An audit cycle unlike any other
When the COVID-19 pandemic hit the United States earlier this year, companies had to quickly adapt to the economic shock, stay-at-home orders and massive workforce disruptions. Although the severity of the shock has varied across industries, all companies have been impacted in some way. Now, six months into the pandemic, the year-end audit cycle is shaping up to be unlike any other. Taking stock of the current situation and rigorously preparing will be critical to meeting audit deadlines.
While certain accounting and reporting issues, such as impairment and going concern, are not unfamiliar to financial statement preparers, COVID-19 has introduced significantly more complexity and urgency that will require greater time and attention in order to successfully navigate these issues. As a result, the 2020 year-end audit cycle is likely to be one of the most challenging in recent memory, as companies confront obstacles such as headcount reductions and remote work arrangements. While many Dec. 31 year-end public companies have been dealing with the accounting and reporting impacts of COVID-19 since their Q1 filings, private companies may soon be coping with some of these issues for the first time.
Every year, auditors and companies have good intentions to prepare early and get ahead of the audit, and yet, every year, audit execution becomes a last-minute fire drill. With the incremental complexities and associated risks this year, companies and auditors cannot afford to fall behind. Fortunately, the challenges of this year’s audit can be mitigated through early planning, engaging with auditors and advisors, and securing additional support where it is needed most.
Here are eight key pressure points companies can expect to face as they head into the year-end audit cycle and what they can do to successfully navigate each:
Impairment: The economic environment is creating potential impairment triggers for goodwill, intangibles and other long-lived assets. Most audit teams will have a default position that the events of 2020 are an impairment trigger, which will require incremental analysis and multiple layers of review from audit teams. Companies will need updated forecasts reflecting detailed plans for continued cost containment strategies, management’s best estimate of timing and pace of recovery, and detailed plans on changes to leased assets. Strategic changes in a company’s plans for physical space, for example, and a shift to long-term remote work arrangements, will require an impairment assessment of right-of-use lease assets.
Workforce actions: With many companies reducing headcount, implementing employee furlough programs, modifying compensation arrangements, and taking other measures to reduce costs and realign the workforce, they must consider the complex accounting impacts of these actions. Employee furlough programs can result in point-in-time expense recognition or expense recognition over the term of the program, all determined by the specific facts and circumstances of the program. Management should analyze the accounting implications of arrangements already in place and carefully consider the impact of modifications or extensions to those arrangements.
Going concern: The economic environment and the high degree of uncertainty add significant complexity to management’s going concern assessment. Forecasting liquidity over the 12-month assessment period requires a comprehensive understanding of contractual arrangements, including covenant compliance and acceleration clauses, their potential impact to liquidity, and a robust assessment of management’s plans. Auditors will be intently focused on this area, as the uncertainty around the timing and pace of recovery increases the risk related to this assessment.
Financing transactions: To ensure access to sufficient capital, many companies have sought additional financing capacity through new or modified debt arrangements or other capital transactions, which can result in complex accounting considerations. Additionally, the Coronavirus Aid, Relief and Economic Security (CARES) Act, which was signed into law in March, includes an option for financial institutions to suspend U.S. GAAP requirements for certain loan modifications that would historically have been considered troubled debt restructuring. Any kind of distressed financing transaction will have multiple accounting complexities that require multiple layers of review and often delay audits if not addressed with auditors before year end.
Tax impacts: The CARES Act provided various forms of tax relief to businesses, including favorable changes to the net operating loss (NOL) carryback rules which may require companies to remeasure deferred tax assets (DTAs). To the extent companies expect to carryback NOLs, the DTAs should be remeasured to reflect the enacted tax rate in the year the NOLs will be utilized. In addition, uncertainty with respect to the timing and speed of a recovery will put tension on realization of DTAs. Auditors will be carefully evaluating companies’ projections of future taxable income and other assumptions to evaluate the need for a valuation allowance. Engaging tax teams and advisors early will be critical to helping management scope out the impact and assess the effort and timeline necessary for year-end tax work.
Virtual audits: With audit teams expected to continue working virtually throughout much of the year-end audit cycle, previously routine activities (e.g., observing the performance of a control or physical inventory counts) have become significant logistical challenges. To avoid incremental testing where auditors had previously relied on in-person procedures, companies should engage in early planning discussions with audit teams and leverage online collaboration and communication tools to lessen the challenges of a virtual audit.
Lower materiality thresholds: Lower revenues and higher expenses, such as impairments and severance, will likely result in lower materiality thresholds than in recent audits, bringing previously immaterial accounts or locations into scope. A change in materiality may lead to new potential audit adjustments but will almost certainly lead to incremental work on the part of companies to get through an audit. Companies should look at their operating results now, revising their internal materiality thresholds and identifying previously immaterial potential problem accounts for resolution before fieldwork.
Leaner accounting teams: Workforce reductions have impacted already lean accounting teams, resulting in the loss of institutional knowledge and additional stress caused by heavier and more complex workloads. These reductions can give rise to knowledge and experience gaps on the team, adversely impact segregation of duties, and create bandwidth issues that ultimately put deadlines at risk. Companies should give thoughtful consideration to the need for additional resources or third-party support, changes to the close calendar, or investment in technology and automation.