The impact of the COVID-19 pandemic has changed the business environment and affected all aspects of business operations. Judgments and estimates now need to take into account these new changes. Management must refocus their judgments and estimates relative to almost every balance sheet and certain income statement accounts while considering the latest accounting and audit guidance from numerous public and private boards and government agencies. While not inclusive of every account that may be impacted, summarized below are some key areas management must examine as they evaluate their current judgments and estimates – revenues, accounts receivable, inventory, other tangible and intangible assets, income taxes, the ability to continue as a going concern, gain contingencies, and subsequent events.
Revenue estimates can be affected by many factors, but the changes in business environment resulting from COVID-19 can lead to changes in variable consideration included in ongoing customer contracts. Accounting for revenue is covered in ASC 606, “Revenue from Contracts with Customers.” At the inception of the contract, it is management’s responsibility to estimate the value of variable consideration to which it will be entitled. For ongoing contracts, the changes in economic climate can result in changes to estimates to complete on long-term contracts, discounts, refunds, price concessions, and more. To that end, management is responsible for estimating the amount of consideration, including those amounts constrained, throughout the life of the contract, updating estimates as necessary at the end of each reporting period. By considering the circumstances surrounding the pandemic, management can make appropriate estimates and disclosures to ensure that the financial statements faithfully represent the company’s financial position.
When accounting for the realizability of accounts receivable, management must rely on ASC 310, “Receivables,” and ASC 450, “Loss Contingencies.” The value of a company’s accounts receivable is assessed in conjunction with the allowance for doubtful accounts. The periodic assessment of the allowance relies heavily on management’s judgments and estimates. This can include historical data, market trends, seasonality, and more. As a result of the COVID-19 pandemic, the business environment has begun to change and can very well impact the collectability of receivables. During such times of rapid change, it is important that while considering historical data, management reassesses the collectability of receivables in relation to the current market and future expectations at the end of each reporting period, often on a customer-by-customer basis. It will be important to assess the financial condition of customers to help determine if accounts receivable will just take longer to collect compared to historical trends or if specific reserves and/or general reserves are needed above and beyond typical reserve levels.
ASC 330, “Inventory,” requires that if a decline in net realizable value or utility of inventory occurs, then this decline must be recognized in the period in which it occurs. The current environment may require modification of judgments and estimates for the value of inventory as an unexpected or uncommon loss may result from obsolescence, contamination, price adjustments, and more. The carrying value of inventory may need to be adjusted if a business experiences a drop in sales due to current market conditions, or if it is experiencing supply chain disruptions. In this case, the level of inventory on hand for each product may currently be in excess of normal inventor turns, but the excess amounts are expected to normalize in the future. If so, management should carefully assess and document its judgments and determination of the need for an inventory reserve. Inventory guidance in ASC 330 states that losses should not be deferred beyond the period in which the loss occurred. If a recovery of theses losses is later made within the same fiscal year, the financial statements should reflect a gain, no greater than the original loss, in the period in which the gain occurred.
The effects of COVID-19 are numerous and far-reaching. As such, it is crucial that businesses affected by the pandemic assess their long-lived assets to determine if the carrying value is recoverable. ASC 360, “Property, Plant, and Equipment,” notes that triggering events such as changes in business climate, significant adverse changes in the way an asset is being used or its physical condition, or a significant decrease in market price can be indicators that an impairment test is necessary. It is important to consider factors outside those historically relied upon when making this judgement as changes in how these assets will be used in the future, relative to the pandemic, may result in necessary adjustments to the depreciable lives of those assets.
Accounting for leases and lease modifications is covered in ACS 840, “Lease Accounting,“ and/or its update, ASC 842, “Leases,” if adopted. Relative to preparing financial statements, a company must consider possible impairment and collectability of lease payments in sales-type/direct financing leases and operating leases, respectively. Management is responsible for developing judgments and estimates relative to the effects of triggering events, such as those resulting from the COVID-19 pandemic. Identifying and evaluating terms of a lease contract is key in determining if a lessor is subject to enforceable rights and obligations to compensate the lessee for the effects of COVID-19. Any provisions of consideration by the lessor to the lessee must be either classified as a lease modification or required under the enforceable terms of the lease.
Goodwill is required to be annually tested for impairment, but if a triggering event occurs, such as change in the business environment, goodwill should be evaluated for impairment when it would more likely than not reduce the fair value below its then carrying value. ASC 350, “Intangibles – Goodwill and Other,” outlines the types of events and circumstances that need to be considered when determining if an impairment test in necessary. By considering the potential effects of current economic conditions brought on by COVID-19, companies can determine if the fair value of their reporting units is in question and therefore require an interim impairment test. By comparing the carrying value of the reporting unit to the fair value of the entire reporting unit, it can be determined if an adjustment is needed. Any excess carrying value is reduced against goodwill. In addition to other events, a drop in share prices, market volatility, and disruption to operations can indicate that an interim impairment test is necessary in order to properly account for goodwill.
Accounting for income taxes is covered in ASC 740, “Income Taxes.” Each reporting period, a company is required to make judgments related to current and prior tax positions it has elected to take. ASC 740 specifically states that management is required to make subsequent measurements of the tax positions “given the facts, circumstances, and information available at the reporting date.” The subsequent remeasurement is driven by new information, not information that was known at the time of the original judgment. ASC 740 further states that “deferred tax liabilities and assets shall be adjusted for the effect of a change in tax laws or rates.” While the CARES Act is not changing tax law, it is allowing companies to make some elections that could affect the realization of deferred tax assets, most specifically net operating loss carryforwards and carrybacks. Every company will therefore need to reassess the judgments previously made related to the realizability of its deferred tax assets.
The evaluation of a company’s ability to continue as a going concern is required every time financial statements are issued. Most often, a detailed evaluation is not required. However, in the current business environment, the evaluation takes on more meaning, and a company’s judgement related to its operations over the following 12-month period will be critical. The need to evaluate going concern is set forth in ACS 205-40, “Presentation of Financial Statements – Going Concern.” In the current business environment, additional factors resulting from COVID-19may result in the deterioration of operating results and financial position. During times of uncertainty, industries can change, making it difficult to perform the required assessments. It is key that management considers not only historical data, but also new estimates based on the effects of the pandemic, to determine what disclosures must be made.
Gain Contingencies – Insurance Recoveries
Business interruptions resulting in anticipated insurance recoveries are subject to the guidance in ASC 450-30, “Contingencies – Gain Contingences.” Many companies have insurance against lost revenue due to business interruptions. While the details of their policies will determine if they are eligible for reimbursement, loss recoveries are only recognized once a company has deemed that the receipt of funds is probable and realized. Most often a gain is not recorded until the proceeds have been received, or a confirmation of the amount of the proceeds has been provided by the issuer, thus resolving the gain contingency.
Consequences of COVID-19 must be evaluated as subsequent events in relation to financial statements for a given period. ASC 855, “Subsequent Events,” details two categories of events, Type 1 and Type 2. Type 2 events are those that provide evidence about conditions that arose after the balance sheet date and are most likely the type of events that will need to be assessed for disclosure but not adjustments to the financial statements.
By December 31, 2019, an isolated outbreak of an unknown disease had occurred in a distant region of the world. One month later, the World Health Organization (WHO) declared it to be a “Public Health Emergency of International Concern,” and by March 11, 2020, the WHO declared COVID-19 to be a pandemic. While the existence of the outbreak does not provide more information about the conditions at the time of the balance sheet date, judgments may be required in order to properly evaluate certain accounts in order to accurately represent them on the financial statements. It is important to consider the extent of the effects in order to determine if disclosures are necessary to prevent the financial statements from being misleading.
The current environment is unique and will place significant pressures on every company, public and private, to clearly review and assess all judgments and estimates utilized to develop financial statements in accordance with quarterly and/or annual reporting requirements. There will be very few accounts that will not require reassessment given the current economic climate. Additionally, it will be even more importance for management to fully document the support behind each judgement and estimate, and the underlying facts and circumstances it considered in arriving at each when preparing the financial statements.
Chess Consulting LLC
At Chess, our professionals have a breadth of experience working in finance and accounting departments, working for large international accounting firms, and supporting companies in their assessment and documentation of judgments and estimates. We have the expertise to provide the support that companies will need to supplement their current resources in addressing the significant effort that may be required to review and document these areas. To inquire about our services, please feel free to contact David Hess, Ed Tharp, or Kevin Davis.