Standards • Auditing & Accounting Considerations

COVID 19: Sector Wise Analysis of Key Auditing and Accounting Considerations

Journal: The Chartered Accountant, September 2021 (Vol. 70, No. 3) • Pages: 54–63 (Journal pp. 302–311)
RS

CA. Radhika Sharma

Member of the Institute • eboard@icai.in

HS

CA. Harinderjit Singh

Member of the Institute • caharinderjit.singh@gmail.com

In today’s environment where many auditors are working remotely, it is their professional responsibility to plan and perform any audit with professional skepticism and with a clear focus on quality and evaluate impact of the various considerations on their audit.

Considering the existing economic environment, this article aims to highlight:

  • Key auditing and accounting considerations for the auditors across sectors of (i) Consumer and retail (ii) Automotive (iii) Industrial manufacturing (iv) Technology and (v) Hospitality
  • Sector specific challenges for the Companies

Further, this article includes an illustrative Checklist for auditors to help initiate the evaluation of management assessment of COVID-19 impact. The issues discussed in this article are illustrative and by no means exhaustive and their applicability depends on the facts and circumstances of each entity.

Audit Consideration Matrix under COVID-19 Disruption

Professional judgement and skepticism
Planning – Risk identification and assessment
Audit evidence & Auditing accounting estimates
Compliance with AS/Ind AS, adherence to laws & regulations
Going concern assessment
↓   ↓   ↓   ↓
Evaluate impact on audit reporting (SA 700 (Revised), SA 701, SA 705 (Revised), SA 706 (Revised))

Management Role and Responsibility

Against the backdrop of COVID-19, it is critical that TCWG (Those Charged with Governance) and the board of directors understand the scope and extent of their statutory and fiduciary duties. As per Standard on Auditing (SA) 260 (Revised), Communication with Those Charged with Governance, it is the responsibility of TCWG to oversee the strategic direction of the entity and obligations related to the accountability of the entity, actively monitor the changing nature of the threat, anticipating and scenario testing how the spread of the COVID-19 is likely to affect their business and its stakeholders for example assessing the business continuity risk, in case a supply chain is disrupted for any critical raw material, evaluating shortage of workforce and its impact, etc.

During COVID-19, it has been increasingly noticed that entities are struggling to justify this fundamental assumption and resorting to prepare financial statements on non-going concern basis. Section 134(5)(d) of the Companies Act, 2013 makes it obligatory for the Board of Directors to assess the appropriateness of going concern basis of accounting while preparing the financial statements of the company and state so in the Board’s report. Thus, it is the management’s responsibility to make a judgement on going concern and auditors are responsible in evaluating management’s assessment of the entity’s ability to continue as a going concern.

Audit Planning

As per SA 300, Planning an Audit of Financial Statements, the objective of the auditor is to plan the audit of financial statements to ensure it is performed in an effective manner and in order to achieve the aforesaid results, the auditor is expected to develop a strategy for addressing potential audit risks and plan the intended course of nature, timing and extent of procedures required to discharge the responsibilities. SA 300 requires that the auditor shall update and change the overall audit strategy and the audit plan as necessary during the course of the audit.

“The purpose of the audit is to obtain reasonable assurance that the financial statements have been prepared, in all material respects, in accordance with the applicable financial reporting framework.”

COVID-19 may result in a rise in modifications to the auditor’s opinion due to, for example, issues related to material misstatement of the financial statements or more circumstances where there is an inability to obtain sufficient appropriate audit evidence.

In this context, the auditor must consider the following industry challenges and related considerations to help obtain an understanding of the impact of COVID-19 on the operations and evaluate potential impact on the planning, audit strategy, reporting timelines and audit report.

A. Consumer and Retail Industry

Industry Challenges Considerations for the Auditor
(i) Tackling change in Consumer Behavior

- Consumers are embracing e-commerce: Consumers have embraced e-commerce to buy groceries, medicines and other goods online and outside-the-store fulfilment options, such as takeaway/ pickup and home delivery in keeping with the necessary lockdown, social distancing and WFH norms.

- Increased Focus on essential buying: The percentage of spending across non-essential categories such as apparel and footwear, consumer durables, automobiles and real estate is likely to decline and there is shift of focus on health, hygiene, and nutrition.
  • Whether forecasts and assumptions prepared by the management are reasonable and free from management bias and have been adjusted for reduction in consumer spending, shift in consumption categories, increased price sensitivity and industry trend in light of existing economic environment.
  • Paragraph 125 of Ind AS 1, Presentation of Financial Statements, requires an entity to disclose information about the assumptions it makes about the future, and other major sources of estimation of uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
  • Whether there are any concerns regarding stock-piling of inventory and whether the company has correctly accounted for obsolete inventory. It might be necessary to write-down inventories to net realisable value due to reduced movement in inventory, lower commodity prices, or inventory obsolescence due to lower than expected sales. (Refer Ind AS 2 and AS 2, ‘Inventories’).
  • Whether estimates made by the management in relation to revenue recognition, inventory valuation, allowance for doubtful accounts, and impairment of long-lived assets, goodwill and other intangibles are reasonable (Refer SA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures).
  • Evaluate the Going concern assumption of the business considering the updated business plans, cash management and forecasts (Refer SA 570 (Revised), Going Concern).
  • Have any lease arrangements undergone any change? (e.g., concession with respect to lease payments, rent free holiday, etc.) Has any lease arrangement become onerous, as a result of COVID-19? A Lessor and a lessee might renegotiate the terms of a lease as a result of COVID-19 or a lessor might grant a lessee a concession of some sort in connection with lease payments. Both lessors and lessees should consider the requirements of Ind AS 116, Leases in this regard. Further, paragraph 46A to Ind AS 116 provides that as a practical expedient, a lessee may elect not to assess whether a rent concession that meets the conditions in paragraph 46B of Ind AS 116 is a lease modification. A lessee that makes this election shall account for any change in lease payments resulting from the rent concession the same way it would account for the change applying this Standard if the change were not a lease modification.
  • Whether the auditor has considered (i) Penalties for any order cancellations, (ii) Reduced potential to receive discounts or allowances from vendors (iii) likely increase in sales returns, (iv) significant uncertainty of collection. Whether revenue has been recognized in accordance with Ind AS 115, Revenue from Contracts with Customers / AS 9 Revenue Recognition.
(ii) Establishing a responsive and flexible Supply Chain

Companies should aim at improving supply chain flexibility and resiliency by creation of shorter, more regional supply chains or a more diverse supplier base.
  • Has the management communicated any disruptions to the supply chain that could impact sourcing or product costs (e.g., delays/ inability to source product)? Auditor to check whether any of contracts have become onerous and have been accounted as per Ind AS 37 / AS 29 (Provisions, Contingent Liabilities and Contingent Assets).
(iii) Embracing Technology and Cybersecurity

The pandemic has been particularly challenging for companies that are behind on the digital transformation curve. Companies will need to guide their employees who can work remotely on new ways of working.
  • Whether the Company has made the required technology investments to address deficiencies and strengthen cyber security and adopted digital applications such as demand sensing (to understand shifts in consumer behavior), track and trace systems (to drive transparency in supply chain), etc.?
  • If any breakdowns in internal control and heightened fraud risks have been noted, their potential impact on audit to be evaluated. (Refer Guidance Note on Audit of Internal Financial Controls Over Financial Reporting issued by ICAI).

B. Automotive Industry

The Indian Automotive Industry has been riddled with fundamental economic challenges during the last few years and demand has slowed, credit availability reduced and discretionary spending dropped. Some of the most affected regions are major production hubs and home to key links in the sector’s global supply chain.

Industry Challenges Considerations for the Auditor
(i) Timely crisis management

Considering the nature of industry, careful scenario planning for determining likely impact is crucial for Automotive Industry to help it sustain. 		Evaluate (i) management plans to address the challenges of reduced production volumes caused by supply chain disruptions, falling consumer demand for new cars, structural and regulatory changes, shift to Shared Mobility and Liquidity Crunch and (ii) impact on Going concern assessment. (Refer SA 570 (Revised), Going Concern).
(ii) Impairment triggers

Significant disruptions to supply or production, decline in consumer demand, or other relevant impacts may represent events or changes in circumstances that indicate that the carrying amounts of certain assets might not be recoverable (requiring impairment tests for the affected assets). 		The cash flow forecasts used to test for impairment and discount rate should be updated to reflect the potential impact of COVID-19. Due to COVID-19, there might be temporary ceasing of operations or an immediate decline in demand or prices resulting in lowering of revenues and profitability and reduced economic activity. These are the factors that the management may consider as the indicators that may require impairment testing for the purpose of Ind AS 36 and AS 28, Impairment of Assets.
(iii) Inventory valuation

Periods of abnormally low production may limit the capitalization of certain costs (e.g., fixed overhead costs) in inventory. Further consumer preferences or demand may affect the valuation of inventory and result in excessive inventory levels. 		Has a management assessment been done –
i. to evaluate the nature of costs to be included in fixed production overheads
ii. for determination of net realisable value and write-down of inventories.
(Refer Ind AS 2, Inventories / AS 2, Valuation of Inventories).
(iv) Management of Workforce

A significant share of workforce in the Automotive Industry is employed in factories where components and vehicles are assembled and so cannot perform work remotely.
  • Whether the Company has developed robust business continuity plans that can help to address contingencies like complete shutdown due to lockdown or lack of available workforce? [Refer SA 570 (Revised), Going Concern].
  • Companies may implement restructuring actions (e.g., layoffs, contract terminations), the accounting for which can vary depending on the nature of the restructuring activity. Whether the same has been accounted for and disclosed as per Ind AS 19 / AS 15 (Employee Benefits)? Also refer Ind AS 37 / AS 29 (Provisions, Contingent Liabilities and Contingent Assets).
(v) Operations and Supply chain

Company may be required to revisit operations and make changes to vehicle design, where parts are being sourced globally.
  • Whether companies with extensive international supply chains have assessed critical components that may be in short supply and considered alternative sourcing strategies. (Refer SA 570 (Revised), Going Concern).
  • Are there any clauses in any customer or supply agreements which may trigger penalties? Due to COVID-19, there is a need for exercising judgement in making provisions for losses and claims. Evaluate accounting and disclosure as per requirements laid out in Ind AS 37 / AS 29 (Provisions, Contingent Liabilities and Contingent Assets).
(vi) Financial considerations and liquidity

The automotive original equipment manufacturers and suppliers should carefully consider their cash, liquidity and working capital and recoverability of receivables.
  • Whether the management has addressed liquidity challenges by performing rigorous, forward-looking stress-testing and sensitivity analyses of the cash-flow statement and evaluated availability of alternative financing sources. (Refer SA 570 (Revised), Going Concern).
  • Whether there is adequate establishment and functioning of the controls to aid in identifying potential accounting and reporting issues in a timely manner. (Refer SA 315, Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment and Guidance Note on Audit of Internal Financial Controls Over Financial Reporting issued by ICAI).
(vii) Strategy

The economic uncertainty may reduce consumer demand in the short term and trigger a shift in consumer preferences (public transport, shared-mobility options, privately owned vehicles).
  • Whether the company has explored diversification into electric vehicles (EVs) and affordable and environment friendly automobile segments as consumers consider new mobility options and the government takes action to stimulate the local economy.
  • Whether there is any material inconsistency between the other information and the auditor’s knowledge obtained in the audit and report accordingly. (Refer SA 720 (Revised), The Auditor’s Responsibilities Relating to Other Information).

C. Industrial Manufacturing Industry

Amid plummeting demand, supply chain bottlenecks and spending slowdowns, major industrial companies have closed facilities and are mulling the extent of layoffs. Many manufacturing jobs are on-site and cannot be carried out remotely. Plant closures (full or partial) could continue to be necessary for manufacturers in hard-hit regions for a prolonged period as the country faces another wave of the pandemic.

Industry Challenges Considerations for the Auditor
(i) Crisis management and response

Manufacturers are facing continuous downward pressure on demand and global supply chain disruptions, leading to cash-flow, liquidity challenges and difficulties in managing debt obligations.
  • Whether the management has assessed how loans, revolving credit and cash flow reserves can support ongoing operations in a low-revenue environment.
  • Whether the critical issues related to (possible) lack of raw material, productivity loss due to lack of remote working capabilities, limited demand for end products, insufficient staffing/workforce due to spread of infection/restriction on movement etc. have been addressed by the management plans. [Refer SA 570 (Revised), Going Concern].
  • Cash flows used for impairment testing should be based on a business plan that reflects the expected and most current impacts of COVID-19. The use of forward-looking information is pervasive in an entity’s assessment of, among other things, the impairment of non-financial assets (including goodwill), the realisability of deferred tax assets, and the entity’s ability to continue as a going concern. [Refer Ind AS 36 and AS 28 (Impairment of Assets), Ind AS 1 (Presentation of Financial Statements) and Ind AS 12 (Income Taxes)].
  • Is there any loan agreement with financial and/or non-financial covenant which may be breached in the current situation? Due to COVID-19 there may be instances of breach of loan covenants which may trigger the liability becoming due for payment and liability becoming current. However, as per paragraph 74 of Ind AS 1, such a liability shall not be classified as current, if the lender agreed, after the reporting period and before the approval of the financial statements for issue, not to demand payment as a consequence of the breach.
(ii) Workforce management

Manufacturers should put in place immediate and contingent safety measures for their employees and should decide which functions can be carried out remotely. The sector may also likely face possible staff reductions.
  • Whether the management has considered whether any of the assumptions used to measure employee benefits and share based payments should be revised.
  • Management should also consider whether it has a legal or constructive obligation to its employees for example sick pay to employees that self-isolate, for which a liability should be recognised.
  • Whether the same has been accounted for and disclosed as per Ind AS 19 / AS 15 (Employee Benefits)?
(iii) Financial impact and disclosure

Disruption in the sector is expected to lead to numerous financial disclosure implications. Stakeholders are making it clear that they expect transparency from companies and disclosures about actual and anticipated impacts, and, most importantly, the risks and vulnerabilities to the business.
  • Whether the management has broadened disclosures considering the impact on the Industry and the business (e.g., inventory obsolescence, receivables collectability, debt covenants, impairments).
  • Auditors to ensure compliance with SA 720 (Revised), The Auditor’s Responsibilities Relating to Other Information.
  • Check whether depreciation has been appropriately charged in accordance with Ind AS 16, Property, Plant and Equipment.

D. Technology Industry

Indian Technology companies have led the way on a variety of strategies that other industries are now using to cope in this crisis — from remote working to a dispersed supply chain, all while ensuring continuity of critical services to clients. Technology demand has risen on account of surge in need for cloud-based, collaborative workplace technologies and increased awareness about Cybersecurity.

Industry Challenges Considerations for the Auditor
(i) Evaluate operations and crisis management strategy

Remote work, online education and social distancing will create demand for products and services delivered by the technology industry.

Organizations will require long-lasting increases in computing power, while also seeking more scalability and built-in cybersecurity and it will be increasingly important to understand and forecast the customers’ evolving needs for services in the technology sector. 		Evaluate the nature of business and services offered by the Company and enquire whether the Company has plans to re-evaluate cost structure, optimize operations and diversify?

(Refer SA 570 (Revised), Going Concern and SA 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment).
(ii) Embracing WFH, Increased focus on Cybersecurity and building secure networks

As companies transition to WFH, the demand for security software has increased. Spending in this sphere will increase as organisations race to secure endpoints, particularly cloud-based tools, log management and VPNs.

IT companies will play a larger role in business continuity planning to help set up resilient, flexible and secure network and disaster recovery systems. 		Check whether the remote working practice implemented is secure and whether adequate internal controls are in place.

Auditor to evaluate impact on the internal controls and report accordingly. (Refer Guidance Note on Audit of Internal Financial Controls Over Financial Reporting issued by ICAI).

E. Hospitality Industry

Social distancing in general and closure of restaurants and restrictions on gatherings have meant the hospitality industry is effectively shuttered.

Industry Challenges Considerations for the Auditor
(i) Liquidity & operational challenges:
  • Limited cash reserves and funding available, accumulated negative cash balances from period of shut down.
  • Intense price competition.
  • Loss of corporate/tourist bookings.
  • Staff retention.
  • As part of the planning and risk assessment procedures, whether the auditor has obtained an understanding of the entity through management inquiries, analytical procedures, observation and inspection including additional risks arising out of:
    • (i) Operational disruption: Impact on changes to key supplier arrangements, termination of management agreements with operators, lease concessions obtained or given; changes to existing financing facilities and changes to legal and regulatory environment will need evaluation.
    • (ii) Contractual non-compliances.
    • (iii) Liquidity and working capital issues. (Refer SA 315 – Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment).
  • Whether impact of new uncertainties and market volatility on accounting estimates and judgements have been considered. (Refer SA 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures).
(ii) Internal Control

Due to shortage of staff, there could be a breakdown of controls such as daily revenue reconciliations, verification of rate variance report, review of rebates provided, payment processing and month-end reporting. 		Whether auditor has ensured exercise of professional skepticism as there may be instances of increased possibility of recording of fictitious revenue and fraudulent management estimates due to breakdown in segregation of duties and automated controls. (Refer Guidance Note on Audit of Internal Financial Controls Over Financial Reporting issued by ICAI).
(iii) Going concern assessment

The assessment of going concern basis of accounting is performed for a period of next 12 months from the end of the financial year and while assessing the assumptions, events subsequent to balance sheet date should also be considered.

While there may be optimism that more people may choose local holidays providing an opportunity to target this market but lack of consumer confidence is a significant risk.
  • Whether auditor has considered increase in risk of default from travel agents and corporates leading to bad debts, impairment of long-lived assets due to significant reduction in the expected future cash flows and the ability of the hotels to continue as a going concern.
  • Whether auditor has obtained sufficient appropriate audit evidence to conclude on the appropriateness of management’s use of the going concern basis of accounting, and whether a material uncertainty exists. (Refer SA 570 (Revised), Going Concern).

Management Disclosure of the Impact of COVID-19

While such a lockdown and disruption is unforeseen and beyond the control of the entities, it is important for entities to ensure that all available information about the impact of these events on the entity and its operations is communicated in a timely manner to its investors and stakeholders.

SEBI Advisory – Circular SEBI/HO/CFD/CMD1/CIR/P/2020/84 dated May 20, 2020

SEBI vide Circular SEBI/HO/CFD/CMD1/CIR/P/2020/84 dated May 20, 2020, encouraged listed entities to evaluate the impact of the COVID-19 on their business, performance and financials, both qualitatively and quantitatively, to the extent possible and disseminate the same. Even companies other than listed companies may refer the illustrative list enclosed in the SEBI circular and ensure adequate disclosure is made in the financial statements in respect of impact of COVID-19.

Reporting Considerations for Auditor

  • Emphasis of Matter (EOM) Paragraph: Where there are substantive COVID-19 related disclosures in the financial statements made by the management of the entity and the auditor is satisfied that these disclosures are appropriate and adequate, then based on the professional judgment of the auditor, an Emphasis of Matter (EOM) paragraph may be included in the auditor’s report. (SA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report).
  • Scope Limitations & Opinion Modifications: Identify scope limitations and cases of non-compliance with laws and regulations which may warrant modification of the audit report. These may be on account of inability to perform physical inventory observations, lack of access to client records, inability to confirm account balances /obtain external confirmations, lack of adequate audit evidence to forecast Going concern assumption, inability to perform subsequent event procedures, inability to obtain management representations. (SA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report).
  • Going Concern Uncertainties: Going concern is one of the fundamental assumptions referred in paragraph 10(a) of Accounting Standard (AS) 1 Disclosure of Accounting Policies / paragraph 25 of Ind AS 1. This requires significant judgement by the management, as no statement about the future can be guaranteed. Auditor to check whether Going concern basis of accounting in the preparation of the financial statements is determined to be appropriate and whether there is any material uncertainty related to going concern. (Refer SA 570 (Revised), Going Concern and SA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report).
  • Key Audit Matters (KAM): The impact of COVID-19 on specific areas of the financial statements needs to be evaluated for the purpose of reporting KAM. Language of KAM should bring out clearly the complexities arising from COVID-19 and the matter should be considered for inclusion as KAM only when the auditor has concluded that it does not warrant modification of the auditor’s opinion and also does not indicate a material uncertainty related to Going concern. Further, EOM is not a substitute for KAM. (Refer SA 701, Communicating Key Audit Matters in the Independent Auditor’s Report).

Conclusion

Companies across the sectors will agree that digital transformation is integral to building fit-for-future organisations and driving key aspects of business growth. The management should evaluate financial reporting requirements, revisit key assumptions in financial projections and communicate current and potential future impacts to shareholders. It is imperative for businesses to evaluate the impact of COVID-19 on economy and industry as a whole and not on the business in isolation, as the situation is extremely dynamic and continuously evolving.

The uncertainty arising from the current environment may increase the challenge in obtaining the sufficient appropriate audit evidence needed to form an independent view about the reasonableness of the management’s estimates and judgments. Across industries, challenges may be faced on account of various restrictions arising out of lock down or otherwise to perform audit procedures to observe physical inventory, accessing client records, understanding and testing internal control, confirming accounts balances and performing subsequent event procedures. The auditor will need to ensure compliance with the Standards on Auditing and report accordingly.