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If you are a director or senior manager of a company, you will be considering or involved in the preparation of the financial statements for 2019-20. The profit-and-loss related targets set in early-2019 would have been more-or-less achieved, but with an enormous question mark hanging over the balance sheet. Most items in the balance sheet are carried at historic cost or fair value on the balance sheet date. There are two doubts that the developments arising from the Covid-19 will cast on the values usually used — what is the fair value and, have items at historic cost been impaired?
Fair value is snatched from published quoted values, (if available) or from comparable transactions; if both are not available, then it’s taken by discounting cash flows associated with an asset or a liability. Assessment of the impairment of assets also uses the same sets of inputs. What used to be a reasonable, straightforward process has been complicated immeasurably by the Covid-19 destruction of the world economy.
Revising assumptions
All predictions of value are based on assumptions. Even a quote from an open, supposedly fully informed market, assumes that it is the fair value of the relevant asset on that date. But the wildly erratic behaviour of the markets in the past three months caused by impossibility of predicting the future of everything, makes that assumption suspect.
The impact of the pandemic will render moot all previous balance sheet assumptions. Company management must present modified financial forecasts with this in mind, for stakeholders’ scrutiny
As for recent transactions, virtually none have happened after the outbreak, and those from prior to it are unlikely to be considered reliable indicators under the new uncertainties. All the assumptions that need to be made for discounting cash flows are also at sixes and sevens. When will the economy revive? What will be the nature of the revival — will it be A, J, L, M, N, U, V, W shaped? How will the revival affect the business of the company, including of its major stakeholders? What support will the government give? How long will it take for labour to be back and the supply chain to stabilise?
What will be the demand for the business’s products and services? Will Covid-related restrictions thwart a return to original levels of production? Will there be inflation of input prices due to supply constraints? What rate will the dollar reach?
Forecasts for the future
Management will already be grappling with these same questions, even as their energies are focussed on the here and now of cash-flow management, assessing vendor and customer situations, logistics restoration, planning the restarting of operations and assuaging concerns of employees and stakeholders. It’s more than likely that managements would be preparing forecasts for at least two years for best-case, worst-case and most-likely scenarios.
The greater challenge will be assessing the impairment of each cash-generating unit. Forecasts for 2020-21 might result in impairments, but not those for the longer term.
These will be moving forecasts, as the behaviour of the government, the economy and the developments directly related to the virus change from day to day. The decisions that management will begin to take, once the focus on short-term survival is elevated, will be driven by the forecasts. These decisions, too, will change constantly as the predictions of the future fluctuate.
Two to three weeks before the finalisation of the financial statements for 2019-20, the management will need to start modifying the accounts-related assumptions that were used till December 2019 for the drawing-up of financials. Using the then current “most likely scenario” will be the way to modify the assumptions. The values to be placed on current assets and liabilities will be relatively easier and the method used will not be much different from that used hitherto. If certain types of customers are likely to face crises, the expected credit loss provision would need reworking, as also the probability that any specific inventory held for that group may not be saleable at previous prices.
The greater challenge will be assessing the impairment of each cash-generating unit. Forecasts for 2020-21 might result in impairments, but not those for the longer term. Management will have to take a long-term view of most such cases, explaining how they will tide over the interregnum.
Retirement liabilities, too, might have used certain assumptions for mortality, premature terminations from employment, wage increases, or returns on fund investments that might not be appropriate given Covid-related developments.
Board consent
Because these are significant matters, it will be important to get the board’s consent to use the forecasts in making accounting assumptions. Therefore, managements might want the board to consent to the specific forecasts they plan to use about three weeks before the finalisation of accounts. In the event that these need modifying after the board has discussed them, that will give time to make the changes.
Full disclosure is the wisest policy when faced with uncertainty. Even wiser is to not put a positive spin on the future, as is the want of most managers and boards when communicating with stakeholders.
It is also not unlikely that by the time the financials are actually brought to the board for approval, the situation would have changed significantly, throwing a doubt over the accounts presented. Therefore, the financial statements will need to prominently clarify that the financials have been drawn up using information available to management up to a specified date. In the event that a significant change has occurred subsequently, this might be adjusted in those items that have material impact on the financials and ignored in the others.
Whatever a board does, there will remain the spectre of the eventual outcome being worse than what has been assumed in the accounts. A prudent board might want to assess the broad impact of the “worst case scenario” and transfer the difference between that impact and what is captured in the accounts, to a “coronavirus impact reserve”, clarifying in the management’s report the policy it has used and emphasising that the estimates are likely to vary significantly in reality.
Finally, if the pedantic application of accounting standards makes the financial results misleading, boards will have to use the “true and fair override” provided by the LODR, disregarding the dark apprehensions of SEBI action from the auditors and the company secretary.
Full disclosure is the wisest policy when faced with uncertainty. Even wiser is to not put a positive spin on the future, as is the want of most managers and boards when communicating with stakeholders. The future is more uncertain than it ever was and every stakeholder is cognisant of it; treating them like children will be foolish.
(The writer serves on the governing council of TERI and as an independent director on the boards of Thermax and Exide Industries)
Published online by Business Line here