Inside Finance | Summer 2020
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.
Nancy Miller, CPA
Senior Director of Accounting, Reynolds Group Holdings
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
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
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.
This column was co-authored by John Hepp, Ph.D., clinical assistant professor
of accountancy in the University of Illinois’ Geis School of Business.