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Law360 (May 18, 2020, 5:57 PM EDT) --
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| Karen Garnett |
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| Joshua Newville |
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| Samuel Waldon |
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| Erica Jones |
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| Michael Maloney |
The scrutiny may take various forms — Division of Corporation Finance comment letters, Office of Chief Accountant oversight, or Enforcement investigations and actions — but it will almost certainly come.
And while it is difficult to predict the SEC's focus, recent statements by senior SEC officials and other SEC staff guidance provide some clues. This article identifies some of the accounting and disclosure issues the SEC is most likely to examine post-crisis, and suggests some steps issuers can take now to minimize regulatory scrutiny down the road.
Accounting Areas of Focus
The Office of the Chief Accountant and the Division of Corporation Finance have issued statements and guidance on accounting areas that may require companies to make significant judgments and estimates in light of the evolving status of COVID-19.[1]
While the Office of the Chief Accountant's statement indicated that it will apply its historical perspective of not objecting to well-reasoned judgements, issuers and their auditors should take note of certain accounting areas more likely to require such judgments and estimates in the current situation.
Asset Issues
The carrying value of assets on the balance sheet requires ongoing scrutiny, analysis and judgement, and the severe economic impacts of COVID-19 require preparers and auditors to make these assessments amid heightened uncertainty and volatility. Issuers should focus on the following:
Fair Value Accounting
A wide range of assets involve fair value assessments under generally accepted accounting principles (e.g., financial instruments, intangibles and business combinations), requiring complex fair value analyses, significant judgements and assumptions, and reliance on items such as comparable market transactions and future cash flow projections that will be significantly more uncertain and volatile amid COVID-19.
Asset Impairment Decisions
A wide range of assets (e.g., goodwill, long-lived assets and investment securities) require impairment assessments annually or based on GAAP-specified triggering events. The SEC has historically scrutinized both the timing and the amount of impairment assessments. These timing and valuation decisions may rank among the most important and difficult amid COVID-19 uncertainties.
Asset Allowances and Reserves
GAAP requires allowances and reserves to be recorded against a wide range of assets (e.g., receivables, inventory, loans and deferred tax assets) to ensure they are carried at net realizable value.
The judgements required in estimating these required allowances and reserves will require rigorous analysis and assessment, particularly regarding whether historical trends and experiences are appropriate bases of estimation in light of elevated levels of future economic uncertainty.
Liability Issues
Properly and conservatively reflecting liabilities required by GAAP also requires significant analysis and judgement, and COVID-19 uncertainties will likely require preparers and auditors to assess both the need to record additional liabilities, and the carrying value of existing liabilities.
Issuers should focus on the following:
Debt Modifications or Restructurings
Many issuers may seek debt modifications or restructurings from lenders due to the sudden and significant impacts of COVID-19. GAAP has very specific rules for debt modifications, extinguishments and troubled-debt restructurings, all of which require significant technical analysis and judgement in order to properly reflect the impact of any such modifications or restructurings.
Restructuring Charges
Issuers initiating business restructuring programs and plans triggered by current economic uncertainty should take note of the very specific GAAP rules for establishing, measuring and taking charges against restructuring reserves, including the treatment of employee termination, contract termination, facility and relocation costs, among others.
Loss Contingencies
The accounting for and disclosure of loss contingencies (e.g., legal exposures, environmental remediation and toxic tort exposures) can be one of the most difficult and judgmental areas of GAAP, particularly determining whether a contingency is both probable and reasonably estimable, and therefore requiring accrual on the balance sheet.
GAAP rules for loss contingencies are relevant to many types of business uncertainties, the instances of which will be elevated due to COVID-19.
Profit and Loss Issues
The economic impacts of COVID-19 will put significant downward pressure on the reported profits and losses of issuers across industries. Issuers and their auditors should guard against pressure to enhance reported profits and losses more aggressively than what GAAP requires or allows.
Issuers should focus on the following:
Revenue Recognition
Most public companies have been reporting under the new revenue recognition standard Accounting Standards Codification 606 since 2018, a more principle-based framework that allows for and requires significant judgements to determine revenue recognition timing and amounts.
Ensuring the continued good faith nature of these judgements will be important amid the business pressures brought on by COVID-19.
Income Taxes
Accounting for corporate income taxes (federal, state and local) is one of the more complex and technical areas of GAAP, and will continue to require significant rigor amid COVID-19, particularly to ensure that any tax relief or accommodations granted by taxing authorities are properly reflected in income tax provisions and related liabilities.
Other Accounting and Reporting Issues
Certain specialized issues in GAAP will take on enhanced importance amid the economic impacts of COVID-19. Issuers should focus on the following:
Going Concern
GAAP presumes that an entity will continue as a going concern, unless conditions or events raise substantial doubt about that prospect, in which case a different basis of accounting, disclosure or audit procedures may be required.
The unprecedented economic impacts of COVID-19 may require entities of all sizes and types to assess their ability to continue as a going concern, and make required accounting or disclosure decisions.
Subsequent Events
GAAP requires assessment of events occurring after the balance sheet date but before financial statements are issued or available to be issued. The assessment of these subsequent events can require changes to the financial statements or additional disclosures.
The rapid pace of COVID-19 events and impacts will require real-time and careful assessment of subsequent events to ensure compliance with GAAP in this area.
Internal and Disclosure Controls
The SEC places significant focus and importance on the quality of issuers' internal control over financial reporting, or ICFR, and on their disclosure controls and procedures, or DCP.
The ability to maintain and monitor strong ICFR and DCP will present new challenges amid COVID-19 disruptions, particularly due to employee furloughs and terminations, remote work arrangements, and unique transactions requiring complex accounting or disclosure considerations due to economic uncertainty.
SEC rules require issuers to disclose any material changes in ICFR during the issuer's most recent quarter. ICFR and DCP certifications by top management, and the required evaluation of management's assessments by external auditors, will take on enhanced importance amid COVID-19 uncertainty.
Disclosure Areas of Focus
The SEC has provided detailed guidance for issuers to consider regarding COVID-19 financial disclosures. As the pandemic response and the business environment evolve, issuers should continue to evaluate the risks and effects of the pandemic and provide disclosures that are specific to their businesses.
Issuers should be particularly focused on providing detailed and specific information about these risks and effects, including how management is responding to them, rather than generic statements about the pandemic's impact on the economy.[2]
With respect to first quarter earnings reports, SEC Chairman Jay Clayton and the Director of the SEC's Division of Corporation Finance William Hinman have urged issuers to provide "as much information as is practicable regarding their current status and plans for addressing the effects of COVID-19."[3]
That guidance will continue to be relevant beyond first quarter earnings releases, as future periods are likely to be affected by the pandemic. Issuers should prepare their disclosures with particular attention to the following areas.
Current Status
Given the unprecedented speed and severity of the COVID-19 crisis, the SEC has noted that issuers must provide robust disclosures regarding their current financial and operational status.
Impact on Operations
The operations of many issuers have been affected significantly by COVID-19 and related mitigation responses. Some issuers have had to substantially scale back operations, while others have adjusted their business models to accommodate changes in demand for services and products or supply chain interruptions.
In some sectors, issuers are also taking steps to protect worker health and well-being as well as customer safety. How management is responding to evolving events, and the impact of those responses on the issuer's results of operations, should be described in detail.
Liquidity Position and Financing Activities
To the extent it is material, issuers must address how the pandemic has impacted capital and financial resources, including overall liquidity position and outlook.
Issuers should consider whether the cost of or access to capital and funding sources has changed, in addition to any changes in sources or uses of cash.
Companies that receive financial assistance under the CARES Act or similar federal and state programs should disclose the nature, amounts and effects of such assistance if it has materially affected its financial condition or results of operations.
Forward-Looking Disclosures
Given the uncertainty surrounding national and global health and economic strategies, issuers will face tremendous challenges providing meaningful forward-looking information to investors. As indicated by the recent statements, the SEC recognizes those challenges.
Nonetheless, the SEC has made it clear that boilerplate disclosures are unlikely to be sufficient.
Future Effects of COVID-19
Issuers are required to disclose known trends and uncertainties that are expected to have a material impact on liquidity, capital resources and results of operations.
Within this framework, issuers should consider management's expectations of COVID-19's impact on supply chains, relationships between costs and revenues, human capital resources and productivity, as well as planned capital expenditures and the ability to service debt or other financial obligations.
Evolving Business Risks
Issuers should consider whether it is necessary to disclose additional risks related to COVID-19 or to update their existing risk factors. If the issuer previously described a risk as potential, and that risk has now occurred, the issuer may need to update the risk factor to describe the occurrence.
Historical Information
Investors and analysts often rely on historical information, including management commentary regarding how historical information will influence future trends and expectations, when assessing a company's future performance.
However, given the impact of the current crisis, such information may be less useful to investors. Issuers should consider providing appropriate caveats around such historical information.
Non-GAAP Financial Measures
Issuers may consider using non-GAAP financial measures or performance metrics to adjust for the impact of COVID-19. The requirements of Regulation G and Item 10(e) of Regulation S-K continue to apply, as does the commission's recent guidance on the use of performance metrics.[4]
Issuers should provide investors with an explanation how management uses the measure or metric and why it is useful to investors in light of the impact of COVID-19 on the issuer's financial position and results of operations. When making adjustments to GAAP measures to reflect the impact of COVID‑19, issuers should take care to limit their adjustments to items that directly relate to COVID-19.
Additional Recommendations
Carefully document decisions and the underlying rationales.
Clayton and Hinman recently stated that "[g]iven the uncertainty in our current business environment, we would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information."
Similarly, as noted above, the Office of the Chief Accountant has stated that it will continue to apply its historical perspective of not objecting to well-reasoned judgements.
That is all no doubt true, but it is not always clear whether an attempt to provide investors information was made in good faith or whether a judgment was well-reasoned — particularly when evaluated in hindsight.
Given those risks, issuers should contemporaneously document the reasons behind their accounting and disclosure judgments regarding COVID-19. This can provide valuable objective evidence of good faith in the event an issuer faces questions in the future.
Be timely.
One key lesson from the financial crisis is that the timing of disclosures can be just as important as the content. After the financial crisis, the SEC brought several enforcement actions against issuers who ultimately made accurate disclosures, but in the SEC's view, did not make those disclosures quickly enough. Once material information comes to light, the clock on disclosure is ticking.
Carefully review methodologies and controls potentially impacted by changed circumstances — because circumstances have changed.
While this is a time of great uncertainty, one thing is clear — methodologies used to determine asset valuations, loss contingencies or reserves three months ago may no longer be appropriate.
In addition, as noted above, issuers should also consider whether it is necessary to enhance any of their ICFR and DCP. And if it is appropriate to maintain methodologies and controls unchanged, that determination should be documented fully and contemporaneously.
Now is not the time to follow a business-as-usual approach.
Karen Garnett, Joshua Newville and Samuel Waldon are partners, and Erica Jones is an associate, at Proskauer Rose LLP.
Michael Maloney is president at Credibility International LLC. Previously, he was the chief accountant at the SEC's Division of Enforcement.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm(s), their clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] See "Coronavirus (COVID-19)", Division of Corporation Finance Disclosure Guidance: Topic No. 9 (Mar. 25, 2020), available at https://www.sec.gov/corpfin/coronavirus-covid-19; Statement on the Importance of High-Quality Financial Reporting in Light of the Significant Impacts of COVID-19 (April 3, 2020) ("April 3 Statement"), available at: https://www.sec.gov/news/public-statement/statement-teotia-financial-reporting-covid-19-2020-04-03.
[2] "Coronavirus (COVID-19)", Division of Corporation Finance Disclosure Guidance: Topic No. 9 (Mar. 25, 2020).
[3] The Importance of Disclosure – For Investors, Markets and Our Fight Against COVID-19(April 8, 2020), available at: https://www.sec.gov/news/public-statement/statement-clayton-hinman. While many issuers have already addressed Q1 disclosures, others may delay their earnings releases and From 10-Q filings under the conditional 45-day extension provided by the SEC for filings due between March 1 and July 1, 2020.
[4] See "Commission Guidance on Management's Discussion and Analysis of Financial Condition and Results of Operations," SEC Release No. 33-10751 (Jan. 30, 2020).
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