As the negative trend in most entities’ bottom lines continues, profitability ratios are also declining. This can lead to significant fluctuations in critical financial metrics like the current ratio, quick ratio, debt-to-equity ratio, and others, which serve as the foundation for financial covenants. As a result, it is imperative to generate a standard-compliant financial report that accurately reflects the current state of affairs. This report will be crucial for stakeholders, especially creditors and investors, to make informed decisions about their involvement with the business.
The economic upheaval caused by uncertainties has hit businesses of all sizes hard, resulting in some being forced to liquidate or close permanently. As we strive towards recovery, those who managed to survive are still facing the possibility of shutdown and have doubts about their ability to continue operations. These survivors are now faced with the additional challenge of addressing accounting concerns to meet the stringent requirements of US GAAP and other regulatory bodies. Providing accurate and reliable business reports during these uncertain times is essential to ensure compliance and meet stakeholder expectations.
Management should consider the following guide questions in assessing the financial statement impact of uncertainties:
- How does the entity consider a significant decline in customers’ ability to make payments in their revenue assessment?
Probability of collection
To recognize revenue, ASC 606, Revenue from Contracts with Customers, requires that collection of substantially all of the consideration must be probable. Therefore, even after revenue is recognized at contract inception, the entity shall reassess if there is an indication of a significant change in facts and circumstances. For example, suppose a customer’s ability to pay the consideration deteriorates significantly; the entity shall reassess whether it is probable that it will collect future consideration for the remaining goods and services that will transfer. If the decline in the customer’s ability to make payments occurs subsequently after the entity recognized revenue, an assessment should be made on possible impairment of receivable (you may refer to the CECL discussion below). Further, before assessing collectability, entities must also consider price concessions they may offer customers as it reduces the transaction price.
Contract modification and termination
As challenges continue affecting businesses, some customers may resort to modifying or terminating an existing contract. A contract modification is defined as a change in the scope, price, or both. The entity shall assess whether a contract modification shall be accounted for as a separate contract, as it requires different accounting treatment. A modification is accounted for as a separate contract if there is an addition of distinct promised goods or services for an amount equivalent to its standalone selling price. The partial or complete termination of a contract will typically be accounted for as a modification, as it is a change to the scope and price of the contract.
The deterioration of a customer’s ability to pay and contract modification or termination arising from uncertainties typically will reduce the revenue to be recognized.
- Does the entity consider relevant information in its estimate of the Current expected credit loss (CECL) for its financial assets?
When developing an estimate of ECL, the CECL model requires consideration of reasonable and supportable information about past events, current conditions, and forecasts of future economic conditions. Entities shall consider how the ripple effects of uncertainties, coupled with volatilities in macroeconomic variables, affect their assessment of ECL.
Entities are expected to recognize a relatively higher allowance for credit losses during the periods affected.
Also read: CECL Adoption Is Just Around the Corner – Is Your Business Ready?
- Does the entity perform the ‘lower of cost or net realizable value test in their inventories?
ASC 330, Inventory, requires an inventory initially measured using FIFO or average costing method to be subsequently measured at the lower of cost or net realizable value. Net realizable value is calculated by subtracting the estimated completion, disposal, and transportation costs from the estimated inventory selling price.
The uncertainties caused widespread supply chain disruption, production stoppage, and inventory damage. It also increased materials, freight, handling, and storage costs, which means higher capitalizable and selling costs. Additionally, selling prices may be lower arising from price concessions granted to customers and a significant decline in demand for the product or service. These are some of the indicators that the net realizable value of the inventory will be lower than its cost, prompting recognition of a loss on inventory obsolescence.
- Are there events or changes in circumstances indicating that fixed assets are impaired?
Long-lived assets and finite-lived intangible assets (fixed assets) shall be tested for recoverability per ASC 360, Property, Plant, and Equipment, whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In addition, the recoverability test follows a review of depreciation estimates and methods.
Supply chain disruption and stoppage of production render facilities and production equipment abandoned or idle. In addition, armed conflicts cripple businesses’ assets. These are circumstances that may necessitate impairment testing and accounting estimate reconsideration. When further testing indicates that the carrying amount of fixed asset is not recoverable, entities shall record an impairment loss. Also, it is plausible that the estimated remaining useful life of the asset will be shortened.
- Are there events or changes in circumstances indicating that indefinitely-lived intangible assets are impaired?
Evaluating the impairment of indefinitely-lived intangible assets usually involves a two-part test. ASC 350, Intangibles—Goodwill and Other, provides for a qualitative test to assess whether it is more likely than not that the asset is impaired but provides an option to go straight to a quantitative test consisting of a comparison of the fair value of the asset with its carrying amount.
Discounted cash flow is one of the most traditional and standard methods of estimating the fair value of an asset. When the general market condition is unpredictable, entities using this method shall be prudent in their revenue and cash flow forecasts and consider how rising interest rates brings the present value factor used in discounting down.
- Is there a possibility of a debt covenant violation?
Some long-term debts require compliance with certain covenants. For example, a note payable may include a financial covenant to maintain a minimum current ratio that, when violated, will make the note due and demandable. Even if the lender waives its call right due to the covenant violation for a period greater than one year while retaining future covenant requirements, the debt will not automatically classify as non-current when the covenant is breached. It will be classified as current if the borrower will not be able to comply with the covenant within the next 12 months from the balance sheet date.
If a debt covenant violation happens or is expected after the balance sheet date, the debt will generally be classified as non-current. Still, disclosure of the fact is required in the current reporting period.
- How do uncertainties impact the probability of recognizing losses on contingencies?
ASC 450, Loss Contingencies defines loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail. Accrual and disclosure of a loss contingency are required when (1) the occurrence of one or more future events confirming the fact of the loss is probable and (2) the amount of loss can be reasonably estimated. ASC 450 does not define “probable,” but is generally considered 75% or more.
Economic instability brought about by uncertainties may cause entities to recognize contingency losses such as those relating to the collectability of receivables, loss or damages of properties and other assets, and product warranties. Accordingly, entities shall be critical in assessing losses as it is a matter of judgment.
- Does the entity consider events and transactions occurring after the balance sheet date?
Subsequent events consist of those events and transactions that provide evidence about conditions that (a) existed at the balance sheet date (i.e., recognized subsequent events) or (b) did not exist at the balance sheet date but arose after that date (i.e., non-recognized subsequent events).
The subsequent impacts of uncertainties cannot be predicted — effects may linger for some entities, but some might get alleviated. Therefore, entities shall consider which subsequent events would entail adjustments in the financial statements. Examples of these events include the bankruptcy of a customer occurring after the balance sheet date that confirms a bad debt existed at the balance sheet date or sales of inventory after the balance sheet date that give evidence about their net realizable value at the balance sheet date.
- Does the entity assess the entity’s ability to continue as a going concern?
ASC 205-40, Presentation of Financial Statements – Going Concern requires management to evaluate, annually and for each interim reporting period, whether there are conditions and events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the financial statements are issued. When substantial doubt about the entity’s ability to continue as a going concern is raised, management shall implement an effective plan of action to alleviate the substantial doubt.
When substantial doubt is raised, regardless if management plans alleviate it or not, the entity shall disclose the principal conditions or events that raised the substantial doubt, management’s evaluation of those conditions or events, and the details of the plan that alleviated (or were intended to mitigate) those conditions or events. Additionally, if substantial doubt still exists after considering management’s plans, the entity shall include a statement in its notes to financial statements indicating that there is substantial doubt about the entity’s ability to continue as a going concern.
Management must perform a going concern assessment as regulators are aware that entities are vulnerable to liquidity risks during this period.
- Does the company have safeguards to mitigate the increased risk of fraudulent financial reporting due to pressure to meet targets and other key performance indicators?
It is logical to expect a rise in the risk of fraudulent financial reporting during these times of economic uncertainty. Certain stakeholder expectations and incentives tied to a financial metric put pressure on management to commit such fraud in the form of revenue falsification and expense understatement. Entities shall put adequate and effective controls in place to prevent this kind of fraud. Examples of these controls include strictly implementing segregation of duties, performing regular account reconciliations, and promoting a culture of integrity and open communication. These practices are especially vital in nonprofit financial reporting, where transparency and trust are crucial for donor confidence and regulatory compliance, as well as broader risk and SOX compliance requirements.
Note that the set of foregoing questions is not an exhaustive list of considerations, and management needs to conduct a thorough company-wide assessment of all significant accounting considerations. Take Action! To effectively assess the impact of uncertainties, entities must gather information from across the organization and collaborate closely. It’s crucial for individuals within the organization to have a solid understanding of the provisions of US GAAP, IFRS, or other relevant reporting frameworks. Utilizing a financial statement disclosure checklist can help ensure that all required disclosures are complete and accurate. In addition, management should carefully analyze financial statements and look for any unusual or suspicious activity. Seeking guidance from technical accounting consultants or other experts can be helpful in addressing complex accounting issues and ensuring compliance with regulations. By taking these steps, entities can be better equipped to navigate the challenges posed by uncertain economic conditions. How Scrubbed Can Help Analyzing the consequences of uncertainties, from sifting through mountains of data to measuring their impact, can be an arduous process. However, generating precise and pertinent business reports is crucial in contributing to a united global recovery, despite the added workload. Fortunately, Scrubbed offers the expertise of trained professionals who can guide businesses through the intricate accounting and disclosure obligations of US GAAP and other relevant regulatory frameworks. This will enable informed business decision-making and facilitate successful navigation through uncertain times. Contact Scrubbed to learn how we can help in your goal of providing relevant and accurate financial statements in times of uncertainty.
