With the unprecedented measures taken by a majority of the countries around the world in response to the coronavirus (COVID-19), global economic downturn is likely imminent. This developing situation is expected to impact companies across all industries. Beyond business resilience, liquidity and other challenges that the companies will likely need to deal with, these impacts will likely require companies to have to also apply certain complex (judgmental) accounting guidance in order to address and properly reflect in the financial statements.
In addition to the accounting implications, companies will also need to provide extensive disclosures in order to articulate the current and expected impacts to their business, and to provide additional information to the users of the financial statements related to the estimates, uncertainties, risks and other judgments used in the preparation of the financial statements.
This publication summarizes key potential impacts that we expect companies will have to consider as they navigate through the situation, and the related fallout effects over the upcoming months.
Impairments: Long-Lived Assets and Goodwill
ASC 350 and ASC 360 are required to perform impairment tests over intangible assets, property, plant and equipment (including right of use asset recorded under ASC 842) and goodwill when certain triggers may be indicative of an impairment. Declines in revenue and increases in costs, which may result from COVID-19 depending on their length and impact, may be deemed to be impairment indicators. Impairment testing will likely involve re-evaluation of projected cash flows, which could also provide certain challenges during the economic downturn and uncertainty created by COVID-19.
Impairments and Expected Credit Losses: Financial Assets
ACS 326 (also known as CECL) applies to:
- Loans receivable
- Trade accounts receivable
- Debt securities classified as held-to-maturity
- Contract assets (recorded under ASC 606)
- Lessor’s net investment in a leases (recorded under ASC 842)
The economic fallout of COVID-19 will likely lead to many of the key assumptions used in the calculation of CECL to estimate a revisit of the economic outlook, the historical loss period, and the duration of the volatility.
The stable economic environment and outlook have been quickly supplanted by a volatile and adverse forecast, making estimates of expected credit losses over the reasonable and supportable forecast even more challenging for companies. Furthermore, the historical credit loss period used as a baseline starting point for the expected credit loss under CECL is likely not reflective of the current conditions and outlook, and will need to be revised. Finally, the duration of the economic decline and the related increased volatility create tremendous uncertainty, adversely impacting valuations and market liquidity.
Available-for-sale (AFS) debt securities will also need to be carefully evaluated to determine whether an impairment where the fair value is below amortized cost is credit-related. Collectability may be in question for many receivables, even those shorter-term receivables. If a receivable is determined to be uncollectible, then it should be written off. It is generally not enough to just record an allowance against it.
ASC 330 is required inventory to be recorded at the lower of cost or net realizable value. Net realizable value is defined as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” In the times of economic uncertainty (such as the ones potentially resulting from the impacts of COVID-19), it is not uncommon for the selling prices to fluctuate significantly. As a result, judgment will be required to determine value of inventory and potential write-offs may need to be recorded.
Impairments: Equity Method Investments
ASC 323 is required to review equity investments for a potential impairment when facts and circumstance indicate that the carrying amount of the investment might not be recoverable. If there is a significant decline in the value of an investee or if the investee recognizes an impairment loss (both of which could happen due to impacts of COVID-19), an investor will need to determine whether the decline is “other than temporary (OTTI)”, and if so, record an impairment loss.
ASC 470 includes guidance related to debt modifications, including Troubled Debt Restructurings (TDRs). To the extent COVID-19 creates liquidity issues and causes companies to restructure the existing borrowing arrangements, a debt modification or a debt extinguishment accounting framework will need to be followed. Further, classification of long-term debt will need to be considered if a covenant violation or other default occurs. It must be noted that the banking regulators issued an Interagency Statement specifically addressing that coronavirus-related loan modifications would not automatically be classified as TDRs if they were short-term and the borrowers were current prior to the outbreak.
ASC 842 requires evaluation of the collectability of lease payments (and any residual value guarantees) for operating leases. Economic uncertainty caused by COVID-19 may lead to a lessor’s determination that collection of the lease payments (including residual value guarantees) may no longer be probable. As such, a lessor may need to reverse the lease income if the amount recognized to date is less than the amount collected to date.
ASC 606 is required to estimate variable consideration (volume discounts, performance bonuses, etc.) and recognize revenue when or as the control for goods and services transfers to customers. These estimates, to the extent not constrained at the inception of the contract, may be impacted as a result of COVID-19 and therefore will need to be updated. Further, such updates to the estimates will likely involve significant judgments and as a result additional disclosures may be required. Finally, any costs related to customer contracts (costs to obtain or costs to fulfill a contract) accounted for under ASC 340 will need to be assessed for recoverability.
ASC 855 requires certain disclosures for the events that occur between the balance sheet date and the financial statements issuance date. For calendar year-end (December 31, 2019) companies, the COVID-19 outbreak would likely not be considered a Type 1 (“recognized”) subsequent event that would require “push back” and inclusion in the financial statements because the first cases of the disease were just emerging on December 31, 2019 (in geographies outside of China). For calendar year-end companies, the COVID-19 outbreak will likely be considered a Type 2 (“unrecognized”) subsequent event because it provided evidence about conditions that arose subsequent to the balance sheet date. Companies with a different (after December 31, 2019) year-end may have to apply further judgment to the determination of the Type of subsequent event.
Risks and Uncertainties
ASC 275 requires disclosures about certain risks and uncertainties, which include qualitative disclosures that could significantly affect the reported financial results or operations within the 12 months after the balance sheet date. Depending on the significance of the expected impact, anticipated exposure resulting from the concentration of business may be more susceptible to COVID-19.
In quarterly reports on Form 10-Q, registrants are required to disclose any new material risks or material changes to previously disclosed risk factors included in the “Risk Factors” section of the registrant’s annual report on Form 10-K. Given the COVID-19 pandemic, registrants must determine if their business is now exposed to any material new risks (or material changes to previously disclosed risks) related to the COVID-19 outbreak and address in the “Risk Factors” section of the quarterly report on Form 10-Q. In January, SEC Chairman, Jay Clayton, acknowledged that, “Effects [of the coronavirus] may be difficult to assess or predict with meaningful precision both generally and as an industry- or issuer-specific basis. This is an uncertain issue where actual effects will depend on many factors beyond the control and knowledge of issuers. However, how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.” Examples of effects on a business could be supply chain interruption or decreased consumer demand.
Management Discussions & Analysis
Registrants impacted by the COVID-19 pandemic should disclose any infrequent or unusual events or any other significant transactions that had a material effect on operating income in the “Results of Operations” section. Examples related to the COVID-19 pandemic could be significant costs incurred to respond to the outbreak or unexpected and significant lost revenue. In accordance with Item 303 of Regulation S-K, registrants must also disclose known trends or uncertainties expected to have a material impact on operating income and liquidity. When a registrant is unable to determine the certainty of a material trend occurring, the registrant must err on the side of assuming the worst and disclose any material future impact on the business. The disclosures will vary from company to company given the unique set of facts and circumstances, but the disclosures should be thorough and robust and address any material financial implications.