COVID-19: Audit Committee Financial Reporting Guidebook

Paula Loop is Leader, Paul DeNicola is Principal, and Stephen G. Parker is Partner at the PricewaterhouseCoopers LLP Governance Insights Center. This post is based on their PwC memorandum.

The global economy and business community are still feeling the profound impacts of COVID-19, and will for sometime in the future. Given the current business and market conditions amid the pandemic, companies and audit committees continue to face accounting and reporting challenges as they meet regulatory requirements and respond to investor expectations.

Audit committees need to be mindful of the impact of working virtually. In addition to considering the impact on internal control over financial reporting, they will want to consider any changes in the operation of internal reporting structures (like risk, HR, legal, compliance) or whistleblower systems, the impact on investigations and resolution timeliness, as well as how and when any material issues are reported to the board. In all areas related to internal controls, companies should ensure that risky shortcuts are not being taken and processes still have the appropriate rigor. It is important for the audit committee to set the tone and ensure management is encouraging employees to ask for more time or additional resources if help is needed to make sure things are done the right way.

And finally, audit committees will want to make sure they are working closely with their internal and external auditors. These are two resources that the committee can leverage in their oversight responsibilities. As it relates to internal audit, priorities may have changed due to COVID-19. The audit committee should understand what projects are delayed and be comfortable that internal audit is prioritizing the appropriate areas of risk.

In light of this rapidly evolving environment, audit committees will want to consider the following financial reporting considerations as they exercise their critical oversight role.

Financial reporting

Closing the books and SEC filing deadlines: As business continuity challenges continue, companies may experience issues with “closing their books” on a timely basis. Companies should apply “lessons learned” from their prior quarter closing to help them improve this quarter. Audit committees should be aware of potential workforce issues, both domestic and international, and the company’s ability to meet reporting deadlines. A system of controls can be  rendered ineffective by people being unavailable or unable to meet responsibilities on which the system relies, or failing to adapt controls to changes in the business environment and how those controls are performed remotely. Ensuring  that internal controls are still functioning effectively should be a continual focus.

Audit committee questions:

  • How is management treating the effect of remote working in considering whether a reassessment of business risk, control risk and the effectiveness of the related controls is needed? Were there any changes needed to the design of internal control over financial reporting or the operators of those controls? What additional steps, if any, did management need to take to ensure that the controls were operating effectively and consistently to ensure   the financial statements were accurately prepared?
  • If management relies on third-party service providers for support in closing the books, what procedures did management perform to ensure that these services were appropriately performed? Were any issues identified in the prior quarter closing, and if so, how were they resolved?
  • What were the focus areas in the external auditor’s audit/review that were particularly challenging due to accounting complexity, management’s remote workforce or access to information maintained at inaccessible locations?
  • Are there any significant updates or changes in management’s representation letter to the external auditors as a result of the challenging circumstances?
  • Have there been any changes to materiality assessments because of changes in current or forecasted financial performance?
  • Were there any challenges with the timing of the company’s prior quarter earnings release in light of the pandemic? Will management be making any changes to the timing of future earnings releases? Has management’s review process changed related to the preparation of the earnings release?
  • Is having a “gap” period between the earnings release and the SEC filing advisable given how quickly circumstances evolve in this environment?
  • What procedures will the external auditor have completed related to their review at the time of the planned earnings release, and what procedures will be performed after the release and before the filing deadline?

Optional deferral of CECL: On March 27, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Among numerous provisions is one that allows companies in the banking sector to elect an optional deferral of adoption of the FASB’s standard that includes the current expected credit losses (CECL) model. The standard became effective for all SEC filers other than smaller reporting entities, as defined by the SEC, for annual and interim periods beginning after December 15, 2019. For banks electing the deferral, the standard will now become effective at the earlier of the date on which the national emergency is terminated or December 31, 2020.

Government assistance: The COVID-19 pandemic has led to unprecedented actions by federal, state and local government officials in responding to the ongoing public health emergency and the economic effects of the coronavirus. Federal legislation enacted in March 2020 alone provided nearly $3 trillion to support healthcare needs and to assist individuals, businesses, and state and local governments impacted by “social distancing” and other measures intended    to contain the number of COVID-19 infections. Additional tax relief and spending increases may be enacted over the course of 2020 as part of efforts to stabilize the US economy and promote economic recovery. Companies should  consider the GAAP and reporting considerations for government assistance. Except for income taxes (for investment tax credits or other forms of government assistance administered through the income tax regime) and revenue recognition for not-for-profit entities (for contributions from the government), US GAAP contains no specific guidance on the accounting for government assistance. Thus, determining the proper accounting treatment for government incentives by business entities can be challenging and will likely depend on a careful analysis of the nature of the assistance and the conditions on which it is predicated.

Audit committee questions:

  • Has the company analyzed the CARES Act and other government assistance programs to determine which elements they can benefit from (government assistance programs, NOL carrybacks, other tax incentives, etc.)?
  • Has the related accounting treatment been determined and discussed with the external auditor?
  • Are there any restrictions or limitations on the company (e.g. executive compensation, severance benefits, dividends, share buybacks, etc.) and what are the repayment provisions?
  • How does management expect to disclose to investors and in public documents its ability and intent to access this government assistance?

Risk factors, Management’s Discussion and Analysis (MD&A) including liquidity and other disclosures: Disclosure of the COVID-19 risks and related effects will still be necessary or appropriate in the MD&A, the business section, risk factors and legal proceedings sections of the financial reporting document. As it relates to risk factors, if something has already occurred, the disclosure should no longer address the hypothetical “risk” of it occurring. Instead, it should describe what has occurred, and then disclose what the risk now is, such as the potential for the situation to worsen. The company should disclose in the MD&A information that it believes will provide the reader with an understanding of   the company’s financial condition, changes to the financial condition and results of operations. It should provide investors with information about the company’s known trends or uncertainties that have had, or that the company reasonably expects will have, a material impact on net sales or revenues or income. Therefore, companies should disclose, to the best of their ability, how COVID-19 continues to impact the company’s financial performance including operations, cash flows, capital investment programs and liquidity. Companies will need to ensure that business plans are updated for the current environment and liquidity risks are assessed and disclosed.

Audit committee questions:

  • What updates has the company made to their risk disclosures as a result of the implications of COVID-19?
  • How has management stress-tested their assumptions when considering trends or uncertainties that are expected to have a material impact on the results of operations or capital resources going forward?
  • As the effects of COVID-19 continue, how has the company’s liquidity position changed and what disclosures will be made? What procedures has the external auditor performed to get comfortable with the liquidity disclosures?

Technical accounting

Revenue recognition and receivables: The disruption in the supply chain and reduced consumer spending could have an impact on revenue recognition. While a company may continue to sell products and services to customers impacted by disruptions caused by COVID-19, revenue can only be recognized for new sales if payment is probable. After  revenue is recognized, companies should assess the need for write-offs or reserves on outstanding receivable balances.

Changes in the way business is conducted must also be identified on a timely basis to address any accounting or reporting implications, such as guarantees, side letters or other agreements that might address coverage of loss, right of return or other aspects that need to be appropriately accounted for and disclosed.

Audit committee questions:

  • Is management comfortable that there have been no significant changes in business practices or, if there have been, have the related controls, accounting and reporting implications been assessed?
  • What is the financial strength of the customer base and how is this reflected in the collectibility of our receivables? Is the company providing customers with any extensions, deferrals or other accommodations on payment terms, product financing or other support arrangements, and how are they being accounted for?
  • Has the company offered current customers future concessions, such as reducing the price or decreasing quantities of goods or services to be delivered (or minimum purchase commitments) and what is the expected impact on revenue?
  • What is the financial strength of the supplier base? Is the company providing suppliers with financing or other support arrangements and how are they being accounted for?

Impairment of goodwill, indefinite-lived intangibles and long-lived assets: COVID-19 may have impacted a company’s projected cash flows due to a decrease in demand for its product, supply chain disruptions, delivery  challenges or other events. In such situations, a company needs to consider whether the disruption in its business and/or the broader market indicates that a “triggering event” has occurred or existed as of the balance sheet date (i.e., the measurement date). If it has, an impairment assessment is warranted and the assumptions and cash flow forecasts used to test for impairment should be updated to reflect the potential impact of current conditions. Given the current environment of uncertainties, we are seeing some companies use an approach whereby they might create different time horizon scenarios and then probability weight them.

Audit committee questions:

  • How have budgets, forecasts and underlying assumptions been updated to reflect the increased risk and economic uncertainty?
  • What are the key assumptions used to determine the forecasts and how has the relative probability of various outcome scenarios been assessed?
  • Have the processes to derive and evaluate the reasonableness of the assumptions changed?
  • What procedures have the external auditors performed to evaluate the reasonableness of management’s conclusions?

Valuations—fair value measurements for an investment: Information used in fair value models should be as of the reporting date. COVID-19 disruptions could cause delays in the availability of the information used in those models, for example, to measure the fair value of an investment. Initial estimates should be updated for any delayed information that becomes available prior to the release of the company’s financial statements if the information provides additional evidence about known or knowable conditions that existed at the measurement date.

Audit committee questions:

  • What is the availability of information to be used in determining fair value?
  • Where is management using estimates in the absence of timely reporting from investees and others?
  • What procedures have the external auditors performed related to the fair value measurements?

Derivatives and hedging: Companies that have designated forecasted transactions in cash flow hedging relationships, such as inventory purchases, sales or revenues, debt issuances or interest payments, may have decreased their forecasts of transaction volume. Companies will have to consider the change in the probability of a hedged forecasted transaction and the impact on the financial statements. In addition, the current economic environment could potentially impact a company’s ability to continue designated hedges or even establish new hedges.

Audit committee questions:

  • Are our risk management and hedging programs still appropriate in relation to our updated business forecast?
  • Has uncertainty about forecasted transactions impacted our ability to apply hedge accounting?
  • Are there any emerging counterparty risks due to current events and market conditions?
  • What procedures have the external auditors performed related to the company’s determination that hedge accounting is still appropriate?

Inventory valuation: Inventories should be measured at the lower of cost and the net realizable value (NRV). Determining NRV at the balance sheet date requires the application of judgment and consideration of all available data, including changes in product prices experienced or anticipated subsequent to the balance sheet date. In addition, inventories should be written down during an interim period to the lower of cost and NRV unless substantial evidence exists that the net realizable value will recover before the inventory is sold in the fiscal year. Situations in which an interim write-down would not be necessary are generally limited to seasonal price fluctuations. Given the significant uncertainties associated with the current market conditions, it would be challenging for a company to conclude that prices will recover before inventory is sold.

Audit committee questions:

  • How has management assessed inventory for NRV?
  • Have “abnormal” production levels (i.e., production levels below the range of normal capacity) impacted how overhead is allocated to inventory?
  • What is the plan to continually assess the NRV of inventory for adjustments?

Accounting for insurance claims: 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 a business is interrupted, the write-down of an asset or the accrual of an obligation (e.g., salaries paid to idle workers) would be considered a loss recognized in the financial statements. However, the absence of expected revenue or income is not a loss recognized in the financial statements. Recovery of lost profits or revenue through an insurance claim would not be recognized until the contingency is considered resolved and realization of the claim for recovery is probable. Typically, a business interruption insurance 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. Any stipulation from the carrier (e.g., “pending final review”) should be reviewed to determine whether it is an indication the claim may not be realizable. The company’s history in collecting such claims should also be considered. When the insured has received payment without the expectation of repayment or refund, the contingency is considered resolved and the gain should be recognized.

Audit committee questions:

  • What is the nature of the disruption to the company’s business and are such impacts covered by the company’s insurance policies?
  • Has there been communication with the insurer such that the company is comfortable recording a business interruption recovery gain in its financial statements? What were the considerations that supported management’s conclusion that the claim is recoverable?
  • Has management assessed whether the insurance carrier has the financial wherewithal to pay the claim?
  • What procedures have the external auditors performed related to any recovery gains recorded in the financial statements?

Debt: Companies may experience significant liquidity issues that may call into question compliance with debt    covenants. Debt covenant violations impact the classification of debt as current and noncurrent. Debt should be classified as current if the debt is puttable at the balance sheet date due to a covenant violation. If a lender waives its right to put the debt based on that particular covenant violation for at least one year from the balance sheet date, the debt will not automatically be classified as noncurrent. A company that has to meet the same or more restrictive covenants going forward must determine if it is probable that it will fail those covenants within one year from the balance sheet date. If it   is probable, the debt must be classified as current despite the waiver. The same assessment must be done if debt is modified to avoid a covenant violation at the balance sheet date.

Debt restructuring during an economic downturn also requires a number of considerations. These considerations   include first assessing whether the restructuring would be considered a troubled debt restructuring. If the restructuring is not considered troubled, it should be assessed to determine if it is a modification or extinguishment.

Audit committee questions:

  • Is the company at risk of failing any debt covenants as of the period end or during the next 12 months?
  • Are there any subjective acceleration clauses in our debt agreements and are these appropriately disclosed when necessary?
  • Has the company been granted any waivers of violations or modified any covenants to avoid a violation?
  • Is the company’s disclosure related to potential debt covenant violations appropriate?
  • Did the company restructure its debt and what was the related accounting and impact on earnings?

Taxes: Companies must reassess the need for a valuation allowance on deferred tax assets at each balance sheet date. If operating results have deteriorated, or if other negative evidence has developed, it would be appropriate for the company to revisit its valuation allowance conclusions. Also, at each interim period, a company is required to estimate its forecasted full-year annual effective tax rate and apply it to year-to-date ordinary income or loss in order to compute the year-to-date income tax provision. This process can be complicated by tax losses in jurisdictions where a related tax benefit cannot be realized, or where a reliable estimate of ordinary income for a particular jurisdiction cannot be made.

Audit committee questions:

  • How has management assessed the need for a valuation allowance, or change thereto, against deferred tax assets? Are the supporting cash flow forecasts consistent with those made for the company in other areas of accounting and disclosed to shareholders?
  • Are there jurisdictions where a reliable estimate of income cannot be made and how will this be addressed in future periods?

Subsequent events: Companies should consider whether events that occurred subsequent to the balance sheet date  but prior to the issuance of the financial statements need to be reflected in the financial statements. Determining whether an event is recognized or unrecognized can be more difficult when circumstances are evolving versus evaluating a single isolated event. When events develop over a period of time, some portions of the impact may be recognized, while other portions are unrecognized. Recognized subsequent events are recorded in the financial statements to be issued. Examples include the realization of a loss on the sale of inventory or property held for sale when the subsequent event confirms a previously existing unrecognized loss. Changes in lower of cost or NRV considerations related to inventory valuation in the subsequent period may also be recognized subsequent events. However, when a specific event results  in the loss of value of the inventory, such as discrete decisions to close stores or governmental actions to restrict individuals’ activities that may not have been reasonably predicted as of the balance sheet date, the inventory would be impaired in the same period that the specific event occurred. Similarly, the effect of a change in tax law is recorded discretely as a component of the income tax provision in the period of enactment.

Audit committee questions:

  • Were there any significant events, or new insights, that management became aware of after the balance sheet date that they believe should have be recognized in the financial statements?
  • What are the disclosures planned around post-balance sheet events that are not recognized?

Going concern: Financial statements are prepared assuming that a company will continue to operate as a going concern. Management needs to assess going concern at each annual and interim reporting period with a look-forward period of one year from the financial statement issuance date. Companies impacted by COVID-19 will have to update their forecasts, and if conditions give rise to uncertainties about the ability to continue to operate (e.g., recurring operating losses), it will be necessary to make adjustments in the financial statements (e.g., record asset impairment losses) and provide disclosures to alert investors about the underlying financial conditions and management’s plans to address them.

Audit committee questions:

  • Has management identified substantial doubt about the company’s ability to continue as a going concern?
  • Is it probable that management’s plans, when implemented, will mitigate the conditions that give rise to substantial doubt within the assessment period (that is, one year from the issuance date)?
  • What procedures have the external auditors performed related to the company’s forecasts and determinations?

Non-GAAP measures: In late March, the staff of the Division of Corporation Finance issued CF Disclosure Guidance: Topic No. 9 (Coronavirus [COVID-19]). This guidance provides several reminders regarding non-GAAP financial measures. It also addressed how to apply the SEC’s requirements to reconcile a non-GAAP measure to the most directly comparable GAAP measure if a company presents preliminary results based on provisional amounts or ranges in an earnings release because of unknown factors relating to COVID-19.

This guidance indicates that in these situations, the staff will not object to companies reconciling a non-GAAP financial measure to preliminary GAAP results that include provisional amounts or a range of reasonably estimable amounts.

It is important to note that this reconciliation guidance is applicable only to earnings releases. In filings in which GAAP financial statements are required, such as filings on Form 10-K or Form 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.

Audit committee questions:

  • Are the disclosures that include non-GAAP measures (and other key metrics communicated to analysts) fair, balanced and transparent?
  • How has management ensured that the calculation of new adjustments to non-GAAP measures and other key metrics are accurate, considering that the information is not typically covered by a company’s internal control over financial reporting and is not audited?
  • How do the company’s non-GAAP measures compare to those of their industry peers?
  • Have the updated non-GAAP measures impacted executive compensation?
  • Are the measures used by management in compliance with SEC regulations and updated guidance?

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