Accounting for the Coronavirus: Subjectivity and Judgment During Times of Crisis
“[D]ifferences between reasonable judgments do not, in themselves, suggest that one judgment is wrong and the other is correct.” (Final Report of the Advisory Committee on Improvements to Financial Reporting to the United States Securities and Exchange Commission, August 1, 2008)
The economic shutdown resulting from governmental responses to the global coronavirus pandemic has disrupted all manner of business relationships governed by contracts. This has brought into sharp focus the critical governance role that accounting numbers – the figures derived from a company’s financial statements – play in many business transactions. In particular, they constitute a kind of “scorecard” for compliance with the terms of numerous types of contracts and agreements, such as debt contracts, supplier agreements, operating agreements, incentive compensation agreements, merger earnouts, and sales commission agreements.
Even in the best of times, accounting and financial reporting – which are often erroneously thought of as objective, straightforward exercises in number crunching – involve a considerable amount of subjectivity and judgment. Companies are often faced with questions to which several reasonable and informed accountants could come up with as many reasonable and informed answers. These judgments can create an opportunity (whether perceived or real) for accountants to manipulate estimates in order to achieve a desired outcome, such as meeting a debt covenant ratio.
Now, in the face of the enormous business challenges created by the pandemic, corporate leaders will need to make even more highly subjective judgments that must also be reflected in their financial statements. And because of the unprecedented nature of the pandemic and its impact on businesses, they will be making those decisions without the benefit of past experience.
The following pages provide examples of the types of subjective estimates appearing in financial statements that may prove to be especially troublesome during uncertain times.
Unusual and Infrequent Events
Entities are required to report transactions or events that are unusual in nature, infrequent in occurrence, or both, as a separate component of income from continuing operations. With the unprecedented nature of the social and economic disruptions caused by the coronavirus pandemic, it may be challenging for many firms to identify which transactions and events can or should be considered unusual and infrequent. The Financial Accounting Standards Board’s (FASB’s) definitions of unusual and infrequent require companies to consider “the environment in which the entity operates.” Given the uncertainty caused by the novel coronavirus, it may be difficult now to define a normal environment.
Because of the great uncertainty in the current economic climate, establishing appropriate and defensible reserve estimates to account for the risk of future losses will be particularly challenging. Thus, reserve estimates established in the first two quarters of 2020 will need to be carefully evaluated in future quarters and reversed promptly if/when the reserve is no longer justified. The fact that a reserve recognized in Q1 2020 is released at a later date does not necessarily indicate that the reserve was established in bad faith.
Firms recognize revenue only to the extent that the amounts are expected to be collected from the customer. In the current environment, collectability of revenues may be highly uncertain. For example, credit card companies may have robust models and extensive historical data that can help predict what portion of fees and interest will be uncollectible. However, these data may not be meaningful in an environment with unemployment levels not seen since the Great Depression.
When the value of an asset on a firm’s balance sheet exceeds that asset’s fair value, firms are required to write down the value of the asset on the balance sheet and recognize a loss. Estimates of the fair value of an asset depend on predictions about the future productivity of that asset – estimates that may prove difficult to develop or support given the uncertainty introduced by the pandemic. For example, whether and the extent to which an asset is impaired may depend on management’s outlook on pandemic-related disruptions. Expectations for a swift return to normalcy could justify little to no impairment, while expectations for prolonged disruptions would likely lead a company to record significant impairments.
Allowances for Credit Losses
Entities adopting the FASB’s new credit loss standard (including most large banks) must consider relevant information about “past events, current conditions, and reasonable and supportable forecasts” (ASC 326-20-30-7) to estimate the amount of current expected credit losses. First, past events may not hold much predictive power in the face of unprecedented economic disruptions. Second, any evaluations of current conditions are bound to be highly subjective and increasingly difficult with the current degree of economic uncertainty. Finally, any forecasts – even those supported by reasoned assumptions – are likely to deviate from actual future outcomes.
Should we expect accounting manipulations designed to avoid violating debt covenants?
It is not difficult to imagine scenarios in which management has incentive to manipulate subjective accounting estimates to achieve certain outcomes. On the one hand, firms at the cusp of violating debt covenants may have flexibility to avoid a technical default by making small adjustments to judgmental accruals. For example, a small change in assumptions about the collectability of lease payments could increase revenue to help meet an interest coverage ratio covenant. On the other hand, firms that are almost certain to violate their covenant thresholds, or firms otherwise seeking to restructure debt, may be incentivized to report lower earnings by taking larger losses earlier in order to elicit concessions from lenders.
Additionally, investors may be forgiving to companies reporting poor results during the current economic crisis, particularly poor results that the company attributes to the pandemic (i.e., by identifying unusual and infrequent events). In this case, lowering earnings by, for example, taking a large subjective impairment now, in a time of distress, conceivably could be costless or beneficial in the current environment and allow a company to report better metrics (such as return on assets or return on equity) as the economy recovers in the future.
No one can predict the future, and the unprecedented nature of the current economic environment created by the pandemic makes attempting to do so even more challenging. But we can look to past research to see how similar situations have unfolded as a predictor of whether we should expect a wave in accounting manipulations in the midst or wake of the coronavirus pandemic. For example, the literature on debt covenants suggests that firms close to violating a covenant can and do use discretion to avoid a technical default.
However, research on how the quality of financial reporting changed in the last financial crisis yields decidedly more mixed results. Some researchers present evidence of increasing opportunistic accounting accruals during the last financial crisis, while others provide evidence of improved earnings quality.
What lies ahead?
The Securities and Exchange Commission requires ads from asset management firms to include the disclaimer that past performance is no guarantee of future results. Given the unique social and market conditions of the coronavirus pandemic, past performance may provide even less predictive power now than in other periods, and many good-faith accounting judgments may turn out to be incorrect. In hindsight, such good-faith judgments could be misinterpreted by some as manipulative.
Thus, it is critical that retrospective evaluations of judgments made in these uncertain times be based on facts known and knowable at the time the judgment was made, focusing on the processes followed by the accountant making those judgments. Whether or not the judgment turns out to be a correct prediction is, in fact, inconsequential in investigating allegations of manipulation.
For this reason, any retrospective evaluation of judgment will be heavily influenced by the quality and availability of contemporaneous documentation supporting well-reasoned judgments. Lack of sufficient documentation of judgmental estimates will make any retrospective evaluation of those judgments much more contentious. Investing in documentation of the assumptions and judgments that influenced accounting decisions now will pay dividends for companies and auditors down the road. ■