FAQ 3.8.4 – Adjustments to the quoted price in an active market

Publication date: 07 Apr 2020

Question:

If there is a quoted price in an active market (that is, a Level 1 input), can a company adjust or disregard the quoted price in a period of significant market volatility when determining fair value?

Solution:

The objective of ‘fair value’ is to determine a price at which an orderly transaction would take place between market participants under conditions that existed at the measurement date. It would not be appropriate to adjust or disregard observable transactions, except in the extraordinarily rare circumstances where those transactions are determined to not be orderly. Generally, there is an extremely high bar to conclude that a transaction price in an active market (that is, a Level 1 input) is not orderly under IFRS 13.

Accordingly, we expect the fair value of a financial asset to be calculated as the quoted price of that financial asset in an active market multiplied by  the quantity held (commonly referred to as ‘P times Q’). This would continue to be the case even in times of significant market volatility.

Illustrative text - Financial instruments - FAQ 3.8.5 – Delays in the availability of information

Publication date: 07 Apr 2020

Question:

COVID-19 disruptions could cause delays in the availability of information used to measure the fair value of an investment. If a company uses estimates of such information in its initial valuation assessment, how should it consider updated information that becomes available before its financial statements are issued?

Solution:

Initial estimates used in fair value models should be updated for any delayed information that becomes available prior to the release of the company’s financial statements if, and only if, the information provides additional evidence about known or knowable conditions that existed at the measurement date.

Illustrative text - Financial instruments - FAQ 3.8.6 – Post market closure events

Publication date: 07 Apr 2020

Question:

Should events that occur after the close of a market but before the end of the measurement date be considered when estimating fair value?

Solution:

As discussed in paragraph 79(b) of IFRS 13, in some situations, significant events (such as principal-to-principal transactions, brokered trades, or announcements) might occur after the close of a market but before the end of the measurement date. In that case, a quoted market price might not be representative of fair value on the measurement date. Entities should follow and consistently apply a policy for identifying and incorporating events that could affect fair value measurements. In addition, if an entity adjusts the quoted price, the resulting measurement will not be classified as Level 1, but it will be a lower-level measurement.

In general, the measurement date, as specified in each accounting standard requiring or permitting fair value measurements, is the ‘effective’ valuation date. Accordingly, a valuation should reflect only facts and circumstances that exist on the specified measurement date (these include events occurring before the measurement date or that were reasonably foreseeable on that date), so that the valuation is appropriate for a transaction that would occur on that date.

Illustrative text - Financial instruments - FAQ 3.8.7 – Uncertainties in cash flow fair value measurement of financial instruments

Publication date: 28 Apr 2020

Question:

How should uncertainties associated with COVID-19 be factored into fair value measurement for financial instruments?

Solution:

For reporting dates in the first half of 2020, COVID-19 has given rise to many significant uncertainties, including the length of time and severity of the impact of COVID-19, how effective the measures taken to control the spread of the virus will be, and how quickly activities might return to more normal conditions once the pandemic is over.

COVID-19 has significantly increased uncertainties related to the amount and timing of cash flows of financial instruments. That impact is not necessarily limited to the credit risk of financial instruments. For example, the amount and timing of the cash flows associated with loans become more uncertain due to payment deferrals already agreed1 and/or additional deferrals that might be offered or imposed by governments as part of their COVID-19 response. For equity investments, the impact of COVID-19 might give rise to greater uncertainty about the amount and timing of the investment’s cash flows. Similarly, there might be greater uncertainty about the amount and timing of cash flows for certain precious metal streaming agreements that are dependent on the production timing of a particular mine (in view of work stoppages) and the price of the underlying precious metals.

The effects of COVID-19 are difficult to forecast, and so it might not be possible for entities  to factor all of the uncertainties arising from COVID-19 into a single set of cash flow forecasts. Rather, there might be a range of potential outcomes that need to be included as different scenarios, with appropriate weightings applied to each. Management would need to document its basis for the factors that have been built into each scenario, including the probability weightings applied to each of the scenarios.

When valuing a financial instrument based on its future cash flows, entities generally determine the future cash flows under each scenario and the associated probability; the fair value of the financial instrument would then be the present value of the probability-weighted sum of all of the scenarios. Conceptually, in using this technique, entities would generally incorporate the impacts of all different risks on cash flows (such as COVID-19 and other uncertainties) in each scenario, resulting in the probability-weighted risk-adjusted cash flow for each such scenario. Each scenario’s cash flow is then discounted at the risk-free rate, and the results are added together to arrive at fair value. This is consistent with the risk-adjusted expected cash flow method described as ‘Method 1’ in paragraph B25 of IFRS 13. For example, for a loan, an entity could factor the effect of the different expected payment options and their estimated ‘probability of default’ and ‘loss given default’ into different scenarios, with each scenario given a probability weighting. All of the parameters in estimating the cash flows should be based, as far as possible, on market observable data, and they must be consistent with market participants’ view and expectations. Each scenario would then be discounted at the risk-free rate, and the sum of the probability-weighted scenarios would be the fair value of the financial instrument.

Alternatively, entities might exclude the impact of credit risk in estimating future cash flows for each scenario and incorporate the impact of credit risk into the discount rate instead. This mixed approach might be taken in practice because the credit spread is often observable, or it can be derived based on credit ratings and comparison to other similarly rated instruments.

The overriding principle is that, to the extent that the cash flows in the scenarios have been adjusted for a certain risk factor, that same risk factor should not be incorporated as an adjustment to the discount rate. Conversely, if a risk factor has not been incorporated in the risk-adjusted cash flows in the scenarios, the discount rate should incorporate that particular risk factor as an adjustment to the risk-free rate. However, incorporating risk factors into the discount rate is often more subjective and difficult than incorporating such factors into different scenarios. See FAQ 2.6.2 on uncertain cash flows for non-financial assets for further discussion.

Additionally, IFRS 13 deals with uncertainty in relation to Level 3 fair value measurements through providing users with appropriate disclosures. These include a description of the valuation techniques used, how decisions are made in relation to valuation procedures and, for recurring fair value measurements, the sensitivity of fair value measurements to significant unobservable inputs.

1 Although agreed, the debtor might or might not take advantage of the deferral opportunity.

Illustrative text - Financial instruments - FAQ 3.8.8 – Should possible future modifications be considered when determining the fair value of a debt instrument?

Publication date: 14 May 2020

It depends. When measuring fair value, an entity must use the assumptions that market participants would use when pricing the instrument1. [IFRS 13 para 22]. Therefore, if market participants would take into consideration the possibility of future modifications to the instrument when pricing it, so should the entity when determining the instrument’s fair value. To the extent that market participants would not take possible future modifications into account, neither should the entity when determining fair value.

For example, market participants might anticipate the possibility that a debt instrument will be modified as a result of events connected with the COVID-19 pandemic, including (expected) government announcements or actions; such government actions might result in certain payments being deferred or reduced. When determining fair value, the entity would therefore take into consideration the possibility, and related uncertainty, of these potential modifications.

The method of incorporating such possibilities into a valuation is complex. Often, the use of multiple scenarios will be appropriate (see FAQ 3.8.7 ‘Uncertainties in cash flow fair value measurement of financial instruments’).

1 Note that government reliefs which are expected to be provided if a loan is modified, but which would not be transferable to a subsequent purchaser of the loan, would not be taken into account by market participants when valuing the loan itself.

Illustrative text - Financial instruments - FAQ 3.8.9 –Consideration of fair value where an entity has breached a debt covenant

Publication date: 20 May 2020

Solution

IFRS 13’s general principle is that the fair value of a liability should reflect the amount at which it could be transferred in an orderly transaction at the measurement date under current market conditions.

However, as an exception to this general principle, IFRS 13 requires the fair value of a liability due on demand not to be less than the amount payable on demand, discounted from the first date when the amount could be required to be paid. [IFRS 13 para 47].

Hence, where an entity has breached a debt covenant (for example, due to financial difficulty) and that breach has caused a borrowing or other issued debt instrument to become due on demand, the fair value should not be less than the demand amount. This applies both for disclosure of fair values of liabilities carried at amortised cost in accordance with paragraph 25 of IFRS 7, and for measurement of fair value for liabilities carried at fair value. It also applies irrespective of whether a current rate of interest would be higher than the stated rate of interest in the debt agreement and whether the entity has insufficient assets to repay the amount due.

Entities could disclose, in their comparison of carrying values and fair values of financial instruments, the liabilities to which this exception to the general fair value measurement principle has been applied, and they could refer to the disclosure about the breach made elsewhere in the financial statements. This can help to increase understandability of the comparison of carrying value and fair value where the disclosed or recognised fair value is likely to be above the value at which the liability could be transferred.

It is important to note that this exception to the general fair value measurement principle only applies to the issuer of a liability; the holder of the related loan asset would still be required to determine fair value based on a hypothetical transfer of the loan asset at the measurement date.

Illustrative text - Financial instruments - FAQ 3.10.1 - Is COVID-19 a ‘rare circumstance’ for insurers?

Publication date: 15 Apr 2020

Question:

Is COVID-19 a 'rare circumstance' that allows reclassification of bonds from trading to amortised cost under IAS 39.50B?

Solution:

Non-derivative financial assets that do not meet the definition of loans and receivables can be reclassified from held-for-trading only in rare circumstances, provided that these financial assets are no longer held for the purpose of selling or repurchasing in the near term and meet the definition of the target category. Financial assets that were designated at fair value through profit or loss upon initial recognition shall however not be reclassified.

’Paragraph BC104D of the Basis for Conclusions of the amendment to IAS 39 defines a rare circumstance as arising “from a single event that is unusual and highly unlikely to recur in the near-term”. In our view, the declaration of a COVID-19 global pandemic by the World Health Organization on March 11, 2020 meets the definition of  ‘a rare circumstance’.

Illustrative text - Financial instruments - FAQ 3.11.1 – What is a ‘significant’ or ‘prolonged’ decline in fair value below cost?

Publication date: 06 Apr 2020

Question

When assessing whether there is objective evidence of impairment for an available-for-sale equity investment, what is considered a ‘significant’ or ‘prolonged’ decline in fair value below cost?

Solution

Assessing what is a ‘significant’ or ‘prolonged’ decline in fair value below an investment’s cost requires judgement. A ‘significant’ decline in fair value should be evaluated against the original cost at initial recognition, and ‘prolonged’ should be evaluated against the period in which the fair value of the investment has been below that original cost.

Whether a decline in fair value below cost is considered ‘significant’ must be assessed on an instrument-by-instrument basis. In our view, the assessment of ‘significant’ should be based on both qualitative and quantitative factors.

The expected level of volatility for an instrument might also be a factor that entities should take into consideration when assessing what is ‘significant’. For example, a larger decline in a more risky stock might be tolerated before an entity records an impairment loss, given the stock’s greater volatility compared with a less volatile company. Importantly, volatility should be determined over a relatively long period. For example, a market downturn due to the decline in the overall economy over a short period of time would not be considered adequate to establish an estimate of expected future volatility.

What is a ‘prolonged’ decline in fair value also requires judgement. In general, a period of 12 months or longer below original cost is likely to be a ‘prolonged’ decline. However, the assessment of ‘prolonged’ should not be compared to the entire period that the investment has been or is expected to be held. For example, if a security’s fair value has been below cost for 12 months, whether that security has been held or is intended to be held for two or 20 years is irrelevant. The assessment is whether the period of 12 months accords with the entity’s chosen policy.

An entity should continue to apply its existing guidance for assessing a ‘significant’ or ‘prolonged’ decline in fair value. The fact that a decline in the value of an investment is in line with the overall level of decline in the relevant market does not mean that an entity can conclude that the investment is not impaired. The existence of a significant or prolonged decline cannot be overcome by forecasts of an expected recovery of market values, regardless of its expected timing.

Illustrative text - Leases - FAQ 4.1 – How should lease concessions related to COVID-19 be accounted for?

Publication date: 01 Jun 2020

On 28 May 2020, the IASB published an amendment to IFRS 16 that provides an optional practical expedient for lessees only from assessing whether a rent concession related to COVID-19 is a lease modification. Lessees can elect to account for such rent concessions in the same way as they would if they were not lease modifications. The FAQ does not take into account the amendment to IFRS 16.

As a result of the COVID-19 pandemic, concessions have been granted to lessees. Such concessions might take a variety of forms, including payment holidays, cash rebates and deferral of lease payments. On 10 April 2020, the IASB issued a document intended to support the consistent application of IFRS to lease concessions related to COVID-19 (see link), referred to below as ‘the IASB document’.

Judgement might be needed to determine the appropriate accounting treatment for lease concessions that are made in the context of COVID-19. Depending on the facts and circumstances, the substance of the concession might be appropriately accounted for as (negative) variable lease payments, forgiveness of some of the lease payments, deferral of some of the lease payments, or a lease modification. Factors to consider in exercising this judgement include the following:

  • Pre-existing clauses in lease contracts. Some lease contracts contain pre-existing force majeure or similar clauses. Where such a clause applies to COVID-19 and results in reduced payments, the substance might be appropriately accounted for as negative variable lease payments that are not dependent on an index or a rate. Under IFRS 16, the effect is recognised by both the lessee and the lessor in the period in which the event or condition that triggers the reduced payments occurs. FAQ 4.2 gives further guidance on the accounting for such force majeure and similar clauses.
  • Actions of governments. Paragraph 2 of IFRS 16 requires an entity, when applying IFRS 16, to consider both the terms and conditions of contracts and all relevant facts and circumstances. The IASB document observes that relevant facts and circumstances might include contract, statutory or other law or regulation applicable to lease contracts. The IASB document also observes that, when applying IFRS 16, an entity treats a change in lease payments in the same way, regardless of whether the change results from the contract itself or from applicable law and regulation. Accordingly, the impact of a lease concession imposed only by law, regulation or government actions might be similar to the impact of a concession required by a pre-existing clause in the lease contract. This might also be appropriately accounted for as negative variable lease payments that are not dependent on an index or a rate, with the effect being recognised by both the lessee and the lessor in the period in which the event or condition that triggers the reduced payments occurs.
  • Forgiveness of lease payments. Where the concession takes the form of a forgiveness of some of the payments required by the lease contract, with no change in the scope of the lease, the substance might be that the lessor is forgiving a part of the lease liability rather than the parties agreeing to modify the lease contract. Paragraph 2.1(b) of IFRS 9 requires IFRS 9’s requirements for derecognition to apply to both lease liabilities (for lessees) and lease receivables (for lessors). A concession in the form of a forgiveness might therefore be appropriately accounted for by applying IFRS 9’s derecognition requirements, with the result that a portion of the lease liability or lease receivable is derecognised. The lessee would reduce the recognised lease liability by the present value1 of the payments that have been forgiven, and it would recognise a corresponding gain in the income statement at the time when the forgiveness occurs. Similarly for the lessor, to the extent that a previously recognised lease receivable has been forgiven, that portion of the lease receivable is derecognised and a loss is recognised in the income statement. Lessors should also apply IFRS 9’s impairment requirements to lease receivables in accordance with paragraph 2.1(b) of IFRS 9.
  • Deferral of lease payments. Some concessions might be in the form of the lease payments being rescheduled rather than reduced – such that, in nominal terms, the consideration for the lease has not changed. An entity might judge that, where such a deferral is proportionate, it is not a lease modification, since there is no change in either the scope of the lease or the consideration for the lease. This would not be inconsistent with the IASB document in the case where the deferral is judged to be proportionate2. However, unless additional interest is charged for the period of the deferral at the rate used to measure the lease liability or lease asset, there will be an effect on the present value of the lease payments. This effect might be accounted for by adjusting the lease liability (for the lessee) or lease receivable (for the lessor in a finance lease) and the recognition of a corresponding gain (for the lessee) or loss (for the lessor) at the time when the deferral is granted.
  • Other concessions. If management concludes that the substance of the concession is not appropriately accounted for using the methods set out above, it should consider whether the substance is a lease modification. An example might be a concession that is negotiated between the lessor and the lessee and that results in a change to the terms of the lease contract. A lessee applies paragraphs 44 - 46 of IFRS 16 to account for lease modifications. The conditions for accounting for the concession as a separate lease will likely not be met, and the IASB document notes that a rent holiday or rent reduction alone is not a change in the scope of a lease. Accordingly, the lessee applies paragraph 45(c) of IFRS 16 and remeasures the lease liability by discounting the revised lease payments at a revised discount rate, with a corresponding adjustment being made to the ‘right of use’ asset. The ‘right of use’ asset should also be tested for impairment in the usual way. It should be noted that, if the concession is accounted for as a lease modification, there will be two principal accounting effects for the lessee3: the first as the lease payments have changed; and the second as the discount rate is revised. The magnitude of the effect of revising the discount rate will depend on:
    • the transition method used when the lessee first adopted IFRS 16; and
    • how each component of the discount rate has changed over time and in the light of COVID-19. For example, in some cases the change in the risk-free component of the discount rate might be approximately offset by the other components (in particular, credit risk).

A lessor applies paragraphs 79 - 80 or 87 of IFRS 16 and accounts for the lease modification as if it were a new lease or, where paragraph 80(b) of IFRS 16 applies, by applying the requirements of IFRS 9.

Entities should also consider what disclosures are required to enable users to understand what the accounting consequences have been and any judgements made.

1 Discounted using the rate used to measure the lease liability – that is, the rate implicit in the lease if that rate can be readily determined, or the lessee’s incremental borrowing rate.
2 The relevant paragraph in the IASB document states, “For example, if a lessee does not make lease payments for a three-month period, the lease payments for periods thereafter may be increased proportionately in a way that means the consideration for the lease is unchanged”.
3 The lessee would also re-assess whether there is a lease (para 11 of IFRS 16) and re-allocate the consideration where the contract contains both a lease and non-lease components (para 45 of IFRS 16).

Illustrative text - Leases - FAQ 4.2 – What are the accounting implications of a force majeure clause in a lease contract in the context of COVID-19?

Publication date: 20 Apr 2020

Background

Some lease contracts contain force majeure clauses that apply in the case of serious unforeseen circumstances beyond the control of the parties to the contract. In addition, actions of governments taken in response to COVID-19 might be accounted for in a similar way to some force majeure clauses. The nature of such clauses can differ. For example, in some cases the clause might relieve the party suffering from the force majeure of all or certain obligations in the contract in the event of explicitly specified circumstances that include a global pandemic as declared by the WHO. In other cases, it might be unclear what rights are established in the case of a pandemic and whether the clause applies at all to the circumstances that have arisen from COVID-19.

What are the accounting implications of such force majeure clauses in the context of COVID-19?

Solution

It depends. Entities should seek to understand how such clauses apply in the context of COVID-19, taking into account both the wording of the clause and the relevant laws and regulations. In addition, actions of governments taken in response to COVID-19 might be accounted for in a similar way to some force majeure clauses (see FAQ 4.1). In some cases, legal advice might be required.

Where it is determined that the clause establishes specific rights and obligations that apply in the current COVID-19 situation (for example, rent reductions of specified amounts or for a specified period), these amounts should be treated as negative variable lease payments not dependent on an index or rate. As a result, in line with paragraph 38(b) of IFRS 16, the benefit of a reduction in payments is recognised in the period in which the event or condition that triggers the reduced payments occurs. Whilst this guidance applies specifically to lessees, we believe that it would be equally applicable to lessors, given that the overall definition of variable lease payments in IFRS 16 applies to both lessees and lessors.

For example, if a lease agreement for a retail store provides for a payment holiday for the period when the store is closed as a result of a force majeure event, the payment holiday is recognised by both the lessee and the lessor over the period when the store remains closed. This is because the event triggering the payment holiday (that is, the store closure) occurs over time as the force majeure occurs. To illustrate, where monthly lease payments are C100, the lessee would derecognise C100 of its lease liability during each month of the payment holiday, with a corresponding gain recognised in the income statement. For the lessor, if it has previously determined that the arrangement is a finance lease, it would derecognise C100 of its lease receivable during each month, with a corresponding loss recognised in the income statement. Where the lessor has determined that the arrangement is an operating lease and that lease income of C100 is recognised each month, for each month of the payment holiday it would also recognise negative variable lease payments of C100. That is, the lease income recognised during the payment holiday period would be zero.

On the other hand, where it is determined that the clause only allows the party suffering from the force majeure to enter into a negotiation with the other party, any changes to the lease payments that are made after such a negotiation will likely not meet IFRS 16’s definition of variable lease payments. In these cases, entities will need to consider whether the negotiated changes might, for example, be appropriately accounted for as the forgiveness of some of the lease payments, which might be treated as a partial extinguishment by applying IFRS 9’s derecognition requirements, or as a lease modification. (See FAQ 4.1 for considerations of lease concessions in the light of COVID-19.)

In any event, where such clauses are triggered, entities will need to consider what disclosures are required to enable users to understand what the accounting consequences have been and any judgements made.

Illustrative text - Leases - FAQ 4.3 – Impairment of lease receivables

Publication date: 23 Apr 2020

Question 1:

What type of lease receivables are subject to IFRS 9’s expected credit loss requirements?

Solution: 

Lease receivables (that is, net investments in finance leases and operating lease receivables) are within the scope of IFRS 9’s expected credit loss (ECL) model.

Such receivables include a lessor’s accrued rent receivables on operating leases (including operating leases of investment properties). These accrued rent receivables might be recognised as a result of lease incentives such as rent-free periods or periods of reduced rental payments, as well as payments made by a lessor to a lessee – for example, an upfront payment in relation to fit-out costs, which is recognised as accrued rent receivable by the lessor and amortised over the lease term to the income statement. 

See FAQ 15.134.2 for further discussion of the accounting for lease incentives.

Question 2:

If a lessor expects a lessee to pay all amounts due under the lease, but later than the contractual due date, does this give rise to an ECL?

Solution:

Yes. Even where a lessee is expected to pay all amounts due, but later than the contractual due date, there will be an ECL if the lessor is not compensated for the lost time value of money (that is, if the lessor does not charge interest for the late payment).

See In the Spotlight – How corporate entities can apply the requirements of IFRS 9 expected credit losses during the COVID-19 pandemic for further details on expected credit losses for corporate entities.

Illustrative text - Leases - FAQ 4.4 – Should lease terms be reassessed as a result of COVID-19?

Publication date: 24 Apr 2020

A retailer entered into a contract to lease a shop for a five-year period, with an option to extend for five additional years. At the commencement date, the retailer considered all relevant facts and circumstances that create an incentive to extend the lease, and assessed that it was reasonably certain to exercise the extension option, and so concluded that the lease term was 10 years. As a result, it included the lease payments of the optional period in the initial carrying amount of its right-of-use asset and lease liability, and it depreciated the right-of-use asset over 10 years.

At the beginning of year 4, COVID-19 lockdowns occur. Should the retailer reassess the lease term?

Analysis

It depends. After the commencement date, a lessee should reassess whether it is reasonably certain to exercise an extension option, or not to exercise a termination option, on the occurrence of either a significant event or a significant change in circumstances that:

  1. is within the control of the lessee; and
  2. affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or not to exercise an option previously included in its determination of the lease term.

[IFRS 16 para 20].

One example of such a significant event or change in circumstances is a business decision of the lessee that is directly relevant to exercising, or not exercising, an option (for example, a decision to extend the lease of a complementary asset, to dispose of an alternative asset or to dispose of a business unit within which the right-of-use asset is employed).

[IFRS 16 para B41].

COVID-19 is not an event that is under the control of the lessee. Therefore, COVID-19 by itself does not lead to a reassessment of the lease term.

However, COVID-19 lockdowns might lead the retailer to revise its business plans and commercial strategy, and to undergo a detailed review of its shop portfolio in the context of this revision. This is a significant event or a significant change in circumstances that is within the control of the lessee.

If, as a result of this commercial strategy revision, the retailer concludes that it is no longer reasonably certain to exercise the extension option, it must reassess the lease term.  

When the lease term is reassessed, the lessee should:

  • remeasure the lease liability by discounting the revised lease payments using a revised discount rate [IFRS 16 para 40];
  • recognise the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset [IFRS 16 para 39]; and
  • depreciate the right-of-use asset over the revised remaining lease term (that is, two years in the example above).

A reassessment can have a significant impact on the carrying amount of right-of-use assets and lease liabilities at the date of the reassessment. As a result, this could have a consequential impact on the amount of depreciation and interest expense recognised subsequently. In addition, the lessee should consider whether the right of use asset is impaired.

A lessor does not reassess, after the commencement date, whether or not an option is reasonably certain to be exercised by the lessee.

Illustrative text - Leases - FAQ 4.5 – Should a lessor in an operating lease continue to recognise lease income when its collectability is uncertain due to COVID-19?

Publication date: 03 Apr 2020

Question

As a result of COVID-19, collectability of rentals on some operating leases has become increasingly uncertain. If a lessor assesses some rents on an operating lease to be uncollectable, should the lessor continue to recognise the corresponding lease income?

Answer

Paragraph 81 of IFRS 16 requires a lessor to recognise lease payments from operating leases as income on either a straight-line basis or another systematic basis. IFRS 16 does not specify a collectability criterion that must be met in order for a lessor to recognise operating lease income. A lessor could therefore continue to recognise operating lease income. However, a lessor is required to apply IFRS 9’s impairment requirements to lease receivables. Impairment losses on lease receivables should be recognised separately as an expense. See FAQ 4.3 for further details.

Illustrative text - Leases - FAQ 4.6 – COVID-19-related modifications to operating leases: lessor perspective

Publication date: 12 May 2020

Question:

Payments due to a lessor under an operating lease agreement might be amended as a result of the COVID-19 pandemic. Given that an operating lessor uses straight-line revenue recognition for operating lease rentals, how would the lessor account for such changes in the following scenarios?

Scenario A: The lessor is required to reduce payments for a particular month because of force majeure clauses in the contract or applicable laws or regulation. These payments are no longer due by the lessee and the lease is not extended.

Scenario B: A lessor voluntarily grants a short-term payment deferral for fixed lease payments that would otherwise be due. There is no interest charged on the deferred payments, and the payments are due at the end of the current year.

Scenario C: A lessor voluntarily forgives certain lease payments in advance of them being due.

Solution

Judgement will be needed to determine the appropriate accounting treatment for lease concessions that are made in the context of COVID-19.

On 10 April 2020, the IASB issued a document intended to support the consistent application of IFRS to lease concessions related to COVID-19 (see link), referred to below as ‘the IASB document’.

Depending on the facts and circumstances, the substance of the concession might be appropriately accounted for as (negative) variable lease payments, forgiveness of some of the lease payments, deferral of some of the lease payments, or a lease modification. Accordingly, a lessor will need to consider all relevant facts and circumstances (including any pre-existing clauses in the lease contract and any relevant laws or regulation that apply to the lease contract) to determine the appropriate accounting treatment. For further guidance, see FAQ 4.1.

Where an operating lease is not modified, but some of the payments are no longer due under the lease agreement (for example, because of force majeure or similar clauses in the contract or applicable laws or regulation), it would be appropriate for the lessor to treat the change to the payments as a negative variable payment and to reduce the recognition of revenue for the periods affected by the amount that is no longer to be paid under the contract by the lessee.

On the other hand, where an operating lessor determines that the concession is appropriately accounted for as a lease modification, it would apply paragraph 87 of IFRS 16. That paragraph requires a modification to an operating lease to be accounted for “as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease”.

Note that, if non-lease components exist within a contract, modifications of non-lease components would be dealt with under the other relevant standard (for example, IFRS 15 for non-lease services).

The application of these principles to each scenario is as follows:

Scenario A: The lessor is required to reduce payments for a particular month because of force majeure clauses in the contract or applicable laws or regulation. These payments are no longer due by the lessee and the lease is not extended.

In this case, the lessor is required by contract or law/regulation to reduce payments. Accordingly, the reduced payments owing by the lessee might not be considered to result from a lease modification, since they are provided in accordance with existing contractual / legal terms. If the entity concludes that the concession is not a modification, it should apply the guidance for negative variable lease payments, as set out further in FAQ 4.2.

Scenario B: A lessor voluntarily grants a short-term payment deferral for fixed lease payments that would otherwise be due. There is no interest charged on the deferred payments, and the payments are due at the end of the current year.

As discussed further in FAQ 4.1, the lessor might consider that the short-term deferral is proportionate, and so it does not change the consideration for the lease. Accordingly, the lessor does not view the change as a lease modification.

In this case, an operating lessor would account for the nominal payments due under a lease over the lease term on the same basis as before the change (which, for operating leases, is typically straight-line), without considering the impact of the time value of money on the related revenue.

Since the modification does not change the total consideration, the amount of revenue to be recognised in each period throughout the lease will not change.

However, to the extent that the deferrals result in a build-up of an accrued rent receivable or debtor relating to straight-line rent recognition, the lessor should apply the relevant impairment requirements under IFRS 9, as discussed further in FAQ 4.3.

Scenario C: A lessor voluntarily forgives certain lease payments in advance of them being due.

The voluntary forgiveness of lease payments that are not yet due (and hence have not been recognised as a receivable) is a modification of the lease. Accordingly, paragraph 87 of IFRS 16 applies, such that the modified lease should be accounted for as if it was a new lease when the payments are forgiven.

The forgiveness will impact the total consideration to be received by the lessor over the term of the lease and, as a result, it will impact the amount of revenue that the lessor records on a straight-line basis over the lease term. The periods in which no payments are owing by the lessee would be similar to a rent-free period granted by the lessor, and similar accounting would result – that is, the lessor would remeasure the total rentals to be recognised based on the revised consideration for the remaining term, and continue to recognise this revised rental revenue on a straight-line basis in the periods forgiven based on this revised calculation.

Illustrative text - Leases - FAQ 4.7 – Accounting by lessees for voluntary forgiveness by the lessor of lease payments when the practical expedient in IFRS 16 is not applied

Publication date: 15 Jul 2020

Question

Lessors might agree to forgive some amount of payments contractually due under the lease contract, without changing the scope of the lease or other terms (for example, if a lessee is in financial difficulty). How should such a forgiveness of lease payments be accounted for by the lessee where such reductions are not required by the contract or by laws or regulation?

Solution

IFRS 9 and IFRS 16 contain different guidance for the treatment of such voluntary forgiveness of lease payments. Therefore, we believe that a policy choice exists for such reductions, as explained below.

A lessee could consider the rent reduction to be a partial extinguishment of the lease liability. Paragraph 2(b)(ii) of IFRS 9 notes that lease liabilities recognised by a lessee are subject to the derecognition requirements in IFRS 9. Paragraph 3.3.1 of IFRS 9 establishes that a financial liability should be derecognised when it is extinguished, and that includes when the obligation specified in the contract is cancelled. Under this accounting, the forgiveness would be recognised as a gain in the income statement, with a corresponding reduction in the lease liability in the period in which the reduction is contractually agreed.

Alternatively, a lessee could consider that the rent reduction is a lease modification, because there is a change in the consideration for the lease (that is, the reduction was not part of the original terms of the lease), and it could apply paragraphs 44–46 of IFRS 16. In this case, the lessee would remeasure the present value of the remaining payments required under the lease using a revised discount rate (that is, the rate implicit in the lease or the incremental borrowing rate, as appropriate) at the date of the modification, and any difference from the previous carrying value would adjust the right-of-use asset.

Entities should choose their treatment as an accounting policy and apply it consistently to amendments to contracts with similar characteristics and in similar circumstances. Entities should also take into consideration local regulators views when selecting their accounting policy. 

Illustrative text - Leases - FAQ 4.8 – Accounting by operating lessors for voluntary forgiveness of amounts contractually due for past rent

Publication date: 15 Jul 2020

Question

Lessors might agree to forgive some amount of payments contractually due for past rent, without changing the scope of the lease or other terms (for example, if a lessee is in financial difficulty). How should such a forgiveness of the lease receivable be accounted for by the lessor where such reductions are not required by the contract or by laws or regulation?

Solution

IFRS 9 and IFRS 16 contain different guidance for the treatment of such voluntary forgiveness of recognised amounts. Therefore, we believe that a policy choice exists for such a reduction in operating lease receivables, as explained below.

A lessor could consider the reduction in payments due for past rent to be a partial extinguishment of the lease receivable. Paragraph 2.1(b)(i) of IFRS 9 notes that operating lease receivables are subject to the derecognition requirements of IFRS 9. Paragraph 3.2.3(a) of IFRS 9 establishes that a financial asset should be derecognised when the contractual rights to the cash flows from the financial asset expire. Under this accounting, the forgiveness would be recognised as a loss (that is, not a reduction in lease income) in the income statement, with a corresponding reduction to the lease receivable in the period in which the reduction is contractually agreed.

Alternatively, in this fact pattern the lessor could consider that the definition of a lease modification is met, because there is a change in the consideration for the lease (that is, the reduction was not part of the original terms of the lease). Therefore, a lessor could follow the guidance in paragraph 87 of IFRS 16 which states that an operating lease modification should be treated as a new lease, and that any ‘accrued lease payments’ must be treated as part of the lease payments for the new lease. Consequently, the lessor would not change the amount previously recognised on the balance sheet for contractually due past rentals immediately on the modification, but it would recognise lower lease income over the remaining term of the lease.

Entities should choose their treatment as an accounting policy and apply it consistently to amendments to contracts with similar characteristics and in similar circumstances. Entities should also take into consideration local regulators views when selecting their accounting policy.  

Note that the above policy choice relates to the forgiveness of amounts contractually due for past rent (regardless of whether they have actually been invoiced). If a lessor forgives rent for a future rent payment that has not been recognised as a receivable, the IFRS 9 guidance would not apply; this is because such amounts have not yet been recognised as financial assets. Where a lessor forgives both past and future rental payments at the same time, the IFRS 9 policy choice would only apply to the portion that is due by the lessee at the time of forgiveness. 

Illustrative text - Leases - FAQ 4.9 – Lessor accounting for initial direct costs where an operating lease is modified

Publication date: 02 Jun 2020

Question

Where a lessor in an operating lease determines that changes to the amount or timing of lease payments should be accounted for as a lease modification, how should the lessor account for initial direct costs associated with the lease?

Solution

Paragraph 87 of IFRS 16 contains specific guidance for lessors in the event that an operating lease is modified. It states that “A lessor shall account for a modification to an operating lease as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease”. Note that, in the event that a lessor voluntarily forgives amounts contractually due for past rent, a policy choice exists as to whether the derecognition guidance in IFRS 9 or the lease modification guidance in IFRS 16 is applied (see further FAQ 4.8).

Where the guidance in IFRS 16 is applied, while paragraph 87 specifies the accounting treatment for any prepaid or accrued lease payments, it does not set out the treatment for any initial direct costs associated with the lease. This might imply that initial direct costs relating to the original lease are derecognised on modification, and only prepaid or accrued lease payments can be considered as payments related to the new lease. However, IFRS 16 requires a lessor to account for a lease modification as a new lease, and so incremental costs incurred in modifying the lease that fit within the initial direct costs definition could be capitalised, given that they are costs of obtaining the modified lease. These incremental costs would not have been incurred if the lease had not been modified.

An alternative view is that, whilst IFRS 16 requires a lessor to account for a modification as a new lease, it contemplates a link to the previous lease by allowing previously recognised prepaid or accrued lease payments to be accounted for as consideration for the modified lease. On this basis, it would follow that any initial direct costs associated with the original lease would equally relate to the modified lease and, therefore, would continue to be recognised and amortised over the remaining term of the modified lease. However, since the definition of initial direct costs refers to costs of obtaining the lease initially, any incremental costs incurred in modifying the lease should therefore be recognised as an expense.

In our view, in the absence of specific guidance in IFRS 16, either approach could be followed. An entity therefore has an accounting policy choice. The policy chosen should be consistently applied and disclosed where material.

Illustrative text - Leases - FAQ 4.10 – What does ‘proportionally’ mean in the context of ‘consideration for a lease’, as described in the IASB’s educational material?

Publication date: 03 Aug 2020

The IASB’s educational material from 10 April 2020 states that, in assessing whether there has been a change in the consideration for a lease, an entity considers the overall effect of any change in the lease payments. For example, if a lessee does not make lease payments for a three-month period, the lease payments for periods thereafter can be increased proportionally in a way that means that the overall consideration for the lease is unchanged. See FAQ 4.1 for further guidance on the IASB’s educational material.

Judgement needs to be applied in the interpretation of the word ‘proportionally’. We believe that, where amounts are forgiven in one period, with the same or similar amounts being added to a subsequent period, this would often be considered to be proportional. For example, if monthly rent of CU100 is forgiven but an increase in CU100 occurs in another period a short while later, this would indicate that the consideration has not changed (that is, the increase would be viewed as proportional). This might also be the case if three months of lease payments are waived because the store was closed (for example, as a result of COVID-19) and three additional months of lease payments are added as an extension at the end of the lease term. In contrast, CU100 might be forgiven, but a CU500 increase occurs in a later period (which is more than the time value of money for the timing difference in the cash flows); or three months of lease payments might be waived, but 12 months of payments are added to the end of the lease term; or there might be a longer-term deferral of lease payments and interest is not charged – in such a situation, the increase might not be considered proportionate, and hence modification accounting might need to be applied, because there would be a change in the consideration for the lease.  

Illustrative text - Leases - FAQ 4.11 – Is it appropriate for a lessor in an operating lease to change the pattern of income recognition in light of COVID-19?

Publication date: 14 Aug 2020

Question:

As a result of the COVID-19 pandemic, lessees might be operating at reduced capacity or be forced to close their premises at various times, either voluntarily or as a result of laws or regulation. Is it appropriate for a lessor in an operating lease to change the pattern of income recognition in these circumstances?

Solution:

No. It would generally not be appropriate to change to a different pattern of income recognition.

Paragraph 81 of IFRS 16 indicates that an operating lessor recognises lease payments as income on either a straight-line or another systematic basis. The ‘another systematic basis’ could be used if it is more representative of the pattern in which the benefit from the use of the underlying asset is diminished.

However, in this case, the lessor’s obligation to provide the lessee with the right to use the underlying asset has not changed. That is, although the lessee might be using the asset in a different way, the use of the asset granted under the lease is still exclusively vested in the lessee during the lease term, and the lessee does not gain or relinquish rights to use the asset more or less than it would have otherwise been entitled to during the remainder of the lease.

For these reasons, the lessee would also generally continue depreciating the ‘right of use’ asset on a straight-line basis, even where the asset is ‘idle’. See FAQ 2.5.1, ‘Can an entity stop depreciating an asset if it is idle?’. Continuing straight-line rental revenue recognition by the lessor is consistent with the lessee’s consumption of the rights within the lease.

Illustrative text - Revenue recognition and government grants - FAQ 6.1.1 – Can government grants for lost income be presented as revenue from contracts with customers or lease income where the entity is the principal of the grant?

Publication date: 27 May 2020

Governments are offering many different relief programmes to support entities during the COVID-19 pandemic. A number of relief programmes are being offered to support entities with lost income.

An entity should first assess whether the relief provided by the government meets the definition of a government grant in paragraph 3 of IAS 20. See FAQ 6.2.2 – Identifying the party that receives a government grant.

Government grants are recognised in the income statement on a systematic basis over the periods in which the related costs towards which they are intended to compensate are recognised as expenses. Grants related to income are sometimes presented as a credit in the statement of profit or loss, either separately or under a general heading such as 'other income'; alternatively, they are deducted in reporting the related expense. [IAS 20 para 29].

Government grants do not meet the definition of either revenue from contracts with customers [IFRS 15 para 6] or lease income. [IFRS 16 para 81]. The netting option in IAS 20 is written in the context of deducting the grant income from the related expense, thereby showing the net expense borne by the entity. It would not be acceptable to apply this approach, by analogy, to grants designed to support lost revenue, because this would result in the grant income being inappropriately classified (for example, within revenue from contracts with customers or lease income).

However, it is acceptable for an entity to present grants given to compensate for lost revenue within ‘other income’, ‘other revenue’ or ‘grant revenue’. We consider that the following presentation alternatives might be appropriate:

  • An entity might present these grants as ‘other income’ outside revenue within operating profit, where income from other government grants is presented when the gross approach is followed.
  • An entity might also view the grant as meeting the broader definition of revenue and therefore being presented within a broader revenue category. This is because IFRS 15 defines revenue as income arising in the course of an entity’s ordinary activities. Therefore if the entity is entitled to the grant as a result of the loss of revenue from providing its goods/services in the ordinary course of business, it might be acceptable to present the grant in total revenue. If the grant is presented as part of total revenue in the income statement, it should be presented separately from revenue from contracts with customers within the scope of IFRS 15 and lease revenue in the scope of IFRS 16 [IAS 20.29]. This separate presentation would be achieved by disaggregating the different components of total revenue. 

In either case, the entity should include a clear accounting policy on the presentation approach that is followed.

Illustrative text - Revenue recognition and government grants - FAQ 6.1.2 – Negative revenue: revision of a ‘highly probable’ variable transaction price due to COVID-19

Publication date: 23 Jun 2020

In 2019, entity A, a travel agency, sold holiday trips (flight tickets, accommodation etc) to travellers. In line with the revenue standard, entity A accounted for these sales as an agent. [IFRS 15 App B para B36]. In the contract with the customer (in this situation, a tour operator), entity A earns a fee unless the traveller does not start the journey – for example, the traveller cancels the travel contract in specific situations or is not able to start the journey due to other circumstances (including force majeure). When assessing revenue recognition, entity A considers that 95% of revenue would meet the highly probable threshold in the IFRS 15 guidance on variable consideration. [IFRS 15 paras 56, 57]. When estimating the expected refundable amount, entity A considers past experience with respect to the amount and the probability of events (and other factors mentioned in para 57 of IFRS 15) that lead to the recognition of a refund liability.

In Q1 2020, due to the COVID-19 pandemic, most holiday trips were cancelled due to travel restrictions imposed by local governments. Entity A is required to refund 95% of the revenue that it recognised in the year to 31 December 2019.

Question

How should entity A present the negative adjustments to revenue in 2020 which relate to 2019 revenue transactions?

Considerations

  • The reduction in revenue relates to a change in the estimate of variable consideration for a performance obligation which was satisfied in 2019. However, the reduction in revenue needs to be recognised in 2020, when the transaction price changes. [IFRS 15 para 88].
  • For certain contracts with customers, revenue for 2020 might become negative as a consequence of the refund related to 2019. Entity A should ensure that it discloses the update of its estimate of the variable consideration as a negative adjustment to revenue in 2020. (IFRS 15 paras 59, 87). This would apply also if entity A’s overall revenue in 2020 would become negative as a result of this adjustment. In the latter case, the statement of profit or loss/ comprehensive income would present a line item ‘revenue’ which is negative.

Illustrative text - Revenue recognition and government grants - FAQ 6.1.3 – Service provider shutdown due to COVID-19

Publication date: 01 Jul 2020

Across the world, governments have taken various measures as a response to the COVID-19 pandemic. These measures range from restrictions on certain business activities to complete lockdown and stoppage of all business activities. Entities might not be able to fulfil their performance obligations to transfer goods or services to their customers and, as a result, they might decide to change their contract terms. Consequently, there could be a temporary suspension or deferral of activities related to providing goods or services to customers during the contract.

Example

Entity E operates a health club. All of the health club contracts with customers are for a two-year period. Such contracts provide access to the health club and use of club facilities. Membership fees are paid upfront and are non-refundable. Entity E recognises the revenue on a straight-line basis over the two-year service period. During 2020, entity E had to shut down its health club for the months of March, April and May, based on the government’s COVID-19 regulation, with no access to customers.

Question 1

How should entities account for suspension of the transfer of goods and services that are satisfied over time?

Considerations

An entity should update its measure of progress to reflect any change in the outcome of the performance obligation as and when the circumstances change over the contract term. [IFRS 15 para 43].

In the given example, the pattern of benefits received by the customers and entity E’s efforts to perform its obligation would not occur evenly throughout the contract term, because of the shutdown period.

Entity E should update its measure of progress and revenue recognised to date as a change in estimate, to depict its performance completed.

Accordingly, entity E should not recognise any revenue during the period of shutdown, because it does not satisfy its performance obligations during this period.

Extension of the original contract term due to COVID-19  

Example

Based on the above example, entity E offers an extended period of membership for three months to its existing customers, as compensation for not being able to access the health club or use club facilities during the period of shutdown.

Question 2

How should entity E account for the extension without receiving any additional fees?

Considerations

Entity E should account for this type of change to the contract terms prospectively. The goods or services provided to the customer could well be seen as distinct from the original contract, because access to the health club is being given for a different period from that in the contract. However, the change (modification) to the contract does not increase the amount received, and so it does not reflect the stand-alone selling price of the additional services. [IFRS 15 para 21(a)].

Therefore, the consideration initially included in the transaction price of the contract before modification, which had not been recognised as revenue, and the consideration promised as part of the modification (if any) should be accounted for as revenue over the remaining contract period, including the three-month extension period, on a prospective basis.

 

Illustrative text - Revenue recognition and government grants - FAQ 6.1.4 – For entities using the cost-to-cost input method for revenue recognition, would additional costs arising from COVID-19 be included in the measure of progress?

Publication date: 12 Aug 2020

Due to the spread of COVID-19, additional costs (such as additional labour costs or costs incurred to comply with ongoing health and safety requirements) might now be required in order to perform construction works after lockdown measures. Such costs were likely not anticipated prior to the COVID-19 pandemic, and they are likely not specifically considered in the price of the contract.

Question:

For entities with long-term construction contracts negotiated before the COVID-19 pandemic, should such additional costs be included in the cost-to-cost input method used to determine the measure of progress for revenue recognition?

Solution:

The measure of progress is intended to depict an entity’s performance in transferring control of goods or services promised to the customer [IFRS 15 para 39], and so the method that best depicts the transfer of control of goods or services should be selected. Where the ‘cost-to-cost’ method (that is, costs incurred relative to total estimated costs) is assessed to be the appropriate method for measuring progress, it should be applied consistently to similar performance obligations in similar circumstances. [IFRS 15 para 40].

Costs that result in a transfer of the control of goods or services to the customer are included in both the costs incurred and total estimated costs in the cost-to-cost method, regardless of whether these costs were anticipated in the contract price. Costs that do not depict progress are excluded from the ‘cost-to-cost’ method. This will include costs of wasted materials, labour and other resources that represent inefficiencies in the entity’s performance, rather than cost contributing to the progress in transferring control of a good or service. Judgement is required to determine if the costs contribute to the progress of the contract based on specific facts and circumstances.

The following scenario illustrates how the principle above might be applied in assessing whether additional costs should be included in the cost-to-cost method selected for revenue recognition of a long-term construction contract negotiated before the COVID-19 pandemic.

Illustration

Due to COVID-19, entity A expects to incur higher labour costs in order to complete a contract than were anticipated before the COVID-19 pandemic. The labour costs increased due to a reduced supply of workers and an increase in overtime pay for more scheduled shift work in order to comply with safe distancing requirements. There was no change to the contract price negotiated prior to the COVID-19 pandemic.

As a result of COVID-19, entities engaged in the satisfaction of this type of performance obligation will need to incur these additional costs in order to satisfy their performance obligation. Therefore, the additional costs do not represent wastages or inefficiencies. Rather, they represent costs contributing to the progress of transfer of control of the construction asset to the customer over the construction period. Entity A should include the additional labour costs in its revenue recognised under the cost-to-cost method.

Illustrative text - Revenue recognition and government grants - FAQ 6.2.1 – Six-step framework to account for the receipt of government grants

Publication date: 27 May 2020

In response to the measures taken to control the spread of COVID-19, governments are providing various relief programmes to lessors, employers, financial institutions and other entities. This FAQ is intended to provide a framework to consider in determining the accounting for these relief programmes.

Steps in approaching COVID-19 government grant accounting

The steps below might be considered to determine the accounting for many of the reliefs provided by the government in the context of IAS 20.

Step 1


Determine whether the relief received is a government grant, based on the definition and scope of IAS 20.

Step 2


Determine whether the entity receives the government grant or rather facilitates the transfer of the relief to the end party on behalf of the government. See FAQ 6.2.2 ‘Identifying the party that receives a government grant’ for guidance on determining whether an entity receives a grant.

Step 3


Consider when the entity that receives a grant meets the ‘reasonable assurance’ criteria in IAS 20.

Step 4


Identify what expense or economic loss the grant is intended to compensate for, and consider how that expense or economic loss is recognised based on the applicable IFRS standard (for example, IFRS 16 for lessors or IAS 19 for employers).

Step 5


Recognise the grant in profit or loss in a manner that matches the pattern of recognition for the related expense or economic loss.

Step 6


Consider the presentation of the grant income. This includes whether the grant is presented gross or net of the related expenditure in accordance with the accounting policy choice in IAS 20. See also FAQ 6.1.1 ‘Can government grants for lost income be presented as revenue from contracts with customers or lease income where the entity is the principal of the grant?’ on grants that compensate for lost revenue.

Below is an illustrative example of how this guidance might be applied.

Example 1

Illustration
A government has introduced a scheme into law that provides a cash rebate (for example, in the form of a property tax rebate) to commercial lessors. The rebate has the following features:

  • The rebate has an explicit requirement that it is passed on to the lessees. Lessors will have an obligation to repay the grant to the government if they do not pass on the grant to the lessee.
  • However, lessors have discretion over the proportion of the rebate allocated to individual lessees and the manner in which the rebate is passed on. For example, for some leases, lessors might provide a fixed amount of rebate per month, whereas for other leases, lessors might provide a percentage rental reduction per month or make a single payment to the lessee. In some cases, the lessors might provide more relief to the lessees than the rebate received from the government. A ‘reasonable’ amount of time is also provided to lessors to make these decisions once the cash rebate has been received.

How should the lessor account for the relief that it receives from the government?

Solution

Step 1 – The relief meets the definition of a government grant in IAS 20, because it is specific government assistance in the form of a transfer of resources to commercial lessors in return for compliance with certain conditions relating to the operating activities of the lessors.
Step 2 – The lessor is the party that receives the relief, because it can direct which lessees receive it and in what proportions the relief is distributed, as well as the manner in which the relief is provided. Lessors also have a reasonable amount of time to determine when the grant must be distributed.
Step 3 – The government has introduced the scheme into law. Lessors need to consider whether there is reasonable assurance that:

  • they would qualify for the scheme and be considered commercial lessors as defined in the legislation; and
  • they would comply with the scheme requirements to pass the relief on to their related lessees.

Step 4 – The lessor determines that the relief is intended to compensate for the reduction of lease income from the lessee. The lessor therefore considers the guidance in IFRS 16 in order to determine the recognition and measurement of the reduction in lease income. See FAQ 4.1 for guidance on how a lessor might make this determination.
Step 5 – The relief should be recognised in profit or loss over the periods in which the lessor recognises as expenses the related costs for which the relief was intended to compensate. [IAS 20 para 12]. The reduction of the lease income from the lessee is equivalent to an expense, and so the relief is recognised over the period of reduced lease income.
Step 6 – The presentation of the relief as other income, or other revenue, will depend on the policy choice selected by the lessor. The policy, as well as any other related IAS 20 disclosures, should be provided if the amounts are material.

Illustrative text - Revenue recognition and government grants - FAQ 6.2.2 – Identifying the party that receives a government grant

Publication date: 27 May 2020

Question

In response to the measures taken to control the spread of COVID-19, governments are providing reliefs to lessors, employers, financial institutions and other entities, with a requirement or expectation that some form of relief is passed on to third parties (such as lessees, employees and borrowers).

How should an entity determine whether it has received a grant to which it applies IAS 20?  

Example

A government provides a cash rebate (for example, in the form of a property tax rebate). The rebate has the following features:

  • The rebate does not have an explicit requirement that it is passed on to the lessees. However, due to strong advice and monitoring by the government, it is expected that lessors will pass on the rebate to lessees in the form of a reduction in rent payments.
  • Lessors have discretion over the proportion of the rebate allocated to individual lessees and the manner in which the rebate is passed on. For example, for some leases, lessors might provide a fixed amount of rebate per month, whereas for other leases, lessors might provide a percentage rental reduction per month or make a single payment to the lessee. In some cases, the lessors might provide more relief to the lessees than the rebate received from the government.

Solution

IAS 20 provides no explicit guidance on determining which party receives a government grant. In many cases, it will be clear which party is the recipient of the grant, because there are only two parties. However, many of the government relief programmes as a result of COVID-19 are targeted at supporting small or medium-sized businesses or individuals and, as a consequence, the government is using other entities (that is, intermediaries) to facilitate the distribution of the relief. Judgement will be required in some cases to determine whether the intermediary receives the government relief and should therefore apply IAS 20.

If the intermediary controls the grant before it transfers to the final party, this indicates that the intermediary is the party that obtains the grant from the government, and it should therefore apply IAS 20. If the intermediary does not control the grant before it transfers to the final party, the intermediary would not apply IAS 20 to the transaction. The intermediary might still need to recognise other assets or liabilities related to the arrangement in order to comply with other IFRSs.

Assessing whether control exists helps to identify the economic resource for which the entity accounts. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that might flow from it. Factors that might be helpful in determining if the intermediary controls the grant before it transfers to the final party include:

  • Whether the intermediary has discretion over which end parties receive the relief. For example, if an employer has discretion over which employees receive a relief package, this might indicate that the employer controls the grant before it is transferred to the selected employees.
  • Whether the intermediary has discretion over how much of the relief it must distribute and the manner in which it makes the distribution. For example, if a lessor can determine how much of a relief package it needs to pass on to lessees, or whether the relief will take the form of a payment holiday, payment deferral or reduced rental, this might indicate that the lessor controls the relief before it transfers to the lessee.
  • Whether the intermediary has discretion over the timing of when it distributes the relief. For example, if a lessee can demand a lessor to pass over relief that was provided under a relief package, this might indicate that the lessor does not control the grant before it transfers to the lessee. 
  • Whether the intermediary initiates the application for the relief or whether this is determined by the end party. For example, if a borrower applies through an intermediary bank for a government-subsidised loan, this might indicate that the bank does not control the grant before it transfers to the borrower.

Consequently, in the illustration above, it is likely that the lessor, and not the lessee, would apply IAS 20 to any rebate that it receives.

An example in which the intermediary might not be the recipient of a government grant is as follows:

The government introduces a scheme in which selected employees are allowed to apply online for government relief, provided that they meet certain criteria. This relief is then paid to the employees by the government via their employer. The employer does not have any discretion about which employees receive the grant or how much is granted. The employer is legally bound to pass on the cash to the employee within seven days of receipt of the related relief payment.

In this example, the employer is not the recipient of the grant, because it does not control the cash relief and it does not have the present ability to direct the use of the cash to obtain benefits. The employer has no discretion over the timing, amount or manner in which the grant is distributed to employees. The employer might still need to recognise other assets or liabilities related to the arrangement to comply with other IFRSs – that is, the cash asset and related liability to employees, to the extent that the cash has been received but not yet distributed at a reporting period end.

Illustrative text - Revenue recognition and government grants - FAQ 6.2.3 – Determining whether a relief or measure is a government grant within the scope of IAS 20

Publication date: 08 Jul 2020

In many jurisdictions, the government might provide multiple reliefs or measures to help affected businesses in dealing with the economic impacts of COVID-19. These reliefs might be provided in a combination of ways, including refunds of prior levies and indirect taxes paid, credits to be applied against future indirect taxes, financial support via loans or guarantees, temporary reductions in tax or business rates, waivers of obligations, or deferred payment arrangements.

Question

How should an entity determine whether a government relief or measure is a government grant within the scope of IAS 20?

Solution

In order to determine the appropriate accounting treatment, it is important to understand the nature of these reliefs and the conditions attached to them. Broadly, these reliefs and measures are government assistance if they are designed to provide economic benefit specific to an entity or range of entities qualifying under certain criteria. [IAS 20 para 3]. But not all government assistance is accounted for as government grants under IAS 20. Only reliefs that meet the definition of government grants (in para 3 of IAS 20) should be accounted for under IAS 20. Determining whether government assistance meets the definition of a government grant requires judgement. Based on the definition of government grants, three key features must exist:

  1. There must be a transfer of resources to the entity – the government assistance could be in the form of a receipt of an asset or a reduction in a liability. The manner in which the relief or incentive is received does not affect the accounting treatment. That said, incremental resources provided to the entity, such as cash refunds or the forgiveness of an existing indirect tax obligation, are more likely to be government grants than reductions in indirect taxes or levies payable in the future.
  2. There must be past or future compliance with certain conditions – the government assistance is provided in return for past or future compliance with certain conditions (implicit or explicit). The more substantive the required conditions are, the more likely the relief is a government grant.
  3. The conditions must relate to the operating activities of the entity – in order to receive or become eligible for the government assistance, there are certain conditions or obligations that are connected with the operating activities of the entity. 

However, in certain circumstances, grants might be awarded without regard to further requirements or further actions by specific entities (for instance, in certain regions or industry sectors). The general requirement to operate in certain regions or industry sectors, in order to qualify for the government assistance, satisfies the conditions required in the government grant definition. [SIC-10 para 4]. The more specific or targeted the relief is, the more likely the relief is a government grant.

Government assistance which cannot reasonably have a value placed on it, and transactions with government which cannot be distinguished from the normal trading transactions to the entity, are not government grants. [IAS 20 para 3]. Reliefs and measures which are in the form of benefits that are available in determining the taxable profits are outside the scope of IAS 20, and they should be accounted for under IAS 12. [IAS 20 para 2]. Other indirect tax benefits or rate cuts that apply to all entities are, in substance, a reduction or discount in the effective levy or tax rates, and they are generally accounted for under IAS 37 and IFRIC 21.

See also FAQ 3.1.6 for the accounting implications of the effects of government financial support in the forms of guarantees or loans. 

The following scenarios use the above guidance and principles in assessing whether the reliefs and measures are government grants.

Illustration 1 – Government measure available to all entities through a rate reduction

The government announced a temporary reduction, that applies to all entities, in the rates of a certain levy payable for the remainder of the financial year. There are no other conditions attached to the government measure.

Solution 1

Whilst the reduction in rates for the levy does generate a reduction in future outflows, there is no incremental resource provided specifically to the entity, as compared to other entities. The government measure does not require compliance with past or future conditions, and it is not linked to the operating activities of an entity (that is, the reduction in rates does not apply to a specific region or industry sector). The government measure therefore does not meet the definition of a government grant, and it should be reflected as a reduction in the calculation of levies payable in the current year.

Illustration 2 – Government measure available to all entities through a cash refund

To boost businesses cash flows, the government approved the cash refund to all entities of land taxes paid in the current year. To participate, the entities need to register and submit certain documents within a period of time.

Solution 2

Whilst the refund results in resources being transferred to businesses (that is, the cash), similar to Illustration 1, there is no incremental resource provided specifically to the entity, as compared to other entities. Although there are some conditions attached to the relief, these conditions are administrative in nature, and they are not linked to the operating activities of the entity. The government measure therefore does not meet the definition of a government grant, and it should be reflected as a reduction in the calculation of land taxes payable in the current year.

Illustration 3 – Government measure available to a specific industry through waiver of an indirect tax

The government is seeking to support businesses operating in the retail industry, who have been particularly impacted by COVID-19 and lockdown measures, and it provides a waiver for their land tax obligations in the current year. The entity is required to operate in the retail industry to be able to utilise the waiver.

Solution 3

The waiver generates a reduction in future outflows, and it provides incremental resources to the entity. This, combined with the requirement to operate in the retail industry, is sufficient to meet the required conditions in the government grant definition under IAS 20. This is consistent with the consensus reached in SIC-10, ‘Government Assistance – No Specific Relation to Operating Activities’.

Illustration 4 – Government measure available to a specific industry through a cash refund

The government announced a cash rebate of the liquor licence fee paid in the prior fiscal year to support businesses in the food sector affected by COVID-19-related lockdowns and restrictions, provided that these entities continue to operate in the affected sector. There are no other conditions attached to the rebate.

Solution 4

The cash rebate is a transfer of incremental resources to the entity. Although the local government does not impose any further conditions to the cash rebate, similar to the rationale in Solution 3, the requirement to operate specifically in the food sector is sufficient to fulfil the other elements of the government grant definition under IAS 20. 

Illustration 5 – Government measure available to all entities through a combination of a cash refund and waiver of future taxes

A government imposes a monthly payroll tax on entities, and this is subject to an annual assessment requiring tiered rates to apply, depending on annual payroll expenditure. The annual assessment might result in an additional payroll tax obligation or a refund, based on the formula. As part of the COVID-19 relief measures, the government provides a cash refund to all entities for the last eight months of payroll taxes paid, and it provides a waiver for the remaining four months of the taxable year.

Solution 5

The manner in which the relief or incentive is received does not affect the accounting treatment. Whilst there is a cash inflow for the refunds and a saving in future cash outflows, there is no incremental resource provided specifically to the entity, as compared to other entities. The relief measures do not require certain conditions that are related to the operating activities of the entities (that is, the measures apply to all entities). Therefore, these relief measures are not government grants.

Illustration 6 – Government measure available to entities that meet specific criteria through a combination of a cash refund and waiver of future taxes

Assume the same facts as in Illustration 5, but the payroll tax reliefs are applicable only to entities that commit to retain at least 95% of their current employees in the next fiscal year.

Solution 6

In contrast with Solution 5, since the relief is applicable to specific entities with a condition linked to their operating activities, the required conditions in the government grant definition are met.

Relevant reference:

SIC-10

[Consensus] Paragraph 3: “Government assistance to entities meets the definition of government grants in IAS 20, even if there are no conditions specifically relating to the operating activities of the entity other than the requirement to operate in certain regions or industry sectors. Such grants shall therefore not be credited directly to shareholders’ interests”.

[Basis for Conclusions] Paragraph 4: “IAS 20.03 defines government grants as assistance by the government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. The general requirement to operate in certain regions or industry sectors in order to qualify for the government assistance constitutes such a condition in accordance with IAS 20.03. Therefore, such assistance falls within the definition of government grants and the requirements of IAS 20 apply, in particular paragraphs 12 and 20, which deal with the timing of recognition as income”.

Illustrative text - Non financial obligations - FAQ 7.4.1 – What are the implications of the COVID-19 crisis for the net defined benefit liability when reporting under IAS 34?

Publication date: 05 Jun 2020

The net defined benefit liability is the difference between the present value of the defined benefit obligation (DBO) and the fair value of the plan assets. Paragraph 58 of IAS 19 requires the net defined benefit liability to be determined with sufficient regularity that the amounts recognised in the financial statements do not differ materially from the amounts that would be determined at the end of the reporting period. Paragraph C4 of IAS 34, ‘Interim financial reporting’, states that IAS 19 requires an entity to determine the present value of the DBO and the fair value of plan assets at each reporting date. The uncertainty and volatility arising from the COVID-19 crisis mean that management should obtain up-to-date information to determine the net defined benefit liability at each interim reporting date.

Plan assets:

The fair value of plan assets is measured at the reporting date, with any movements in the market, post reporting date, being non-adjusting post balance sheet events. The reporting date for an interim period is the date at the end of the reporting period. Where there are adjustments to fair value changes which occur during the interim period reported, these adjustments are usually reflected in other comprehensive income, and they do not affect the calculation of the interim profit and loss charge. [Refer to the following FAQ for more guidance, FAQ 8.2.3].   

The DBO: Management should reconsider the following assumptions at an interim reporting date, to determine whether there has been a material change for which the DBO should be adjusted:

  • the discount rate;
  • the impact of conditional increases of payments to pensioners; and
  • the rate of price and wage inflation.

The impact on the net defined benefit liability will vary depending on the specific facts and circumstances of each entity.

Any change in the defined benefit obligation as a result of changes in the assumptions used to measure the DBO will be recognised in other comprehensive income.

Illustrative text - Non financial obligations - FAQ 7.4.2 – What are the implications of the COVID-19 crisis for the pension expense when reporting under IAS 34?

Publication date: 05 Jun 2020

Paragraph B9 of IAS 34, ‘Interim financial reporting’, states that the pension cost for an interim period is calculated on a year-to-date basis by using the actuarially determined pension cost rate as at the end of the previous financial year. Paragraphs 122A and 123A of IAS 19 require, when there is a curtailment, settlement or plan amendment, the current service cost and interest on the net defined benefit obligation for the remainder of the financial year to be determined using the assumptions used to remeasure the net defined benefit liability. The assumptions determined at the beginning of the period are therefore updated in interim reports to reflect assumptions current at the time of these events. These revised assumptions are then used to determine the current service cost and net interest cost for the remainder of the period.

Paragraph B9 of IAS 34 also suggests that the pension cost should be adjusted for significant market fluctuations. It does not define significant market fluctuations. An adjustment for market fluctuations, however defined, in a particular interim period might affect the pension cost for the rest of the year, which would be inconsistent with the principle in paragraph 28 of IAS 34 that the frequency of interim reporting does not affect the measurement of the annual results. We consider that this inconsistency means we believe that management has an accounting policy choice for the presentation of the pension cost as a result of changes in pension assumptions:

  1. present the changes after the significant market fluctuation in the income statement; or
  2. continue to present the changes in other comprehensive income until the end of the financial year (assuming that there is no curtailment, settlement or plan amendment).

The policy chosen should be applied consistently and disclosed, if material.

Illustrative text - Going concern and events after the reporting period - FAQ 8.1.1 – How does an entity prepare financial statements on a non-going concern basis?

Publication date: 03 Apr 2020

The measures taken to control the spread of COVID-19 will create operational and, in some cases, liquidity challenges for some entities. In some cases an entity might conclude in accordance with the guidance in IAS 1, that it is no longer a going concern. An entity that is not a going concern does not prepare financial statements on a going concern basis. IAS 1 permits an entity that is no longer a going concern to prepare financial statements on a different basis but still in accordance with IFRS.

IFRS does not prescribe the basis of accounting for an entity that is not a going concern. Financial statements might be prepared on a liquidation or break-up basis, but sometimes this will be inappropriate. For example, an entity might be placed in administration, with liquidation or break-up being only one of the possible outcomes. The basis of accounting might be mandated by the administrator. The financial statements might be prepared under an accounting framework other than IFRS if the relevant legislation permits it.

The measurement of assets and liabilities of an entity that is not a going concern, but continues to apply IFRS, might be affected by changes in judgements resulting from the entity’s intention to liquidate or cease trading. For example, estimates of recoverable amounts of assets might be revised, potentially resulting in some assets being impaired.

If the financial statements continue to be prepared in accordance with IFRS (but not on a going concern basis) the entity should develop its accounting policies in accordance with the guidance in the Conceptual Framework and in IAS 8. For example:

  • profit should not be recognised before an asset is sold, unless that asset is measured at fair value;
  • an expected gain on disposal of one asset or cash-generating unit (‘CGU’) cannot be offset against the impairment of another asset or CGU;
  • an entity should not recognise a liability (for example, in connection with restructuring or employee benefits) unless there is a present obligation at the reporting date; and
  • an entity should consider whether executory contracts have become onerous.

Illustrative text - Going concern and events after the reporting period - FAQ 8.2.1 – Should the effects of COVID-19 impact the measurement of assets and liabilities for entities with a reporting date in the first quarter of 2020?

Publication date: 15 Apr 2020

The impact of COVID-19 has been an evolving situation since late 2019. Given the events and circumstances that existed at 31 December 2019, the impact of COVID-19 would likely not be considered a factor that would have had a material effect on the measurement of assets and liabilities (see In brief INT2020-04). However, since then, both the impact and the available information about that impact have changed. On 30 January 2020, the World Health Organisation declared a global health emergency amid thousands of new cases in China and, in March 2020, it declared the spread of COVID-19 as a global pandemic. Consequently, for entities with a 31 March 2020 reporting date, the need to consider the impact of COVID-19 is likely substantial and should be considered a factor that might have a material effect on the measurement of assets and liabilities.

For entities with a January or February reporting date, judgement is required to determine whether the condition (that is, COVID-19) that existed at the reporting date is material and hence should be incorporated into the measurement of assets and liabilities at the reporting date.

The question that an entity should ask when making this judgement is whether, at the reporting date, it was known or knowable that COVID-19 could materially impact the measurement of assets and liabilities. Factors that an entity might consider in making this judgement include:

  1. the reporting period date (for example, COVID-19 is more likely to be considered to materially impact the measurement of an entity’s assets and liabilities where the entity has a 29 February 2020 reporting date compared to an entity with a 31 January 2020 reporting date);
  2. the territory (for example, COVID-19 is more likely to be considered to materially impact the measurement of an entity’s assets and liabilities where the entity is operating in China compared to an entity in a territory in which the spread of the virus occurred later);
  3. the industry (for example, COVID-19 is more likely to be considered to materially impact the measurement of an entity’s assets and liabilities where the entity’s business crosses borders, involves travel by customers, staff or suppliers, and would not have been considered 'essential' to the public); and
  4. the customer base and supply chains specific to the entity.

If an entity has determined that it was known or knowable that COVID-19 would materially impact the measurement of assets and liabilities, a further question arises: ‘Should the entity incorporate developments after the reporting date when measuring the assets and liabilities at the reporting date?’. This might, in some cases, depend on the asset or liability in question, the relevant accounting standard, and the measurement basis for that asset or liability. The following FAQs, 8.2.2 and 8.2.3, might be helpful in this regard.

Illustrative text - Going concern and events after the reporting period - FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value

Publication date: 14 Apr 2020

A number of non-financial assets are measured on a basis other than fair value when they are impaired. The most common examples are assets measured using ‘value in use’ under IAS 36 or at net realisable value under IAS 2.

Management might have judged that the impact of COVID-19 existed at the reporting date and should be incorporated into the measurement of assets and liabilities at the reporting date (see FAQ 8.2.1). An entity has to determine whether developments after the reporting date provide management with better information about a condition that already existed at the balance sheet date. [IAS 10 para 3]. This requires judgement and an analysis of the facts and circumstances in order to distinguish between adjusting and non-adjusting information. The impairment test should be updated after the reporting date if material developments provide better information relating to the reasonably expected impacts of COVID-19 than existed at the reporting date.

A continuation of a previously observed trend does not usually warrant further adjustment, because the trend should have been incorporated into the most recent impairment calculation. However, material developments subsequent to the reporting date relating to COVID-19, that provide better information about the conditions that already existed at the reporting date (that is, the reasonably expected impact of COVID-19), might require management’s assumptions to be updated in the impairment calculations.

For example, an entity might make the following assessments:

  1. An entity with a 31 March 2020 reporting date had not anticipated a material government relief programme as one of the possible scenarios in its cash flow modelling. During the period after the reporting date but before the financial statements are authorised for issue, the government provides the relief. Management judges that the government relief programme is a material development which could have reasonably been expected at the reporting period. This development provides additional information about a condition (that is, the reasonably expected impact of COVID-19) that existed at the reporting date. Therefore, management updates the cash flow model to include the scenario, with an appropriate probability weighting.
  2. An entity with a 31 March 2020 reporting date has used an ‘expected cash flow’ approach in its value in use model, with three scenarios. One of those scenarios incorporates a government lockdown and the other two do not. After the end of the reporting period but before the financial statements are authorised for issue, the government imposes a lockdown. The entity might consider updating its scenarios to reflect the higher probability of the lockdown.

Illustrative text - Going concern and events after the reporting period - FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value

Publication date: 15 Apr 2020

A number of assets are measured at fair value, either through remeasurement (investment properties) or through impairment (fair value less cost of disposal).

A fair value measurement is based on information available at the date of measurement. [IFRS 13 para 15]. An entity should not make any adjustments for events after the reporting period for fair values that are based on only Level 1 or Level 2 inputs. This is because using Level 1 or Level 2 inputs means that the entity has already incorporated all of the information that a market participant would have considered at the date of measurement. 

Even where Level 3 inputs are used to measure fair value, the fair value measurement objective remains the same (that is, an exit price at the measurement date from the perspective of a market participant that holds the asset or owes the liability). Therefore, unobservable inputs should reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk. [IFRS 13 para 87]. Level 3 inputs should be developed using the best information available in the circumstances, which might include an entity’s own data. However, the entity’s own data should be adjusted if reasonably available information indicates that other market participants would use different data. Information that becomes known after the measurement date is only taken into account where reasonable and customary due diligence would have identified the additional information at the measurement date. An entity should revise its fair value estimates if reasonably available information indicates that other market participants would use different data. [IFRS 13 para 89].

For example, an entity might make the following assessments:

  1. An entity with a 31 March 2020 reporting date had not anticipated at all a material government relief programme as one of the possible scenarios in a Level 3 discounted cash flow model during its period-end process. After the end of the reporting period, but before the financial statements are authorised for issue, the government provides a material relief programme. Management should consider the facts to determine whether a market participant would likely have incorporated some expectation of a government relief programme into its discounted cash flow modelling. However, the fact that the government provided a relief programme does not, in itself, mean that a market participant would have included this as a possible scenario. The entity should not use hindsight to give this scenario a 100% weighting, but it should estimate the likelihood of a government relief programme being implemented, consistent with what a market participant would have assumed at the reporting date.
  2. An entity with a 31 March 2020 reporting date has used an income approach to measure fair value. The model includes three scenarios that use Level 3 inputs. One of the scenarios incorporates a government lockdown and the other two do not. After the end of the reporting period but before the financial statements are authorised for issue, the government imposes a lockdown. At the reporting date, a market participant would not have known that a lockdown was a certainty, and so the entity should not adjust its model to have only one scenario with a 100% weighting.

Illustrative text - Presentation and disclosure - FAQ 9.1.1 – Presentation of the COVID-19 impact in the income statement

Publication date: 12 May 2020

As a consequence of COVID-19, entities might wish to present items within the income statement in a particular way, to draw specific attention to the effect of COVID-19.

IAS 1 requires entities to present information in a manner that provides relevant, reliable, comparable and understandable information.

Is it acceptable to provide sub-totals and extra headings in the income statement?

Paragraph 85 of IAS 1 permits disaggregation and additional line items in the income statement if such presentation is relevant to the understanding of the entity's financial performance. Further, guidance in paragraphs 97–98 of IAS 1 requires separate disclosure of material items of income and expenses, which might include presentation in the income statement. Consequently, additional line items, subtotals or headings representing the incremental costs as a result of COVID-19 might be acceptable, provided that they give more understandable information and do not obscure other material information.

An entity should follow its existing accounting policy when making decisions on how expenses, including material items, are presented in the income statement. Entities might describe these types of expenses as exceptional. If there is no accounting policy in place describing the presentation of material and exceptional items, an entity might develop one to address presentation issues resulting from COVID-19. This policy would then need to be applied consistently by the entity in the future. The accounting policy adopted by the entity regarding the presentation of exceptional line items would generally be disclosed in the notes to the financial statements.

How should additional information be presented?

Provided that the principles in IAS 1 are complied with, there might be a number of acceptable ways of presenting this information in the income statement. For example, an entity might present an analysis of expenses by nature, and it might have an accounting policy to present exceptional items as additional line items. To comply with the IAS 1 requirements to consistently present expenses by nature, the entity might need to present more than one additional line item if the COVID-19 exceptional expenses relate to multiple expenses by nature. In many cases, judgement will be required to determine if a proposed presentation is acceptable.

IAS 1 would not permit pro-forma amounts1 to be presented in the income statement. However, IAS 1 would allow an entity to present separately a significant impairment recognised under IAS 36 as a direct result of COVID-19.

Further examples of material items that it might be acceptable to draw attention to, as a result of COVID-19, include:

  • incremental costs of acquiring specific medical devices to protect employees, such as face masks;
  • termination penalties paid to suppliers;
  • debt modification expenses (which would still need to be presented as part of finance costs); and
  • write-off of deferred tax assets resulting from reduced expectations of taxable profits (which would still need to be shown as part of taxation).

The consumption of existing assets that were not able to generate income as a result of COVID-19 would generally not be included within additional line items. This is because it is the lost income that is the exceptional event as a result of COVID-19, rather than these ‘sunk costs’. Sunk costs are therefore those expenses that would have been incurred regardless of COVID-19. Examples of such sunk costs might include:

  • normal salary costs of employees whose productivity has been impacted as a result of COVID-19; and
  • depreciation and other facilities costs.

Regulators often have a view on the appropriateness of the use of additional line items and pro-forma information, and so regulated companies should exercise caution when departing from a ‘standard’ presentation. For example, the European Securities and Markets Authority has issued a specific alternative performance measures-related Q&A in this respect (ESMA Q&A 18).

Some entities might choose to keep the established income statement presentation but to disclose specific COVID-19 information in the notes to the financial statements. [IAS 1 para 112(c)]. Regardless of the approach taken, further disclosure might also be needed in the notes, to comply with other IFRS requirements related to COVID-19.

Other factors to consider

There might be a mixture of factors impacting the entity’s financial performance, and it might be difficult in some cases to separate the effect of COVID-19 from other external factors (for example, the impact of a reduction in commodity prices). In such situations, management might need to apply judgement. Management might also need to clearly explain why a particular income or expense presentation is primarily as a result of COVID-19.

1 ‘Pro-forma amounts represent items of income and expense that do not constitute amounts determined in accordance with IFRS principles. For example, ‘pro-forma’ revenue would be revenue that the entity would have earned if there was no negative impact resulting from COVID-19.

Illustrative text - Presentation and disclosure - FAQ 9.1.2 – Classification of inventory costs, during closure, in an income statement presented by function

Publication date: 20 Jul 2020

Due to lockdown measures, a number of entities have had to close or limit their manufacturing facilities for some time. During the lockdown periods, the manufacturing facilities were operating at zero or limited capacity, and the unallocated fixed and variable overhead costs might still have been charged to the income statement as unallocated overhead costs. [IAS 2 para 13].

Question:

How should entities which present income statements by function classify such costs in the income statement?

Solution:

Entities applying a ‘by function’ method in presenting their income statements should classify expenses according to function.

Paragraph 38 of IAS 2 requires unallocated production overheads and abnormal amounts of production costs of inventories to be recognised under ‘cost of sales’. Therefore, unabsorbed overhead costs arising from reduced capacity of the manufacturing facilities should be presented under the ‘cost of sales’ function.

Entities might, however, consider presenting a disaggregation of ‘cost of sales’ for the unallocated overhead costs, where this is necessary for an understanding of performance (see FAQ 9.1.1 ‘Presentation of the COVID-19 impact in the income statement’).

Illustrative text - Interim financial statements - FAQ 10.1 – Implications of goodwill impairment in interim financial statements

Publication date: 03 Apr 2020

Entity A, with a 31 December year end, prepares interim financial statements using IAS 34 for the first quarter of 2020. At 31 December 2019, it had goodwill with a carrying amount of C1,000. The coronavirus (COVID-19) pandemic and general economic downturn caused a trigger to test for impairment in the first quarter of 2020. Entity A completed an impairment review at 31 March 2020 which resulted in the goodwill being written down to C600 and an impairment of C400 recognised in the income statement. By 31 December 2020 the pandemic is under control and the economy has recovered; if an impairment test was performed at 31 December 2020 on the original goodwill of C1,000, no impairment would be required.

Question

Can entity A reverse the C400 goodwill impairment at year end?

Answer

No. Entities preparing interim financial reports using IAS 34 are required to apply IFRIC 10, which does not allow an entity to reverse an impairment loss of goodwill recognised in a previous interim period prepared under IAS 34. Even if the economic outlook improves before year end, such that the recoverable amount of the cash-generating unit is higher than the carrying value including goodwill of C1,000, the entity would not be permitted to reverse the impairment of goodwill. The C400 will be reported as goodwill impairment in the full year’s financial statement.

Illustrative text - Interim financial statements - FAQ 10.2 – What is the impact on impairment testing of providing financial information (such as a Q1 trading update) during the year but not in accordance with IAS 34?

Publication date: 18 May 2020

Many entities will be impacted to some degree by the COVID-19 pandemic and current economic uncertainty. During this time of uncertainty, many entities will still produce interim information. Some entities provide supplementary financial information (for example, quarterly earnings releases) that does not constitute a complete set of interim financial statements in accordance with IAS 34, ‘Interim financial reporting’. The supplementary financial information that is provided might show impairments at the time when the supplementary information is provided.

Question

If an entity has recorded an impairment in interim financial information which is not in accordance with IAS 34, does it need to record the same impairment when it reports in accordance with IFRS?

Solution

No. The interim financial information was not in accordance with IFRS (IAS 34), and therefore the principles in IAS 36, ‘Impairment of Assets’, were not necessarily followed. At the next period end when a set of IFRS-compliant financial statements is produced (either at half year or year end), the normal principles of IAS 36 should be followed. If an impairment is recorded, the amount could be different from the amount that was recorded or disclosed in the interim financial information.

Example

An entity prepares a mandatory Q1 result announcement for the quarter ended 31 March 2020. This publication has not been prepared in accordance with IAS 34. Management indicated, in the Q1 information, that, in the current economic environment, there would likely be an impairment of goodwill, and it included a range. If the entity had prepared IAS 34-compliant interim financial statements, it would have recognised an impairment of goodwill.

The entity subsequently prepares an interim report, for the six months ended 30 June 2020, in accordance with IAS 34. The entity considers whether there are impairment indicators at the reporting date (that is, 30 June 2020). [IAS 36 para 12]. If there are indicators present, the entity would perform an impairment test. The entity performs the annual test of goodwill at the time of its usual annual test.

Illustrative text - Interim financial statements - FAQ 10.3 – How should an entity estimate the weighted average annual effective income tax rate?

Publication date: 03 Jul 2020

Background

Since taxation is assessed based on annual results, determining the tax charge for an interim period involves making an estimate of the likely effective tax rate for the year. [IAS 34 para 30(c)].

The tax charge or benefit cannot be properly determined until the end of the financial year (or, if different, the tax year), when all allowances and taxable items are known. Calculating tax on the basis of the results of the interim period, in isolation, could result in recognising a tax figure that is inconsistent with the manner in which tax is borne by the entity. Therefore, the calculation of the effective tax rate should be based on an estimate of the tax charge or benefit for the year, expressed as a percentage of the expected annual accounting profit or loss. This percentage is then applied to the interim result, and the tax is recognised evenly over the year as a whole. [IAS 34 App B para B12].

To the extent practicable, a separate estimated average annual effective income tax rate is determined for each taxing jurisdiction and applied individually to the interim period pre-tax income of each jurisdiction. While that degree of precision is desirable, it might not be achievable in all cases, and a weighted average of rates across jurisdictions is used if it is a reasonable approximation of the effect of using more specific rates. [IAS 34 App B para B14].

Governments around the world have reacted to the impact of COVID-19 with a variety of measures, some of which have involved tax law changes. The estimation of the annual and interim tax charge or benefit should use the tax rates and laws applicable to the full year that have been enacted or substantively enacted by the end of the interim reporting period. [IAS 34 App B para B13].

The tax effect of ‘one-off’ items should not be included in the likely effective annual rate, but it should be recognised in the same period as the relevant ‘one-off’ item. The estimated annual effective tax rate (excluding ‘one-off’ items) will, in that case, be applied to the interim profit or loss, excluding the ‘one-off’ items. [IAS 34 App B para B19].

Question

Where a group operates in multiple territories, it is not always straightforward to estimate the weighted average effective income tax rate for the full financial year. The estimates needed to determine expected full-year taxable profits and losses by jurisdiction, and thereby the tax rate applicable to expected total annual earnings, might be subject to a wider degree of uncertainty than usual, given the on-going impact of COVID-19 on both business activity and tax laws.

How should an entity estimate the weighted average annual effective income tax rate?

Solution

In some cases, the actual rate for the interim period, excluding the impact of one-off items, might be a reasonable estimate of the weighted average annual effective income tax rate for the full financial year. 

The information used to estimate the average effective tax rate should be consistent with the information used in other financial statement estimates (for example, the forecasts and budgets used for impairment, viability and going concern assessments). However, these forecasts are not always drawn up with the objective of forecasting pre-tax results to the level of granularity required to calculate the expected tax charge in each territory. The challenges and uncertainty arising from COVID-19 might make it more difficult to estimate the annual effective tax rate. Pre-tax profit in a multinational group needs to be allocated to business functions, intellectual property, financing etc.   The territory-by-territory estimate also needs to take account of adjustments such as interest restrictions and minimum tax levels, and it might be necessary to consider the extent to which tax losses are recoverable in a given jurisdiction. All of these factors can have a disproportionate impact on the effective tax rate, resulting in much greater sensitivity to geographical profit assumptions and estimates.

Many groups have undertaken large-scale scenario planning exercises, given the on-going impact of COVID-19, but those planning exercises might have been focused at a trading profit level, and they might not have taken into account all of the factors that need to be considered to determine taxable profits by geography.

Therefore, whilst the assumptions used to estimate the weighted average annual effective income tax rate expected to apply to the full financial year should be consistent with those used in other financial statement estimates for elements that are comparable, the actual rate for the interim period (excluding the impact of one-off items) might provide a reasonable basis for estimating the effective rate for the full year, adjusting for the effects of any seasonal or COVID-19 variations and associated progressive tax rate impacts.

Paragraph 16A(d) of IAS 34 requires disclosure of the nature and amount of changes in estimates of amounts reported in prior periods (either interim periods within the current financial year or in prior financial years). Since COVID-19 has introduced uncertainty, entities should update their disclosures to explain the assumptions made in estimating the weighted average annual effective tax rate, including related sensitivity analysis.

At the date of each interim financial report, an entity should re-estimate its effective annual tax rate and apply that to the profits earned to date. There should be no restatement of previously reported interim periods for the change in estimate, but disclosure is required of the nature and impact of the change, where significant. [IAS 34 App B para B13].

Illustrative text - FAQ index by standard

Publication date: 01 Jul 2020

FAQ index by standard Reference
IFRS 9 - Financial Instruments
FAQ 3.1.1 – How will factoring or other sales of trade receivables be impacted by COVID-19? IFRS 9
FAQ 3.1.2 – How should a bank and a borrower account for a loan repayment holiday imposed by law? IFRS 9
FAQ 3.1.3 – What is the accounting treatment of a loan repayment holiday negotiated between a bank and a borrower? IFRS 9
FAQ 3.1.4 – When is a new loan granted to an existing borrower, in substance, a payment holiday on the original loan? IFRS 9
FAQ 3.1.5 – New loans granted to defaulted debtors IFRS 9
FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19 IFRS 9
FAQ 3.1.7 – Monetary items forming part of the net investment in a foreign operation IFRS 9
FAQ 3.2.1 - Impact of COVID-19 payment holidays on ECL staging IFRS 9
FAQ 3.2.2 - How should modified loans, such as loans subject to ‘forbearance’, be classified within the IFRS 9 expected credit loss (‘ECL’) impairment model? IFRS 9
FAQ 3.2.3 – In the context of COVID-19 and ECL, what information is ‘reasonable and supportable’? IFRS 9
FAQ 3.2.4 – Example of a provision matrix for corporates in a COVID-19 environment IFRS 9
FAQ 3.2.5 – Impact of price concessions on expected credit losses of trade receivables IFRS 9
FAQ 3.2.6 – Cash collateral held for trade receivables or lease receivables: recognition and impact on measurement of ECL IFRS 9
FAQ 3.2.3.4 - To what extent should additional COVID-19 related information after the reporting date be included in the ECL estimate? IFRS 9
FAQ 3.3.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IFRS 9)? IFRS 9
FAQ 3.3.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IFRS 9)? IFRS 9
FAQ 3.3.3 – Hedge accounting and payment holidays IFRS 9
FAQ 3.3.4 – Recoverability test for hedging reserves IFRS 9
FAQ 3.3.5 – Fair value hedge accounting and debt modifications (IFRS 9) IFRS 9
FAQ 3.5.1 – How is the accounting for supplier finance arrangements impacted by COVID-19? IFRS 9
FAQ 4.3 – Impairment of lease receivables IFRS 16, IFRS 9
FAQ 4.5 – Should a lessor in an operating lease continue to recognise lease income when its collectability is uncertain due to COVID-19? IFRS 16, IFRS 9
   
IFRS 13 - Fair value measurement
FAQ 2.6.1 - Impact of COVID-19 on investment property valuation IFRS 13, IAS 40
FAQ 2.6.2 - Uncertainties in cash flows and change in valuation technique for level 3 fair value measurement IFRS 13
FAQ 2.6.3 – Additional considerations for discount rates used in Level 3 fair value measurements IFRS 13
FAQ 2.6.4 – 'Determining fair value where an entity might be forced to liquidate assets' IFRS 13
FAQ 3.8.1 – Determining whether a market is still active in a period of market disruption IFRS 13
FAQ 3.8.2 – Assessing prices in inactive markets IFRS 13
FAQ 3.8.3 – Determining whether transactions are orderly IFRS 13
FAQ 3.8.4 – Adjustments to the quoted price in an active market IFRS 13
FAQ 3.8.5 – Delays in the availability of information IFRS 13
FAQ 3.8.6 – Post market closure events IFRS 13
FAQ 3.8.7 – Uncertainties in cash flow fair value measurement of financial instruments IFRS 13
FAQ 3.8.8 – Should possible future modifications be considered when determining the fair value of a debt instrument? IFRS 13
FAQ 3.8.9 – Consideration of fair value where an entity has breached a debt covenant IFRS 13
FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value IAS 10, IAS 36, IFRS 13
   
IFRS 15 - Revenue from contracts with customers
FAQ 6.1.2 – Negative revenue: revision of a ‘highly probable’ variable transaction price due to COVID-19 IFRS 15
FAQ 6.1.3 – Service provider shutdown due to COVID-19 IFRS 15
   
IFRS 16 - Leases
FAQ 4.1 – How should lease concessions related to COVID-19 be accounted for? IFRS 16
FAQ 4.2 – What are the accounting implications of a force majeure clause in a lease contract in the context of COVID-19? IFRS 16
FAQ 4.3 – Impairment of lease receivables IFRS 16, IFRS 9
FAQ 4.4 – Should lease terms be reassessed as a result of COVID-19? IFRS 16
FAQ 4.5 – Should a lessor in an operating lease continue to recognise lease income when its collectability is uncertain due to COVID-19? IFRS 16, IFRS 9
FAQ 4.6 – COVID-19-related modifications to operating leases: lessor perspective IFRS 16
FAQ 4.7 – Accounting by lessees for voluntary forgiveness by the lessor of lease payments IFRS 16
FAQ 4.8 – Accounting by operating lessors for voluntary forgiveness of amounts contractually due for past rent IFRS 16
FAQ 4.9 – Lessor accounting for initial direct costs where an operating lease is modified IFRS 16
   
IAS 1 - Presentation of Financial Statements
FAQ 8.1 – How does an entity prepare financial statements on a non-going concern basis? IAS 1
FAQ 9.1.1 – Presentation of the COVID-19 impact in the income statement IAS 1
FAQ 9.1.2 – Classification of inventory costs, during closure, in an income statement presented by function IAS 1
   
IAS 2 - Inventories
FAQ 2.4.1 – How is overhead cost allocated to inventory where the number of units produced reduces due to COVID-19? IAS 2
   
IAS 10 - Events after the Reporting Period
FAQ 8.2.1 – Should the effects of COVID-19 impact the measurement of assets and liabilities for entities with a reporting date in the first quarter of 2020? IAS 10
FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value IAS 10, IAS 36
FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value IAS 10, IAS 36, IFRS 13
   
IAS 16 - Property, Plant and Equipment  
FAQ 2.5.1 – Can an entity stop depreciating an asset if it is idle? IAS 16
   
IAS 20 - Accounting for Government Grants and Disclosure of Government Assistance  
FAQ 2.1.6 – Does an entity incorporate cash flows from government assistance or grants when determining the value in use of a cash-generating unit? IAS 20
FAQ 3.1.6 – How to account for financial support arrangements put in place by central banks in response to COVID-19 IAS 20
FAQ 6.1.1 – Can government grants for lost income be presented as revenue from contracts with customers or lease income where the entity is the principal of the grant? IAS 20
FAQ 6.2.1 – Six-step framework to account for the receipt of government grants IAS 20
FAQ 6.2.2 – Identifying the party that receives a government grant IAS 20
FAQ 6.2.3 – Determining whether a relief or measure is a government grant within the scope of IAS 20 IAS 20
   
IAS 23 - Borrowing costs
FAQ 2.5.2 – Suspending capitalisation of borrowing costs IAS 23
   
IAS 34 - Interim Financial Reporting
FAQ 7.4.1 – What are the implications of the COVID-19 crisis for the net defined benefit liability when reporting under IAS 34? IAS 34
FAQ 7.4.2 – What are the implications of the COVID-19 crisis for the pension expense when reporting under IAS 34? IAS 34
FAQ 10.1 – Implications of goodwill impairment in interim financial statements IAS 34, IFRIC 10
FAQ 10.2 – What is the impact on impairment testing of providing financial information (such as a Q1 trading update) during the year but not in accordance with IAS 34? IAS 34, IFRIC 10
FAQ 10.3 – How should an entity estimate the weighted average annual effective income tax rate? IAS 34
   
IAS 36 - Impairment of Assets  
FAQ 2.1.1 - Is the coronavirus (COVID-19) pandemic an impairment indicator? IAS 36
FAQ 2.1.2 - Should the business plan prepared by management be revised to incorporate the impacts of COVID-19? IAS 36
FAQ 2.1.3 – How can impairment tests that incorporate cash flow forecasts be more reliably performed in periods of uncertainty? IAS 36
FAQ 2.1.4 – What are the consequences of the COVID-19 pandemic on the discount rate? IAS 36
FAQ 2.1.5 – Level at which impairment testing is performed IAS 36
FAQ 2.1.6 – Does an entity incorporate cash flows from government assistance or grants when determining the value in use of a cash-generating unit? IAS 36
FAQ 2.1.7 - Is an entity permitted to change the timing of its annual impairment test of goodwill, in the light of COVID-19 if the test was not historically performed at year end? IAS 36
FAQ 2.2.1 - Which impairment disclosures will be of particular interest to users of financial statements this year? IAS 36
FAQ 8.2.2 – Adjusting events affecting impairment calculations related to non-financial assets with a measurement basis other than fair value IAS 10, IAS 36
FAQ 8.2.3 – Adjusting events affecting remeasurement/impairment calculations related to assets with a measurement basis of fair value IAS 10, IAS 36, IFRS 13
   
IAS 39 - Financial Instruments: Recognition and Measurement  
FAQ 3.4.1 – How do floors in variable-rate loans affect the application of cash flow hedge accounting (IAS 39)? IAS 39
FAQ 3.4.2 – What factors should be considered in assessing the ‘highly probable’ criterion for cash flow hedges of forecast purchases or sales in light of disruptions to the supply chain or sales process as a result of COVID-19 (IAS 39)? IAS 39
FAQ 3.4.3 – Hedge accounting and payment holidays (IAS 39) IAS 39
FAQ 3.4.4 – Fair value hedge accounting and debt modifications (IAS 39) IAS 39
FAQ 3.10.1 - Is COVID-19 a ‘rare circumstance’ for insurers? IAS 39
FAQ 3.11.1 – What is a ‘significant’ or ‘prolonged’ decline in fair value below cost? IAS 39
   
IAS 40 - Investment Property
FAQ 2.6.1 - Impact of COVID-19 on investment property valuation IFRS 13, IAS 40
   
IFRIC 10 - Interim Financial Reporting and Impairment  
FAQ 10.1 – Implications of goodwill impairment in interim financial statements IAS 34, IFRIC 10
FAQ 10.2 – What is the impact on impairment testing of providing financial information (such as a Q1 trading update) during the year but not in accordance with IAS 34? IAS 34, IFRIC 10
   
 
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