An entity does not operate in isolation; along with internal policies, numerous external factors impact an entity. While internal policies can be impeccably formulated and resources and technology aligned to achieve the targeted numbers, external factors can be a stumbling block.

The publication highlighted the following external factors and its impact on accounting and reporting:

It is imperative to understand the impact of these factors on the following accounting items in preparation of financial statements:

1. Impairment (MU) (CG) (GU): Impairment is impacted by all factors, macroeconomic, climatic, and geopolitical. Macroeconomic factors like inflation affect the cost line, higher interest rates influence the net recoverable amount, and the entity will have to make a sensitivity disclosure if a change in key assumptions will cause the carrying amount to exceed the recoverable amount. Climate changes will call for the purchase of greener fixed assets, in which case the assets in use will have to be re-evaluated. Similarly, going greener may increase costs, which must be factored into the cash flow forecast for impairment assessments. Geopolitical conditions like wars and international sanctions impact the physical assets in affected areas, inventory, assets, or subsidiaries. Companies also need to assess the recoverability of the carrying amount of an asset or CGU.
2. Debt Covenants (MU): Higher interest rates could lead to higher discounting rates, resulting in reduced asset values, which could lead to a breach in the asset-to-liability ratio and debt-to-equity ratio. The terms of existing debt/loan arrangements for possible breaches and waivers before year-end must be evaluated and reclassified to non-current if the debt covenants are not satisfied.
3. Expected Credit Loss (CG) (GU): Climate change causes credit risk changes in periods usually over 12 months. Companies should evaluate if a 12-month probability of default remains supportable or if a lifetime ECL needs to be estimated due to the significant increase in credit risk. Geopolitical conditions will call for an assessment of ECL due to trade restrictions, payment restrictions, and recoverability from debtors with operations/ customers in affected areas.
4. Green Financing (CG): Sustainability or green bonds are unique, and their proceeds can only be used for specific climate-based projects. The consequences of not abiding by these restrictions and its impact must be evaluated by the issuers. Also, accounting for these bonds can be complex as there is variability in the amount of interest payable since it depends on meeting ESG targets. Issuers should also consider the changes in expected cash flows if ESG targets are unmet.
5. Provisions (CG) (GU): Changes in contracts, increased costs, and potential revenue loss due to changing preferences towards sustainable products or sourcing will bring a need to recognise new provisions. If a detailed formal plan to make significant changes in operations is underway, then a provision for restructuring must be made. Due to geopolitical conditions, if revenue from a contract cannot cover the losses, then a provision for an onerous contract must be made. Also, existing provisions should be recognised to record any obligation from delayed/cancelled deliveries to customers or breaches in contractual terms.
6. Going Concern (MU) (CG): Highly leveraged companies need to conduct a robust assessment to see the impact of material uncertainties on the ability to continue as a going concern owing to higher interest rates. This will require prudent judgement and measures to mitigate the conditions that cast significant doubt. Cash flow projections must also be updated with current interest and discount rates. In times of war or unrest, the entity should be assessed to know if there is a significant deterioration in the company’s net working capital position, thus questioning going concern.

KNAV Opinion

The significance of evaluating the impact of various external factors on financial reporting cannot be overstated. Auditors’ experience allows them to analyze economic conditions, predict geopolitical events that may affect financials, and take prompt corrective action to ensure that financial statements represent the true state of affairs. By performing audits of the highest quality, auditors contribute to the growth and success of the economy even in challenging conditions and build investor confidence. Directors and Audit Committees are the first filter for quality financial reporting. A mindful and knowledgeable Audit Committee can play a positive role in ensuring the highest quality of financial statements.

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