2009 Reminders
In our last annual review, we indicated tight credit conditions and economic difficulties can have far-reaching, and perhaps unanticipated, impacts on financial reporting – something that didn’t change in 2009.
Accounts receivable and revenue recognition
In order to recognize revenue, the customer’s consideration must be
realizable, i.e., collection must be reasonably assured. Some vendors may
have extended their customary payment terms to customers with outstanding
balances, or issued rebates and concessions after the initial transaction.
Consequently, if management plans to continue issuing rebates and
concessions, it should carefully evaluate the impact of this practice on the
realizability of future transactions before concluding they should be
recognized in revenue. Further, if management records a bad debt expense in
the same period that revenue was initially recorded, it may call into
question whether it was proper to recognize revenue for the affected
transaction in the first place.
Investments in securities
When the fair value of a security falls to a level lower than its cost basis
at the measurement date, this should trigger a test to determine if the
impairment is other than temporary. The FASB changed the approach for making
this assessment for debt securities in 2009 (see below), while there was no
revision to the method for assessing equities. As companies manage their
cash needs, one option may be to liquidate their investments. The FASB’s new
model requires an impairment to be recorded if management either intends or
will be required to sell an underwater security before its recovery. The
option to sell underscores the importance of a thorough other-than-temporary
impairment
analysis since a sale may represent a source of much-needed cash.
Financial instruments carried at fair value
Valuations of financial instruments may require significant judgment at
times like this, particularly if the instruments are not actively traded or
are sold in distressed transactions. The accounting for these instruments
has generated significant controversy and even calls by some for suspension
of fair value accounting. Companies should consider all of the relevant
facts and circumstances to evaluate the fair values of their financial
instruments. In 2009, the FASB provided additional guidance (see below) for
estimating fair value when markets become inactive and for identifying
distressed transactions.
Inventory
As companies assess whether an adjustment is necessary to reduce the cost of
inventory to market, the economic downturn may have contributed to an
accumulation of slow-moving or obsolete products that should be evaluated.
In addition, excess overhead arising from production decreases must be
charged to earnings instead of being capitalized as part of inventory.
Goodwill and intangible assets
US GAAP requires an interim period impairment test of the goodwill of a
reporting unit if an event occurs or circumstances change that would more
likely than not reduce the fair value of a reporting unit below its carrying
amount. Similarly, indefinite-lived intangible assets must be tested on an
interim basis if events or changes in circumstances indicate they might be
impaired. The impairment triggers (or warning signs) for goodwill and
indefinite-lived intangibles can include: (i) a decline in market
capitalization and/or recent cash or operating losses due to market
conditions with an expectation that the declines or losses may continue,
(ii) weakness in a particular industry segment, such as the financial
institution and automobile industries, (iii) downward revisions to future
period profit forecasts, and (iv) restructuring activities such as layoffs
or plans to dispose of a reporting unit or a significant portion of it. As
discussed below, new accounting guidance for business combinations may cause
companies to redefine their reporting units, which in turn, could increase
the likelihood of a goodwill impairment charge.
Long-lived assets
Long-lived assets, such as fixed assets, can also become impaired in an
economic slowdown. US GAAP requires that these assets be tested to determine
whether any changes in circumstances indicate the company will be unable to
recover the carrying amount of the asset group through future operations of
the asset. This test is important now because it is likely to involve cash
flow projections based on revenue and cost assumptions that may be adversely
affected by market and economic conditions.
Deferred tax assets
If a company has a pattern of operating losses, it may need to reevaluate
the realization of its deferred tax assets. US GAAP requires that companies
consider all the positive and negative evidence in making these assessments.
The evidence is then weighted according to the extent to which it can be
objectively verified, with the result that an expectation of future taxable
income without other evidence will generally not be sufficient to overcome
an actual history of recent losses. As part of this evaluation, companies
should consider the Worker, Homeownership and Business Assistance Act of
2009 (the “Act”), which was signed into law on November 6, 2009. A key
provision of the Act is the expansion of certain net operating loss
carryback provisions to all taxpayers. However, companies should also be
mindful of the guidance in US GAAP that requires changes in the tax law to
be reflected in the period that includes the enactment date. As an example,
calendar year-end companies that prepare interim financial statements would
reflect the tax law change in the fourth quarter. For additional BDO
insights on the Act, click here.
In addition, US GAAP provides an exception to the recognition of a deferred
tax liability for the temporary difference created by an excess of the book
basis over the tax basis of an investment in a foreign subsidiary or joint
venture as long as that excess is indefinitely invested in the foreign
entity. Because such an excess is typically caused by undistributed earnings
of the subsidiary or joint venture, the parent company may need to record a
deferred tax liability if it plans to repatriate the foreign entity’s
earnings or is otherwise unable to assert such funds will remain invested
indefinitely.
Retirement plans
Companies may need to reconsider the assumptions and/or asset values used in
their accounting for retirement plans for several reasons: (i) Falling
interest rates can trigger changes in the assumptions for discount rates,
resulting in an increase in the present value of pension obligations, and
(ii) declines in share prices can shrink the fair value of retirement plan
assets, resulting in greater expenses or charges to other comprehensive
income and ballooning deficits that require greater cash contributions to
defined benefit pension plans.
Foreign exchange gains and losses
The effects of turbulence in the currency markets can trigger exchange
losses. They can also increase a company’s focus on hedging foreign exchange
exposures, leading to greater use of forward contracts, futures, and
options. In some cases, companies may find that as a result of the economic
slowdown, their revenue estimates were overly optimistic and therefore their
incomes were overhedged. The need to unwind overhedging can adversely affect
corporate earnings and create accounting challenges.
Consolidation
Management’s efforts to protect the assets of an unconsolidated entity or to
provide an entity with some sort of liquidity support can cause the entity
to become a variable interest entity (VIE), with the result that the support
provider may need to consolidate the entity. In some cases, these actions
may lead to a reconsideration of whether implicit variable interests exist.
Examples of actions that may require careful assessment include: (i) making
capital contributions, (ii) providing financial guarantees on assets or
debt, (iii) providing standby letters, or (iv) providing other forms of
relief when not legally obligated to do so (e.g., rebates, lower service
fees or converting short term receivables
into long term receivables). Further, all companies will soon need to
reassess their involvement with VIEs for potential consolidation under the
revised VIE accounting model that the FASB issued in 2009.
Debt restructurings
Many borrowers have faced pending debt maturities or other borrowing terms
that they would have difficulty meeting. As a result, companies have
negotiated new or amended financing arrangements. Because of the
significantly different accounting treatments, borrowers should first
consider whether such transactions fall within the scope of accounting
literature covering troubled debt restructurings or induced debt conversions
before moving onto the modification vs. extinguishment analysis.
Going concern
Management’s assessment of the company’s ability to continue as a going
concern must take into account a wide range of factors relating to current
and expected profitability, debt repayment schedules and potential sources
of replacement financing. The existing requirements and guidance for
evaluating an entity’s ability to continue as a going concern are provided
only in the auditing literature by the AICPA’s auditing standards
codification in AU Section 341, The Auditor’s Consideration of an Entity’s
Ability to Continue as a Going Concern, and in the comparable standard
adopted and amended by the PCAOB. In October 2008, the FASB started the
process for incorporating the requirements into the accounting literature
through the release of an exposure draft. The project has moved slowly, and
current plans are to finalize the new guidance by the end of June, 2010.
Financial Reporting News is provided by Somerset’s Assurance Team for our clients and other interested persons upon request. For additional information on the issues discussed, please contact us. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review.
These articles were written by and published herein with the permission from professionals of BDO Seidman, LLP. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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