Among the many consequences of the COVID-19 coronavirus pandemic is that entities will face many financial reporting implications and challenges — and they’ll face them as soon as the next interim financial statement preparation period.
While some long-term economic and business consequences are ultimately unknown, there are some clear areas of generally accepted accounting principles (GAAP) that are going to have to be applied with a much more careful approach in the very near future. Below are 10 of those considerations.
1. Asset impairments
Many companies carry non-financial assets on their balance sheet such as goodwill and intangibles, as well as long-lived assets such as property, plant and equipment. Given the unpredictability in the economic outlook as a result of COVID-19, entities experiencing decreased revenues, supply chain disruptions or halted operations should consider whether a triggering event has occurred that would require an impairment test on these non-financial assets.
A triggering event holds different definitions in U.S. GAAP depending on the asset in question. For indefinite-lived intangible assets such as goodwill, a triggering event occurs when there are indicators that the fair value of an entity (or a reporting unit) may be below its carrying amount. Guidance covering long-lived assets such as capital assets considers a triggering event to be an event or changes in circumstances that indicates that an asset’s carrying amount may not be recoverable. Triggering events can be macroeconomic conditions, industry and market conditions or other factors that have a negative effect on an entity’s earnings and cash flows. The impact of COVID-19 is likely to be such an event.
Guidance on impairment tests of these nonfinancial assets varies depending on the asset but generally uses a recoverability model, which relies on the development of cash flow projections. These projections are subject to significant uncertainty and should be reassessed and updated as appropriate.
2. Restructuring costs
Depending on the ultimate duration of the COVID-19 pandemic, companies may decide to execute a restructuring plan, close a facility or sell or abandon certain assets in order to preserve liquidity. This would include involuntary employee termination benefits in accordance with a one-time benefit arrangement (e.g., severance pay). These are referred to as exit or disposal activities under GAAP, which provides guidance on when to record such costs as well as the disclosure requirements of an exit activity. A liability for costs associated with an exit or disposal activity is recognized at fair value in the period the liability is incurred.
Costs associated with one-time employee termination benefits are measured at the time employees receive communication of the termination and are either recognized on the communication date or over the service period, depending on whether future services are required. A liability for costs associated with closing a facility and relocating employees is not recorded until the costs are incurred.
3. Loss contingencies
The economic volatility and instability resulting from COVID-19 may result in entities incurring losses that may need to be recognized or disclosed in their financial statements. Accounting guidance requires accrual of a loss contingency when 1) it is probable that a loss has been incurred and 2) the amount can be reasonably estimated.
If the criteria for accrual are not met, disclosure of the nature of a contingency is required when there is at least a reasonable possibility that a loss has been incurred. For contingencies that meet the threshold for disclosure, but no liability has been recognized, companies must disclose an estimate of the possible loss or the range of possible losses or state that such an estimate cannot be made. Companies should consider whether any contingent loss resulting from the COVID-19 pandemic is reasonably possible and make disclosures as appropriate.
4. Going concern
COVID-19 is significantly impacting the operations of many businesses. Entities may face continued hardships such as extended operating shutdowns, supply chain disruptions, difficulty collecting receivables from customers, limited access to credit markets and loan covenant violations. Entities must take careful consideration as to whether such factors raise substantial doubt about whether the entity may be able to continue as a going concern.
In connection with preparing financial statements for each annual and interim reporting period, GAAP requires management to evaluate the entity’s ability to continue as a going concern. As part of this analysis, management must consider whether 1) there are conditions and events that, when considered in the aggregate, raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date on which the interim or annual financial statements are issued and 2) these conditions are able to be mitigated by management’s plans.
If management concludes there is substantial doubt, then disclosure in the financial statements is required, even if management’s plans alleviate that substantial doubt. If management’s plans do not alleviate substantial doubt about the entity’s ability to continue as a going concern, in addition to the required disclosures, GAAP requires management to state in the notes to the financial statements that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date on which the annual or interim financial statements are issued.
5. Insurance recoveries
It is common for companies to carry insurance policies to protect against unforeseen events such as property damage, product liability or business interruptions. If an entity incurs a loss attributable to damaged property or the incurrence of a liability, and it expects to recover all or a portion of that loss through an insurance claim, the entity should record an asset for the amount for which recovery from the insurance claim is considered probable (but not to exceed the amount of the total losses recognized).
However, the accounting for insurance claims related to business interruptions such as expected losses incurred as part of the COVID-19 pandemic differs from other types of insurance in that it is designed to protect the prospective earnings or profits of the insured entity. Anticipated reimbursements for lost profit margins related to business interruptions are considered to be gain contingencies. Since the expected proceeds recorded as a receivable should not be greater than costs incurred to date, expected proceeds for lost profits are treated entirely as a contingent gain and typically only recorded at the settlement date and not accrued when considered probable.
Finally, entities should carefully review their business interruption policies, as they may contain exclusions for events, such as pandemics, that cause business interruptions.
6. Accounting estimates
As a result of the uncertainty resulting from COVID-19 pandemic, entities will likely face inherent challenges in developing reliable estimates in their financial statements. To develop estimates, entities will need to consider all available information. Some of the more common accounting estimates in financial statements relate to items such as an allowance for doubtful accounts and a reserve for obsolete inventory. These estimates can be based on factors that have significantly changed in the current landscape of COVID-19, such as a customer’s credit risk when evaluating an allowance for doubtful account or future product sales when estimating an inventory obsolescence reserve.
Further, companies that prepare estimates which may be used in the discrete financial reporting process should ensure the assumptions underlying those estimates agree or reconcile. An example would be revenue forecasts used for impairment testing of long-lived assets should reconcile with revenue forecasts used for purposes of determining realizability of deferred tax assets.
7. Debt modifications and loan covenants
Economic disruption following the COVID-19 pandemic has caused a considerable financial burden for many borrowers. Impacted companies may experience cash flow issues as a result of prolonged disruptions in their operations, lost revenues or higher operating costs — all of which may lead to a greater number of debt restructurings. Accounting guidance states a borrower must assess whether a change in an existing debt arrangement is a troubled debt restructuring, a debt modification or a debt extinguishment. Each of these has different financial reporting implications.
Borrowers with debt arrangements that include covenant requirements may also be impacted by COVID-19. These covenants often require borrowers to achieve a specified level of profitability or interest coverage. If a debt covenant violation occurs on or before the end of a reporting period and gives the lender the right to demand repayment within 12 months of the end of the reporting period, the liability associated with the debt would generally be classified as a current liability in the borrower’s financial statements.
8. Income taxes
Entities should consider how changes in forecast cash flows, liquidity and impairment concerns resulting from COVID-19 might impact their income tax accounting under GAAP.
In particular, entities that have experienced disruptions in their operations from temporary closures or decreased revenues coupled with forecasted future losses will likely need to reevaluate their conclusions on the realizability of their deferred tax assets. Future realization of deferred tax assets ultimately depends on the existence of sufficient taxable income.
Based on the current economic environment, if a company concludes that, more likely than not, some or all of its deferred tax assets will not realized, a valuation allowance is required to be recorded for that portion not expected to be realized.
“More likely than not” in the context of GAAP means better than 50%, which is subjective and requires judgment. Entities should carefully assess both positive and negative evidence and give more weight to any evidence that is objectively verifiable. GAAP also states that recent cumulative losses or the expectation that a company will have cumulative losses constitutes significant negative evidence about the realizability of deferred tax assets that is difficult to overcome.
9. Income statement classification of COVID-19 impact
Many companies could incur significant costs due to the current and future impacts of COVID-19. These entities will need to determine whether these impacts should be reported or disclosed separately in their financial statements. There is specific guidance in U.S. GAAP around the accounting for “unusual or infrequently occurring items.” The guidance describes unusual in nature as possessing a high degree of abnormality that is clearly unrelated to the ordinary activities of the entity. Further, infrequency of occurrence represents an event that would not reasonably be expected to recur in the foreseeable future.
If an entity concludes that a material event is of an unusual nature or occurs infrequently (or both), the entity must either report the nature and financial effects of the event as a separate component of income from continuing operations or provide disclosure in the notes to the financial statements.
Put another way, it would generally not be appropriate for entities to report these losses “below the line” or after total operating income in the statement of profit and loss. It is likely that most companies will consider COVID-19 to be an unusual or infrequent occurring item. Determining whether to separately disclose these amounts should be based on the material impact on its financial statements.
10. Changes in production capacity
The COVID-19 pandemic may affect manufacturing entities in a number of ways, including work stoppages during government-mandated shelter in place orders or shortages of labor and materials in the production process. These factors may result in production levels to drop below normal capacity levels.
Companies should consider the impact of such situations on their inventory costing. Accounting guidance states that fixed overhead is to be allocated based on normal capacity of the production facilities. If an entity ceases production or significantly reduces production for a period of time, significant portions of fixed production overhead (e.g., rent, utilities and depreciation) will need to be expensed rather than capitalized and not increase the amount of fixed overhead costs allocated to each inventory item.
Normal capacity is the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. Some variation in production levels from period to period is expected and establishes the range of normal capacity. Judgment is required to determine when production is lower than normal capacity. The range of normal capacity can vary based on business and industry-specific factors.
Preparing financial statements during and after COVID-19
We are in unprecedented times. Many of the considerations noted above are concepts that we may remember learning about in college, but now we are going to be applying many of them to our financial statements as we move forward during these uncertain times.
More than ever, preparation of financial statements requires due care. Research and consultation are key during these times, and we encourage all financial statement preparers to arm themselves with the most accurate knowledge when preparing financial statements. The above is by no means an all-inclusive list of areas impacted by COVID-19; however, we feel this is a very good starting point of items to consider as you prepare financial statements during these uncertain times.
For more information, please visit Wipfli’s COVID-19 resource center or reach out to your Wipfli relationship executive. Stay safe.