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Accounting and Financial Reporting Considerations for the Effects of the COVID-19 Pandemic

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Rödl & Partner Accounting Matters Vol 2020– 2, published in August 2020


The Coronavirus pandemic (COVID-19) is above all a global human tragedy. The spread of the pandemic is also having serious economic implications. Numerous sectors of the economy are suffering, and the long-term economic and business consequences remain unknown. Among the many consequences of COVID-19, are the financial reporting implications and challenges that many entities will face. Impacts such as business and production disruptions, supply-chain interruptions, negative impacts on customers, volatility in the equity and debt markets, reduced revenue and cash flows, and other economic consequences may occur. This client letter provides succinct reminders to entities about some accounting considerations under accounting standards generally accepted in the United States of America (“US GAAP”) that have increased importance and risk in the current environment.

 

Table of Contents

1.    Asset impairments
1.1  Inventory
1.2  Goodwill and other indefinite-lived intangible assets
1.3  Long-lived assets
1.4  Financing receivables and contract assets
1.5  Deferred tax assets
2.   Debt modifications and loan covenants
3.   Employee termination costs
4.   Revenue recognition
5.    Financial statement disclosures
5.1  Accounting for an unusual or infrequent event
5.2  Loss contingencies
5.3  Risk and uncertainties
6 .   Going concern
7.    Other less common accounting considerations

1. Asset impairments

Many entities have seen or expect to see a decline in revenues, as well as supply chain disruptions and temporary business closures in affected regions. All of which may limit their ability to meet demand for their products. Entities may also see their costs rise when replacing suppliers or moving operations to another region. These factors could be indicators of impairment, depending on the significance and duration of the disruption. While short-term, temporary disruptions may not indicate an impairment; the effects of a prolonged outbreak may cause asset impairments.

If an entity determines that the effects of the coronavirus outbreak are impairment indicators that require them to perform impairment tests, the entity needs to make sure it performs those tests in the appropriate order. Indefinite-lived intangible assets are tested first for impairment in accordance with Accounting Standards Codification (“ASC”) 350, Intangibles – Goodwill and Other. Groups of long-lived assets are then tested for impairment in accordance with ASC 360, Property, Plant, and Equipment. Goodwill is tested for impairment last, and those tests are performed at the reporting unit level.

1.1 Inventory

If there is a decline in the net realizable value or utility of inventory, ASC 330, Inventory, requires the decline to be recognized as a charge in the period in which it occurs. A loss may result from damage, contamination, physical deterioration, obsolescence, changes in price levels or other causes. Inventory measured using any method (e.g., first-in, first-out (FIFO), average cost) other than LIFO (last-in, first-out) or the retail inventory method, is measured at the lower of cost or net realizable value. Entities whose supply chains have been disrupted or whose sales have fallen because of the outbreak, should evaluate whether they need to adjust the carrying value of their inventory. Seasonal inventories, perishable products and products with shorter shelf lives would be most exposed to the risk of loss.

Unplanned work stoppages, labor or material shortages, or production bottlenecks could cause production levels to drop below normal capacity levels. If this happens, an entity will need to consider the effects on its inventory costing. The amount of fixed overhead allocated to each unit of production is not increased when production is abnormally low, and the costs associated with underutilized capacity (known as “excess capacity costs”) are expensed in the period they are incurred without adjusting overhead absorption rates. Entities will need to use judgment to determine when production is lower than normal capacity. The range of normal capacity can vary based on business- and industry-specific factors.

1.2 Goodwill and other indefinite-lived intangible assets

Unamortizable goodwill and indefinite-lived intangible assets are tested for impairment at least annually and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. ASC 350 provides examples of events and circumstances that should be considered in evaluating whether an interim impairment test is required for both goodwill and indefinite-lived intangible assets. To determine whether an interim impairment test is required, entities will need to consider the potential effects of the outbreak on the fair value measurement of their reporting units and indefinite-lived intangible assets.

Goodwill that is being amortized under the Private Company Accounting Alternative should be tested for impairment when a triggering event occurs indicating that the fair value of the entity (or the reporting unit) may be below its carrying amount. The financial impact of COVID-19 would be considered a triggering event if there is a material negative effect on the entity’s operating results and cash flows.

1.3 Long-lived assets

Long-lived assets to be held and used (including right-of-use assets under ASC 842, Leases) are tested for impairment when factors are present that indicate that the recorded value of a long-lived asset or asset group may not be recoverable. The impairment evaluation of long- lived assets to be held and used involves three steps:

Step 1: determining whether an indicator of impairment exists and, if one is present, proceeding to Step 2.

 

Step 2: testing the long-lived asset or asset group for recoverability – If the carrying amount of the long- lived asset or asset group exceeds the estimated undiscounted cash flows (i.e., the carrying amount of the long-lived asset or asset group is not recoverable), the entity would proceed to Step 3.

Step 3: measuring the amount of the impairment.

Entities may need to revisit their estimates of service periods for long-lived assets if they take steps such as relocating factories or business units to other locations. Changes in the planned service period could result in changes to the depreciable lives of those long-lived assets.

1.4 Financing receivables and contract assets

Entities with financing receivables (e.g., loans, trade accounts receivable) and contract assets should consider the guidance in ASC 310, Receivables, to evaluate whether and to what extent the coronavirus affects the collectability of their receivables and contract assets.

1.5 Deferred tax assets

Under the guidance in ASC 740, an entity should reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance shall be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized.

2.  Debt modifications and loan covenants

Affected Entities may experience cash flow challenges as a result of disruptions in their operations, higher operating costs, or lost revenues. Such entities may need to obtain additional financing, amend the terms of existing debt agreements, or obtain waivers if they no longer satisfy debt covenants. Affected entities may need to consider the debt guidance in ASC 470-50, Debt – Modifications and Extinguishments, and ASC 470-60, Debt – Troubled Debt Restructurings by Debtors, to determine whether any changes to existing debt arrangements represent a troubled debt restructuring, a debt modification or potentially a debt extinguishment, which would have accounting implications in each case. In addition, they may need to consider the guidance in ASC 470-10-45 on the classification of long-term debt when there has been a covenant violation or other default at the balance sheet date.

3.  Employee termination costs

An employer may provide benefits to employees when terminating their employment due to the COVID-19 implications. Termination benefits generally fall into one of the following categories:

  • An entity may provide contractual termination benefits through a contract, such as a union agreement, only if specifically defined events, such as a plant closing, occur.
  • An employer may offer special termination benefits for a short period of time to induce employees to voluntarily leave the entity.
  • An entity’s ongoing severance plan may provide benefits only for specified terminations, such as involuntary terminations without cause. The plan provides a formula for determining benefits.
  • An entity may decide to provide benefits to employees that are involuntarily terminated as a result of a specific event, such as a restructuring or a plant closing. The employees would not have been entitled to the benefits under any pre-existing or ongoing arrangement.

ASC 712 includes different accounting treatments for the type of arrangements described above.

Employee termination cost with exit or disposal obligations require additional accounting consideration in accordance with the guidance of ASC 420. This includes the requirement to account for the cost related to the one-time involuntary employee termination benefits provided to current and former employees. A one-time termination plan exists when:

1) Management that has the authority, commits to the plan,

2) The plan identifies the number of employees to be terminated, the department that they work in, their job descriptions, and expected completion date,

3) The plan includes sufficient detail to enable the employees to determine the amount and benefit that they will receive if they are terminated involuntary,

4) It is probable that there will not be significant changes to the plan, or that it will be withdrawn.

4.  Revenue recognition

The coronavirus outbreak could affect revenue estimates in new and ongoing customer contracts in the scope of ASC 606, Revenue from Contracts with Customers. This is because when a contract with a customer includes variable consideration (e.g., discounts, refunds, price concessions, performance bonuses and penalties), an entity is generally required to estimate, at contract inception, the amount of consideration to which it will be entitled in exchange for transferring promised goods or services. The amount of variable consideration an entity can include in the transaction price is constrained to the amount for which it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainties related to the variability are resolved.

An entity that makes such an estimate is also required to update the estimate throughout the term of the contract to depict conditions that exist at each reporting date. This will involve updating the estimate of variable consideration (including any amounts that are constrained) to reflect an entity’s revised expectations about the amount of consideration to which it expects to be entitled, considering uncertainties that are resolved or new information about uncertainties related to the coronavirus outbreak.
Estimation of variable consideration and the constraint may require entities to exercise significant judgment and make additional disclosures. For example, an entity is required to disclose information about the methods, inputs and assumptions used for estimating variable consideration and assessing whether an estimate of variable consideration is constrained. Entities should also consider the requirements to disclose the judgments and changes in judgments that significantly affect the determination of the amount and timing of revenue.

 

5. Financial statement disclosures

An affected entity’s disclosures will depend on the magnitude, duration, and nature of the effects on its business. Entities will need to closely monitor developments and assess the implications for their businesses. Affected entities will be required to make disclosures that generally address loss contingencies, risks and uncertainties and/or subsequent events. In other cases, disclosures may depend on the nature of the loss (e.g., whether an asset is impaired). When other circumstances contributed to a triggering event, entities should be transparent about all circumstances contributing to the impairment or loss.

5.1 Accounting for an unusual or infrequent event

ASC 225 requires that a material event or transaction that is considered to be of an unusual nature or of a type that indicates infrequency of occurrence or both should be reported as a separate component of income from continuing operations. The nature and financial effects of each event or transaction should be presented as a separate component of income from continuing operations or, alternatively, disclosed in the notes to financial statements. Gains or losses of a similar nature that are not individually material should be aggregated. Such items should not be reported on the face of the income statement net of income taxes.

 

Entities should evaluate whether the impairments and other charges to the operations resulting from COVID-19 should be separately presented on the face of the income statement or separately disclosed in the footnotes of the financial statement.

5.2 Loss contingencies

ASC 450 requires disclosure of the nature of a contingency when there is at least a reasonable possibility that a loss has been incurred. For contingencies that meet the threshold for disclosure, but no liability has been recognized, Entities must disclose an estimate of the possible loss or the range of possible losses or state that such an estimate cannot be made. If an entity has recognized a liability, it has to disclose the amount only if not doing so would make the financial statements misleading. If there is at least a reasonable possibility that a loss in excess of the amount recognized exists, the entity is required to disclose an estimate of the possible loss or range of losses or state that such an estimate cannot be made.

5.3 Risk and uncertainties

ASC 275 requires disclosures about certain risks and uncertainties. They include qualitative disclosures about risks and uncertainties that in the near term (i.e., within one year from the date of the financial statements) could significantly affect the amounts reported in the financial statements or the functioning of the reporting entity. Entities whose operations are affected by the outbreak may be required under ASC 275 to disclose certain significant estimates and current vulnerability due to concentrations (e.g., concentration in the volume of business with a particular customer or supplier or in a market or geographic area).

 

Certain significant estimates

Entities should disclose certain estimates that are sensitive to change such as those used to evaluate an asset for impairment if information known to management before the financial statements are issued or available to be issued meets both of the following criteria:

1. It is at least reasonably possible that management’s estimate of the effect on the financial statements of a condition, situation or set of circumstances existing at the date of the financial statements will change in the near term as a result of one or more future confirming events, and

2. The effect of the change would be material to the financial statements.

 

For uncertainties that meet both of ASC 275’s criteria for disclosure, entities are required to state the nature of the contingency or estimate that is sensitive to change and indicate that it is reasonably possible that a change in the estimate will occur in the near term. Additionally, ASC 275 encourages, but does not require, disclosure of the factors that cause an estimate to be sensitive to material change.

Current vulnerability due to certain concentrations

Entities with concentrations face greater risk of loss than other entities. ASC 275-10-25-18 requires the disclosure of certain concentrations if, based on information known to management before the financial statements are issued or available to be issued, all three of the following criteria are met:

1. The concentration exists at the date of the financial statements,

2. The concentration makes the entity vulnerable to the risk of a near-term “severe impact.”, and

3. It is at least reasonably possible that the events that could cause the severe impact will occur in the near term.

 

Entities that have identified concentrations of activities in areas affected by the outbreak (e.g., a high volume of business with customers in that region or key suppliers in that region) that have not previously disclosed the concentration because they did not believe that the entity was vulnerable to the risk of a near-term severe impact should reconsider making such a disclosure.

When the criteria for disclosure are met, an entity should provide information that is adequate to inform users of the financial statements of the general nature of the risks or uncertainties associated with the concentration. For concentrations of operations located outside of the entity’s home country, an entity is required to disclose both the carrying amount of net assets and the geographic areas in which they are located.

6. Going concern

ASC 205-40, Presentation of Financial Statements – Going Concern, requires management to evaluate an entity’s ability to continue as a going concern within one year after the date the financial statements are issued (or available to be issued, when applicable). Disclosures in the notes to the financial statements are required if management concludes that substantial doubt exists or that its plans alleviate that substantial doubt. Management is required to make its evaluation and provide the relevant disclosures for both annual and interim reporting periods.

Affected entities will need to consider the effects of the outbreak in their going concern evaluations. For example, prolonged plant closures, significant delays, or the inability to collect from counterparties whose businesses are severely affected by the outbreak, may significantly affect an entity’s operating cash flow and liquidity. Accordingly, management may need to update the cash flow projections it uses in its going concern evaluation.

7. Other less common accounting considerations

– ASC 323, Investments — Equity Method and Joint Ventures. Evidence that could indicate the carrying amount of the investment might not be recoverable.

– ASC 326, Financial Instruments — Credit Losses. Entities applying ASC 326 are required to consider reasonable and supportable forecasts of future economic conditions in the estimate of expected credit losses.

– ASC 842, Leases – evaluate the collectability of lease payments (and any residual value guarantee) for operating leases.

– ASC 820, Fair Value Measurement, defines the term fair value and provides a principles-based framework for measuring fair value when US GAAP requires or permits a fair value measurement.

– ASC 815, Derivatives and Hedging, the entity will need to consider whether the transaction is still “probable of occurring,” whether the volume or amounts involved will be lower than forecasted or whether it is now probable that the forecasted transaction will not occur.

– Insurance recoveries – Entities often maintain insurance to mitigate the losses associated with property damage (property and casualty loss) or a business interruption, such as lost revenue during extended periods of suspended operations or stemming from supply chain interruption (i.e., business interruption insurance). The accounting for insurance claims 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. Accounting for any potential insurance recovery needs to be carefully evaluated. Anticipated reimbursements for business interruption (e.g., lost revenue) are considered a gain contingency and are subject to the guidance in ASC 450-30. This guidance requires that all contingencies must be resolved before such a reimbursement can be recognized in earnings. The contingencies would be considered resolved only if the proceeds have been received or if confirmation of the amount of the proceeds has been received from the insurer.

– For asset impairments not addressed by other literature, ASC 450, Contingencies, provides guidance on the initial and subsequent measurement and recognition of loss contingencies.

For more information on the accounting and financial reporting considerations for the effects of the COVID-19 pandemic, or should you need assistance with performing any calculations described herein (goodwill impairment, fixed assets impairment, net operating loss carrybacks, forgivable portions of PPP loans, non-capitalizable fixed costs in labor and overhead allocation rates, etc.), please contact your Rödl & Partner professional.


This publication contains general information and is not intended to be comprehensive or to provide legal, tax or other professional advice or services. This publication is not a substitute for such professional advice or services, and it should not be acted on or relied upon or used as a basis for any decision or action that may affect you or your business. Consult your advisor. We have made reasonable efforts to ensure the accuracy of the information contained in this publication, however this cannot be guaranteed. Neither Rödl Langford de Kock LLP nor any of its subsidiaries nor any affiliate thereof or other related entity shall have any liability to any person or entity which relies on the information contained in this publication, including incidental or consequential damages arising from errors or omissions. Any such reliance is solely at user’s risk.
Any tax and/or accounting advice contained herein is based on our understanding of the facts, assumptions we have been asked to make, and on the tax laws and/or accounting principles in effect as of the date of this advice. No assurance is given that the conclusions would be the same if the facts or assumptions change, or are not as we understand them, or that the tax laws and/or accounting principles will not change subsequent to the issuance of these conclusions. In addition, we do not undertake any continuing obligation to advise on future changes in the tax laws and/or accounting principles, or of the impact on the conclusions herein. No part of this document may be reproduced, retransmitted or otherwise redistributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Rödl Langford de Kock LLP.
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