Considering the Effects of COVID-19 on Financial Reporting

The emergence of COVID-19 throughout the world has caught many businesses by surprise and highlights the importance of being prepared to respond to economic uncertainty. As we are reminded by daily headlines, the full economic impact has not been determined, and the situation remains fluid.

While businesses are planning for the impact of the virus, it is important not to overlook the potential financial reporting implications. Businesses may face supply chain disruptions, labor shortages, declining revenue, an increase in bad debt write offs, as well as other factors that may stress profitability, cash flows and put pressure on loan covenants.

Profitability, Cash Flow and Asset Impairments

Financial statement items susceptible to impairments due to decreased demand should be considered for additional disclosure or possible value changes. Items such as inventory, receivables, goodwill and investments may be affected by a downturn in economic conditions. Supply chain disruption and manufacturing slowdowns are being reported around the world. As companies in the U.S. alter working arrangements and adjust capacity for changes in expected market demand, companies should consider the accounting implications. For example, if production declines below normal capacity, organizations will need to evaluate the impact on inventory costing as ASC Topic 330, Inventory provides that cost inefficiencies caused by lower than normal production are to be expensed as incurred rather than capitalized as part of inventory costs. As a result, profitability may decline.

If demand or related sales prices for a company’s products declines, businesses may also need to evaluate whether there has been a decline in the net realizable value of its inventory. Those carrying inventory that has a short shelf life or is seasonal in nature may see a greater impact.

Accounting standards for revenue recognition require that at contract inception, variable consideration be estimated and reassessed throughout the duration of the contract as additional information becomes available. For contracts where total consideration is based on the occurrence or nonoccurrence of future events (e.g. satisfaction of performance criteria, completion times, delivery schedules, etc.), businesses may need to reassess their estimates of variable consideration.

As the economic impact continues to unfold, receivables associated with prior sales may become uncollectible. Businesses will need to evaluate their allowance for uncollectible accounts and determine whether additional write offs are necessary. In addition, revenue from contracts with customers is only recognized for contracts where collection of substantially all of the consideration in the contract is considered probable. While businesses may have considered their contracts probable of collection prior to the outbreak, they may reach a different conclusion in new or modified contracts. If collection of substantially all of the consideration in the contract is not considered probable, revenue would not be recognized until certain criteria are met (refer ASC 606-10-25-7 for these criteria).

Businesses that carry goodwill on their balance sheet are required to assess goodwill for impairment at least annually. Impairment testing is performed by assessing whether the carrying value of a reporting unit exceeds its fair value. In the midst of the outbreak and the uncertainty it has caused, businesses may need to consider whether a triggering event has occurred requiring interim impairment testing.

Additional consideration should be given to whether other assets, such as property and equipment, are impaired. These assets are tested for impairment when facts and circumstances indicate that the carrying amount may not be recoverable. If the carrying amount is not recoverable, an impairment should be recognized.

Loan Covenants

As liquidity positions become more stressed as a result of reduced profitability and cash flow, it is important to consider the impact on loan covenants. Many loan agreements include covenants based, at least in part, on income, cash flow or equity. These covenants may be negatively impacted in times of economic uncertainty. Covenant violations may result in increased disclosure and reclassification of balances from noncurrent liabilities to current liabilities. Ongoing communication and transparency with lenders will be critical to evaluating covenant violations and identifying an appropriate path forward.

Taxes

Many closely held small corporations and owners of flowthrough businesses may use the safe harbor method of calculating and paying their estimated taxes each quarter. Under the safe harbor method, taxpayers pay-in based upon the assumption that their tax will equal, or for higher income taxpayers, exceed their prior year tax. Once taxpayers have made an estimated tax payment, it is generally unrecoverable until such time as the taxpayer files their annual return for the tax year. As a result, taxpayers who fail to carefully and proactively plan now for the making of estimated payments may find that they have effectively loaned a portion of their crucial cash reserves to the U.S. government, interest free. See DHG’s landing page for more information.

Going Concern

Financial statements are prepared based on the assumption that an entity will continue as a going concern. Management is required to assess an entity’s ability to continue as a going concern. Substantial doubt about an entity’s ability to continue as a going concern exists when conditions or events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date that the financial statements are issued (or available to be issued). Businesses experiencing or expecting decreased profitability, liquidity issues or loan covenant violations as a result of economic uncertainty need to consider whether any of these factors raise substantial doubt about their ability to continue as a going concern. Additionally, those with debt maturing within a year may need to consider the potential impact of economic conditions on credit markets and their ability to renew. This may result in expanded disclosures in financial statements.

Subsequent Events and Disclosures

In preparing financial statements, businesses are required to evaluate subsequent events and determine whether they require adjustment to or disclosure in the financial statements. In performing the subsequent events analysis, businesses should consider whether events related to the outbreak provide additional evidence about conditions that existed at the balance sheet date. If the conditions existed at the balance sheet date and became apparent before the financial statements are issued (or available to be issued), they may require adjustment to the balances presented. If the conditions arose subsequent to the balance sheet date but became apparent before the financial statements are issued (or available to be issued), they may need to be disclosed in the financial statements.

In addition to considering subsequent events, businesses should consider whether additional disclosures will be required under ASC Topic 275, Risks and Uncertainties and ASC Topic 450, Contingencies.

Businesses who believe they may be impacted by the current global economic situation or by any other significant changes during 2020 should strongly consider the direct and indirect impact on financial reporting. Maintaining open lines of communication with financial statement auditors, tax professionals, investment advisors, lenders and other key stakeholders can help in navigating the economic uncertainty.