Third-quarter earnings season is here, and the consequences of the coronavirus pandemic on the economy overall and on individual companies are not going away anytime soon. A new report from Deloitte highlights financial reporting and accounting challenges that should be top of mind in this environment.
“Companies need to be proactive in responding to changes in both their internal and external business landscape,” said Eric Knachel, senior consultation partner at Deloitte’s National Office - Accounting and Reporting Services and author of the report. “The mindset is no longer solely about how long this will last but also about what changes are going to be part of the new normal.”
Although some of the issues faced will be the same as in the first two quarters of this year, Knachel encourages companies not to approach the current environment and third-quarter reporting as more of the same. Here are highlights from Deloitte’s report:
Forecasting is critical to many accounting estimates for third-quarter accounting and financial reporting. The timing of cash flows and liquidity is more sensitive and of more interest to investors and analysts in the current environment. “Companies tend to focus on what recovery will look like and return to their pre-COVID-19 numbers and growth assumptions, but maybe these won’t resume and it’s time to think about a new normal,” Knachel said. He recommends companies prepare multiple forecast scenarios and weight them for probability.
Knachel notes many companies are looking to the financial crisis of 2007-2008 to guide their forecasting, but there are a number of important differences to consider. “This period is a useful data point, but there are fundamental differences today in customer behavior, supply chains, and the workforce that were not present then,” he said. “In addition, there were certain liquidity issues and frozen financial markets then that do not exist during this pandemic because of federal actions.” He acknowledges the third quarter is a tough time to make these judgments, and it is easy to be second-guessed.
Internal controls. There is a linkage between the ability to prepare forecasts and the need for companies to evaluate and adjust their internal controls to changes in their businesses. “Although the environment has changed, there has not been any change in the regulatory requirements to have an effective system of internal controls because of the pandemic,” Knachel said. “It may not be sufficient or compliant to only do what is practical or what others are doing under these circumstances.”
Changes in operations and how people are working, along with unusual types of transactions, affect the design and operation of internal controls. Segregation of duties continues to be an important issue. “Companies should have a systematic process to monitor employees working at home or changes in the number of employees or their responsibilities due to furloughs so nothing falls through the cracks,” Knachel said. “The internal control process that was in place in March may not be the same as today’s, and companies must evaluate and document whether the controls are still appropriate today.”
Cyber-security issues and risks have increased tremendously as a result of remote work, so internal controls in this area are critically important.
“It’s becoming apparent that the situation with COVID-19 is not going away. If companies are going to survive, they need to figure out how to maximize their performance and not stand still and just wait this out, or they will fall behind their competitors. This goes for their accounting and financial reporting as well.”
Eric Knachel, Senior Consultation Partner, Deloitte
Realizability of long-term assets and going concern. Changes in the economy overall, along with company-specific circumstances and industry-specific challenges from the pandemic, require a third-quarter assessment of the potential for write-downs or write-offs of goodwill and intangible assets due to impairment. Even if these assets would normally be tested for impairment at year-end, there should be an assessment in the third quarter for any triggering events that would require an analysis and accounting now.
Going concern considerations might be a new issue for many companies. Disruptions to business operations, reduced demand for products and services, changes in customers, cash flow issues, and inability to repay debt or the need to obtain new financing are among the conditions and events that could raise substantial doubt about a company’s ability to continue as a going concern. In addition to the accounting assessment to be made, there are required disclosures in interim financial statements even if management has plans to alleviate the doubt about the company’s ability to continue as a going concern.
“Assessing the realizability of long-term assets and the ability to continue as a going concern have always been areas requiring a high degree of judgment, but the difficulty around those judgments is magnified right now,” Knachel said. “Just think about the uncertainties surrounding the economy for the next six to 12 months and beyond. Developing an accounting analysis using that level of uncertainty is not easy.”
Communicating with stakeholders. All these issues and many others increase the need for transparent and timely communications in the third quarter and beyond. These include financial statement disclosures and communications with stockholders and investors in earnings releases, corporate presentations, and on company Websites. The Securities and Exchange Commission has previously emphasized the importance of disclosures related to COVID-19.
Non-GAAP adjustments reflecting COVID-19 impacts were used by more companies in their second-quarter reporting than in the first quarter because of the timing of the pandemic, as Knachel and others had anticipated. But there were not as many as expected given all companies are impacted in some way. “I think the biggest reason we are not seeing as many non-GAAP COVID-19 adjustments is companies are concerned about year-over-year comparisons going forward and potentially setting themselves up for unfavorable comparisons in future periods,” Knachel said. He explained this situation results from companies making non-GAAP adjustments for “unusual” expenses in the current period but then not being able to adjust for higher “new normal” expenses in the future because they become recurring. Companies may instead decide to describe unusual results in their current management’s discussion and analysis.
Knachel does expect to see non-GAAP adjustments for the pandemic in the quarter that ended Sept. 30. He suggests there will be two main drivers: “The first is companies will want their approach to non-GAAP to be comparable to their competitors,” he said. “The second is they will need to consider the evolution of COVID-related activities and costs and if they will become their new normal, and whether those costs will be increasing or decreasing in future periods.”
COVID-19 and uncertainties about the global economy will continue for at least the remainder of 2020 and probably extend into 2021 as well. Although individual companies will be in different stages of recovery or transformation over time, no company will totally escape the impacts on accounting and financial reporting. “It’s becoming apparent that the situation with COVID-19 is not going away,” Knachel said. “If companies are going to survive, they need to figure out how to maximize their performance and not stand still and just wait this out, or they will fall behind their competitors. This goes for their accounting and financial reporting as well.”