IFRS: December 2020 year-end accounting reminders

Following the financial crisis, the replacement of benchmark interest rates such as LIBOR and other interbank offered rates (‘IBORs’) has become a priority for global regulators. Many uncertainties remain but the roadmap to replacement is becoming clearer.

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We continue to see a large number of questions around the accounting for supplier financing arrangements, and ever more complicated arrangements involving special purpose vehicles, charitable trusts with companies having both payables and investments tied up in the arrangements. Such arrangements raise the question of whether the trade payables that are the subject of the supplier financing should be derecognised and replaced by a bank borrowing and whether any investment vehicles should be consolidated by the entity. Given the incidences of high profile corporate failures such as Carillion in the UK, accounting correctly for supplier financing arrangements has attracted significant attention from the regulators, with focus, amongst other areas, on a company’s source of finances. This includes whether a company has made material use of supplier finance, if this is transparent from the annual report, whether related balances are appropriately presented as bank debt or trade creditors and whether subsequent cash flows are appropriately presented in the statement of cash flows.

In September 2019, the UK FRC’s Financial Reporting Lab published a report on disclosures of sources and uses of cash.
This includes an appendix on the subject of supplier finance which provides, among other things, an illustrative example of good disclosure. The FRC note that IFRS 7 ‘Financial Instruments: Disclosures’ requires companies’ accounts to disclose information that allows readers to understand the nature of and risks around financial instruments, including liquidity risk and that IAS 1 requires companies to consider whether balances are financing or working capital in nature and present them accordingly. It is clear that they expect these requirements to lead companies to disclose the nature of any material supplier financing arrangements, the implications for the company’s liquidity and the relevant amounts, along with any significant accounting judgements.
In February 2020, the IFRS IC has also been asked to consider both the accounting and disclosure of supply chain finance in corporate entities. Their initial discussions are expected to take place shortly. The level of disclosure that the FRC has indicated it expects with regards to supplier finance arrangements may be greater than the disclosures currently provided by many companies. Companies and engagement teams may wish to revisit existing disclosures and consider if they wish to include any additional disclosures in light of regulator communication and stakeholder attention to this area.
Further guidance on supplier finance arrangements and indicators of extinguishment are available in chapter 44 of the IFRS Manual of Accounting.
The accounting for supplier finance arrangements will depend on the exact facts and circumstances relating to them.
In addition entities should consider how the accounting for supplier finance arrangements is impacted by COVID-19.

We continue to see a large number of questions on the restructuring of issued debt instruments, for example loan facilities or bond financing and modification of derivatives to take advantage of low interest rates. This is a complex area of accounting which can require significant judgement. To assist engagement teams in understanding the potential issues, some of the key accounting considerations (under IAS 39 and IFRS 9) are summarised below. Relevant guidance (under IAS 39 and IFRS 9) is provided in IFRS MoA paras 44.106 – 44.110.

• Determining whether the new and old debt have substantially different terms – Under IFRS 9, where a financial liability is exchanged or its terms are modified but the liability remains between the same borrower and the same lender, it is necessary to assess if the terms are substantially different. If they are substantially different, the transaction should be accounted for as an extinguishment of the original financial liability and the recognition of a new financial liability.

• Treatment of gain or loss on modification/extinguishment of debt. In October 2017 the IASB confirmed that when a financial liability measured at amortised cost is modified without this resulting in derecognition, a gain or loss should be recognised immediately in profit or loss. The gain or loss is calculated as the difference between the original contractual cash flows and the modified cash flows discounted at the original effective interest rate. This means that the difference cannot be spread over the remaining life of the instrument which may be a change in practice from IAS 39
• Treatment of fees incurred as part of the renegotiation – whether the fees should be recognised immediately or whether they can be capitalised. (IFRS MoA paras 44.117 – 44.119)
• Use of an Intermediary – A corporate entity may use a bank as an intermediary when restructuring its debt. For example, when a corporate wants to change the terms or maturity date of an existing bond, it may use a bank as an intermediary to buy back the original bonds and then sell the modified bonds to investors.
  The accounting for this is complex. A key accounting consideration in this situation is whether the bank is acting as an agent or as principal, which is highly judgmental. If the bank is not acting as principal the corporate would have to treat the modification of the bonds as an extinguishment with any gains/losses recognised in profit and loss.
• Modifications when a credit facility is undrawn. Treatment of a gain or loss arising on modification of derivatives, particularly where no cash payment or receipt is made at the time of the modification. There is often a difference in value due to changes in credit spreads or bank profit margins. This value change does not relate to any existing or future hedge relationships and, if unobservable, that is not directly related to changes in market conditions, should not be recognised in profit or loss immediately.

Impairment is an ongoing area of concern for many of our clients. Regulators remain focused on this area and continue to push for increased transparency in disclosures. Groups holding significant amounts of goodwill and intangibles are at greater risk of a regulatory challenge to their impairment assessments and in particular the related disclosures.

The key points in impairment testing are:

• For the value-in-use (VIU) model key assumptions should stand up against external market data. Cash flow growth assumptions should be comparable with up-to-date economic forecasts.
• In times of greater uncertainty, it is likely to be easier to incorporate these uncertainties in impairment testing by using multiple cash-flow scenarios and applying relative probability weightings to derive a weighted average set of cash flows rather than using a single central forecast and attempting to risk adjust the discount rate to reflect the higher degree of uncertainty in the environment.
• IAS 36 requires that the VIU model uses pre-tax cash flows discounted using a pre-tax discount rate. In practice, post-tax discount rates and cash flows are used which theoretically give the same answer but the need to consider deferred taxes makes this very complicated to achieve. Therefore if a post-tax VIU model results in a ‘near miss’ the next step should be to determine fair value less costs of disposal (FVLCD).

The fair value model, which is a posttax model, must use market participant assumptions, rather than those of management.

• In assessing for impairment, the carrying value should be determined on a consistent basis as the recoverable amount. For example:
• Where the recoverable amount is determined using the fair value model, the carrying amount tested should include current and deferred tax assets/liabilities (but exclude assets for tax losses, because these are treated as separate transactions).
• Where the VIU model (i.e. pretax) is applied, deferred tax assets should not be added to the carrying value and deferred tax liabilities should not be deducted (i.e. are not included in the carrying amount of the CGU). This could result in the carrying value for VIU being higher than the carrying value for FVLCD. However, in situations where there is significant deferred tax upfront, an IAS 36 VIU test may not be the most appropriate method to determine the recoverable amount of a CGU.

The required disclosures in IAS 36 are extensive. IAS 36 requires disclosure of the key assumptions (those that the recoverable amount is most sensitive to) and related sensitivity analysis. Note also IAS 1 para 125 requires disclosure of critical accounting judgements and of key sources of estimation uncertainty. Where a reasonable possible change in key assumptions would reduce the headroom (excess of the recoverable amount over the carrying amount) of a CGU to nil, it is required to disclose this headroom.
Where the headroom is sensitive to changes in key assumptions, an entity would need to disclose the specific changes in assumptions that would erode headroom to nil (+/– x% in sales growth or discount rates). However, in cases where no reasonably possible change would either erode headroom for CGUs when testing goodwill or give rise to a material adjustment to any carrying value in the next year, companies should take care that additional sensitivity disclosures do not give the wrong impression or become confusing to users. Given the increased uncertainty and volatility in many markets at present, the range of reasonably possible changes has widened which means that more extensive impairment disclosures will be required.
Key assumptions and wider ranging assumptions covering multiple Cash Generating Units (‘CGUs’) should be clearly disclosed. Where material, assumptions specific to each CGU should be identified. Changes to assumptions used, such as the discount rate, which has changed significantly from the previous year should be explained. Furthermore, in an impairment case, the entities would need to clearly disclose what the cause of the impairment was and whether this is based on external data or changes in the company’s own estimates. An entity with a material impairment loss or reversal additionally need to disclose the recoverable amount of the asset(s) or CGU(s) affected (IAS 36 para 130 [e]).
Regulators have observed that, whilst the long-term growth rate used to extrapolate cash flow projections (to estimate a terminal value) and the pre-tax discount rate are important; they are not ‘key assumptions’ on which the cash flow projections for the period covered by the most recent budgets or forecasts are based. Therefore, attention should also be paid to the discrete growth rate assumptions applied to the cash flows projected to occur before the terminal period. Accounting policy disclosures should always be consistent with the basis used in the according impairment test. The regulators have pointed out, that they will continue to challenge companies where the recoverable amount is measured using VIU, but the cash flow forecasts appear to include the benefits of developing new business or to rely on future investment capacity.

Key points to consider for impairment related disclosures in 2020 accounts:

• Brexit and other political/ macroeconomic risks
• Climate change and environmental impact
• Impact of Coronavirus
• Interaction with IFRS 16.