The purpose of financial reports is to present a true and fair picture of the financial performance and position of a business entity.
True — implies that the financial statements are factually correct and do not contain any mis-statements. When these statements are prepared in compliance with Indian Accounting Standards (Ind AS), it should not mislead the users.
Fair — suggests that the financial statements depict the information faithfully without an element of bias. They should reflect not only the legal form of business transactions but also the underlying economic substance. Investment analysts aligned with stock-broking / fund houses should never take the reported annual statements at face value. Analysts should read between the lines of financial reports to understand the true and fair picture.
The world economy in general, and India in particular, would be leaned towards recession where GDP nosedived for one quarter. A series of lockdowns that followed the outbreak of the pandemic had disrupted supply chains, closed factories, idled assets, downed the shutters of retailers, dried revenue streams, and exposed businesses to a variety of fixed expenses which cannot be wished away. Most of the sectors need life support and liquidity to survive the crisis. Indian companies have to reassess the recoverability of its accounts receivables after considering the possibility of insolvency filings by customers/clients. Appropriate amount has to be either written off or provided for bad debts in anticipation of future losses. Equity research warrants deep diving into these cold numbers to gain insights required for taking an investment call.
The coronavirus scenario being a black swan event (a negative event – occurrence of an event which is impossible to predict such as 9/11 attack, dotcom crash, financial crisis of 2007-08 etc) needs accounting data scrubbing and recasting the financials. Key accounting variables have to be adjusted (upward/downward) by analysts to make the financials reflect ground reality. Sectoral analysts in metals, pharma, telecom, retail, banking, etc. may be consulted wherever necessary.
Listed Companies – SEBI Requirements
- Disclosures made should be both quantitative and qualitative in nature.
- Disclosures must go much beyond reporting shutdown of operations.
- Disclose steps taken to ensure smooth functioning, restarting of operations, and ability to maintain the operations in factories & offices.
- Specify impact on liquidity, profitability, and debt serviceability.
- Listed companies should report the impact on financial statements.
Dent on Financials:
All the key elements of a financial statement – incomes, expenses, gains, losses, assets, and liabilities of the reporting financial year 2019-20 would be adversely impacted.
While every corporate entity had struggled because of the coronavirus, the exact impact on their financial reports depend on the nature of the business, location of plants, intensity of capital, debt load, working capital requirement, magnitude of fixed assets, employee strength, usage of temporary labor, etc. Specifically, the damage to financial statements would be felt because of revenue recognition, inventory valuation, impairment of non-current assets and goodwill, forex gains/losses due to rupee volatility, insurance claims for loss of lives or losses due to shutdowns, and so on and so forth.
Analysts while looking at annual reports through a microscope should figure out whether the core risks have been identified and quantified to showcase the harsh reality especially in the following arenas:
Revenue Recognition: We should recognize revenue for sale of good/service only when there is a high degree of certainty of its collection as and when due. In the current scenario, many trade debtors are finding it difficult to liquidate their stock. Hence, there would be a high incidence of bad debts necessitating write-offs which would impact the bottom-line.
Inventory Valuation: Inventory got piled up in the warehouses due to lockdowns. The restricted movement of the goods resulted in accumulation of stocks across the supply chain. Valuation of inventory might have taken a severe beating because of obsolescence or lowering of selling prices in the wake of reduced purchasing power of the customers. The realizable value of inventory would be lower than its cost of manufacturing in the present situation and impacts net profits.
Impairment of Non-current & Intangible Assets: Fixed assets erode in value when the future cash flow generation from the sale of goods churned out by it diminishes. Selling and billing pressure is the new normal because of this unprecedented human crisis. Hence, the value of the fixed asset should be reduced to that extent. This would squeeze the net margins and reflects the economic reality.
Foreign Exchange Gains/Losses: Foreign exchange rate differences between the transaction date and settlement date of monetary items should be recognized as income or expense. If both transaction and settlement happen in the same accounting period, the exchange difference should be recognized in the same period. Forex rates became volatile as New York became an epicenter of the pandemic and the USD became more volatile against INR impacting the reported profits.
Insurance Claims: A host of sectors including automobiles, hospitality, infrastructure, real estate, aviation, textiles, banks, and financial institutions were in doldrums because of the spread of the virus. Some of these businesses may get partial bailout by the government as the latter cannot remain a silent spectator. Other corporates might receive compensation from their insurance companies because of having coverage against business disruption. Such cash flows should be taken into cognizance before we estimate the effect on financial performance.
There is a big question mark on whether a business should consider itself as a going concern or not as companies do not have the resources to operate indefinitely into the future. Bankruptcies will be on the rise due to the jolt of coronavirus and existing assets are prone to liquidation. As COVID-19 would impact the future costs, revenues and contracts they need to be estimated and captured in the documents mandated for external reporting.
Against this backdrop, it would be extremely demanding to prepare financial statements for FY 2019-20 and thereafter. As users of financial statements, Equity analysts are challenged to rework on core metrics to advice stock market clients whether to buy, sell, hold, or wait.
1) How should an Analyst interpret the government assistance accounted in the financial reports?
2) What is the impact of liabilities not being valued properly in the balance sheet?
3) What happens when the assets are not carried at an appropriate amount in the balance sheet?
4) Which financial year (2019-20 or 2020-21) would be more challenging for an analyst to recast the data?
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