The COVID-19 pandemic has disrupted life around the world, but business, in altered fashion, goes on. Companies will have to report on their operations, financial condition, and cash flows during this crisis, and those reports will have to be audited. The author details considerations management and auditors will need to take when preparing and auditing financial statements.
There will likely be many interrelated financial reporting and auditing implications of the coronavirus (COVID-19) pandemic and its impact on economic activity. Numerous articles have already been published on the subject; a selection of materials appears in the Exhibit. The purpose of this article is to highlight some of the most common matters for consideration, and to provide practical guidance for auditors and preparers, especially in cases where substantial judgment and professional skepticism are necessary to assess the facts and ensure that the operative standards are applied. This article is intended only to help identify possible audit scope limitations and other issues, and make such judgments. In most cases, it does not offer reliable resolutions of the issues identified, tailored to specific fact scenarios. Although references are made to certain accounting and auditing standards, it is beyond the scope of this article to summarize all relevant provisions of the authoritative literature.
Selected Nonauthoritative COVID-19 Resources
AICPA Center for Plain English Accounting:
Robert Durak, Mike Austin, and Thomas Groskopf, “Consequences of COVID-19: Financial Reporting Considerations,”
March 18, 2020 (https://bit.ly/2YqUc8A)
Mike Austin, “Consequences of COVID-19: Illustrative Public Company Disclosures,”
March 31, 2020 (https://bit.ly/2YySOka)
Kristy Illuzzi, Chuck Landes, Robert Durak, and Thomas Groskopf, “Consequences of COVID-19: Potential Auditing Challenges,” April 1, 2020 (https://bit.ly/2Sw12G3)
Journal of Accountancy
Ken Tysiac, “Remote Auditing Comes to Forefront During Pandemic,” March 24, 2020 (https://bit.ly/3avENGs)
“Financial Reporting Considerations Related to COVID-19 and an Economic Downturn,” March 25, 2020 (https://bit.ly/3bC2FcW)
Technical Line, “Accounting and Reporting Considerations for the Effects of the Coronavirus Outbreak,” March 31, 2020 (https://go.ey.com/2KxdqRL)
To the Point, “Relief Provided by the CARES Act Will Affect Accounting and Financial Reporting,” April 3, 2020 (https://go.ey.com/2Y2romF)
Snapshot, “Impact of CARES Act on Accounting for Income Taxes, March 31, 2020 (https://gt-us.co/3cJ4Rzq)
New Developments Summary, NDS 2020-04, “COVID-19 Pandemic: Accounting and Financial Reporting Considerations,”
April 23, 2020 (https://gt-us.co/3aQZ0qs)
Hot Topic: Coronavirus, “SEC Provides Coronavirus-related Disclosure Guidance,” March 27, 2020 (https://bit.ly/2VYyXIf)
“Accounting for the Tax Provisions of the CARES Act,” March 27, 2020 (https://rsm.us/2VRkzBI)
Use of estimates.
One principle that pervades the issues arising from the pandemic is the use of estimates to ensure timely financial reporting. As discussed below, many of the issues will require greater-than-usual reliance on accounting estimates; due to the higher level of uncertainty, these estimates will be inherently more difficult and less reliable.
Auditors must exercise considerable professional skepticism and vigilance, staying alert for indications of management bias, intentional or not, in its estimates. For example, it is common to be overly conservative in a bad year when providing for loss contingencies, to facilitate improved earnings in a succeeding period. (When intentional, this fraudulent practice is known as “taking a big bath.”)
Each time financial statements are to be issued, virtually all estimates carried forward from prior periods will need to be revisited in the light of COVID-19 risks and developments, subject to the accounting and disclosure provisions of Accounting Standards Codification (ASC) Topic 250, “Accounting Changes and Error Corrections.”
For an accounting estimate to be acceptable as reasonable by an auditor, it must be supported by sufficient objective evidence to enable a conclusion that it is based on the best information available at the time the financial statements are issued and is free from management bias. The latter entails careful risk assessment and the exercise of professional skepticism.
If management’s best estimate is viewed as subject to material variability, that fact should ordinarily be disclosed, at least qualitatively. When a single-point estimate relates to a loss contingency, its additional maximum exposure to loss should be disclosed if possible. FASB’s Conceptual Framework for Financial Reporting states that “if the level of uncertainty … is sufficiently large, that estimate will not be particularly useful” (Concepts Statement 8, para. QC 16). If insufficient evidence is available, and no reasonable estimate can be made, that fact ordinarily should be disclosed. In some extreme circumstances, however, the inability to make an estimate may constitute a material scope limitation that necessarily leads to a qualified, or a disclaimer of, opinion by the auditor [AU-C 705 or Auditing Standard (AS) 3105]. Report modifications due to scope limitations are generally not acceptable to the SEC because they are viewed as noncompliant with federal securities laws.
As of this writing, the AICPA’s Accounting Standards Board (ASB) and the PCAOB have recently proposed (https://bit.ly/3cIb12I) or issued amendments intended to strengthen their respective standards controlling the nature and extent of audit procedures required to support management’s estimates. These standards (AU-C 540 or AS 2501) and the outstanding proposed amendment to AU-C 540 afford considerable useful guidance to auditors. (AS 2501, in its latest form, is currently scheduled to become effective for audits of financial statements for fiscal years ending on or after December 15, 2020.)
Audit effectiveness is highly dependent upon the auditor’s ability to identify risks of material misstatement, and design and implement appropriate responses that adequately address those risks. In connection with the risk assessment process conducted in every audit, circumstances surrounding the COVID-19 pandemic will need to be closely examined in almost all audit areas. Properly conducted, this exercise will identify several new or heightened risks of material misstatement, many of which are discussed below, that must be addressed when designing an effective audit scope. Auditors will need to be particularly alert to circumstances that present fraud risks and therefore require special attention.
ASC Topic 855, “Subsequent Events,” and the related auditing standards (AU-C 560 and AS 2801) govern reporting on subsequent events. The standards describe two types of subsequent events. The first type consists of events or transactions that afford evidence of conditions that existed as of the balance sheet date and are therefore recognized in the financial statements; the second relates to conditions that did not exist at the balance sheet date but arose subsequently. These are not recognized but merely disclosed in the financial statements, if material, along with an estimate of their probable effect in the subsequent period or a statement that such an estimate cannot be made (ASC 855-10-50-2).
Recognizable or disclosable subsequent events that are consequences of the COVID-19 include lending and other contract modifications, capital contributions, curtailments or shutdowns of operations, and substantial losses on financial assets measured at fair value. In addition, the pandemic could cause debt covenant violations or activate subjective acceleration clauses.
Unfortunately, there is no authoritative definition or explanation of “conditions that existed as of the balance sheet date.” In calendar year 2019 financial statements filed with the SEC in the first quarter of 2020, it is evident that the pandemic had been almost, but not quite, universally viewed as the second type of subsequent event and therefore merely disclosed. This appears most likely because 1) the earliest reported cases in the United States occurred in mid-January 2020, 2) the World Health Organization did not declare the pandemic a global public health emergency until the end of that month, and 3) no government actions were taken in the United States that affected economic activity until 2020. Some hold the view, however, that since the risk was initially identified in November 2019, its identification represents a “condition that existed as of the balance sheet date,” December 31, 2019.
Those who hold the latter view have considered certain 2020 events or transactions as direct effects of that 2019 condition. Therefore, consistent with their interpretations of the provisions of Topics 855 and 250, they have recognized certain effects of these 2020 events or transactions in their 2019 financial statements. At the same time, they have treated other events or transactions as more directly attributable to 2020 developments, such as stay-at-home orders and government assistance programs, and therefore unrecognizable (but disclosable) in 2019.
Accordingly, professional judgment should be applied to each discrete subsequent event under consideration for either recognition or disclosure, and it should be carefully documented, especially for SEC issuers, as the SEC has been known to challenge the timing of loss recognition.
Auditors are reminded that the longer the subsequent period is extended beyond the norm, for example, due to COVID-19, the greater the risk of material misstatement with respect to subsequent events. Therefore, auditors’ subsequent events review procedures will need to be more extensive and robust.
Any unaudited, quantitative, unrecognized subsequent events information disclosed in audited financial statements, such as optional pro forma presentations, must be clearly designated as unaudited.
According to the PCAOB (https://bit.ly/2yEmpOo), “Changing incentives or increased pressures on management, especially when taken together with changes in internal controls or increased ability for management override of controls, may result in new risks of material misstatement due to fraud. … Similarly, increased pressure on, and changes in, management processes, systems, and controls may give rise to increased risk of error.”
Travel and work-at-home restrictions, layoffs, furloughs, illnesses, and other significant disruptions to operations being experienced as a result of the pandemic may have adverse effects on existing internal controls over financial reporting (ICFR). The risk of new deficiencies in ICFR may be increased, for example, due to reduced segregation of duties or effective monitoring controls, which may give rise to increased fraud risk of potential management override. These developments may cause ICFR to become deficient and fail, or need modification or replacement. In any event, auditors need to update their understanding of ICFR for the conditions prevailing during the audit and subsequent periods.
Such changes in ICFR could include the reassignment of personnel to internal control functions for which they are untrained or inexperienced, and the alteration of access to IT systems to enable a remote workforce, with some resulting in a potential increase in exposure to cybersecurity risk and other fraudulent activity. For these and other reasons, it may be impossible to perform otherwise planned tests of controls, and all such factors should be considered for their potential effect on the risks of material misstatement, the scope of substantive testing, and—for SEC issuers—management and auditors’ reports on ICFR.
Accessibility to Audit Evidence and Client Personnel
During the pandemic, accessing client records and key personnel may present formidable risks for auditors, especially in cases where records are still maintained on paper, and auditors or client employees are required to work at home (if at all). Accessibility may be particularly challenging for foreign operations, in view of travel restrictions. All such difficulties are required to be communicated to audit committees or others charged with governance.
In some circumstances, auditors may be able to obtain copies or scans of selected records, but they will need to evaluate the effect of these circumstances on reliability and fraud risk, and consider whether it is necessary to exercise heightened professional skepticism by insisting on originals of certain documents. Inability to access client documents needed for an audit is a scope limitation that will ordinarily affect the audit report, as described above. In such cases, auditors may be well advised to inform clients that the audit cannot be satisfactorily completed without a report modification for a scope limitation.
Changes in work habits and schedules may interfere with the ability to timely obtain satisfactory audit evidence by direct confirmation and may force auditors to seek alternative, sometimes less reliable, sources of audit evidence.
Disclosure of Risks and Uncertainties
The pandemic has the potential to affect many significant accounting estimates, such as those related to sales volume discounts, revenue recognition, asset impairments, and fair value inputs for investments. Disclosure of estimates that have for the first time become subject to material change in the next year is required by ASC Topic 275, “Risks and Uncertainties.”
Companies whose operations are likely to be significantly affected adversely by COVID-19 may also be required under Topic 275 to disclose newly heightened vulnerability to concentrations (e.g., in the volume of business conducted with a particular customer, group of customers, supplier, or group of suppliers). If an entity uses insurance or another technique to mitigate concentration risks, Topic 275 encourages, but does not require, disclosure of the risk-reduction strategy.
Going Concern and Liquidation Basis
U.S. GAAP requires financial statements to be prepared on the basis that the reporting entity will continue to operate as a going concern unless liquidation of an entity’s net assets is imminent, and a plan for liquidation is either 1) approved by the person or persons with the authority or 2) imposed by other forces, such as an involuntary bankruptcy proceeding. When liquidation is deemed imminent, use of the liquidation basis of accounting is required (ASC Topic 205, “Presentation of Financial Statements”), and use of the going concern basis in such a circumstance is a GAAP departure (ASC 205-30-25-1 and -2) that will probably warrant an adverse opinion.
The events or conditions that give rise to substantial doubt as to an entity’s ability to continue as a going concern need not have occurred before the balance sheet date; they may have occurred in the subsequent period. Such an assessment and conclusion may require the preparation of a management forecast that is based on assumptions judged to be reasonable and therefore sufficiently reliable for this purpose even if not examined by the auditor. In the event substantial doubt was present before the financial statements are issued, even if adequately alleviated by management’s plans, certain disclosures about going concern uncertainty are required by U.S. GAAP, including management’s plans for alleviation (ASC 205-40).
Substantial doubt about an entity’s ability to continue as a going concern is considerably more likely to arise for previously healthy or even marginal small to medium-sized businesses as a result of COVID-19. Unless, in the auditor’s judgment, management’s plans are likely to be successful in alleviating the doubt, these disclosures will require emphasis in audit reports; if substantial doubt is satisfactorily alleviated by management’s plans, emphasis in the audit report is permitted at the auditor’s option.
Because an evaluation of an entity’s ability to continue as a going concern (or the imminence of an involuntary liquidation) is a relatively short-term consideration, it is distinctly different from an impairment consideration, which is typically a longer-term evaluation. Because of the imminence of the planned or expected liquidation, asset values reported on the liquidation basis of accounting are typically lower than those reported on the going concern basis, even after an impairment adjustment.
Valuation of receivables, inventories, investment securities, and deferred tax assets.
The curtailment of operations, diminishing liquidity, and other economic hardships currently being experienced by customers and borrowers must be considered when valuing receivables for collectability and establishing allowances. Entities also should consider the impact of the downturn in financial markets and the extreme volatility in fair market values of traded investment securities pursuant to ASC Topic 820, “Fair Value Measurement.” For debt securities and equity method investments, the “other-than-temporary” impairment test should be applied under ASC 320, “Investments—Debt and Equity Securities,” or ASC Topic 323, “Investments—Equity Method and Joint Ventures,” respectively. For equity method investments, the impairment valuation described in ASC Topic 321, “Investments—Equity Securities,” may be elected; for loans and receivables, the methods described in either ASC Topic 310, “Receivables,” or the new current expected credit loss (CECL) model in ASC Topic 326, “Financial Instruments—Credit Losses,” should be applied. Lessors in sales-type and direct financing lease arrangements should likewise follow the impairment testing guidance prescribed for financial assets in Topics 310 or 326, as applicable, when determining credit losses on lease receivables.
Because of the worldwide adverse effects of the COVID-19 pandemic on economic activity, many supply chains have been interrupted, and the replacement cost of inventory items, depending on the industry, has risen or fallen materially. Dramatically reduced replacement costs would likely have the effect of reducing net realizable values, or for inventories carried at LIFO or on the retail method, market values (as per ASC Topic 330, “Inventory”), market demand, or even ultimate salability considerations used for inventory valuation. Manufacturing and construction companies will likely need to expense overhead costs related to reduced or idle production capacity rather than allocate them to inventory, and plant shutdowns might prevent a manufacturer or contractor from meeting their normal production levels or construction goals or result in excess inventory because of an inability to distribute or construct product on a normal schedule. Any of these situations may require inventory writedowns. Management must also reconsider the effects on current uncertainties about future operations on the valuation allowance provided for any deferred tax assets.
Impairment of goodwill, other intangibles, or long-lived assets.
Consequences of the pandemic can be observed in many forms, including revenue reductions, supply chain disruptions, business closures, work stoppages, significant volatility in financial markets, increased exposure to credit risk, and increased costs. Many travel, hospitality, retail, entertainment, and other enterprises have experienced a serious decline in operating activity; in some instances, businesses have been forced to close temporarily and possibly permanently. It is uncertain how long these effects will persist and how widespread they will be. Any or all of these could be indicators of asset impairments.
While there is no concept of an “other-than-temporary” condition requirement for an impairment adjustment for these assets (as there is for investments in financial securities), short-term disruptions may not indicate an impairment. For an expected prolonged suspension of activities, however, these factors might indicate impairment of certain nonfinancial assets that management and auditors will need to consider.
ASC Topic 350, “Intangibles—Goodwill and Other,” requires entities to test goodwill and other indefinite-lived assets for impairment if “an event occurs or circumstances change that would more likely than not [i.e., a greater than 50% chance] reduce the fair value of a reporting unit below its carrying amount” (i.e., “triggering” conditions or events). Valuation techniques prescribed by the standard are beyond the scope of this discussion, but generally involve consideration of historical and estimated future performance and conditions. This may likely entail use of valuation specialists (AU-C 620 or AS 1210).
Examples of triggering conditions or events applicable to goodwill and other indefinite-lived assets include adverse changes in financial performance, legal or political factors, entity- or industry-specific events, or market considerations. Following such an event, management should consider whether the direct and indirect effects of COVID-19 require it to test and adjust the carrying value of the asset for impairment between required annual testing dates. Also, if there are any indicators that an entity has changed (or expects to change) its classification of an intangible asset from indefinite-lived to finite-lived due to COVID-19, an accounting adjustment may be required.
ASC Topic 360, “Property, Plant, and Equipment,” requires entities to evaluate property, plant, and equipment and amortizable finite-lived intangibles, referred to collectively as long-lived assets, for recoverability “whenever events or changes in circumstances indicate that its carrying amount may not be recoverable.” Therefore, entities must consider whether the direct and indirect impact of COVID-19 constitute events that would require testing long-lived assets for recoverability, such as 1) a significant decrease in the market price of the assets, 2) a significant adverse change in the extent or manner in which the assets are being used or their physical condition, or 3) a significant adverse change in the business climate that could affect the recoverability of the assets’ carrying value. In addition to impairment considerations, such changes could cause the estimated useful lives of such assets to be shortened for depreciation or amortization purposes. If a lessee has adopted ASC Topic 842, “Leases,” the impairment requirements of Topic 360 will also apply to right-of-use assets recognized on leasing arrangements recorded under Topic 842.
If management decides to dispose of long-lived assets, they should be classified as held for sale after being written down to their impaired fair value and either presented separately on the face of the balance sheet or disclosed in the notes in accordance with ASC 360-10-45-14 or -10-50-3(e). If management decides to sell or abandon certain assets or execute a restructuring plan, it should account for costs associated with exit or disposal activities under ASC Topic 420, “Exit or Disposal Cost Obligations.”
Because necessary adjustments to the carrying amount of the reporting unit must occur prior to the goodwill impairment test, all nonfinancial assets should be tested for impairment in a prescribed order, as follows:
- Indefinite-lived intangibles and other assets outside of the scope of Topics 350 and 360, such as inventory or capitalized costs to obtain or fulfill a revenue contract
- Long-lived assets
Professional judgment must be applied to each discrete asset or asset group under consideration for an impairment write-down, and the basis for conclusions, especially when little or no writedown is deemed necessary, should be carefully documented. This is particularly important for issuers, since the SEC has been known to challenge the timing of impairment loss recognition (see, e.g., SEC AAER-4064).
Loss contingency accruals and disclosures.
The timing of recognition and disclosure of expected losses is governed generally and primarily by ASC Topic 450, “Contingencies,” and in certain specific circumstances by Topic 855 and other guidance. A “loss contingency” is defined in Topic 450 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 to occur.”
Accrual of a loss contingency (i.e., recognition of the loss) is required when 1) the occurrence of one or more such future events is probable, and 2) the amount of the loss is subject to reasonable estimation. Although there are diverse views about the quantitative meaning of “probable,” Accounting Standards Update (ASU) 2014-15 suggests that, in an ASC 450 context, it is intended to refer to at least a 70% chance of occurrence. If both criteria for recognition are not met, and the matter is material, disclosure is required. In addition, an entity should not delay recognition of a loss because of an inability to estimate a single amount; instead its estimate of the minimum probable loss incurred should be accrued [ASC 450-20-25-2(b)].
There are, however, exceptions. For example, a loss should not be accrued in advance of enactment of proposed legislation, even if the entity believes such enactment to be probable or if enactment has occurred in the subsequent period.
Business interruption insurance recoveries.
Entities often maintain insurance to mitigate losses from business interruption (i.e., disruption), such as lost revenue during periods of suspended operations. Management may believe, rightly or wrongly, that losses from business slow-downs or shutdowns, disruptions in the supply chain, or other consequences of COVID-19 are recoverable through such policies. Such interruption losses, however, are typically covered only when associated with physical damage to covered property. Absent such damage, whether expressly excluded by policy language or not, coverage would likely be denied unless a specific clause or rider for losses caused by disease or other disasters was negotiated and accepted in advance of the loss and an additional—likely significant—premium paid. Even then, there would likely be qualifying conditions and limitations as to the extent of recovery available.
According to an article by Andrew G. Simpson (“P/C Insurers Put a Price Tag on Uncovered Coronavirus Business Interruption Losses,” Insurance Journal, Mar. 30, 2020, https://bit.ly/2yDgaKK), in March 2020, New Jersey, Ohio, and Massachusetts were considering legislation to force carriers to pay for such losses for businesses closed or restricted because of COVID-19; a bipartisan group in Congress has considered creation of a reinsurance program. In addition, several lawsuits have been initiated by policyholders seeking coverage that was denied. But the insurance industry, which sees its very financial viability threatened by such actions, is fighting hard against these measures in the state legislatures, Congress, and the courts, and the outcomes are not predictable.
Therefore, extreme caution must be exercised by auditors whose clients are proposing accruing or disclosing any material expected business interruption insurance recoveries in their financial statements. Auditors must verify such coverage and its qualifying conditions and limits by reference to express policy language, by obtaining confirmation from the carrier or a professional insurance agent, or in the event of potentially disputed coverage, by obtaining a legal opinion from the client’s counsel.
Proper accounting for insurance recoveries varies, depending on factors such as the nature of the claim, the amount of proceeds (or anticipated proceeds), and the timing of the loss and recovery. When applicable, estimated reimbursements for business interruption are generally considered gain contingencies subject to ASC 450-30, which requires that such contingencies be resolved before such a reimbursement can be recognized. These contingencies would be considered resolved only when the proceeds have either been received or the expected amount has been confirmed by the insurer or a duly authorized representative.
Future operating losses.
There is no opportunity in U.S. GAAP for the accrual of expected lost revenues, except in the form of business interruption insurance claims receivable when realization is assured. Nevertheless, estimated future operating losses ordinarily should be disclosed to the extent reasonably possible. One needs to consider, however, whether (and in what period) to recognize committed costs and expenses for which, due to the effects of the economic slowdown caused by COVID-19, there may not be any matching revenues forthcoming or goods or services expected to be received in exchange. Examples of such committed costs or expenses are short-term rent or depreciation on idle facilities and benefits for furloughed employees.
An entity that self-insures for medical claims by its employees may also need to consider whether it is reasonably possible that, at its balance sheet date, some of its employees have had exposure to COVID-19 that will result in additional medical claims, and whether the estimated costs thereof need to be accrued as “incurred but nor reported.”
The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law on March 27, 2020. Its principal potential financial reporting and auditing consequences follow.
The CARES Act includes several significant provisions, including but not limited to increasing the amount of deductible interest for corporations under Internal Revenue Code (IRC) section 163(j), allowing taxable corporations to carry back certain net operating losses (NOL) and increasing the amount of NOL that corporations can use to offset income. These changes may have significant effects on a company’s income tax provision, especially when there are NOLs or section 163(j) carryforwards and a valuation allowance against deferred tax assets.
ASC Topic 740, “Income Taxes,” requires that the effects of tax law changes be reflected in the estimated annual effective tax rate in interim financial statements, the deferred tax attributes, and the tax accounts no earlier than the period of enactment (ASC 740-270-25-5 and -6).
Government loans and other benefits.
The CARES Act enables small businesses and not-for-profit entities that have experienced or are expected to experience significantly lower revenue to be eligible for certain government loans and grants. For example, as of the time of this writing, the act provides Small Business Administration (SBA) loans or grants for certain qualifying small businesses and not-for-profit organizations with fewer than 500 employees to help retain workers (e.g., by paying salaries and providing paid medical leave and insurance benefits) and pay debts or for education and training. Under certain conditions, the SBA loans are eligible for forgiveness of amounts spent on stipulated benefits. Once in place, the terms of these loans and grants, if material, will have to be disclosed and compliance verified in future audits. Penalties for noncompliance with loan or grant conditions will have to be considered for accrual or disclosure when applicable.
Other employer benefits not related to income taxes include 1) allowing employers to defer payment through December 2020 of the employer share of Social Security payroll taxes payable over the following two years and 2) allowing eligible employers to receive a 50% credit on qualified wages against their employment taxes each quarter.
Because some of these benefits are conditional upon limiting executive compensation and certain benefits, some employers may wish to modify arrangements with highly paid workers to comply with these limits, which may result in adjustment to previously recorded amounts and disclosures. Modifications or cancellations of certain share-based payment awards that either have previously vested or are probable of vesting do not require reversal of any compensation and may result in the acceleration of previously unrecognized compensation cost. Entities may need to consider what effect, if any, accepting government assistance may have on management’s going concern evaluation under ASC 205-40.
Relief for financial institutions from certain GAAP provisions.
The CARES Act contains provisions providing temporary relief from certain GAAP requirements. A financial institution may elect to not apply GAAP requirements to loan modifications related to troubled debt restructurings arising out of the COVID-19 pandemic (section 4013). Insured depository institutions, bank holding companies, or any affiliate thereof may elect relief from adopting ASU 2016-13, Measurement of Credit Losses on Financial Instruments, until the earlier of the end of the national emergency or December 31, 2020 (section 4014).
Uncertainties related to COVID-19 and related market conditions may prompt entities to modify existing contracts with customers or reassess the probability that the contracted consideration will be collected. Pursuant to ASC Topic 606, “Revenue From Contracts With Customers,” an entity is required to update its revenue recognition estimates and related disclosures throughout the term of each customer contract that provides for variable consideration (e.g., discounts, refunds, price concessions, performance bonuses, penalties) for conditions that exist at each reporting date to reflect the entity’s revised expectations. Reporting entities may have to revise disclosures about the methods, inputs, and assumptions used.
For contracts that contain bonus provisions based on time of completion, the likelihood that the bonus criteria will be met may have changed based on the effects of governmental health protection measures (e.g., quarantines, travel restrictions) and how other changes in customers’ business practices, operations, and behavior may affect revenue recognition assessments and similar estimates.
In addition, entities will need to consider disclosing how COVID-19–related uncertainties may affect the terms of future contracts with customers, including collectability assessments and pricing.
Leases and Other Contract Modifications
Many lessors and lessees will negotiate modifications of key terms of a lease agreement as the result of COVID-19. In cases where the new lease standard has been adopted, a lessee must determine whether a lease modification will be accounted for as a separate contract or as a change to the existing contract. Entities that have not adopted the new lease standard will follow ASC Topic 840, “Lease Accounting,” which requires lessees and lessors to analyze lease modifications (other than renewals or extensions) to reconsider the lease classification under the modified provisions (ASC 840-10-35-4).
In addition to revenue contracts and leases, the COVID-19 crisis may precipitate negotiated modification in other executory contracts with accounting or disclosure implications.
Debt Covenant Compliance
It is likely that a business slowdown, shutdown, staff furlough, or other decline in operating activity subsequent to year-end will cause an entity to violate a debt coverage ratio or other covenant or requirement of a loan agreement, such as late issuance of audited financial statements. Alternatively, the entity might sustain a “material adverse change” that triggers a subjective acceleration clause. Such an event will require debt reclassification or obtaining a waiver from the lender.
Entities significantly affected by the pandemic may request other accommodations from their lenders, including temporary payment deferrals, modifications to debt covenants, or amendments to other terms of their debt agreements. Such accommodations are probably debt modifications that should be evaluated for proper accounting, and an entity must first consider whether the modification qualifies as a “troubled debt restructuring,” as defined in ASC Topic 470, “Debt.” If not, then the modification and extinguishment provisions of ASC 470-50 will apply.
The AICPA’s chief auditor, Bob Dohrer, recently summarized how under GAAS an auditor may be able to gather sufficient evidence to support the existence, completeness, and valuation of inventory ordinarily obtained by physical observation when required to work at home, legally prohibited from entering, or judged unsafe to enter the client’s premises (“How Auditors Can Test Inventory Without a Site Visit,” Journal of Accountancy, Mar. 26, 2020, https://bit.ly/2xanayq). He points out how such evidence may be obtained by alternative means, particularly when observation “may pose threats to the auditor’s safety” (AU-C 501.A34). PCAOB standards are substantially the same as GAAS in this respect.
Dohrer suggests that it may be possible to delay the physical inventory count and observation to a later date (i.e., after the access restrictions have been lifted and the health risk reduced) and “roll back” the count by auditing interim sales and purchases. It will likely be impossible to predict how long this may take, and the longer this period, the more an auditor will have to rely on controls that may be difficult to test and may have become unreliable during the intervening roll-back period. Using a perpetual inventory system and periodic test counts may more readily permit rollback or roll-forward procedures, but with much of the same potential pitfalls.
Auditors must seriously consider whether doing all they can in a particular situation translates into doing enough to reduce the risk of material misstatement to an acceptable level. If not, there is a scope limitation, which must be reported accordingly.
EOM, Explanatory, and CAM/KAM Paragraphs
Auditors may determine that an emphasis of matter (EOM) or explanatory paragraph in the auditor’s report is required or appropriate to direct the reader’s attention to events and transactions discussed in the financial statements and notes and their effects on the entity without modifying the opinion. Substantial doubt as to an entity’s ability to continue as a going concern is an example of a discretionary EOM paragraph, when alleviated by management’s plan (AU-C 706.A2), or a required EOM (AU-C 570.24) or explanatory paragraph (AS 2705) when not alleviated.
Auditing standards also suggest that a major subsequent event or catastrophe that has had, or continues to have, a significant effect on the company’s financial position is an example of circumstances where the auditor may include a discretionary EOM (AU-C 706.A4) or be required to include an explanatory paragraph (AS 3101.19).
In addition, auditors may decide that matters related to COVID-19 are required to be included in the audit report for an SEC issuer as a critical audit matter (CAM), or if engaged by a private company to do so, as a key audit matter (KAM).
MD&A and Other Disclosures for Public Companies and Governments
In areas of their SEC filings outside the financial statements, such as management’s discussion and analysis (MD&A), SEC issuers must consider disclosing COVID-19 risk factors and effects experienced to date and expected.
On March 25, the SEC’s Division of Corporation Finance (DCF) issued CF Disclosure Guidance:Topic 9 (https://bit.ly/2VWrrxF), recommending that issuers consider disclosing, in the MD&A or elsewhere outside the financial statements, any of 10 items with respect to COVID-19 and related business and market disruptions that it characterized as “illustrative but not exhaustive.”
Under GASB Statement 34, Basic Financial Statements—and Management’s Discussion and Analysis—for State and Local Governments, governments must include a narrative introduction presented before their annual audited financial statements that provides an objective and easily readable analytical overview of its financial activities based on known facts, decisions, or conditions, including those that are expected to have a significant effect on its future financial position or results of operations. Accordingly, the GASB 34 version of an MD&A is intended to bring key issues to the financial report user’s attention that will likely affect a government’s future financial health and that may not otherwise be apparent. Therefore, it should contain much of the same COVID-19–related disclosures that an SEC issuer’s MD&A should contain.