Understanding the indirect impacts of the coronavirus can prepare management to communicate key information to stakeholders.
The World Health Organization declared the coronavirus (COVID-19) to be a public health emergency on January 30. The virus has had tragic consequences across the globe, and its full impact is not yet known. In addition to the immeasurable human toll, the coronavirus is altering business and consumer activity in affected areas and beyond. There are obvious and well-publicized impacts common to most companies, like to the supply chain, but the indirect impacts may be overlooked in times of crisis. Have you considered how it might impact revenue recognition, goodwill and intangible valuations, hedge accounting, and stock compensation? Companies will want to have a firm grasp of the full scope of financial impacts when stakeholders ask, because they will ask.
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The coronavirus may impact a company’s operations, and consequently, the amounts and disclosures in the financial statements.
Companies may need to adjust revenue recognition for changes in estimates of amounts customers will pay.
When disruption to the supply chain and reduced demand affect financial projections, there’s the possibility of goodwill or intangible impairment.
There may be impacts in other areas, like hedge accounting, stock compensation, and more.
Stakeholders, including the SEC, are focused on the transparency of disclosure of the actual as well as anticipated impacts.
Given the disruption in the supply chain and reduced consumer spending, estimates of variable consideration may need to be adjusted. Variable consideration takes many forms, including volume discounts, rebates, returns, refunds, and royalties. Consideration is also variable if it is contingent on a future event occurring or not occurring, such as meeting performance goals or deadlines, or a customer achieving a certain outcome, such as a distributor meeting a target level of gross margin upon resale. Variable consideration is estimated at contract inception and needs to be reassessed at each reporting date. But variable consideration can only be recognized to the extent it is probable a significant reversal will not occur when the uncertainty is resolved. Management should consider whether they’ve met this threshold and adjust variable consideration accordingly.
Revenue can be recognized only when collection of consideration is probable. A company may continue to sell products and services to customers impacted by disruptions caused by the coronavirus. Not only should companies assess the need for write-offs or reserves on outstanding receivable balances, but revenue can only be recognized for new sales if payment is probable.
Companies may need to assess whether an asset impairment has occurred as a result of the impact of the coronavirus. A company’s current financial performance or estimates of future earnings may be significantly affected by the loss of a significant supplier or customer whose own operations are impacted by recent events. The guidance for goodwill and intangibles requires that an impairment test be performed when a triggering event occurs. Companies should assess whether a triggering event has occurred, and if so, management should follow the applicable guidance. The company should consider how key assumptions in its financial projections may be impacted by decreased demand for its products or services or extended disruptions to its supply chain, manufacturing operations, or global workforce.
“This is an uncertain issue where actual effects will depend on many factors beyond the control and knowledge of issuers. However, how issuers plan for that uncertainty and how they choose to respond to events as they unfold can nevertheless be material to an investment decision.”
Reduced production levels could have an effect on fixed overhead allocations. Companies may have idle production capacity as a result of its workforce having to remain at home. During periods of “normal” production, fixed overhead should be allocated to inventory on a per-unit basis. However, during periods of “abnormal” production levels (i.e., production levels below the range of normal capacity), the excess overhead should not be allocated to inventory, but instead should be recorded as an expense in the period incurred. Facilities that are temporarily vacant or idle should continue to be depreciated. Depreciation would only cease if the facility is permanently abandoned.
Recovery of lost profits or revenue under business interruption insurance is considered a gain contingency. Business interruption insurance policies (e.g., loss of use of property or equipment) generally cover losses of gross profit or reimbursement of certain expenses while a company is unable to conduct its business. When business is interrupted, an insurance recovery of lost profits or revenue would not be recognized until the contingency is considered resolved. Typically, a business interruption recovery gain would not be recognized prior to the insurance carrier acknowledging that the claim is covered and communicating the amount to be paid to the company. The company should consider any stipulation from the carrier (e.g., “pending final review”) and the company’s history in collecting these types of claims to determine whether the claim may not be realizable.
There are a range of areas that may be impacted indirectly
Companies should consider the relevant GAAP and SEC disclosure requirements when evaluating whether the impact of the coronavirus may require disclosure within the financial statements or in other areas of SEC filings. This evaluation may include the direct effects on their own operations as well as potential second order effects, which could include changes in demand for products/services, the effects on supply chains, service providers, and business partners, and changes in business practices (e.g., recent relief provided by some banks to affected customers).
Within the financial statements, companies should consider disclosure of risks and uncertainties and whether, how, and when events might impact the many judgments inherent in their financial reporting, including those discussed above. Additionally, companies should evaluate whether subsequent events have occurred that require disclosure in the financial statements.
Disclosures may be required outside of the financial statements. Areas of focus might include disclosures about the business, risk factors, and management’s discussion and analysis of results, liquidity, and capital resources (including consideration of trends and uncertainties). As events continue to unfold, decisions in these areas will likely evolve.