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Mind The GAAP: Covid-19 And The Financial Reporting Challenge
Companies with financial periods ending after December 31, 2019, the effects of the crisis will be primarily visible in the February and March 2020 financials.
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The speed and scale of the economic crisis caused by the outbreak of Covid-19 has been unprecedented in recent times. Accounting regulators and standard-setters around the world have had to scramble to issue guidance to financial statement preparers for upcoming quarterly and annual financial reporting. In some jurisdictions, this has assumed direct regulatory significance since the tone has been set by the market regulator e.g. Securities and Exchange Commission (SEC) in the US. In others, such as India, this has taken the form of ‘advisory’ guidance e.g. an accounting and auditing advisory issued by ICAI in March 2020. Despite these differences, preparers, audit committees and auditors world-wide will be very attentive this year to the areas highlighted in these special guidelines.
For companies with financial periods ending after December 31, 2019, the effects of the crisis will be primarily visible in the February and March 2020 financials. These have already taken various forms such as shrinking revenue and margins, declining commodity prices and sharp falls in asset values across financial markets. Apart from immediate direct income statement impacts, other financial statement consequences will arise from deferment of capital projects, asset write-downs and contract renegotiations or terminations especially those related to leases, loan covenants, employee compensation and fixed price commitments under procurement contracts. The effects of these developments are likely to be revealed in company financial statements through the quarterly financials of 2020 and beyond as information becomes more certain and accounting values become more reliable. Therefore, all published financial results progressively commencing from March 2020 quarter-end will be closely scrutinized by shareholders, market participants and regulators.
One key area of focus is the ‘going concern’ assumption underlying financial statements. Under ordinary circumstances, companies prepare financial statements based on the assumption that the underlying business is viable and does not face an existential doubt into the foreseeable future. For practical purposes, this future is usually interpreted as 12 months from reporting date. Depending on the degree of stress over liquidity, extent of indebtedness and future cash flow projections, companies with shaky pre-crisis balance sheets will particularly need to demonstrate to the satisfaction of their audit committees and auditors, that there is no significant risk of folding up. Company managements will also have to draw upon mitigating measures already taken or underway e.g. renegotiation of loan agreements or asset sale programs. In the immediate upcoming financial statements, determining and disclosing whether the business is a going concern will involve significant judgements and measurement uncertainty, since the full potential of the crisis and its resolution path is still highly uncertain.
Another important area is with respect to carrying values of assets on the balance sheet. Almost the entire range of non-financial assets including inventories, receivables, deferred tax assets, fixed assets and intangibles such as goodwill are in scope. For example, companies with already slow-moving pre-crisis inventories are likely to face steep write-downs. Certain industries such as automobile, construction equipment and other capital goods may see significant income statement impact through inventory write-downs or uncertainties in revenue recognition. Impairment testing for property, plant and equipment may be widely triggered and it may be a huge challenge to demonstrate reliable cash flow projections necessary to determine the extent of impairment. Goodwill impairment testing is particularly likely to bite companies with significant competitive acquisitions in the past. The larger the size of goodwill on the balance sheet pertaining to acquisitions in a troubled industries, the greater the income statement scrutiny and impact that one can expect to see in the forthcoming quarters.
Under Generally Accepted Accounting Principles(GAAP) - both IFRS and US GAAP, the degree of accounting estimations required to be made by companies has significantly increased in recent years. This is due to a number of recent accounting standards issued and adopted world-wide (including India) in areas such as fair value measurements of financial instruments, revenue recognition and expected credit losses on receivables and loan portfolios of financial institutions. This poses a special challenge to companies and auditors at this time, since the robustness of the estimation process and soundness of judgements will play a key role in arriving at reliable accounting values and clear disclosures about the impact of the crisis. At this time, business expertise, robust data processing, soundly challenging accounting assumptions, and exercise of professional scepticism on the part of auditors, will be critical in raising the quality of financial information. Further, effective co-ordination between accounting regulators, professional accounting bodies and large preparers will be necessary to address complex accounting issues as they emerge. The crisis is not only likely to reveal the quality of companies’ financial statements but also test the robustness of their financial statement close processes. Investors will be watching closely.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.