The Impact of the Coronavirus Outbreak on Financial Reporting
International concern continues to grow over the global outbreak of the novel coronavirus disease (COVID-19), which has been declared a pandemic by the World Health Organization (WHO). Although the virus’s impact on human health and equity markets is still evolving, its effects on consumer behavior are beginning to take shape. Accounting and financial reporting is one area where businesses have begun to see an impact, a message reinforced by the Securities and Exchanges Commission (SEC) last week, which granted conditional relief from certain publicly traded company filing obligations. Finance and accounting management teams should evaluate the financial implications of the outbreak and examine their disclosure requirements, as stakeholders are likely to more carefully consider companies’ responses during this critical time.
Revenue recognition
In certain industries and geographies, decreases or disruptions in customer demand or the supply chain may result in declining sales volume, which would impact estimates in revenue accounting. When a transaction price includes a variable amount, such as a volume-based rebate, companies are required to estimate this variable consideration. Other contracts with customers may include contingent revenue amounts that cannot be recognized until a constraint has been lifted (i.e., when it is probable that a significant reversal in the amount revenue recognized will not occur). Companies should evaluate how such estimates and contingent revenue will be impacted as a result of any forecasted changes in sales volume or other factors linked to the virus.
Accounting teams should also identify which customers or customer-bases have been negatively impacted by the virus. For example, if customers are identified as having an increased credit risk, companies should evaluate their intent and ability to pay promised consideration when due as part of their revenue recognition process in the determination of whether a contract with a customer exists.
Goodwill and indefinite-lived intangible assets should be reevaluated between annual tests if circumstances change, which would make it likely that an impairment has occurred or that the carrying value of an asset is not recoverable—a concept known as a “trigger.”
Asset impairment
A company’s projected financial performance may be significantly impacted by reduced customer spend in a specific geography or an inability to get product to market because of supply issues caused by the virus. Although goodwill and indefinite-lived intangible assets are tested annually for impairment, they should also be reevaluated between annual tests if circumstances change, which would make it likely that an impairment has occurred or that the carrying value of an asset is not recoverable—a concept known as a “trigger.” If a trigger to perform an impairment test is deemed to have occurred, accounting teams will need to carefully evaluate the impact of the virus on the various inputs and assumptions included in these impairment tests, including estimated future earnings and discount rates. Note that the requirements to perform an impairment test for indefinite-lived assets such as goodwill or developed technology differ from those used for definite-lived assets such as machinery, equipment or tradenames. Companies must follow the specific sets of rules established for each.
Debt agreements
Companies may need to evaluate liquidity requirements, and, as a result, consider new debt agreements or modify existing ones. Changes to existing debt agreements should be carefully reviewed by accounting teams to determine whether the updates require modification accounting, a gain or loss on extinguishment, or potentially represent a troubled debt restructuring. Even if no changes to debt agreements are considered, accounting teams should continue to review the terms of existing debt agreements, specifically covenants that require the company to meet certain targets, typically tied to revenue, earnings, or balance sheet ratios. Companies may seek to amend agreement terms with lenders in order to modify these targets, at which point an accounting analysis surrounding the modification of the agreement must be performed.
Contingent consideration
Companies that have recently completed a business combination may have agreements in place that obligate the buyer to transfer additional assets to the selling entity if certain future events occur or conditions are met. Often, those future events and conditions are tied to earnings or other performance targets of the acquired entity. As companies remeasure any assets or liabilities associated with contingent consideration at fair value, they should consider the impacts of the virus to both any company-specific forecasts or supply chain, which may impact earnings. Additionally, any changes in the terms of such agreements should be incorporated into an updated fair value analysis.
Stock options
Similar to amendments to debt covenants or sales and purchase agreements that contain contingent consideration, given the unpredictable impact of the virus on company operations, certain organizations may consider updating stock option terms that are linked to specific earnings criteria. Any modification to earnings targets that trigger a stock option to vest or that impacts the probability of vesting may be considered a modification of the award requiring further evaluation and potentially additional compensation expense.
Disclosure
Companies that wish to take advantage of the SEC conditional relief must provide an explanation on how they have been impacted by the coronavirus outbreak. Beyond the impact of the relief itself, however, the SEC’s statement is an acknowledgment that there are likely circumstances beyond a company’s control that would delay accurate financial reporting. For example, local accounting teams in geographically impacted areas may not have access to company offices or systems, resulting in the inability to obtain updated financial information.
Although the SEC’s relief relates specifically to public companies, private companies with operations in affected areas may face similar financial reporting delays. Specifically, private companies that have yet to issue annual financial results should consider discussing potential deadlines extensions with their stakeholders—including lenders, banks, and investors—as they chart the right path forward.
Beyond compliance with financial reporting deadlines, companies must provide stakeholders with the proper disclosure and insight into their response to the coronavirus. In the same SEC statement providing certain companies with relief, SEC Chairman Jay Clayton reminded companies that although much of the future impact of the virus is uncertain, providing stakeholders with information on their current assessment of and plans for addressing material risks to their business and operations resulting from the coronavirus is important. How companies plan and respond to the events can be a material investment decision.
As companies consider the accounting and financial reporting implications of the coronavirus, proactively communicating with impacted parties, such as lenders or other key stakeholders, is important. As the events and impacts of the coronavirus continue to unfold, companies should work with their audit committees and auditors to ensure that management teams are maintaining proactive and robust accounting and financial reporting processes.
