Judgment Day: Five Significant Financial Reporting Areas to Consider Now

The SEC’s Office of the Chief Accountant has highlighted five areas finance must carefully consider in the wake of COVID-19.

When the World Health Organization declared the COVID-19 outbreak a pandemic on March 11, 2020, it recommended global containment and mitigation measures. It didn’t take long for companies across the world to feel the impacts, from supply chain disruptions to workforce safety. While we all hope to recover from the pandemic and its effects as quickly as possible, some of the changes we made this spring and early summer will carry on. There are key items that will need to undergo constant evaluation and require significant judgment in the coming months as financial statements are prepared and the situation evolves.

On April 3, 2020, SEC Chief Accountant Sagar Teotia wrote in “Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19” that while the Office of the Chief Accountant appreciates the challenges COVID-19 has created in complying with financial reporting obligations, it expects financial reporting to continue to uphold a high standard and “provide investors with high-quality financial information.” Teotia highlighted several areas where companies may have to make significant financial reporting judgments and estimates related to the impact of COVID-19 in the financial statements, ranging from fair value assessments to hedging.

As we all struggle with the constantly shifting challenges created by the pandemic, here are five financial reporting areas that could be impacted by the changed business environment and deserve our careful consideration.

IMPAIRMENT OF NONFINANCIAL ASSETS

Companies are required to assess whether there is any impairment of nonfinancial assets whenever there is an indicator that the carrying amount may not be recoverable. For many firms, the sudden loss of business and changes in consumer behavior could constitute an indicator that the related assets should be tested for impairment. For companies that have adopted ASC 842, this will include the right-of-use assets associated with operating leases.

Determination of recoverability requires forecasts of expected future cash flows under various scenarios. The scenarios should reflect the relative probabilities of different future economic conditions over the remaining useful life of the asset. At this time, experts differ as to the timing and extent of economic recovery and whether some of the changes in employment and consumer behavior are temporary or permanent. It is reasonable to expect considerable variability in the timing and amount of estimated future cash flows, and that will complicate the process. Additional disclosure may be required to help the users of the financial statements understand the assumptions and related risks.

FAIR VALUE MEASUREMENTS

The same factors that affect recoverability also affect many fair value measurements. These will need to be taken into consideration if an asset is determined to be impaired and whenever a Level 2 or Level 3 valuation technique is used to measure a nonfinancial asset.

Uncertainty about future economic conditions will also affect measurement of financial assets. Whether using the legacy other-than-temporary impairment (OTTI) model or the newer current expected credit losses (CECL) methodology, multiple assumptions will be necessary about current conditions and reasonably supportable forecasts of future conditions. (The Coronavirus Aid, Relief, and Economic Security (CARES) Act contains provisions that defer implementation of CECL, but only for certain insured depository institutions.)

When using models for valuation purposes, it will be more difficult than usual to estimate future interest rates, inflation, overall economic growth, and the prospects of individual issuers of debt and equity securities, which have all been affected by the COVID-19 outbreak, government and regulator reactions, and likely changes in future behavior. In addition to making assessments in an environment of unprecedented uncertainty, reporting entities will need to consider the sensitivity of the results to changes in those assumptions, as well as any interactions between those assumptions.

GOING CONCERN ASSESSMENTS

At the extreme, some companies will need to evaluate their ability to continue as a going concern. Specifically, when preparing financial statements for each annual and interim reporting period, management will need to evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. When evaluating an entity’s ability to meet its obligations, management should consider information about conditions and events known or reasonably knowable at the date of the financial statements. As already noted, any forecast, even over the short term, is very difficult under conditions of unprecedented uncertainty. Management will need to constantly evaluate the financial situation and outlook as well as any plans for addressing expected and possible outcomes, and be prepared to disclose the principal conditions, management’s evaluation, and any plans that may or may not alleviate the concerns about the entity’s ability to continue operations.

IMPACT OF MODIFICATIONS OF CONTRACTS

Due to the impacts of COVID-19, many companies are renegotiating contracts, including contracts with customers, leases, and debt and covenant arrangements. Where there are significant assumptions being made in relation to the modification of contracts, a company should document its assessment and consider disclosure if material to the financial statements. Significant judgment in the treatment of the new or modified terms should be considered for disclosure. For instance, estimated revenue for contracts with discounts based on estimated annual sales should be reevaluated to determine the impact of revised sales forecasts. Debt renegotiations will need to be evaluated to determine whether the changes constitute a modification or extinguishment of debt. Rent concessions will have to be assessed by both the lessee and the lessor to determine whether to account for the concession as a modification of the contract or variable rent. FASB and IASB have issued a Q&A and temporary guidelines respectively to help in making that decision. Changes in forecasted transactions can also affect the accounting for cash flow hedges, and FASB issued a second Q&A that discusses those impacts.

GOVERNMENT ASSISTANCE AND INCOME TAX CONSIDERATIONS

The federal, state, and local governments have introduced legislation and stimulus packages to help companies weather the storm, such as the CARES Act. These measures have taken many forms and were passed into law rapidly, leaving certain details relating to their accounting and reporting treatment a bit vague. Since so many of the eligibility and reporting requirements have been a moving target, it is important to use the latest information in your financial statements.

As COVID-19 and other economic factors create turmoil, it’s our job to create clarity. By continuing to uphold the same high standard of accuracy and transparency in financial reporting, and providing our strategic insight, we can help our organizations turn the storm into a passing shower.

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 This column was co-authored by John Hepp, Ph.D., clinical assistant professor of accountancy in the University of Illinois’ Geis School of Business.