The COVID-19 crisis presents unique challenges for public companies that are in the middle of drafting their first quarter Form 10-Qs. Periodic reports entail and reflect significant judgment concerning matters such as the valuation of assets, whether to take an impairment (and, if so, the appropriate size) and how to best describe the company’s operations and outlook. The quickly changing macroeconomic environment due to COVID-19, the extreme bouts of market volatility and the short-term price dislocations for some assets have created extraordinary challenges to management making those judgments — judgments that regulators are likely to scrutinize closely after the crisis ends.
In anticipation of this scrutiny, public companies should take extra care to document the rationale for accounting and disclosure judgments and to ensure that their internal controls over financial reporting continue to function as intended. In this regard, companies should consider whether COVID-19 or governmental or corporate responses, such as shelter-in-place rules or remote-work arrangements, have adversely affected their internal control over financial reporting or disclosure controls and procedures. To the extent that they have, companies should consider what mitigating steps they may take to ensure their controls are functioning properly and assess the effects on their financial reporting and public disclosures.
U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton and Corporate Finance Director William Hinman recently noted in a joint statement that public companies may face difficulties in determining how to draft forward-looking statements that specifically address COVID-19-related issues. Despite the challenges, in their view, it is important for public companies “to provide as much information as is practicable regarding their current financial and operating status, as well as their future operational and financial planning.” In considering how to best draft forward-looking statements, companies should focus on those that specifically relate to COVID-19 and whether to discuss aspects of their operations that have not previously been included in their periodic reports (such as disclosures relating to supply-chain finance arrangements).
Forward-looking statements and other disclosures about the effects of COVID-19 are not the only aspects of periodic reports that may require extra focus in the current environment. Accounting judgments, in particular, will require careful assessments in light of COVID-19. This includes judgments concerning, among others,
- valuation of tangible assets or illiquid securities held on balance sheets
- fair value of goodwill and other intangible assets, and any related impairments
- revenue recognition (which could be affected by changes in arrangements or courses of dealing between a company and its customers — discounts, refunds, price confessions, returns, etc. — and customers’ ability to pay)
- bad debt reserves and loan loss reserves
- tax liability
- healthcare-related liabilities or expenses
All of these issues can be complicated even in normal circumstances, and COVID-19 may make them even more difficult. Indeed, as the SEC’s Chief Accountant recently noted, “accounting and financial reporting implications of COVID-19 may require companies to make significant judgments and estimates” and “[c]ertain judgments and estimates can be challenging in an environment of uncertainty.”
Eventually, we expect the staff from the Divisions of Corporation Finance and Enforcement will focus on the financial reporting and disclosures of public companies to look for instances of accounting or disclosure misconduct related to COVID-19. For example, consistent with its prior enforcement focus, the Commission staff will likely attempt to determine whether a company has failed to appropriately impair assets held on the company’s balance sheet, has misleadingly implied that write-downs or other adjustments are the result of COVID-19 instead of other reasons or has tried to use COVID-19 as an excuse to take a “big bath” to clean up its financial reporting. The staff may also assess whether a company failed to appropriately disclose drivers and known trends or uncertainties associated with COVID-19 in management’s discussion and analysis, risk factors or other portions of a company’s periodic report. Commission staff scrutiny may be most likely in instances where an accounting judgment has a significant or unanticipated effect on the company’s financial reporting, results in press coverage or is the subject of a submission to the Commission’s whistleblower program.1
The risk of SEC scrutiny does not necessarily mean there will be second-guessing or judging by hindsight. As the Chief Accountant recently reiterated, the Office of the Chief Accountant “has consistently not objected to well-reasoned judgments that entities have made, and we will continue to apply this perspective.” Because the Commission staff generally will show deference to well-reasoned judgments, public companies should confirm that their internal controls over financial reporting are reasonably designed and are functioning in a manner to produce that type of judgment. Likewise, an investigation by the SEC staff will likely include a review of internal communications, work papers and other documentation created in the course of preparing the periodic reports. Sometimes these documents will indicate that there were differences of opinion during internal deliberations, and the staff may closely examine accounting or disclosure judgments that were the subject to internal disagreement. Companies therefore should assess whether they are appropriately and thoroughly documenting contemporaneously the rationale for their accounting and disclosure judgments in a way that will enable the company to establish that those judgments were reasonable and based on the best available information at the time they were made. If companies attribute write-downs, adjustments or other occurrences to COVID-19, they should also maintain sufficient documentation to establish how COVID-19 was relevant.
Public companies should remain mindful that although the current environment is in many ways unprecedented, the Commission staff may still question accounting judgments made during this time and could, in appropriate circumstances, consider bringing enforcement actions.
1 An issuer that believes an employee has contacted the Commission regarding purported misconduct should carefully assess how to proceed in light of the statutory and regulatory protections afforded to such individuals.
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