How Will the COVID-19 Health Crisis Affect Financial Reporting?
The COVID-19 outbreak — officially a pandemic as of March 11 — has rightly become the focus of massive public attention in recent weeks. In addition to concerns about the health of their workers, businesses may be concerned about how it will affect their financial results and the performance of their supply chain partners.
Though the full effects of the COVID-19 outbreak are yet unknown, the impact is already global. Every business is affected in some way.
As the outbreak continues to grow worldwide, U.S. companies, large and small, are devising contingency plans and reworking their goals and budgets to address potential risks. Likewise, investors and other stakeholders want to know how companies are responding to this emerging risk factor.
How (and when) should companies report the effects of this outbreak on their financial statements? Disclosure requirements largely depend on materiality — and whether failure to disclose this risk factor would make the financial statements misleading to investors.
The effects of the outbreak are being felt around the globe, including here in the United States. Accounting Standards Codification (ASC) Topic 855, Subsequent Events, requires companies that follow U.S. Generally Accepted Accounting Principles (GAAP) to disclose events or transactions that occur after the balance sheet date but before financial statements are issued (or available to be issued).
Under GAAP, there are two types of subsequent events:
- Recognized subsequent events. These events provide additional evidence about conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements.
- Unrecognized subsequent events. These provide evidence about conditions that didn’t exist at the date of the balance sheet being reported on but arose after that date.
Moreover, ASC Topic 450, Contingencies, outlines the accounting and disclosure requirements for loss and gain contingencies. For example, this standard requires companies to accrue for potential lawsuits based on the probability that a claim will be made, and loss will be incurred.
Possible financial effects
Under GAAP, U.S. companies may be required to factor COVID-19-related risks into their financial statements. Examples of balance sheet accounts that may be materially affected by the outbreak include:
Financial assets. Companies should consider the potential for impairment, as well as the need to adjust cash flow projections and other assumptions used to measure nonquoted financial instruments. Financial assets reported at fair value on the balance sheet may result in realized and unrealized losses.
Receivables. Customers that are adversely affected by the outbreak may be unable to pay outstanding invoices. This situation could result in additional credit and liquidity risks, higher than usual bad debt, and even impairments and write-offs. Cash flows from operations may also be affected.
Inventory. The outbreak may disrupt supply chains and productivity. Companies with reduced or idle production capacity may be unable to allocate overhead costs to inventory as they usually do. In addition, inventory that can’t be turned over because of travel restrictions may have to be evaluated for impairment. Finally, changes in prices and reduction in the level of demand will also have to be taken into consideration.
Pensions and other post-retirement plans. Financial market volatility has affected the measurement of these accounts. Companies may have to revisit both the expected return on plan assets and the funded status of the plans.
Deferred tax assets. If estimates of earnings of foreign subsidiaries change, companies may have to reconsider some of their tax strategies, or they may not be able to realize all deferred tax assets.
Goodwill and other indefinite-lived intangible assets. Subsidiaries in areas heavily affected by COVID-19 may see their revenues or net income affected by the outbreak. This may trigger impairment testing for goodwill and other intangibles. The reassessment of key accounting estimates and projections may result in an immediate impairment. Additionally, impairment testing may have to be done more than once this year if management considers that evolving circumstances result in more than one triggering event.
There are many unknowns about the severity and duration of the COVID-19 pandemic. Disclosing and recognizing its financial effects may require management to exercise significant judgment. Contact your Brown Smith Wallace advisor to help navigate this crisis and its potential effects on your company’s financial statements.
SEC urges companies to provide robust coronavirus disclosures
In February, as COVID-19 was already rapidly spreading and starting to adversely impact businesses worldwide, Securities and Exchange Commission (SEC) Chairman Jay Clayton issued a statement emphasizing the need for public companies to consider providing subsequent event disclosures to investors.
Currently, most calendar year-end public companies are starting to file their Form 10-Ks. Clayton advised companies that haven’t already filed their annual reports to look at their risk disclosures more closely. However, he admitted that estimating the financial effects of the outbreak is challenging because COVID-19 and its impact on the market continue to be uncertain.
“This remains a dynamic situation where the effects on any particular company may be difficult to assess or predict, because actual effects may depend on factors beyond the control and knowledge of issuers. However, how issuers plan and respond to the events as they unfold can be material to an investment decision, and we urge issuers to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements,” said a recent SEC statement.
On March 4, the SEC announced that itis granting public companies extra time to file certain reports because of COVID-19. “The impacts of the coronavirus may present challenges for certain companies that are required to provide information to trading markets, shareholders, and the SEC. These companies may include U.S. companies located in the affected areas, as well as companies with operations in those regions,” said the SEC.
Clayton reminded all companies to disclose information about their assessment of risks related to the outbreak “to the fullest extent practicable” to keep investors informed. He added, “Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.” Safe harbor means that companies won’t be held liable for the statements.
Transparency about the nature of the event and management’s response to the outbreak is key. Public companies that fail to provide robust disclosures about this risk factor or recognize its impact on operations may receive comment letters from the SEC — and potentially even be hit with lawsuits from investors.