COVID-19 has clearly disrupted life as we know it. Despite these disruptions, businesses continue to operate (some at an altered state) and therefore are required to provide financial reporting to stakeholders.
As management prepares for their year-end financial reporting, they are facing implications due to the economic impact of the pandemic. Many of the accounting issues affecting companies are situations they have never had to contemplate in more typical times. While the accounting methods for these issues are not new, management may not be familiar with the nuances and complexities of the relevant accounting standards. Although concerns will vary depending on specific circumstances and industries, here are some of the most important issues to consider.
Accounting for goodwill and potential impairment during the COVID-19 pandemic will be a consideration for many companies with goodwill on their books. A nuance in the goodwill impairment model is that calculations to determine if there is impairment need to be done at the time of a triggering event; defined as an event or circumstance indicating that, more likely than not, the fair value of a reporting unit is below its carrying amount. A company may determine that the pandemic caused a triggering event and an impairment assessment is warranted. If so, the accounting standards require the loss to be recorded at the time of the event without regard to future developments. As a result, the assessment may result in an impairment loss in March or April that would remain even if the business were to improve and recover by December. Furthermore, the calculation to determine the fair value of the reporting unit versus the carrying value, as required in the goodwill impairment model, typically requires a valuation by a third-party specialist which can be costly.
Costs Associated with Exit or Disposal Activities
The accounting standards require companies to record a liability at fair value when a contract is terminated before the end of its term. This can be involuntary employee termination benefits, or costs to consolidate or close facilities and relocate employees. A less obvious example is operating leases that may be terminated for a struggling location, or one that shut down, but payments on the lease continue to be made. The requirement to record a liability at fair value when terminating a contract before the end of its term might surprise a lot of private companies who are still accounting for leases. While operating leases are the most common type of exit, this also applies to any contracts that have:
- costs to terminate a contract before the end of its term or
- costs that will continue to be incurred without economic benefit to an entity
The applicability during COVID-19 could be very broad and may not be familiar to many private companies.
Leases – Impairment of Right of Use Assets
We have not seen widespread adoption of the accounting standard ASC 842 at this time among private companies. However, for those who have adopted, considering the right of use asset for impairment is a new concept to apply.
Accounting standards establish the concept of allocation of fixed production overhead costs based on normal operational capacity. Using judgment to identify abnormally low production levels and atypical production costs, and then charging excess costs to operations rather than capitalizing to inventory, are concepts that may not be familiar to private companies that will come into play during the pandemic.
Special attention should also be given to whether inventory has become obsolete due to any factors such as cancelled customer orders or programs or due to a spoilage date or expiration date of the materials.
For those companies who adopted the new revenue recognition standard (known as ASC 606), there are several considerations to highlight:
- Assessment of whether collection is probable at the beginning of a contract: The new standard says that if collection is not probable when entering into a contract then the contract is not valid from the standpoint of revenue recognition. In that case revenue will not be recognized until cash is collected or until collection is probable.
- Consideration of enforceable rights and obligations: Management should consider the enforceable rights and obligations in a contract and if there are any new rights or obligations that arise due to the pandemic that need to be accounted for.
- Reassessment of variable consideration and allocation of any changes to all performance obligations: For instance, does an estimate of the amount of variable consideration change based on the economic climate?
- Are there any impairment considerations related to contract assets or accounts receivable based on a customer’s ability to pay?
- Have sales incentives been offered to customers and were material rights created by sales incentives?
- Were there contract modifications to provide future concessions that would decrease goods to be delivered, or change minimum purchase commitments?
- Was there a significant financing component in an effort to assist customers with liquidity issues?
- Additional disclosures related to revenue recognition and the impacts of COVID-19.
Management will have to spend time assessing transactions to determine if there is a modification or extinguishment of debt, including forgiveness of debt. There are special criteria to determine if a restructuring of debt is a modification or an extinguishment including several disclosure requirements.
For companies that received a PPP Loan, management should consider the government grant accounting options available to for-profit entities.
Classification of Financial Liabilities
Management should pay special attention to the classification of current and non-current financial liabilities. If there are violations of financial covenants due to the volatility related to the pandemic, discussions should happen early with lenders. Open communication may help to get covenants waived thereby maintaining long term debt or other liability classifications.
There may be accounting treatment considerations if a company continues to pay employees who are furloughed or to provide benefits to separated employees. The accounting requirements will differ depending on the facts and circumstances. In some cases the costs are required to be accrued and in others, they cannot be accrued.
As CFOs, controllers, and other financial managers prepare for their year-end financial reporting, they should set aside time to consider the many areas of financial reporting that could be impacted by the pandemic. Communicating with their outside accountant in advance on these issues will help save time and cost for those companies that are required to have their financial statement reviewed or audited. For additional information, call us at 248.208.8860 or click here to contact us. We look forward to speaking with you soon.