Sometimes, even the most thought-out plans don’t work out. Organizations experienced this first-hand over the last two years with COVID-19. Almost overnight, everything changed: operating models, financial forecasts, and the labor market, to name a few of the biggest impacts. Even now, many Bay Area and California companies are grappling with the effects of an uncertain economy. External events, like the pandemic, have the potential to upset the typical financial reporting process. Questions remain about how to reflect external pressures on internal reporting; what needs to be adjusted and when, and how management can best respond to changing conditions while still meeting current compliance requirements. In other words, the pandemic and other events have made it difficult for management to make essential estimates required for financial reporting. Here are some key factors to consider during this time of uncertainty.
What’s the Impact of External Events, Like COVID-19, on ‘Going Concern’ Statements?
External events like COVID-19 are referred to as triggering events, or the point in time when changes in circumstance affect the ongoing materiality of an asset. Specific timing can be hard to determine. COVID-19 would be an example of a broad triggering event, where asset impairments happen over time.
The economic uncertainty brought on by COVID-19 cast significant doubt on many companies’ ability to operate. Whether an organization’s continued viability was or is still in question or if the going concern assumption is still valid, may need to be assessed.
Going concern disclosures are important for year-end financial transparency. And when there are events like COVID-19 that interrupt the normal workflow, the going concern assessment may need to change. In a new assessment, management may need to consider more than one assumption for going concern. It might be necessary to extend the timeframe for going concern; 12 months from the date the financial statements are available to be issued is the minimum, but it can be longer depending on individual facts and circumstances.
When considering different future scenarios, management may also want to consider at least one worst case scenario. In extreme situations, the impact of external events like COVID-19 might mean that the previous going concern assumptions are now invalid, which would result in adjusted financial statements.
How Would Financial Statement Forecasts Be Affected in These Future Scenarios?
Budgets prepared last year might be irrelevant when external conditions are changing quickly. To that end, COVID-19 probably requires updated forecasts for sales, gross margins, and working capital. Then, another look at whether overall financial performance can meet debt obligations.
Business owners will want to consider current and revised estimates for cash flow and credit lines to meet short-term needs. This revised assessment should also reveal whether lender terms need to be renegotiated or if operating costs need to be updated.
These revisions would also depend on the organization’s risk tolerance, credit rating, and applicable regulatory considerations.
What Should Organizations Do When Conditions Improve?
At each reporting period, organizations have had an opportunity to assess the ongoing impact of COVID-19. If previous forecasts required an adjustment to financial statements or a revised approach to impairment loss, it may be time to review and reevaluate those estimates. Under FASB ASC 360-10-35-20, once an impairment loss is recognized it may not be reversed. This contrasts with International Financial Reporting Standards (IFRS) which permits reversal of impairment losses for long-lived assets (except for goodwill), under International Accounting Standard (IAS) 36, Impairment of Assets.
Can Management Estimates Be Used in More Than One Scenario?
Yes. While an organization is dealing with record uncertainty, management will need to estimate various forecasts, including the worst-case scenario mentioned above. These assumptions can be used for more than one purpose. For example, estimated cash flow can be used for multiple impairment tests and going concern evaluation.
The biggest consideration for business owners in this regard is to ensure that the same assumption is being used in each analysis unless otherwise prohibited by U.S. Generally Accepted Accounting Principles (GAAP). Consistency in these assumptions is especially important for organizations with global operations, decentralized accounting systems, or broader regulatory oversight.
How Should Management Estimates on Revenue Recognition Be Handled?
In 2020, organizations may have had to modify several aspects of financial reporting, ranging from customer and vendor contracts, debt covenants, and impairment, mentioned above. Revenue recognition may still be impacted by supply chain disruptions or other mitigating factors. If an organization cannot meet its financial performance obligations on time, the timing of when revenue is recognized may need to change, too.
Under ASC 606, revenue recognition may be delayed until the organization can satisfy its promise to transfer goods or services to the customer. Transaction prices may still be affected and there could be penalties for failing to meet performance obligations.
If revenue recognition cannot be fulfilled at all, business owners need to assess the appropriate accounting impact of terminating the contract, reversing previously recognized revenue, or a refund liability. If adjustments to revenue recognition must be made, financial statements need to have clear disclosures that detail accounting estimates and judgments.
Detailed guidance on impairment of long-lived assets can be found in FASB ASC 360, Property, Plant, and Equipment. Impairment testing can be difficult and complex and usually requires the assistance of an experienced valuation expert.
The economic uncertainty created by the pandemic, and other world events, have made it difficult for management teams to provide needed estimates. If you have questions about the information outlined above, or need assistance with a financial statement audit, or other issue, Abbott Stringham & Lynch can help. For additional information call 408-377-8700 or click here to contact us. Our team looks forward to speaking with you soon.