In this unprecedented time where the whole world is severely affected by COVID 19, many companies are forced to address the impact on their businesses, including accounting and financial reporting implications. The whole perspective is how the businesses are looking for this aspect on their operations. The way businesses operate today have started bringing a lot of fundamental changes in their operations. Companies are increasingly moving towards cost–cutting. Leasing and travel costs are expected to be reduced significantly. Also, the adoption of data–driven tools had led to a shift from people–driven business to a technology–driven business. Because of all these conditions, there would be a considerable change in financial reporting. In this article, we would like to discuss the expected changes in accounting estimates and goodwill due to COVID 19 as well as provide practical guidance to the auditors, particularly in those cases where substantial judgment and professional skepticism are essential to assess the facts.
Change in accounting estimates
It is the management’s responsibility to recognize and measure the accounting estimates and other relevant disclosures in accordance with the applicable financial reporting framework. Organizations make many assumptions about the estimates. For instance, useful life or salvage value of an asset, pension costs, doubtful debts. While preparing the financial statements, the change in estimates will require a revisit because of the changes in the way organizations are going or expected to operate which is now inevitable. This is an obvious impact on the financial statements. There would be expected a considerable amount of change in the estimates finance function has made in the past and what they are expected in the present scenario. Therefore, entities must make the estimates that are reliable, prepare comprehensive documentation supporting the basis for such estimates, and also provide the proper disclosure of the key assumptions made and, potentially, their sensitivity to change
For an accounting estimate to be reasonably acceptable by an auditor, it must have sufficient objective evidence to conclude that it is based on the relevant information available at the time of issuing the financial statements and also free from any management bias.
As mentioned in The CPA Journal, the material variability in the management’s best estimate should be disclosed at least qualitatively. In case sufficient audit evidence is not available and no reasonable estimate can be made, that fact ordinarily should be disclosed. According to FASB’s Conceptual Framework for Financial Reporting “if the level of uncertainty is sufficiently large, that estimate will not be particularly useful” (Concepts Statement 8, para. QC 16).
Impairment is defined as the amount by which the carrying amount of an asset exceeds its recoverable amount. Undoubtedly, COVID 19 has adversely impacted the global economy which is expected to continue at least in the short term. The financial condition of many companies is severely deteriorated. Several industries like, airlines, hotel and travel are severely impacted. During this rapidly changing environment, organizations need to assess whether the effects of COVID 19 will result in a triggering event for the impairment testing of Goodwill. Goodwill is an intangible asset that is recorded as a result of business acquisition. For instance, when Company X has the nest assets of $ 100 million and Company Y acquires it at $ 125 million, the difference of 25 million is recorded as goodwill which is paid because of the reputation of Company X.
Goodwill = Purchase Price – Net Assets.
Organizations need to assess whether the impairment of goodwill is permanent or temporary. They must revise the forecast to cover the impact of COVID 19 on the business at present and in future. The reporting entities must also determine whether the decline in the entity’s fair value is the result of a decline in other assets’ value. Goodwill impairment needs to be assessed annually, however, there can be triggering event, such as COVID 19 which requires an assessment on an interim basis. Apart from the COVID 19, following are some of the reasons that that may indicate a triggering event and consequently interim impairment test is required:
- Deterioration in general macroeconomic conditions, foreign exchange rates fluctuation or other changes in equity and credit markets.
- Increase in costs, such as raw material, labor and other overheads that adversely affect the earnings as well as the cash flows.
- Organization restructuring, such as changes in management, strategy or key personnel.
- Significant adverse variance in financial performance between actual and projected. For instance, a decline in revenue or earnings in the current year as compared to the previous year.
If based on the triggering event, it is found that there is a probability of more than 50 percent that the carrying value exceeds the fair value, the entity needs to perform the quantitative goodwill impairment test in accordance with ASC 280 Segment Reporting.
While evaluating the impairment of goodwill, it is essential to take into account the impairment of the rest of the assets, such as property, plant and equipment, inventory, accounts receivables. The impairment of such assets should be shown in the carrying values in the reporting unit before the goodwill impairment test. According to ASC 820 Fair Value measurement, there are three approaches for calculating the fair value of the reporting unit.
Market Approach that uses prices and other pertinent information generated as a result of market transactions that includes identical or comparable assets, liabilities or a group of liabilities.
Cost Approach that shows the amount that is currently required to replace the service capacity of an asset.
Income Approach that converts future cash flows or income and expenses amount to a single current discounted amount, reflecting current market expectations about those future amounts.
Change in Internal Controls: Furthermore, management must make the changes in the design of the controls or add new controls as a result of COVID 19 pandemic to ensure the effectiveness of internal controls over financial reporting (requirement of Sarbanes Oxley Act 2002). Organizations must also take into account the use of Goodwill Impairment Analysis Expert in the constantly changing environment. The involvement of the expert will help the management analyzing the suitability of the model used for impairment analysis and thus ensure to incorporate the appropriate amended controls for financial reporting.
Goodwill Audit: Auditing goodwill for impairment amid COVID 19 is a cumbersome task. It involves a careful analysis of carrying values as a result of a triggering event. Under the present scenario, auditors are required to perform additional testing procedures to ensure that goodwill is recorded appropriately. While evaluating management’s control over goodwill impairment, auditors may need to consider if the management has ensured the appropriateness of the internals for working remotely, the accuracy of fair value calculations and the sensitivity of the inputs. Impairment testing of goodwill requires disclosure of the key assumptions used to determine the recoverable amount. (IAS 36)
The outbreak of COVID 19 is undoubtedly a triggering event, especially from a smaller private business perspective that lacks the resources to cope with the current recession. Particularly under the present circumstances, measuring impairment is a challenging task. Organization must stay abreast of changes to evaluate how the downfall is expected to affect their operations in future.
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