THE season for financial reporting for 2022 has begun and is destined to be challenging and requires careful consideration. The geopolitical tensions in Russia and Ukraine and the various trade sanctions coupled with new Covid-19 cases daily have created a vague global gloomy economic outlook, fuelling volatility in equity and commodity prices. These events pose additional challenges for preparers of financial statements to affirm the carrying amounts of assets and liabilities.
Note that IFRS 13 denotes “fair value” as an orderly transaction between the market participants to sell an asset or pay to transfer a liability at the measurement date. The orderly transaction is not a forced transaction and allows for marketing activities to take place. Further to that, IAS 36 is clear that if the assets’ carrying amount is higher than the recoverable amount, they shall be impaired. Recoverable amount here means fair value less cost of disposal, or its value in use, whichever is higher.
Let’s take nickel – a commodity and critical ingredient for electronic vehicle manufacturing, as an example in determining fair value at the measurement date. Nickel was trading below US$25,000 per tonne in early March 2022. Within a day, on March 8, 2022, the price soared to US$100,000 per tonne, forcing a shutdown of nickel trading on the London Metal Exchange. It was a rare shutdown coupled with a thin market volume. The market on that day indicates it was not trading in an orderly fashion, albeit outside the realm of regular expectations.
We view the quoted price on that day as unsuitable to determine the fair value due to the market shutdown. However, it is not uncommon for chief financial officers (CFO) to take other inputs to determine the fair values of assets and liabilities, and IFRS 13 allows for that. The same can’t be said regarding commodities facing transitory price movements as was the case for crude petroleum.
The pandemic brought new challenges, too, in determining the fair values of financial assets and liabilities. Credit risk has been growing since, from trade receivables’ doubtful debts to possible defaults of sovereign or corporate bonds. Impairment is inevitable in some cases, say in the case of trade receivables, by looking at the provisioning metrics embedded within the expected credit loss model. Care has to be exercised in assessing the fair values of financial instruments as risk-adjusted returns of issuers may have changed with the current environment, where the complications increase with unquoted instruments as it becomes more judgemental with the reliance on observable and unobservable inputs.
For the case of non-financial assets’ impairment assessment, the CFO may need to consider the following:
• The underlying cash flows incorporate the latest economic and industry outlook in congruence with the expected business and economic perspective.
• The incorporation of asset risk factors must not be double accounted.
• The changes in the cost of transportation due to the supply chain disruptions.
• The surge in cost of production due to the rise in raw commodity prices.
• The changes in the expected equity returns and cost of debts for the business.
• The changes in the entity’s incremental cost of borrowings.
• The shift in inflation expectations or monetary policies.
The ordeal extends for the CFO if businesses own assets subjected to trade sanctions, eg assets held in Russia or with Russian banks or corporations. It is reasonable to doubt the financial quality of such assets as their status quo to remain liquid or restricted assets is questionable. Likewise, such assets are likely to be subjected to higher discounts for lack of marketability (DLOM) in light of limited potential buyers. The CFO can’t just rely on observable prices as the assets lack marketability and are likely further impeded by limited market participants in Russia. Similarly, markets with extreme volatility can signal for higher DLOM adjustments too.
The above are some of the dilemmas to be faced by CFO in preparing financial statements in light of the recent global events. The pointers given here are crucial too for the formulation of corporate financial risk management strategies. We suggest that businesses stress-test their balance sheet due to the current global economic and political uncertainties. This can steer away unpleasant surprises and ensure nothing flies under the radar. It is equally important for users of financial statements to be critical in evaluating them, and we hope reading this article has contributed to that.
This article is contributed by Mazars associate director & Young MICPA (The Malaysian Institute of Certified Public Accountants) Task Force member Roger Loh Kit Seng, and business & financial adviser Sukh Deve Singh Riar. The views expressed here are the writers’ own.