Organizations of all sizes have been in survival mode since the beginning of 2020 to get through the pandemic and the economic downturn that followed. But now, as the world moves towards recovery and growth, entities must carefully consider their unique circumstances and risk exposures when analyzing how recent events may affect their financial reporting.
In addition, the federal government enacted various stimulus measures that businesses will need to properly account for and memorialize.
Here are a few key areas that may be impactful to many organizations:
Accounting for Financial Assets
Although the stock market has mystified us all with its V-Shape from March to July 2020, there are continued areas of volatility and continued net declines in the fair value of many financial assets. Most debtors received forbearance in accordance with provisions of their lending agreements, or by laws enacted. However, they will need to continue to comply with the terms of loans.
Other adversely affected financial instruments and contracts may be at risk of reductions to future cash flow streams. Each contract, instrument and security will need to be carefully considered for appropriate impairment and loss recognition guidance. Additionally, companies that have historically held debt and equity investment securities to maturity may have to consider classification as available-for-sale securities.
Revenue from Contracts with Customers
Even though the Financial Accounting Standards Board (“FASB”) gave reprieve for private entities that had not yet filed financial statements or adopted Accounting Standards Codification (“ASC”) 606 – Revenue From Contracts with Customers – most private entities have been operating under the new standard. Companies are required to continually assess the impact of variable consideration at each reporting date.
Variable consideration consists of any adjustment to a transaction price whether it is based on meeting performance targets, volume discounts, refunds or royalties, all of which can be impacted during a down economy. Companies may also have to reassess whether collection is still considered probable for ongoing contracts, in anticipation of delivering new goods and services for which are already contracted. Many entities have been approached to renegotiate the terms of existing contracts, add special provisions to new agreements or supplement arrangements in process.
Revenue treatment is based on the effective terms of contracts with customers, and modifications can significantly affect those recognition principles.
Recognition of Expense: Compensation Arrangements
Many companies are unfortunately faced with the difficult decision of restructuring their organization through workforce reductions. These organizations will have to carefully analyze whether they are providing one-time termination benefits or severance, according to pre-established contractual language or practices. The timing and estimation of liabilities and recognition of expense can vary significantly depending on the termination plan.
Furthermore, companies that incentivize their employees through equity awards may be inclined to modify performance conditions tied to vesting or reduce the strike price of options. The accounting for share-based compensation modifications carries several complexities that will have to be considered under the specific circumstances.
Lease Modification Accounting
Due to the COVID-19 pandemic, work-from-home arrangements and overall office revamp requirements, landlords are providing lease concessions to tenants in the form of rent abatement, extensions and escalations, and in-kind transfers. Pre-COVID, these concessions would generally result in lease modification accounting. The FASB staff released “Q&A” guidance under ASC 842 allowing companies to make certain elections to make accounting less complex for some of the common concessions, such as payment deferrals and avoid re-measurement of lease liability and right of use assets.
While all assets should be considered for impairment or allowances, there are added complexities for long-life assets. Inventory sell-through may become clearer by the end of 2020 for some calendar year-end companies, while others with longer business cycles must grapple with longer term pricing estimates.
Companies must leverage well-prepared, forward-looking information to assess the impairment of nonfinancial assets (including goodwill), the ability to realize deferred tax assets and the entity’s ability to continue as a going concern. Using a measure known to have a high degree of uncertainty, management will need to project the business costs and time needed for a return to a “new normal.” These variables are difficult to predict but should take into account the governments restrictions imposed and the related compliance of customers and employee, as well as the type and effectiveness of government assistance.
Impairment tests for long-lived assets, intangibles and goodwill require recoverability models that rely on the development of these cash flow projections. The newly-established cost basis for the assets do not permit the subsequent reversal of the recorded impairment. Although many companies have policies in place that contemplate an annual impairment test, technically these impairments should be performed when there is a noted downturn to the market or negative unforeseen events. If favorable developments occur in subsequent periods, the recognized impairment would no longer be indicated, but would not be reversed.
Accounting for PPP Loans
Many public and private companies received stimulus money from the federal government through stimulus programs, including the Paycheck Protection Program (PPP) through the Small Business Administration (SBA). There are a variety of options that acceptable for accounting for these types of cash infusions, but typically fall into two option categories: 1) Treatment as a loan until it is actually forgiven, or 2) Accounted for deferred revenue from a government grant, if the company can evidence that forgiveness is reasonably assured. The differences in these two possible treatments include how interest expense is recorded and how the relief of the liability is recorded through the income statement. Many businesses will find it easier to utilize the debt treatment, as there are less assumptions and support that the entity must provide to auditors, and it may offer more clarity to the readers of the financial statements.
Most internal controls teams have been forced to change in this new environment, as companies move virtual or significant physical changes have been made to work flows. Fraud risks are heightened in these new internal control environments, as there may be unknown gaps in the control framework. It is increasingly difficult to use financial analytics in many categories, as operations are not likely comparable from period to period. Companies should analyze the current environment and in some cases implement new control designs, approval processes, and inspect month end reconciliations.
Going Concern During Downturns and Recessions
During an economic downturn, it becomes increasingly difficult for entities to evidence that they will meet financial obligations based on static historical financial statements. This is because many impairing activities can occur during the year in a turbulent economy. Auditors are going to expect Management to support their assertions.
An initial assessment will require an entity to consider the extent of business disruption, new product and service demand forecasts, contractual obligations due within the one-year period, current liquidity requirements, as well as any shortfalls and existing sources of financial support. Companies must assess all of these items before considering its management’s plans. These plans can only be based on information that is available as of the issuance date of the financial statements.
Management must be prepared to provide broad disclosures in its financial statements, when they identify events and conditions that raise substantial doubt about the entity’s ability to continue as a going concern. Management’s plans may alleviate this doubt, but they would need to be equally disclosed.
Although many private (non-public) companies may be able to push these good-faith assessments of future cash flows until year-end to produce compliant financial statements, the design and agreement with auditors is something to start now. The requirements to produce comprehensive documentation supporting the basis for such estimates could be significant.
We acknowledge companies are in survival mode and thus impacts of financial reporting might not be the first priority for many. However, we all hope for normalcy as we approach the end of 2020, when compliance issues will resurface. BPM’s Technical Accounting group is here to assist, so you can focus on your day-to-day operations and rest assured these other items will be addressed. Contact us today to learn more.