The Coronavirus Disease of 2019, or COVID-19, is an evolving concern that has dealt a huge blow in the Global Financial Market and industries in general, disrupting value chains and daily living of the world’s population. Originally declared as a public health emergency on January 30 by the World Health Organization, the phenomenon is now considered as a Pandemic, and full impact remains evolving. As it affects and creates a toll on human activity and quality of living in general, COVID-19 poses great uncertainty to other facets of businesses. Directly, we have seen the effects in the companies’ supply chains as it halts workforce, production of goods and rendering of services, and forces governments to regulate economic activities. Further, we have identified selected indirect effect on the companies’ financial statements that may pose significant effects in the long run.
FASTalks is here to affix your senses on things that matter to your stakeholders, and ensure that your accounting teams—the Scrubbed team— cover considerations that stakeholders might ask—because in times of crisis, stability and knowing the impact of uncertainties matter.
In a Nutshell
- COVID-19 poses 2019 financial statement modifications on Going Concern (ASC 205-40) and Subsequent Events (ASC 855)
- COVID-19 affects Revenue Recognition for Q1’2020 onwards (ASC 606 and 326)
- COVID-19 presents accounting for unusual expenses for Q1’2020 onwards (ASC 220 and 225)
- COVID-19 opens uncertainties towards impairment of certain assets (ASC 350 and 360)
- COVID-19 affects Lease accounting for Q1’2020 onwards (ASC 84
- COVID-19 required regulatory reforms by providing tax filing reliefs for State (CA) and Federal Tax Returns
2019 FINANCIAL STATEMENTS IMPACT
Consistent with ASC 855 provisions, companies should evaluate whether events occurring subsequent to the Balance Sheet date (12/31/2019) require disclosure or adjustments in the financial statement.Managements’ action point is to consider the adjustment in the financial statement, via notes, or via adjusting financial amounts.
- Non-Adjusting Events / Nonrecognized Subsequent Events. For 12/31/2019 filings, financial reporting impacts will be limited to disclosures in the notes to financial statements. Examples include closure of facilities, change in debt arrangements or restructuring, change in business practices (such as movement to online channels), and modifications in covenants.
- Adjusting Events / Recognized Subsequent Events. Consistent with current practice, if the event is a culmination of an already existing event as of Balance Sheet date, example of which is the US-China trade restriction, then the financial impact of the event constitutes adjustment in the financial statement details as of 12/31/2019.
Significantly, for those not yet issuing the financial statements for 12/31/2019, a grave consideration is the factor of the identified uncertainty (COVID-19). Consistent with the provisions of ASC 205 Subtopic 40, a reporting entity’s exposure to coronavirus-affected areas may raise or contribute to other existing facts and circumstances that collectively raise substantial doubt about the entity’s ability to continue as a going concern.
Managements’ action point is to reassess the following:
- Assess whether liquidation accounting is applicable (COVID-19 may have disrupted an entire industry, and lack of revenue-generating activities may affect the viability of the business);
- Consider whether impact of COVID-19 is material to the company’s ability to continue as a going concern (did it significantly alter the business model of the company?);
- Consider Managements’ plans to mitigate the adverse conditions or events;
- Consider effective implementation of managements’ plans and viability of resolving the substantial doubt as to the impact in the company’s operations.
Currently, 42% of SEC Issuers have included COVID-19 as incremental business risk and considered the factor in the companies’ abilities to continue as going concern. If positive outcome is expected based on the action points above, then a mere disclosure is required, considering that COVID-19 impacts the operations of the company materially.
CONSIDERING REVENUE RECOGNITION CONSTRAINTS OF COVID-19
Consistent with ASC 606 provisions, three factors affecting revenue recognition and subsequent collection must be taken into consideration when recognizing revenue for Q1’2020 onwards.- Adjustment of Variable Considerations. Variable consideration is estimated at contract inception and needs to be reassessed at each reporting date. But variable consideration can only be recognized to the extent it is probable a significant reversal will not occur when the uncertainty is resolved. ASC 606 describes examples such as volume discounts, rebates, returns, refunds, and royalties, liquidating damages. Consideration is also variable if it is contingent on a future event and its occurrence, such as meeting performance goals or deadlines, or a customer achieving a certain outcome, such as a distributor meeting a target level of gross margin upon resale.
Given the disruption in the supply chain, management is enjoined to consider the following: (a) adjust the rates of returns and refunds with some kind of forward-looking factor, as opposed to historically analyzing rates. In this view, retrospective analysis may need to be adjusted; (b) consider the probability of performance goals or deadlines not being met due to adverse effects in the economy. - Assessment of Collectability of Contracts at Day 0. Salient provision of ASC 606 is to ensure that contracts must meet the collectability threshold—being probable. US GAAP defined “probable” as “likely to occur,” which is generally considered at 75% to 80% threshold. While it is a standard procedure to assess the bad-debts on occurring sales, it is a great concern as to whether the credit quality of the customers have been impaired at the onset of the sale/rendering of service.
We opt to remind Management that revenue can only be recognized when collection of consideration is probable at the perfection of the contract/delivery of goods. This criteria must be met, and Management is encouraged to assess customers who are credit-impaired on Q1’2020, in order to address existence issues of revenues.
- Impairment of Receivables amidst COVID-19. While incurred losses model generally apply for private companies, it is important to note that ASC 326, guidance on current expected credit loss model (CECL), suggests that a forward-looking adjustment be considered in the computation of impairment of receivables.
We encourage management to consider a forward-looking adjustment (e.g. adjustment of rates such as increase in expected impairment rate) related to overall credit deterioration of customers. Historical analysis (net flow rates) and previous credit profiling may not be applicable in the face of the pandemic, and we are encouraged to adjust our models accordingly.
ACCOUNTING FOR UNUSUAL EXPENSES RELATED TO COVID-19
Unexpected costs are likely to be incurred because of COVID-19. In recognizing these expenses, ASC 220 and ASC 225 provide guidance on what items are considered “unusual” and “infrequent.”“Unusual” events are those with high degree of abnormality that is clearly unrelated, or incidentally related to the ordinary activities of the business in its operating environment. On the other hand, “infrequent” events are those that are not reasonably expected to be incurred again in the future, within the operating environment.
The standard also classifies the operating environment to consider the characteristics of the industry, the geographical location and the governmental regulation. For example, an entity handling national disasters, may consider expenses from response for emergencies as part of their normal operations, and would not be classified as “unusual” or “infrequent”.
Examples of which are, but not limited to, the following:
- Planning, preparation, and prevention activities for Management’s response to COVID-19
- Cancellation of events and delays in the production costs
- HR Expenses (additional security and staffing)
- Increase in IT related expenses due to additional access management tools/remote work set-up
Management’s action point is to provide separate consideration in accounting for these expenses.
When incurring unusual and infrequent expenses, generally, these expenses are presented as part of the statement of comprehensive income with supporting disclosure. A detailed list of the accounting treatment for these items are summarized below in accordance with ASC 220:
- Presentation as a separate component of income from continuing operations, (not presented net of tax);
- Presentation as a separate component of the financial effect of unusual and infrequent events;
- Disclosure of unusual and infrequent expenses, including nature and circumstance; and
- Recognition of receivable/gain from insurance policies to the extent that the amount of losses has been recognized in the financial statements (ASC 450)
Our consensus with management disclosure and analysis is this: in order not to disrupt the performance measurement of some industries, these expenses should be considered outliers, and there should be a separation in the evaluation and management of key performance indicators (especially in the healthcare industry).
PROBABLE IMPAIRMENT OF ASSETS
Respective companies’ financial performance and future projections as to the health and wealth of the business may be significantly affected, either on the demand side or the supply side. Factors include:- Demand Side. A significant demand for certain industries have become affected negatively, such as airlines, hotel and hospitality, travel, and large-scale event-based industries. Since uncertainty played a significant role, revenue generation and possible cash inflow may be negatively affected. Management needs to adjust revenues conservatively to check value in use.
- Supply Side. If supply chain is based on geographical locations widely affected by lockdowns or severe inability to mobilize workforce due to the health toll of the disease, and constraints in the supply meant inability to cater to demand, then Management needs to adjust revenues limited only to the expected supply.
- Other factors. Other factors needing to be considered for triggering events include presence and availability of alternative workforce and other regulatory restrictions.
The guidance for goodwill and intangibles requires that an impairment test be performed when a triggering event occurs. In this case, the triggering event is the volatile and negative impact of the event in the Stock Markets—and normal litmus test is to check whether market capitalization falls below carrying value of the assets.
If a thorough analysis is conducted, companies should assess whether a triggering event has occurred, and if so, management should follow the applicable guidance. Normally, this includes Step 0—qualitative assessment of factors, then Step 1—quantitative assessment. The company should consider how assumptions in its financial projections may be impacted by decreased demand for its products or services or extended disruptions to its supply chain, manufacturing operations, or global workforce.
Other considerations for Asset Impairment include:
- Similarly, triggering events discussed above relates to tangible assets as well. Idle property and equipment may present factors of impairment through lack of utility.
- In inventories, write-down of value due to Net Realizable Value (NRV) decline may be expected. Excess inventory for goods without demand must be carefully analyzed. Other excess inventory that will not be realized within the normal operating cycle may be classified as “long-term” assets.
- Idle production capacity, and depreciation of idle assets in the event of production restriction due to lockdown, may be charged outright to cost of goods sold rather than capitalizing to inventories.
- For equity instruments, investment in companies situated in hardly-hit areas needed to be assessed as to whether “other than temporary impairment” factors exist.
COVID-19’S IMPACT ON LEASE accounting
Certain impact of COVID-19 in lease accounting needs to be considered operationally and financially. They are as follows:- Impairment. On lessee scale, one or more of the aforementioned economic and financial markets effects may trigger a requirement for the lessee to assess one or more of its asset groups that includes an ROU asset for impairment under ASC 360 (property, plant and equipment). For example, the economic effects of the COVID-19 outbreak may result in a ‘significant adverse change in the business climate that could affect the value of the long-lived asset.
Lessors may find that some of their underlying assets held for lease are impaired if lessee demand for those assets significantly decreases or rental rates decline precipitously. - Abandonment. A company may commit to abandon an ROU asset if it concludes it can no longer make use of it as a result of the COVID-19 outbreak, and either cannot or will not sublease it. For example, a company that is leasing overflow fulfillment center space may determine that space is no longer needed because sales have, or are expected to, decline significantly.
- Lessee discount rates. A lessee’s incremental borrowing rate, typically used by lessees as the ‘discount rate for the lease’, may be affected if interest rates significantly change (e.g. due to central bank monetary stimulus) or its borrowing costs otherwise change (e.g. because its credit rating declines).
- Lessee reassessments. One or more actions a lessee takes in response to the effects of the COVID-19 outbreak may trigger a requirement to reassess the term of, or an option to purchase the underlying asset in, one or more leases.
- Fair values. Multiple aspects of ASC 842 lease accounting depend on fair value (e.g. of underlying assets and ROU assets). The fair value of an ROU asset affects whether and how much impairment is recognized on an ROU asset. Fair values may be affected by significant economic events such as the COVID-19 outbreak.
- Collectability. Collectability of lease payments at inception of contract, and subsequent collection thereof is governed by the effects of COVID-19 as discussed in the previous pages (ASC 606 and ASC 326).
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To ensure that all factors are considered in the pursuit of relevant and fair financial reporting, our outsourced accounting team services like SaaS accounting expertise can be scaled to accommodate your business needs, especially in considering accounting and reporting impact of COVID-19. Our Technical accounting Group supports the accounting services and provides a thorough analysis of factors outside the normal course of business.E-mail us at [email protected] for full consultancy assessment.
Disclaimer
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. It is not intended to be relied upon as accounting, tax, or other professional service. Please refer to your advisors for specific advice. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.
