Asset measurement during a state of epidemic and economic slowdown. Part 1

Piotr STASZKIEWICZ
Audit Partner at RSM Poland

We have recently written a lot about financial instruments: their definition, classification, measurement, impairment, etc. Since all this remains relevant and topical, we will soon be publishing a Q&A with the most frequently asked questions and explain the different aspects of financial instruments that keep baffling our readers.

Today, however, partly due to functioning in a state of epidemic and partly because I want to continue with the topic of impairment of assets (receivables), I decided to focus on the measurement of balance sheet items at fair value.

We have already discussed post-balance sheet events and how the suspension of trade or production should be reflected in 2019 financial statements. Now it is time to think about how to disclose the economic slowdown in 2020 accounts, especially as companies will soon be preparing their semi-annual reports and presenting the impact of COVID-19 and economic downturn on asset measurement.

The impact of coronavirus and economic downturn on financial reporting boils down to the analysis of the following:

• going concern assessment;
• asset measurement;
• increased uncertainty of the estimates of the entity’s management;
• appropriate descriptions of both estimates and risk management;
• necessary additional disclosures in financial statements, including contingent liabilities or provisions;
• the auditor’s sceptical analysis of report contents.

Going concern assessment

In corporate reporting, the essential thing is whether the management can properly assess whether the company can continue its business as a going concern or not. If the management decide that it cannot, financial statements must be prepared applying reporting rules that are somewhat different than the “usual” ones, both according to the Accounting Act and IFRS. Pursuant to Article 29 of the Accounting Act, if the going concern basis is not justified, assets shall be measured at the sale price that can be achieved but it cannot be higher than current asset values (i.e. purchase price or manufacturing costs less any impairment losses or amortisation). What must be created is a provision for additional and anticipated expenses resulting either from discontinuation or the inability to continue as a going concern. According to IFRS 1 par. 25 and the Underlying Assumptions to IFRS par. 4.1, whenever financial statements are not prepared on a going concern basis, the situation must be clearly presented along with the information about the rules and principles of measurements and data presentation which are applied in such a case.

Asset measurement

Some entities apply fair value measurement for their property, plant and equipment or investments in real estate (on the basis of IAS 16 and IAS 40). These entities should reconsider IFRS 13 – Fair Value Measurement, in order to anticipate any potential problems ahead of time.

What are the implications of IFRS 13?

This standard applies whenever any other standard requires or permits fair value measurement or when disclosures of fair value measurement are required. Fair value measurement principles defined in IFRS 13 do not apply to share-based payment transactions (IFRS 2), leasing transactions (IFRS 16) or measurements that have some similarities to fair value but are not fair value (IAS 2 – inventory measurement at net realisable value) or IAS 36 – impairment of assets).

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. I will try to present some suggestions of what the company’s management should do to apply fair value measurement properly in times of economic recession: be it temporary, caused by an epidemic, for example, or long-term, resulting from economic cycles, demographic changes or decisions made by many governments.

Having identified an asset to be measured, the entity’s management should find an appropriate market that would be the most advantageous for the measured asset and select both the measurement technique and inputs to be used for the measurement.

Valuation techniques and fair value hierarchy

In the simplest terms, valuation techniques include:

• market approach: based on market transactions involving identical or similar assets (or liabilities, but for the purpose of this article I am focusing on asset measurement);
• income approach: based on future amounts resulting, e.g., from cash flows, discounted to present value;
• cost approach: based on the amount that would currently be required to replace the asset.

What you need for a reliable valuation is appropriate inputs. While the standard fails to define which valuation technique is better or worse or has a higher or lower priority, there is a hierarchy of inputs used to measure the fair value. According to IFRS 13, it is important that techniques used to measure fair value maximise the use of observable inputs and reduce the use of unobservable inputs. In other words, the rules of fair value measurement and the fair value hierarchy presented below focus on inputs, and not on a valuation technique as such.

What is the fair value hierarchy?

• First (Level 1 inputs), you should rely on inputs without adjustment (quoted prices) in an active market for assets that are identical with our assets to be measured. This is the most reliable evidence of fair value and as such should be the first choice.
• Secondly (Level 2 inputs), you should rely on observable inputs (objective and measurable), yet different from those in the first approach, observable for the measured asset either directly or indirectly.
• Last (Level 3 inputs), if level 1 and level 2 inputs are not available, you have the right to rely on unobservable inputs.

COVID-19 and asset measurement

In view of the above, when conducting an asset measurement in the current economic situation, you should consider the following:

• responses to COVID-19 resulting in a surge in remote working and its effect on rates, e.g. vacancy rate with regard to investment property valuation;
• responses to COVID-19 affecting the access to capital or the market;
• lower interest rates on risk-free instruments and changes of liquidity that may affect discount rates or
• changes of risk premium.

In particular, if you rely on level 3 inputs, you have to take the validity of measurable data and the effects of risks or uncertainties when using a discount. During the measurement and with cash flows applied, you also need to consider any amendments of contracts (e.g. lease), probability of contract termination, probability of cash inflows, etc.

What is more, when relying on level 1 and level 2 inputs, you have to recognise the fact that COVID-19 or economic slowdown bring about financial market volatility, which, in turn, may affect the credibility of market prices.

Finally, there is a question of how to measure other assets covered by IFRS 15, IFRS 9 and IFRS 16? I am going to discuss this in my next article.