Forward-Looking Statements and Transparency: Esther Mills on Accounting for Pandemic-Related Losses

To the many business disruptions caused by the coronavirus pandemic, add one more: It has made it extraordinarily difficult for companies to make estimates required for financial reporting. How should accountants manage this problematic situation, and are the customary standards that they use as tools up to the task? In this Q&A, Analysis Group affiliate Esther Mills, president of Accounting Policy Plus, spoke with Vice President John Drum about the ways in which the practice of accounting will have to deal with these unprecedented events, and why it behooves companies to be as transparent as possible with investors, analysts, and regulators.

What challenges will accountants face as a result of the coronavirus pandemic?

Esther Mills: President, Accounting Policy Plus

Financial accounting statements are typically viewed as conveying a company’s historical results. In other words, they’re usually seen as retrospective documents. In reality, however, financial accounting statements reflect a significant number of forward-looking estimates that incorporate a wide variety of variables. Accounting for pension obligations, for example, requires a company to estimate a long-term expected return on pension plan assets. Similarly, accounting for a company’s obligations under a loyalty program requires it to predict future consumer behavior in order to estimate the expected forfeiture of points or miles. And most tests performed to assess whether intangible assets and goodwill are impaired rely on detailed cash flow projections.

One last example: Banks are required to record expected loan losses on their financial statements, but to do so, they often must estimate future economic conditions, such as unemployment rates and the effects of government interventions.

In “normal” times, estimates such as these are informed by historical experience, and companies can rely on a significant amount of their own or industry-specific data, such as uncollectable receivables and loan losses, or consumer usage of airline miles rewards. These, however, are unprecedented times, so what do you do when you can’t count on history anymore? If historical experience ceases to be a reliable indicator of future results, companies are likely to have an especially difficult time making these estimates when filing their statements, or supporting them after the fact.

Investors, creditors, analysts, and regulators all have strong and legitimate interests in having access to information about the impact of COVID-19 on a company’s business operations. What information would be most helpful to share with them?

First, I would encourage companies to consider increasing the amount of information and detail contained in disclosures regarding accounting estimates, especially when it comes to the forward-looking inputs and assumptions that are necessary for making estimates. Although many businesses are understandably cautious about giving away more information than is absolutely necessary, they also need to understand that, in such uncertain times, leaving too much to their investors’ (and regulators’) imaginations can be just as risky.

Second, investors are interested in understanding how COVID-19 has affected a company’s business. But businesses following GAAP [generally accepted accounting principles] to prepare their financial statements are running up against the fact that the guidelines are better suited to stating what happened, not what might have happened.

The pandemic’s negative impacts can be viewed as incremental costs incurred and revenues lost. Incremental costs incurred due to COVID-19 are generally much easier to quantify than revenues lost. This is because incremental costs are the result of past transactions or events that can be identified and measured, whereas calculation of lost revenues requires assumptions about what would have happened during the period had the pandemic not occurred. GAAP is simply not designed to provide this type of but-for information readily.

John Drum: Vice President, Analysis Group

Expand on that a bit. Why can’t GAAP provide the type of information users would want regarding the impact of COVID-19 on business operations? And what options are available to firms in terms of reporting pandemic-related losses?

Although GAAP requires entities to make forward-looking estimates, it’s still focused on reflecting the results of past transactions and events. A calculation of revenues lost due to COVID-19 would effectively require firms to forecast what their revenue would have been in the absence of the pandemic. GAAP requires entities to separately disclose unusual or infrequent events, but, unlike a single unusual event, COVID-19 can affect an entire business. This kind of analysis – essentially, forecasting financial results but for COVID-19 – would typically be relegated to litigation, equity analyst reporting, or internal monitoring, but not disclosed publicly by the company itself. Again, my recommendation is for companies to increase their explanatory discussion of the assumptions that underlie any disclosure of COVID-related losses.

Why might firms be reluctant to offer this level of detail about their estimates?

As a general matter, companies are hesitant to disclose anything that’s not required. There are several reasons for this reluctance, including a perceived risk that the estimates will be subject to after-the-fact scrutiny from investors, creditors, and regulators, and a perceived risk that providing too much forecasted information could reveal proprietary knowledge to competitors. Add to those the fact that estimates made during this crisis will be particularly challenging and, as a result, may be less reliable.

Nonetheless, the more a company discloses, the better users of financial statements can understand the assumptions on which they are based, and how those assumptions comport with their view of the world. Furthermore, increased disclosure may create better accounting for all companies. In this regard, I’m reminded of the 2008 financial crisis, when increased disclosure about the valuation of exotic financial instruments led to increased dialogue within banks about the best way to value those instruments. Ultimately, additional transparency helps everyone.

What options do firms have for reporting the impact of COVID-19 outside of financial statements? What pitfalls should they avoid?

Given the limitations of GAAP financial statements, non-GAAP measures disclosed outside of the financial statements may be a preferable or necessary way to isolate and explain pandemic-related items in financial statements. However, a company’s management can’t just say whatever they think will benefit them the most. These supplemental disclosures must still comply with SEC [Securities and Exchange Commission] guidance on non-GAAP measures.

In March 2020, the SEC issued a publication that simultaneously acknowledged the fact that non-GAAP metrics may be critical for investors to understand the impact of COVID-19 on a company’s financial statements, and reminded companies of their obligations with respect to these metrics under SEC rules. For example, non-GAAP metrics should not be provided just to present a more favorable view of the company. Instead, they should be shared to clarify for investors how management uses these metrics in managing or monitoring business performance. They must also be reconciled to the most directly comparable GAAP metric, and must not be more prominently cited than this metric. Additionally, the SEC stated that publicly disclosed non-GAAP metrics should be limited to those used to report financial results to the board of directors.

In addition, a non-GAAP metric that adjusts for the impact of revenues but for COVID-19 would be considered a hypothetical measure, and thus may be viewed as misleading and potentially subject to challenge by the SEC. However, a company can discuss how the pandemic has impacted its revenues, and how the company expects it will impact future revenues (for example, based on planned changes to the business model) in its MD&A [Management’s Discussion and Analysis of Financial Condition and Results of Operations].

How can firms ensure that they provide accurate estimates to stakeholders? And what advice do you have for firms in preparing disclosures?

First, I would say that the term “accurate estimate” is a misnomer. It’s inevitable that the future we experience will differ from the expectations we create today, so I prefer the term “best estimate.” The best thing firms can do is provide as much detail as possible regarding the inputs to their estimates.

I would also encourage companies to prepare and disclose sensitivity analyses that explain how different assumptions might impact the accounting estimates. Users of financial statements are likely to have a wide range of expectations, and disclosing information about sensitivity analyses would allow those users to understand how their own expectations might impact a company’s reported financial condition. When future conditions differ from estimates made today, investors, creditors, analysts, and regulators may not be caught as much by surprise if companies have clearly made these disclosures. This kind of transparency may also help businesses avoid litigation and regulatory penalties. ■