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Time for a Checkup: How COVID-19 Can Affect Your Financial Statements

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Secondary to the toll the coronavirus pandemic is having on people’s health and lives around the globe is its impact on companies. It’s forced companies to adapt quickly to shifts in supply, production and distribution, customer demand and workforce logistics while trying to plan for what’s next in the wake of uncertainty. On top of all that, they have much to consider as they begin to report their financial results for the first quarter of 2020, as the condition of the business has likely changed significantly. Companies not only need to assess the health of their financials, but they also need to document the process they use to perform this checkup as part of their disclosure controls and procedures.

When the auditors make their rounds (even if their rounds are performed through Zoom meetings and email), key vital signs they’ll be looking at include:

  • Asset impairment
  • Employee costs
  • Revenue assumptions
  • Company debt

Asset Impairment

Companies need to determine whether the disruptions in their business are short term in nature or whether they represent longer-term impairment indicators. In either case, documentation surrounding the company’s assessment as of each reporting period is important. As you consider the assets on your balance sheet and begin analyzing them for impairment, keep in mind that the accounting guidance requires you to evaluate assets in a particular order:

1. Accounts receivable, inventory and other assets: Companies that have adopted the new credit standard (ASC 326) should consider the COVID-19 pandemic when assessing their forecast of future economic conditions. For companies that have not yet adopted the standard, historical credit quality and experience may be less of an indicator of collectability and additional focus will be needed on the current economic environment.

Companies also need to assess the carrying value of their inventories, both in terms of inventory reserves based on diminished customer demand and in terms of their costing methodologies. The global pandemic has created labor and material shortages and has even shut down factories; however excess capacity costs should be expensed in the period incurred and not allocated to inventories as overhead. Other assets to consider when evaluating impairment might include prepaid expenses and equity method investments.

2. Indefinite-lived intangible assets (other than goodwill): These are intangibles not subject to amortization and may include trade names or in-process R&D work that has not yet been completed. Factors that may impact the fair value of these intangibles include changes in an entity’s cost factors, declines in revenues or cash flows, industry and market considerations and general macroeconomic conditions, including access to capital, fluctuation in exchange rates or other developments in the capital markets that could significantly impact the fair value of the indefinite-lived intangible.

3. Long-lived assets: Property and equipment, software development costs and intangible assets subject to amortization should be tested for recoverability when events or changes in circumstances indicate the asset’s carrying amount may not be recoverable. In light of the pandemic, factors to consider include changes in the extent or manner in which the asset is being used, a forecast that demonstrates continuing losses associated with the use of the asset or a current expectation that the long-lived asset will be sold or disposed of before the end of its useful life.

Before assessing long-lived assets for impairment, companies need to group their long-lived assets with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. If your company has not had to evaluate long-lived assets for impairment before—and has not therefore gone through the exercise of assessing asset groups—plan ahead. This is a highly judgmental area and requires a careful look.

4. Goodwill: Even if it’s not time for your annual impairment test, an interim assessment may be warranted. Factors to consider include many of those noted above for long-lived assets and intangibles, but also could include changes in key personnel, strategy and customers. Wondering why measuring goodwill impairment is last on the list? Impairment of long-lived assets and intangibles may also impact the fair value of the reporting unit.

Employee Costs

Employee costs is a broad category, but in the midst of the pandemic, there are three important areas to pay attention to:

1. Restructuring costs: Employee severance costs representing a one-time benefit arrangement are recognized once management has approved a plan and it has been communicated to employees. Whether the termination requires the employee to stay beyond a minimum retention period will determine if you recognize such costs immediately or ratably over the remaining service period.

2. Contractual termination benefits: Companies may have contractual termination benefits that stem from executive employment agreements, benefit laws in a specific country or other means. Different from one-time benefit arrangements, contractual termination benefits are typically recognized when it becomes probable that the employee will be entitled to the benefits and an estimate can be made, even if employee communication hasn’t yet occurred.

3. Performance metrics: Performance targets are most commonly aligned with management and executive cash bonus programs and equity-based compensation. For cash bonuses, companies will want to assess their accrued compensation benefits and revise forecasts for future expense recognition. For equity awards with performance-based vesting, reevaluate the estimated quantity of awards for which it is probable that the performance conditions will be achieved and adjust stock-based compensation cost accordingly.

For public companies, keep in mind that performance-based equity awards are considered contingently issuable shares when computing diluted EPS. You will need to assess the number of shares that would be considered issuable if the end of the reporting period were the end of the contingency period.

Revenue Assumptions

Companies with revenue contracts that include variable consideration likely require a robust reassessment of their estimates based on the effects of the pandemic. ASC 606 requires companies to estimate the transaction price at contract inception, including variable consideration (e.g., volume discounts, rebates, returns, refunds, price concessions and royalties, to name a few). Variable consideration is included in the transaction only to the extent that it is probable the company won’t have a significant reversal of cumulative revenue recognition down the road as the uncertainties related to the variability resolve.

Estimates of variable consideration are required to be updated throughout the contract term to reflect conditions that exist at the end of each reporting period, which may include changes in customer demand (especially in the retail market), supply chain disruption, and impacts to manufacturing and distribution channels. Also, companies may be more likely to offer price concessions or increase existing ones to help drive demand.

In addition to reassessing estimates, factor in the possible deterioration in your customers’ ability to pay and the impact that may have on revenue recognition. To qualify as a “contract” under ASC 606, it must be probable that the company will collect substantially all of the consideration to which it’s entitled in exchange for the goods or services that will be transferred. If the collectability of the A/R balance is questionable, give additional thought as to whether revenue recognition on new transactions with that customer is appropriate.

Company Debt

The pandemic is creating significant and unexpected changes in the cash flows and results of operations for many entities. As a result, companies may find that they are not in compliance with some of their existing debt covenants. If the debt is callable upon a covenant violation, the company may need to reclassify the debt as current. Even if the company obtains a waiver for the current reporting period, if it is probable that the company will fail the covenants within one year from the reporting date, the debt would still be required to be classified as current.

As businesses consider modifications to their existing debt arrangements—whether to increase lending, extend payment terms or to change the debt covenants—they will need to assess whether the debt modification is viewed as a troubled debt restructuring, which dictates different accounting treatment than a standard modification.

As you go over the steps necessary to vet the wellness of your company’s financial statements, know that RoseRyan is standing ready to assist. Our team of finance and accounting experts can also help to assess whether additional review is needed based on your company’s specific financial picture.