COVID-19 and Common GAAP Financial Reporting Considerations
Tuesday, June 9, 2020
By Mark Batey, CPA
As the U.S. economy begins to reopen from the lockdown caused by the COVID-19 pandemic, management and business owners are currently faced with a lengthy to-do list ranging from issues such as supply chain management to new health and safety measures. The monitoring of the company’s financial reporting should be included on this to-do list. Management and owners should be aware that their accounting and financial reporting might be impacted in several areas depending on how COVID-19 has impacted their business. The receipt of monetary assistance from governmental agencies through programs such as the Paycheck Protection Program (PPP), modifying existing debt or incurring additional expenses to retrofit to a “new normal” method of business operations will all need to be accounted for in 2020. Some of the common financial reporting considerations that many companies will have to consider include:
- Loan Forgiveness from the PPP or Other Governmental Loan and Grant Programs
Currently, companies should have the PPP proceeds on the balance sheet as a loan. The loan should remain on the balance sheet until official notification is received from the lending institution of the forgiven amount. Current accounting standards indicate that the forgiven amount should not be netted against the related expenditures such as payroll, rent, and utilities (the expenditures for which the proceeds of the PPP loan were used). However, there is not any specific accounting guidance regarding loan forgiveness from a governmental entity. Common practice absent the issuance of a specific rule would currently indicate the gain from the forgiveness would not be included in income from continuing operations. The suggested appropriate section is a component of other income, which is the section that includes transactions such as interest income and interest expense. Both the forgiveness and the eligible covered expenses will be M-1 adjustments for tax purposes.
- Inventory Costs and Valuation
Many manufacturing and distribution companies currently have reduced the amount of inventory being produced and held due to many factors, including supply chain issues or customer demand. If the reduction in inventory production is determined to be below normal capacity of the facility where it is produced or stored, then more likely than not there will be an increase in cost of sales in 2020. This increase is a result of fixed overhead costs that would normally be capitalized with the production of inventory having to be expensed as a period cost. Current accounting standards indicate the amount of fixed overhead costs allocated to a unit of inventory produced cannot be increased as a result of abnormally low production or because of an idle facility. The current standards do not provide specific definitions of what constitutes low production or abnormal production costs; thus, management will have to use judgment using various metrics such as the history of production capability at each of its facilities.
When sales prices decrease due to a lack of demand or supply chain disruptions, management will have to consider remeasurement of inventory valuations. For companies that use inventory as collateral for loan borrowings, an increase in the allowance for obsolescence or a required write-down of inventory balance to net realizable value (NRV) may impact the amount available to be borrowed. The determination of NRV should be done whenever financial statements are issued, including interim periods during the fiscal year. Current accounting standards would require the write down in the interim period in which the inventory value decreases unless there is substantial evidence that the NRV will recover before the inventory is sold before the end of the fiscal year. Unfortunately, substantial evidence might be difficult for management to currently obtain with the current market conditions caused by COVID-19.
- Recognition of Unusual or Infrequent Expenses Due to COVID-19
The additional expenses that might be incurred in accounting for inventory (both additional production costs and market write-downs) plus other new expenses such as additional IT costs to adjust a business to the “new normal” will certainly affect 2020 operating results. Current accounting standards suggest that these expenses could be presented as a separate component of income from continuing operations. The expenses could be presented separately if considered to be either unusual or infrequent. An expense is unusual if it is the result of an event or transaction that is abnormal, and management can demonstrate is unrelated to the company’s typical and ordinary activities. If not unusual, the expense could be considered infrequent, which means it is not reasonably expected to recur in the foreseeable future. To satisfy either one of these criteria, management will need to evaluate the company’s operating environment. A company’s operating environment includes the characteristics of its industry, geographic location of operations, and the nature and extent of governmental regulation. For many industries, the forced government shut down has never previously occurred. Management could use this evidence to assess the probability of it occurring again in order to make the assessment of meeting the unusual or infrequent threshold.
- Property, Plant, and Equipment
With many production facilities running below normal or not at all (currently idle) what does a company do about the periodic recognition of depreciation expense for its property, plant, and equipment (PP&E). Current accounting standards indicate that the depreciation expense should be recognized as if there was no change in the use of the asset. Depreciation would only stop in a situation where management has determined to sell the asset being depreciated, thus classifying it as “held for sale” or if the asset is derecognized. Management may also need to consider if COVID-19 has caused a direct or indirect impact sufficient to require testing for determining whether the remaining book value of the long-lived asset (PP&E) will be recovered over the remaining estimated useful life. For example, has COVID-19 caused enough damage to the business environment that there is either (1) a significant decrease in the market price of the long-lived asset or (2) a significant adverse change in the extent or manner in which the long-lived asset is being used or (3) is the damage considered to be long term and thus affecting the value of the long-lived asset.
- Debt Restructuring
In addition to government loan programs, COVID 19 has caused many companies to negotiate with their lending institutions for various modifications to debt agreements. Some of the more common modifications include temporary payment deferrals, changes to debt covenants, or changes to interest rates. According to current accounting standards, these are categorized as debt modifications and need to be evaluated to determine if changes in the carrying amount of the debt on the balance sheet will be required. In addition, the presentation of debt between current and long-term obligations based on any changes in the payment terms will have to be considered.
No change may be required in the carrying amount, but the analysis should be considered to determine if the agreed-upon changes meet either 1) the classification of a “troubled debt restructuring” (TDR), 2) the extinguishment of the existing debt agreement or, 3) just a modification of the existing debt agreement. Depending on the results of the analysis, there is potentially some impact on current year income, such as gain on debt extinguishment if it is a TDR and future cash flows of the restructured debt are less than the carrying amount of the current debt. If the agreed-upon debt changes are considered not to be a TDR but an extinguishment of the existing debt then any unamortized debt issuance costs associated with this debt as well as any new fees paid to the lender for the agreed-upon changes would more likely than not have to be charged to interest expense in the current year. In addition, a gain or loss would have to be recorded if there is a difference between the carrying value of the current debt and the fair value of the new agreed-upon debt. If it is determined to just be a modification of the current debt agreement, then any existing debt issuance costs would continue to be amortized, and any new fees paid to the lender for the agreed-upon changes would be capitalized.
For additional information on any of the topics covered in this document, please contact Mark Batey, CPA, or your Apple Growth Partners professional.
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