Focus on some accounting consequences of the war in Ukraine and the sanctions against Russia

On 24 February 2022, Russia launched its invasion of Ukraine. The conflict has been unfolding for more than two months and the situation is changing daily, not only in military - and human - terms, but also in terms of economic sanctions against Russia.

Keywords: Mazars, Thailand, IFRS, Accounting,Ukraine, Russia, IFRS 5

25 May 2022

More broadly, this conflict is having an impact on many parts of the economy, particularly in Europe, whether it be the rise in the price of certain raw materials (and energy in particular), supply difficulties, exchange rate fluctuations, etc.

While these events generally had little impact on the financial statements for the period prior to 24 February 2022 (information in respect of a "non-adjusting" post-reporting date event was to be provided on a case-by-case basis in the financial statements not yet authorised for issue, with a reassessment, if necessary, of the going concern assumption), the rapid deterioration of the situation at every level is expected to have a more significant impact on the financial statements for financial years commencing after 24 February 2022. These consequences will be specific to each entity, depending on its geographical location, the scale of its economic relations with Ukraine and Russia and, more broadly, its exposure to the potentially wide-ranging impacts of the conflict.

Mazars presents some key considerations for the 2022 accounts (interim or otherwise), in addition to the positions of some market regulators.

Presentation of the impacts of the Russian-Ukrainian crisis on the income statement and on financial communication more generally

The conflict between Russia and Ukraine and its many consequences are likely to impact the financial performance of companies to a greater or lesser extent, depending on the geographical areas and business sectors in which entities are operating. These impacts may be exactly identifiable or more diffuse.

The question of how to present these impacts in the income statement is analogous to the question of how to present the effects of the COVID-19 crisis in the 2020 (and 2021) income statements. It therefore seems worth recalling the positions taken at the time, in particular by ESMA.

Ahead of the publication of the 2020 interim financial reports, ESMA advised caution regarding separate presentation of the impacts of the COVID-19 pandemic in the statement of profit or loss. Instead, it encouraged issuers to provide qualitative and quantitative information on the significant impacts recognised, in a separate note to the financial statements.

We believe that these positions continue to apply to the presentation of the effects of the Russian-Ukrainian crisis in the income statement.

That said, it is also useful to recall that IAS 1 requires additional line items to be presented in the income statement when such a presentation is useful for understanding the entity's financial performance. For example, the impact of the loss of control over a subsidiary in Ukraine or Russia may, if material, deserve separate presentation in the income statement.

Finally, with regard to the use of Alternative Performance Measures (APMs), it is also appropriate to recall that following the update of its Q&A during the health crisis, ESMA advised that APMs should be used consistently over time, that the introduction of a "COVID-19" APM was not in principle appropriate and that priority should be given to enriching the disclosures provided in the notes to the financial statements. Once again, we believe that this position should apply to the case of the Russia-Ukraine conflict.

Ability to continue as a going concern

In accordance with IAS 1, each time an entity prepares its financial statements, it must assess its ability to continue as a going concern taking into account all available information about the future, which extends at least, but is not limited to, twelve months from the end of the reporting date. The going concern assumption should therefore be applied unless management intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.

In accordance with IAS 10 on events after the reporting period, the going concern assumption must be assessed up to the date the financial statements are authorised for issue (i.e. taking into account all facts and circumstances at that date). Therefore, an entity may not prepare financial statements on a going concern basis if it becomes aware, between the end of the reporting period and the date when the financial statements are authorised for issue, that its ability to continue as a going concern is irredeemably compromised, even if the event leading to this situation is a “non-adjusting event” under IAS 10.

If there are material uncertainties around the entity’s ability to continue as a going concern, but this ability is not irredeemably compromised, the entity may still prepare financial statements on a going concern basis. Nevertheless, these uncertainties must be disclosed in the notes. It is as well to recall the existence of teaching material published by the IASB in January 2021 aimed at supporting companies in the implementation of IFRS when preparing their financial statements on a going concern basis.

In the present case, and in contrast with the situation at the height of the COVID-19 pandemic, the going concern risk is likely to relate mainly to subsidiaries in Ukraine and Russia, and to those whose operations are carried out almost exclusively with these countries. It is therefore unlikely that the going concern assumption will have to be abandoned in the consolidated financial statements.

In practice, if a subsidiary has to prepare its individual accounts in net asset values because its going concern status is irretrievably compromised, it will be necessary for consolidation purposes to restate these values at the carrying amounts determined in accordance with IFRS if the group has established that it can continue to prepare its consolidated financial statements as a going concern. Nevertheless, the implications of this situation for the consolidated accounts will have to be considered, particularly in terms of the valuation of that subsidiary's assets.

Impairment of assets

Assets held in Ukraine

Many companies have tangible assets in Ukraine held either directly or through leases, and these assets are usually covered by damage insurance policies.

These assets may have been destroyed or damaged by bombing; or it may be that companies have no information on the physical integrity of their assets in conflict zones.

Under these circumstances, it is useful to recall the following principles:

  • if the asset has been destroyed, it should be derecognised;
  • an insurance product can only be accounted for as an asset if it is virtually certain that the company will be compensated (see below);
  • if the company is uncertain about the physical integrity of any of its assets, it will have to disclose this uncertainty in the notes to the financial statements, but it will not be able to apply a separate accounting treatment to the destroyed assets, or even to fully depreciate the assets concerned.

Special attention should be paid to assets held through leases. This is because, while the points above may apply to the right-of-use in leased assets, the consequences for the lease liability are more difficult to appreciate. Entities will need to examine the facts and circumstances relating to the conditions of use of the asset, the reasons that restrict access to it, and the particular contractual arrangements.

What is more, the current situation in Ukraine is in itself an indication of impairment, which should lead the groups concerned to conduct impairment tests on their tangible and intangible assets, including goodwill, for the preparation of the 2022 interim or annual accounts. Under these circumstances:

  • if the recoverable amount of individual assets can be determined, then those assets should be tested individually and if necessary impaired. However, if only the fair value of the assets is determinable, and this is less than their net carrying amount, the value in use of the Cash Generating Unit (CGU) to which the assets belong should be calculated to confirm the need for impairment;
  • given the situation in the country, we believe it will be necessary to carry out a country-level impairment test in all cases.

If the group has no goodwill allocated at the country level:

Any impairment will be allocated to the country's assets in proportion to their relative carrying amounts.

If goodwill is allocated at a higher level (e.g. geographical area), then an impairment test will also need to be performed at that level but only after recognising impairment losses arising at country level.

If the group allocates goodwill at the country level:

Any impairment loss should first be applied to the value of the goodwill allocated to the country and secondly, if necessary, to that country’s other assets in proportion to their relative carrying amounts.

Assets held in Russia or Belarus

For assets – and activities – in Russia or in Belarus, the issue is very different. There is no real risk to the physical integrity of the assets or the ability to operate them.

However, international sanctions and the deterioration of a number of economic parameters have caused operating conditions and prospects to deteriorate significantly, which is an indicator of impairment that justifies impairment testing.

As with the first closures following the start of the COVID-19 pandemic in 2020, conducting these tests involves updating business plans, based on operational assumptions in a highly uncertain environment. Disclosure of these assumptions, together with sensitivity testing, will therefore be key to the quality of financial reporting for groups with significant operations in Russia.

Over and above the operational assumptions, particularly given the fall in the rouble and soaring inflation in Russia, reporting on sensitivity to financial assumptions also seems necessary, taking into account a wider than usual range of reasonably possible scenarios.  

Impairment of operations outside Russia or Ukraine

The activities of certain groups outside Ukraine or Russia may also be affected, either because significant transactions with these countries (sales or supplies) have become more difficult or even impossible, or because of a sensitivity to energy prices or the cost of certain raw materials whose price has risen sharply.

In their 2022 financial statements, these entities will have to determine whether there is evidence that warrants impairment testing. In all cases, operational and financial assumptions will need to be updated, at least for the annual impairment tests. As with the COVID-19 pandemic, the duration of the effects of the crisis, particularly for inflation or supply prices, will be a key assumption.

Assessing the degree of control or influence over Russian and Ukrainian entities

Aside from the accounting impacts on the value of assets and liabilities due to the Ukrainian crisis, the current context may lead groups to question the level of control or significant influence exercised over interests held in entities located in Ukraine or Russia.

In the case of Ukrainian entities, the war has led some entities to question whether they still control their activities, given the sometimes substantial intervention of the Ukrainian administration in the management of their day-to-day operations (especially in the case of activities that are already highly regulated, or related to the war effort), the departure to the front of some of their employees, the flight of others, and the difficulty in maintaining contact and obtaining information on the current status of their activities, or indeed on the integrity of their production assets.

When assessing the level of control or influence over Ukrainian entities, all the facts and circumstances specific to that entity should be taken into account. Nevertheless, the fact that the group has less room for manoeuvre, or that the role of the regulator is more burdensome, or that the war situation locally no longer allows operations to be conducted as expected (or even forces the temporary suspension of operations) does not necessarily mean that control is lost. Generally speaking, and despite the new constraints on the business, the entity will always be presumed to have retained control.

In the case of Russian entities, the question is posed in different terms. On the one hand, the economic sanctions on Russia may cause some to fear that it will be difficult to operate in the future, while on the other hand, political and media pressures may lead entities established in Russia to seek to disengage from this country, at least until the economic and geopolitical context has eased. Finally, the risks of nationalisation or expropriation cannot be ruled out.

In any event, a group must continue to consolidate its subsidiaries as long as it has control, and the mere intention to leave Russia is not sufficient to qualify as a loss of control.

The main objective may be a simple concern for appearances (e.g. expressing solidarity with the Ukrainian people or fear of unfavourable media coverage by remaining in Russia), but it may also be the result of anticipated difficulties in managing the entity in an environment where sanctions make management from a distance complicated, or even the simple fact that the subsidiary's economic prospects in a "post-sanctions" economic environment no longer justify remaining in that country.

In practice, and in order to reconcile diverging objectives such as the desire to distance themselves from Russia on the one hand, and the need to safeguard the future on the other, some groups may envisage a "temporary" withdrawal (at least potentially), by combining the sale of a majority (or even all) of the shares of a Russian entity with a purchase option that can be exercised in the future, allowing them to return to the country.

In such a case, any conclusion as to whether there is control of the Russian subsidiary will depend on the individual facts and circumstances. Demonstrating loss of control will require an entity to show, inter alia, that it retains no right to make decisions about the relevant business during the "interim" period between the sale of a majority of the shares and the date of possible exercise of the purchase option, and it has no power to regain these rights without delay.

In the same spirit, it will also be necessary to show that the transferee cannot be considered a de facto agent, in other words that it does not act on the group's behalf during the interim period, despite the fact that the "choice" of transferee was doubtless guided by the group's confidence in it, and even if the group can negotiate protective rights (intended to limit the extent of the changes that may be decided by the transferee). Since the notion of a "de facto agent" is both very subjective and rather poorly defined, the assessment of control will require a significant level of judgment on the part of management, which should be detailed in the notes.

More generally, and in all cases, the notes to the financial statements should explain the group's situation regarding the Ukrainian and Russian subsidiaries and their impact on the accounts.

Application of IFRS 5

Finally, it may also be necessary to consider the question in the light of IFRS 5 where a loss of control is contemplated or occurs. The application of this standard has consequences for:

  • the statement of financial position. The classification on a specific line (on the assets and liabilities side) of assets (and liabilities linked to assets) "held for sale" (i.e. when the sale has not yet taken place), presupposes an entity's commitment to a process of disposal (or loss of control) which is highly likely to be completed within one year. Here it should be noted that the mere risk (or even threat) of nationalisation - or expropriation - cannot in itself be a criterion for the application of IFRS 5. However, a law or other government decision in Russia requiring the transfer of ownership of the subsidiary's securities or business may trigger the application of IFRS 5 to the subsidiary's assets and liabilities.

When the conditions are met, the carrying amount of assets held for sale is compared with the fair value less costs to sell, and any unrealised loss is recognised immediately as an impairment loss. However, this calculation does not take account of exchange differences, as these are recognised in "other comprehensive income" within equity and will only be recycled to profit or loss on the date that control is lost. Where appropriate, it will be necessary to allocate a portion of globally assessed goodwill to those entities held for sale. In practice, estimating the fair value of a Ukrainian or Russian subsidiary is likely to pose practical difficulties and leave considerable room for judgment. This clearly justifies full disclosure of the assumptions applied (and a sensitivity analysis of the various parameters) in the notes;

  • the income statement. The concept of discontinued operations, which leads to the reclassification of all the entity's results and the result of the disposal (if any) on a separate line of the income statement ("result of discontinued operations") for all the periods presented, only partially overlaps with the concept of an asset held for sale. In other words, where the size of the subsidiary justifies classification as a discontinued operation, this derogating classification is applied not only to activities held for sale but also to ceased activities as well as to a divested business (or over which the group has lost control);
  • despite the unusual circumstances, and although the concept of a discontinued operation also involves judgement, the criteria for classification as a discontinued operation remain unchanged and normally assume a certain, if not a definite, size (since the implicit rationale for restating the income statement over all the periods presented is that failure to restate would impair the transparency of the group's performance). This is because IFRS 5 defines a discontinued operation as a component of the group that has been disposed of or is classified as held for sale and that represents a separate major line of business or geographical area of operations.

Thus, for each actual or anticipated loss of control, it is necessary to consider the application of IFRS 5 to the statement of financial position, income statement and cash flow statement (which is also impacted by the identification of a discontinued operation).

Employee benefits

Wages paid in advance

Some businesses have chosen to pay their Ukrainian employees several months' advance wages.

These businesses do not always know exactly what their employees are doing, or even what has become of them. Some have moved to neighbouring countries or other parts of Ukraine and are managing - or not - to work from their new location. Others have remained in conflict zones to defend their country and will not be working for the company in the coming weeks or months.

A wage paid in advance is naturally recognised on the asset side as a prepayment, as the company can legitimately expect to receive services from the employee in the future.

However, in the current situation it is legitimate to question whether these future services really exist. It is likely that some of these employees will be unable to perform these services when requested.

Accordingly, each entity will need to determine what portion of these wages will not generate services in the future and should therefore be expensed at the time of payment.

Maintaining wages

Against this the background, some entities have chosen to continue to pay wages while allowing their employees not to work over a given period. Generally, employees will not work, will work little or will work under unduly constrained conditions during this period.

We believe that this situation resembles a short-term benefit and is not far removed from the case of paid absences (e.g. holidays or short-time working): in theory, the company can ask the employee to return to work at any time and could suspend payments to those employees who do not attend when required.

IAS 19 specifies that only accumulating paid absences give rise to the recognition of a liability (i.e. a situation where employees accumulate rights to further paid absences as they render services to the company). Otherwise (i.e. in the case of non-accumulating paid absence entitlements), the company recognises the expense when the absence occurs. 

Under the present circumstances, there is no accumulation of paid absence rights for employees. Therefore, these wages paid during periods of employee absence should not be provisioned, but simply expensed in the period to which they relate.

Damage coverage through insurance contracts

War is generally excluded from coverage by standard damage insurance policies. However, the conflict that broke out some years ago between Ukraine and Russia led many companies to take out insurance against political risks and political violence, which covers most of these exclusions, as long as one of the other four members of the UN Security Council does not enter into conflict with Russia. In general, it is clear to both the insured and the insurer whether a loss is excluded from insurance cover. However, the coverage of cyber-attacks in a war context remains unclear under these insurance policies and will probably merit specific legal consideration.

Credit insurance policies also usually contain exclusions in the event of "declared or undeclared" war between certain countries. They also include exclusion arrangements by default for sanctioned debtors. These factors are not always standardised and will have to be considered on a case-by-case basis by both the insurer and the policyholder. For policyholders, the economic challenge is accompanied by an accounting challenge when this credit insurance contributes to the deconsolidation effect of a programme to assign receivables under IFRS.

An insurance claim receivable first meets the definition of a contingent asset and can only be recognised in the accounts when it is virtually certain to be paid (IAS 37.33). If there is uncertainty about the inclusion of a loss in the insurance cover, the insurer's confirmation that the loss is covered will demonstrate the near-certain nature of the payment and allow it to be recognised as an asset. An insurance claim receivable is generally recognised separately from the risk covered, rather than, for example, as a reduction in the impairment of an asset.