Financial and Accounting Reporting During a Pandemic: The Case of COVID-19

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Financial and Accounting Reporting During a Pandemic: The Case of COVID-19

Events have struck the world in the past most of which have only hit a section of the world, allowing other regions to continue with their operations. However, the dawn of coronavirus pandemic is one event that has resulted in lockdowns across the world, bringing to a standstill human life and business activities (Ozili, 2020). The pandemic has had immediate effect upon business activity levels and secondary effects upon business measurement activities like financial statements. Khatri (2020) reasons that COVID-19 pandemic has created significant changes in the accounting and auditing professions, hence changes in the development of financial statements. Consequently, regulators across the world are advising financial statements’ issuers to work closely with their accountants and auditors to ascertain that their financial statements, auditing, and review processes are sufficiently robust in the glare of the shifting business circumstances under COVID-19 environment (KPMG, 2020a). On 31^st December 2019, China reported to the World Health Organization (WHO) regarding an unusual instance of coronavirus in Wuhan (Ozili, 2020). However, little information was known about the virus’ symptoms as well as risks of exposure to the virus until 2020 when concerted efforts were directed to understanding it in details. From the accounting viewpoint, the emergence of COVID-19 is regarded as a non-adjusting event for the year 2019 for most organizations in many nations owing to the fact that the main outbreak happened in most parts of the world in the middle of 2020. Similarly, when the organizations were sanctioned to make use of their financial statements, they will possibly be required to include a detailed post-balance sheet review in their financial year-end (Khatri, 2020). The effect of COVID-19, according to Tas (2020), may be regarded as an adjusting event for all reporting periods ending 31^st January 2020 onwards as the impact and scale of the COVID-19 disruptions continue to manifest itself in the years to come. The aim of this paper, therefore, is to elucidate some of the auditing and accounting implications and challenges that professionals and companies are undergoing due to the COVID-19 pandemic.

Economic Crises and Pandemics

Pandemics cause economic crises, which consequently affect management accounting in a variety of ways. Lakshminarayan (2020) found out that whereas there is an increase in the employment of activity-based costing systems along with strategic management accounting methods during economic crises, there is decreased employment of traditional cost accounting methods during such periods. Thus, reposition of management accounting is needed for a company to remain relevant during crises. KPMG (2020a) states that during financial crises, most analysts blame the mark-to-market or fair value accounting principles since such crises require analysts to write down the assets that were troubled to the costs they were bought at on the open marketplace before the crisis. KPMG (2020b) adds that systematic banks employ income smoothing accounting principles during economic recessions. According to ICAEW (2020), economic agents, during pandemics, minimize their engagement in economic undertakings that need person-to-person exchanges, particularly if the pandemic is contagious. As a result of uncertainty and fear, financial marketplaces become volatile since investors become risk-averse, opting for safer options of investment (PwC, 2020). Equity becomes scarce, private investors reduce in number, supply becomes affected as production declines, operation costs rise, and profits fall, resulting in poor firms’ performance during pandemic periods (Grant, 2020). Under these accounting situations, companies can employ accounting methods in financial reporting to help mitigate the effect of a pandemic upon companies’ performance.

Accounting Principles and Pandemics

There are several accounting principles that are susceptible to the effects of pandemics as discussed below.

Big-Bath Accounting, Stimulus Packages, Bailout Funds

Big-bath accounting, as Tas (2020) states, is an earning management method in which large accounting write-offs are taken against income during the pandemic periods with the aim of minimizing assets which results in reduced expenses in the subsequent period. In nations with bailouts or stimulus packages given to monetary and non-financial companies during pandemics , companies may have incentives to take part in big-bath accounting, especially big-bath incomes management after receiving the bailout funds or stimulus packages.

Companies can employ big-bath income management by charging a single-time large expense against incomes to minimize expenses in the future. The single-time large expense that is charged against income during the pandemic year will lower net income for that year and the hope of higher net incomes in subsequent years (Lakshminarayan, 2020). Notwithstanding the fact that auditors and accountants are able to detect big-bath practices in companies, companies can defend such practices by asserting that the choice to write-off their large expenditures during a pandemic year was as a result of the negative effects of the pandemic upon business activities along with the fact that the resulting fall in profit would be alleviated through the use of stimulus package received by the company (ICAEW. 2020). Studies by Gould and Arnold (2020) and Dave and Mahanta (2020) show that incentives for big-bath behaviours are high for companies with poor pre-managed performances.  Such companies often tend to acknowledge a larger than needed loss so that they can save for a better future since the possibility of realizing their financial objectives during the present period is low (Grant, 2020).

Fair Value Accounting

Fair value accounting refers to the practice of reporting liabilities and assets on a company’s balance sheet at a fair value as well as recognizing variations in fair value as losses and gains in the company’s income statement (Levy, 2020). Company managers can depend upon fair value accounting (mark-to-market accounting) methods to minimize their liability. During pandemics, such as COVID-19, companies that have large liabilities or significant amounts of securitized responsibilities may have incentives for revaluing their obligations at fair value by making use of the present marketplace price or a close substitute, and this can minimize the amount to be paid as well as the total liabilities of leveraged companies. This is applicable if a liability contract entered by a company includes a fair value measurement option. Some academia accept that fair value accounting practices contribute to financial crises during pandemics, while others theorize that the practice serves as a leeway for financial crises (Levy, 2020).

Avoidance of Income-Increasing Earnings

During pandemics linked to contagious illnesses, Gould and Arnold (2020) state that companies often perform poorly since suppliers minimize production, consumer demand falls, and employees often become unable to work safely within their companies’ premises. Köster and Igoe (2020) add that during pandemics, earnings forecast fall, and shareholders expect low dividend and profit during the pandemic year, implying that there is anticipation of high profit margins during the pandemic year yet there is little motivation to participate in income-generating engagements. Additionally, companies that receive bailout funds and stimulus packages during pandemic periods are unlikely to participate in income increasing earnings management to avert regulatory and political scrutiny on the companies’ large profit margins (Zhang et al., 2020). Since bailouts are given to distressed companies to support them during pandemics, companies that report profits in the pandemic years, even after receiving stimulus funds, may countenance greater criticism and scrutiny as to whether such companies have been beneficiaries of the bailout funds or stimulus packages.

Loss Avoidance and Greater Income Smoothing Accounting

A company, in the absence of bailouts or stimulus packages, will strive to stay competitive in a pandemic by employing accounting methods that help it report average profits to show that the company is not doing poorly relative to its rivals during the pandemic period (Odysseas & Kostakis, 2015). Such accounting methods are loss avoidance and income smoothing accounting techniques. Income smoothing entails minimizing, or smoothening out, profit fluctuations over time to ensure that reported earnings are not too low or too high (Ole-Kristian & Wang, 2018). Companies may smoothen their incomes by minimizing labour costs or delaying research and development expenses during a pandemic (Dave & Mahanta, 2020). Similarly, companies can undertake loss avoidance practices by pushing forward their large expenses to a future year and by acknowledging future profits during the pandemic to avert reporting losses, possibly by postponing the purchase of equipment, machinery, technology hardware or software, making large purchases on credit, as well as recognizing future cash flows during the pandemic (Ole-Kristian & Wang, 2018).

Relaxing Accounting Principles

Relaxing accounting principles or giving companies’ management extra flexibility in monetary reporting may be necessary to avert challenges of poor performance or corporate bankruptcy during a pandemic (Odysseas & Kostakis, 2015). However, relaxing accounting principles during pandemics equally opens doors for challenges of cloudy financial reporting or manipulation of accounting figures, which can eventually minimize the dependability of accounting data during a pandemic (Köster & Igoe, 2020). Zhang et al. (2020) add that relaxing accounting principles, like fair value measurement principles, results into manipulation and minimizes the reliability of accounting data as a result of lack of transparency regarding the worth of a company’s assets. Whereas it is commonplace for governments to stress adherence to accounting standards, relaxing accounting principles during a pandemic affects a large number of monetary institutions. The counter- debate is that accounting principles ought to be flexed during a pandemic since companies can reasonably expect that accounting principles will be relaxed and this has the eventual effect of diminishing their incentives to reduce risks in the first instance (Odysseas & Kostakis, 2015).

COVID-19 and Accounting Principles

Since its dawn, COVID-19 has significantly affected accounting practices globally. The prevailing economic variables are compelling firms in several sectors to postpone their non-essential expenditures. Similarly, firms are making concessions to their borrowers, lessees, and customers (Tas, 2020). Organizations are paying salaries (half or full) to employees who are not working, working partly, or working fulltime despite not generating sufficient income (Ozili, 2020). Most financial statement items are subject to difficult approximations, making financial reporting questionable. Accountants and management’s judgments would be needed to determine whether an event that occurred after the end of a financial reporting period is an adjusting or non-adjusting event. Management of companies would have to carefully review and assess events along with their impacts and update them.

Further, accounting and auditing professionals may have to employ a lot of their verdict according to accounting principles and standards regarding revenue recognition during the COVID-19 pandemic since under COVID-19, revenues and margins are fast shrinking (Dave & Mahanta, (2020). Customer contracts may have to be assessed owing to the changes in policy considerations with regard to discount, price concessions, performance bonuses, and refunds, among other factors. Contracts may also not be honoured at all. Khatri (2020) notes that under International Financial Reporting Standard (IFRS) 15, an understanding of terms and conditions of business contracts is crucial before any revenue are acknowledged.

Additionally, company accounting and auditing experts need to keenly look at asset recognition impairment losses since the pandemic period has experienced a fall in asset values across monetary marketplaces (Lakshminarayan, 2020). The global spread of COVID-19 has resulted in temporary closure of companies and also led to limitations on travel and importation and exportations of goods (ICAEW, 2020). All these, according to Ozili (2020), may be regarded as indicators of assets’ impairment since organizations are unable to recover the carrying or book value either by selling their assets or using them. Put differently, entities ought to take into consideration whether they are facing any circumstance like decreased revenues, store closures, supply chain disruption, order cancellation, or falls in share prices. These variations may signify that a company’s assets ought to be tested for impairment.

Another financial reporting area that COVID-19 has significantly impacted is the good will principle. Tas (2020) suggests that the good will item is most likely to affect firms with substantial competitive acquisitions during past periods. If the size of good will in a company’s financial statement shows that the company’s financial status within a troubled industry is high, Khatri (2020) states that there are possibilities of more scrutiny of the company’s income statements as well as its impacts. A goodwill impairment charge may impact a company’s profitability for subsequent years. 

There have been various government measures to deal with the impacts of COVID-19 eruption. Measures, like tax reduction or exemption, direct subsidies, minimization of credits and taxes, low-interest loans, or minimization of rents, have been employed by various governments to help cushion their economies from collapsing (Grant, 2020). Accountants and auditors, therefore, ought not to assume that these measures by governments also have significant impacts upon financial reporting by organizations.

The fair value measurement (owing to fluctuations and uncertainty in markets across the globe) is one other item that is impacted upon by COVID-19. Companies’ management have to make proper disclosure of their companies’ financial information to enable users to comprehend whether the pandemic has been regarded for fair value measurement or not (Tas, 2020). Similarly, Gould and Arnold (2020) argue that, in 2020, fair value measurement regarding financial paraphernalia and investment property may need to be reviewed to ensure that values reflect the circumstances at balance sheet date. ICAEW (2020) adds that measurement will be founded upon unobservable inputs that replicate how marketplace participants would regard the impact of COVID-19 in their anticipations of future cash flows associated with liability or asset at the time of reporting.  

Several industries are likely to be affected as a result of the effect of the pandemic on hedged items in companies’ cash flow. Industries like construction, heavy engineering, automobiles, equipment, along with other capital goods have high chances of being affected greatly on their income statements due to great uncertainties or inventory write-downs in revenue recognition (Grant, 2020). The International Accounting Standards Board (IASB) also notes that COVID-19 may affect hedged items, which include (i) the purchase or sale volumes that fall under the levels initially forecasted, (ii) planned debt issuances cancelled or delayed such that interest payments decline below levels initially projected; and (iii) business disposals or acquisition that are cancelled or delayed (IASB, 2020b). The board further guides that in case an entity proves that the projected transaction is no more highly possible, yet is still anticipated to happen, the entity must prospectively terminate its hedge accounting and postpone the loss or gain on the hedging tool that has been identified in some detailed income accumulated in equity until the projected transaction happens (Dave & Mahanta, 2020).

Inventory valuation is another area of financial reporting affected by the COVID-19 outbreak. Inventory valuation has been difficult since companies have been forced to shutdowns, sizeable fall in companies’ net realizable margins since there is a fall in demand, as well as possibly non-performance of purchase and sales contracts (Gould & Arnold, 2020).  Counting of end year stock may be impossible or challenging, thus sound judgment of companies’ auditor and management would be crucial. Additionally, if suppliers are not able to achieve their obligations under regulation due to impermanent closer of companies’ operations, they would require recognition of provisions, thus, customers’ contracts would be burdensome. Accountants and managements will have to employ their ruling for justifiable approximations for appropriate disclosures and provision in their financial statements (Grant, 2020).

It is argued that the provision of bad debts is often founded upon expected credit losses (ECL). As a result of coronavirus occurrence, Levy (2020) reasons that the ECL models may have lost their significance as indicators of future anticipations of bad debts since these models are founded upon companies’ historical experiences. Thus, they should be updated suitably in light of the present circumstances.

COVID-19 has also impacted negatively deferred taxation, which includes recognition of deferred tax obligations linked to investment subsidiaries, recognition of deferred tax assets, and recognition of anticipated manner of reversal as well as interim reporting tax rate (Gould & Arnold, 2020). Tax experts reason that for established companies that have history of profitability, deferred tax assets are usually acknowledged without argument for deductible impermanent differences. For other businesses, deferred tax assets are acknowledge from the businesses’ non-capital losses, but only when backed up by persuading evidence of taxable profit in the future (Grant, 2020). Tax professionals add that when it is no more likely that future taxable profit would be available, the resultant deferred tax asset can no more be acknowledged (Dave & Mahanta, 2020).

Gould and Arnold (2020) state that international subsidiaries, having amassed foreign profits, are often reinvested in overseas operations or employed in financing further worldwide expansion. However, under COVID-19, companies may be evaluating whether these profits should now be repatriated to the parent company’s country via dividends (Lakshminarayan, 2020). Köster and Igoe (2020) argue that dividends that are received by the taxpayer may in the long run have a full dividend deductions associated with the dividends provided that they are paid out of active commercial earnings of the international subsidiary. With the COVID-19 pandemic, preparation of financial statements ought to be designing possible contingency plans that include the need to fund future deficits linked with any resulting economic recession that the company may face (Levy, 2020). 

Additionally, the International Accounting Standards (IAS) 34 requires the employment of effective tax rate (ETR) technique. Nonetheless, the components of taxable income could highly be uncertain because of various governments’ programmes aimed at cushioning their economies (Dave & Mahanta, 2020). Companies may equally have to evaluate the receipts of government aid to determine whether any government aid received is encapsulated in the IAS 12 or IAS 20’s scope (Lakshminarayan, 2020). Other areas like risk exposure, net realizable value, loan modifications, and other accounting approximates will have financial reporting challenges and implications for companies as well as accounting experts.

Financial and Accounting Reporting Challenges during COVID-19

Going Concern Issues

The going concern is a term employed to imply that a business entity will continue to operate in the future and will not be bankrupt or be compelled to stop operations as a result of any other reason (Grant, 2020). An entity is said to be a going concern if there is no proof that it will have or will to discontinue its operations in conceivable future. The growing concern issues, according to Levy (2020), will pose challenges with regard to obtaining proper documentation as well as evidence collection and projecting for accountants and auditors. Accountants and auditors, thus, may have to put extra efforts as well as employ procedures to determine suitable ‘going concern’ issues of their organizations (IASB, 2020a).

According to the IASB 2020 guidelines, it is the obligation of a company’s management to evaluate the company’s capability to continue as a ‘going concern’ (Zhang et al., 2020). Whenever necessary and relevant, a company’s management ought to consider both the anticipated and present effects of the COVID-19 pandemic on their company’s operations through the valuation of the suitability of the employment of the ‘going concern (IASB, 2020b). Additionally, the IASB 2020 guidelines point out that the ‘going concern’ evaluation should be performed up to the date on which a company’s financial statements are issued (IASB, 2020a). Köster and Igoe (2020) reason that firms which are likely to be affected adversely by COVID-19, like small businesses or businesses in the media, leisure, retail, hospitality, aviation, and travel sectors, need to take into consideration the ‘going concern’ issues. It is also debated by accounting experts that recoverability of debtors by companies is going to be a serious challenge than it is during normal business days, and thus may affect the going concern (Khatri, 2020). There would also be a need to carry out sensitivity assessments for such business establishments to determine whether there is any material’s unpredictability on their capability to continue as a ‘going concern.’

Cash flow is another going concern issue that is related to financial reporting. Questions are ensuing in various companies whether they have sufficient cash to survive as long as COVID-19 stays. It is definite that under COVID-19, organizations may experience cash flow problems as a result of disrupted operations, high operating costs, and lost revenues (Ozili, 2020). It is likely that auditor’s risk evaluation, and as a result of new threats, there is a need for revising the significant risks, for instance, regarding an organization’s liquidity stance (Zhang et al., 2020). Consequently, such occurrences, like COVID-19, require extra disclosures in financial statements, and possibly accountants and auditors may have to state this in their reports.

Obtaining Evidence

Presently, there are restrictions or bans of travel from law enforcement agencies, thus, unanticipated hurdles and challenges are encountered by accountants and auditors in securing dependable data to execute the audit or assessment of their clients’ financial statements (Khatri, 2020). Auditors and accountants have to continue complying fully with the International Standards in Auditing (ISAs) despite the present COVID-19 conditions, like bans on travels.. Nonetheless, the regulators have been raising worries that auditors and accountants have difficult time gaining access to the individuals and evidence they require to back their audit opinions (Zhang et al., 2020). 

Moreover, the audit planning carried out by auditors may not fully be workable since they may fail to offer expected audit proof, compelling auditors to alter their strategies and approaches (Köster & Igoe, 2020). For instance, clients’ debtors and banks may not give confirmations regarding transactions or unsettled balances as dependable audit evidence. The auditors. Thus, auditors have to take into consideration alternative techniques or employ knowhow in sharing information or holding virtual meetings possibly as highlighted in ISA-500 to gather audit proof (Köster & Igoe, 2020). Auditors also need to comprehend that companies’ international control systems are normal systems and they are still functioning or have some of the risks and associated controls altered.

Auditing and accounting professionals also suggest that auditors and accountants should consider the difficulties that are encountered by their clients in developing company’s future forecasts.  They ought to acknowledge the highly fluid circumstance along with the greater uncertainty that is involved by their client businesses as a result of coronavirus.  These forecasts may equally change in short periods in accordance with changes in situations along with the impact of COVID-19. Nevertheless, accountants and auditors may need to have proactive consultations with their client entities on the impact of the COVID-19 activities, business, as well as reporting time tables (Zhang et al., 2020).

Conclusion

The speed and scale of the impact of COVID-19 on the global economy is unpredictable. Markets, financial reporting, and the economic environment are expected to continue facing significant risks and challenges in the conceivable future. Business establishments are currently experiencing conditions usually linked to a general economic recession. As such, company management, auditing, and accounting experts are expected to handle the financial impacts of the COVID-19 outbreak in the development of financial statements for interim or annual reporting periods ending 2020. The timely and meaningful disclosure of the possible impacts of COVID-19 upon the financial stance, operating performance, liquidity of an organization, and their communication are very crucial for companies to regain their stakeholders’ trust and confidence. Additionally, some professionals believe that financial reporting of probable effect of COVID-19 is unlimited only to annual and interim financial statements, yet equally required to be updated in disclosure if risk management and in management discussion and analysis.