The coronavirus (COVID-19) outbreak has rightly become the focus of massive public attention in recent weeks, and financial markets around the world have reacted accordingly, with the S&P 500 experienced its single largest daily drop in history last week.
As a result, auditors have to be mindful of heightened audit risks this year.
- Valuation of financial assets – With financial markets reacting to concerns over the spread of the virus, the measurement of financial assets will be a risk. The duration of the disruption is still unknown, but auditors and management may want to consider the potential for impairment. Financial assets reported at fair value on the balance sheet may also result in realized and unrealized losses. Management and auditors will also have to exercise judgment around critical estimates and cash flow projections used in the fair value measurement of non-quoted financial instruments.
- Hedging – Hedge accounting may be disrupted by higher-than-anticipated levels of volatility resulting in higher levels of hedge ineffectiveness to recognize in earnings. Clients may also rethink the likelihood of occurrence of a hedged forecasted transaction, with potential immediate consequences on earnings as well. Finally, management may be re-thinking their hedging strategies.
- Valuation of inventory – Supply chains are disrupted, and production levels may be affected. If your client has reduced or idle production capacity, their overhead costs may not be allocated to inventory as they usually are. In addition, inventory that cannot be turned over because of travel restrictions may have to be evaluated for impairment. Finally, changes in prices and reduction in the level of demand will also have to be taken into consideration.
- Credit and liquidity risks – Your clients’ customers, as well as your clients themselves, may find themselves in financial difficulty, resulting in additional credit risks, higher than usual bad debt and even potentially impairments and write-offs. Cash flows from operations may also be affected. Don’t forget that liquidity risks must be disclosed and are often scrutinized by analysts.
- Measurement and funded status of pension and other post-retirement plans – Both the expected return on plan assets and the funded status of the plans may have to be revisited in light of the volatility in financial markets.
- Valuation allowance on deferred tax assets – If estimates of earnings of foreign subsidiaries change, management may have to reconsider some of their tax strategies or may not be able to realize all deferred tax assets. This is another area that auditors should consider carefully when assessing critical estimates.
- Valuation of goodwill on subsidiaries in affected areas of the globe – Subsidiaries in areas heavily affected by the Coronavirus may see their revenues or net income affected by the outbreak. This may trigger a goodwill impairment test. The reassessment of key accounting estimates and projections may result in an immediate goodwill impairment. Goodwill may also have to be tested more than once this year if management considers that evolving circumstances result in more than one triggering event over the next year. This is equally true for other intangible assets.
- Subsequent events – The situation around the spread of the Coronavirus is evolving daily, sometimes even hourly. Auditors should ensure that their clients include the appropriate subsequent event disclosures in their annual and interim financial statements. Should a subsequent event just provide additional information about conditions that exist as of the end of the reporting period, they may even require an adjustment to the financial statements.
- Disclosures – Events that significantly affect customers’ business and operations may require disclosures, both in the financial statements and outside of the financial statements, in various SEC filings and other parts of the 10-K or 10-Q (business, risk factors, management’s discussion and analysis, etc.). The SEC has already signaled that it will be looking for disclosures around the impact of the Coronavirus.
- Critical Audit Matters and Communication to Audit Committees – A number of critical accounting estimates and assumptions may be affected by the Coronavirus outbreak and they may rise to the level of critical audit matters that may now have to be communicated in the auditor’s report. With this in mind, auditors should engage in a dialogue with the audit committee. No doubt that Audit Committees will also have questions for you regarding your client’s preparedness to such a crisis as it develops.
While the Coronavirus outbreak generates audit risks, by engaging with Audit Committees, auditors can demonstrate their value as a trusted business advisor.