Although many see financial accounting as primarily focused on historical results, today’s financial statements are based, in significant part, on expectations and estimates of future conditions. Forward-looking assessments affect how companies report a broad range of items, such as receivables, loans, investment securities, inventory, fixed assets, and intangibles. They affect whether a company can recognize revenue on long-term contracts. Assessments of future conditions also support how a reporting company determines whether certain items reported are temporary or result from long-term trends.
They’re applying all the tools at their disposal, such as cloud-based data-gathering systems, external reporting platforms, spreadsheets, virtual communications, and professional judgment. The situation may be leading financial reporting practitioners to consider their needs around new, modernized solutions.
ACCOUNTING GUIDELINES
A source of complexity in financial reporting comes from navigating and interpreting detailed regulations and guidelines issued by the Financial Accounting Standards Board (U.S. Generally Accepted Accounting Principles, GAAP) and the International Accounting Standards Board (International Financial Reporting Standards, IFRS). These guidelines give different formulations for applying the concepts of valuation and impairment to different financial statement items. U.S. GAAP has a current expected credit loss (CECL) model for receivables, loans, and similar debt securities.
The reporting of indefinite-lived intangible assets, regardless of whether assessed individually (such as trademarks) or as part of a unit (goodwill), requires an assessment of fair value. Inventory can’t exceed its net realizable value, and long-lived assets, including right-to-use (leased) assets, require an entity to determine whether the cost is recoverable by comparing carrying values to expected cash flows.
IFRS has similar guidelines that direct the reporting of these items based on forward-looking assessments. Financial instruments such as receivables, loans, and debt securities require estimation of expected credit losses (ECL). Inventory can’t exceed its net realizable value. Long-lived assets, intangibles, and goodwill require consideration of the recoverable amount by referring to fair value or the present value of expected cash flows.
Organizations have workable solutions to gather basic financial data. Meeting complex reporting regulations and guidelines that depend on estimates, expectations, and projections, however, typically requires additional layers of process. Reporting entities analyze trends, peers, industry, and economic data. Accountants look for appropriate metrics and indicators from the past to develop expectations for the future.
Even as companies have invested in new solutions, many still rely on various cumbersome, formula-driven spreadsheets for aggregating data and metrics from multiple internal and external sources. Even the largest companies often describe their accounting technology as “patchwork,” having prioritized technology solutions for areas other than finance and accounting.
ENTER COVID-19
In March 2020, as corporate teams began their Q1 closing processes, there was a sudden need to reassess assumptions and models. Examples of disruption are numerous. Air carriers, hotel and conference centers, and cruise operations saw fewer (if any) customers. While some medical supply companies responded to excessive demand for personal protective equipment, others saw a slowdown or standstill as elective surgeries ceased.
Beverage and consumer packaged goods producers had diminished sales to commercial users such as hotels, restaurants, and airports, but some could reconfigure operations to deliver product to consumers. Finance, technology, and professional services companies are reconsidering their long-term leased office space as employees work remotely. All of these factors become assumptions and inputs to determine expected collections, realizable value, fair value, recoverability, and projected cash flows.
Practitioners noted particular challenges around the new CECL guidelines (or the similar ECL standard under IFRS), which became effective for U.S. public companies beginning in 2020. Unlike the previous incurred loss model, CECL explicitly requires the consideration of collection expectations over the entire lives of financial assets, including trade receivables and loans.
Before CECL, assessing customer creditworthiness could require nothing more than a few pieces of data and access to a commercial credit database. Measuring credit losses was a straightforward process based on aging reports and historical loss metrics. In the pandemic era, historical credit ratings and loss metrics are inadequate.
Pandemic conditions mean asset impairment considerations, which rely on assessments of forward-looking cash flows. The Wall Street Journal reported that U.S.-based companies recognized $261 billion in impairment charges through mid-year 2020. As with credit losses, this accounting requires professional teams to gather and reassess data around expected demand and the extent to which the asset will be used in the future.
UNKNOWN TERRITORY
When COVID-19 hit, practitioners couldn’t rely on history to provide adequate comparisons. The nearest historical comparison, the 2008-2009 financial crisis, was driven by the mortgage market collapse and the structuring of financial instruments, fundamentally different circumstances than the current pandemic. Financial statement preparers had to rethink all of their prior assumptions and build new models to comply with the guidelines for various reported items.
The pandemic represents a new era of unprecedented, fast-changing conditions. Early in 2020, the extent to which particular geographic regions were being affected and the pace at which other geographic regions would become affected were unclear. It was also unclear how the pandemic would affect particular industries and businesses. Importantly, financial reporting teams need to consider the critical element of timing: How long until aspects of the economy return to normal or revert to historical trends? Or, will reopening be at partial capacity, such as 25% or 50%, to allow for safe distancing? Will businesses recover, or will the impacts permanently change business models?
It’s valuable for financial reporting professionals to reconsider not only the information needed for these projections, but also to reconsider their reliance on the existing patchwork of solutions and spreadsheets that slow down the process. Systems improvements can facilitate the development of critical estimates and create the supporting documentation, an evidentiary trail of review and oversight by senior management, audit committees, and auditors.
The pandemic quickly crystallizes and accelerates the need to modernize accounting software, particularly around forward-looking assessments. Financial reporting professionals need agility and the right balance of tools for the uncertainties of disruptive crises.
Reconsidering the patchwork in favor of the right solutions may allow for quicker access to the right data, analytics, and control over these sophisticated assessments and enable financial reporting professionals to efficiently apply the critical element of judgment.
October 2020
