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How IFRS reporting is impacted by global volatility and vulnerability

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How do businesses account for challenges like geopolitical risks, macro economic events and climate change in their IFRS financial statements?


In brief

  • Companies are expected to face increasing internal and external pressures on their cash flows due to factors related to climate change.
  • The need is greater than ever for transparent financial statements that show the true impact of the economic slowdown on a company’s performance and prospects.
  • All of these factors will impact company's IFRS financial statements.

The International Monetary Fund (IMF) issued its latest World Economic Outlook, highlighting that global economic activity is experiencing a broad-based and sharper-than-expected slowdown, with inflation at its highest levels in several decades. The IMF referred to a cost-of-living crisis, tightening financial conditions in most regions, the war in Ukraine, and the lingering COVID-19 pandemic as reasons for the current level of increased uncertainty and high inflation. This market uncertainty affects company’s IFRS financial statements.

Investors need timely, relevant information about the effects of macroeconomic events. Information will be relevant if investors could reasonably expect that it will have a significant impact on the business and, therefore, influence their investment decisions.



IFRS standards require companies to reflect the effects of these developments in the accounting (for example, the measurement of expected credit losses or when assessing assets for impairment) and disclose information that is relevant to an understanding of the financial statements .



High and volatile commodity prices

High volatility in commodity prices has resulted in some market disruption driven in particular by the war in Ukraine. Increases in commodity prices, such as oil and natural gas, have led to a sustained increase in input costs for many manufacturers as they affect the acquisition and construction cost of many different assets (such as property, plant and equipment, intangible assets and inventories).

 

Many commodity producers and users enter into hedging transactions with derivatives to protect themselves from commodity price volatility. Whilst these derivatives reduced the direct impact from the recent price increases, the rise in commodity prices may trigger margin calls on the derivative contracts affecting companies' liquidity position. When markets are disrupted, derivatives may no longer perfectly offset changes to the hedged risk, resulting in the recognition of hedge ineffectiveness directly in profit or loss when applying hedge accounting. Developments may also require entities to reconsider the application of the ‘own use exemption’, for example, if physical delivery of commodities is no longer intended contrary to the initial expectation.

 

Increasing interest rates

Interest rates globally are rising due to increased market risk and central banks’ actions to slow down inflation. Companies that have debt will face the strong headwinds of increased borrowing costs and potentially higher refinancing costs in the future. Furthermore, many IFRS standards use discounting to account for the time value of money in measuring non-current assets and liabilities (for example, the fair value measurement of investment properties using discounted cash flows). When interest rates increase, the present value of those assets and liabilities will decrease. This may affect areas of financial reporting including impairment calculations, provisions, retirement obligations, leases, financial instruments and revalued tangible and intangible assets.

 

High inflation

Inflation is at a multi-decade high in many economies and more persistent than initially expected. There is a general business risk that many companies may have fixed-price sales contracts which no longer cover the cost of fulfilling those sales, making their contracts onerous. Companies may also have contracts that are explicitly inflation-linked and this may mean assets and/or liabilities, for example, real estate leases, need to be adjusted for inflation.



There are a number of IFRS standards that specifically refer to inflation as one of the assumptions to be considered for measurement purposes.



For example, inflation is particularly relevant in assessing asset impairments, which require estimates to be made about future revenue and expenditure. Inflation also affects many other areas of accounting, such as determining the residual value of property, plant and equipment and net realisable values of inventories. The measurement of provisions for obligations in the future (for example, decommissioning provisions), can also be significantly impacted by inflation.

Some entities may also be impacted by hyperinflation, which has its own IFRS standard. There is currently an upward trend in the number of countries with hyperinflation, which has a specific definition, and countries that are determined to be hyperinflationary are within the scope of a specific standard in IFRS. Applying IFRS standards to hyperinflationary subsidiaries is complex and can have a significant impact on the consolidated balance sheet and the income statement.

The war in Ukraine

The war in Ukraine has had a number of economic impacts. Many countries continue to impose sanctions on specified Russian entities and individuals and sanctions have also been imposed on Belarus. This and potential fluctuations in commodity prices, foreign exchange rates, restrictions on imports and exports, availability of local materials and services and access to local resources will directly impact companies that have significant operations or exposures in, or with Russia, Belarus or Ukraine. The situation triggers a number of IFRS accounting considerations for companies that could be exposed to fluctuations in commodity prices and foreign exchange rates, as well as the possibility of a protracted economic downturn. For instance, restrictions on performing certain activities can impact the entity either directly through the recognition of impairment losses and onerous contracts, or indirectly, for example, through increased expected credit losses.

The COVID-19 pandemic

The COVID-19 pandemic has significantly impacted the world economy and while many lockdown restrictions have eased, many companies are still experiencing the effects. The financial effects of the pandemic can be seen in almost all areas of a company’s IFRS financial statements (for example, the accounting for changes in leases or obsolete inventories). How to present and disclose these effects continues to be an important consideration for companies that are still facing them.

Climate change

The push to reduce society’s impact on climate change has never been greater. At the same time, there is unprecedented pressure from stakeholders for companies to communicate clear commitments which is set to continue for the foreseeable future.

Although there is no single explicit standard on climate-related matters under IFRS, climate risk and other climate-related matters may impact a number of areas of accounting. 



While the immediate impact to the financial statements may not necessarily be quantitatively significant, there are increasing expectations from stakeholders that companies explain how climate-related matters are considered in preparing their financial statements to the extent they are material from a qualitative perspective.




Stakeholders also expect robust disclosures on the most significant assumptions, estimates and judgements made related to the physical and transition risks resulting from climate change, including relevant information on the scenarios applied by management to determine future cash flows.

Summary

Companies are facing a perfect storm of extraordinary events from the cost-of-living crisis, tightening financial conditions in most regions, the war in Ukraine and the lingering COVID-19 pandemic. This is in addition to climate change becoming an ever more urgent issue for companies and investors alike. Assessing the potential effects for companies and how these should be reflected in IFRS financial statements will be critical for financial reporting in 2022.


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