In a preview of his Accounting & Assurance column in the summer 2020 Pennsylvania CPA Journal, James J. Newhard, CPA, talks to us about the coronavirus pandemic’s effect on financial reports, focusing on areas such as revenue recognition and risks and uncertainties. He also discusses the general turbulence the crisis is bringing to the auditor’s role.

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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor

Podcast Transcript

Among the havoc that coronavirus is wreaking on business is the area of financial reporting. In the summer 2020 edition of Pennsylvania CPA Journal, today's guest, James J. Newhard, CPA, explores that impact, focusing on effects in the area of revenue recognition, risks and uncertainties, and more, while also discussing the general turbulence it's bringing to the auditor's role. Today, he joins us to provide a preview of his summer 2020 Pennsylvania CPA Journal Accounting & Assurance column.

Can you give us a general summary of what COVID's effect on financial reporting has been so far? Or is it too early to tell?

[Newhard] We're learning more and more every day, and when I was thinking about this I was thinking about an analogy. A number of years ago, I had to do a business project in Maui.

While I was there, and my son came out with me, my adult son, we did this thing on ... there's Haleakala National Park, and it's on the mountain. There's a downhill road, a 25-mile stretch that you just bike, and your only job is monitor the brake the whole time. You're just coming down. It's the longest downhill biking peak in the world. It's amazing.

The reason I'm telling that story is that it's all relatively safe as long as you don't make any sudden turns, and you keep in control, and you're aware of the brake, and you don't get reckless. Now, here's the analogy. What we have now, we're going downhill. There is nonstop cross traffic of ... I'll liken it to heading down to the shore on Friday afternoon. They're not paying any attention to you and at any point in time, it's all over, and you don't know where the end is.

So we have the accounting issues of uncertainty, but we have uncertainty in every aspect of this. That deadline of opening up keeps getting pushed back and pushed back. Then they're also saying, "Hey, you know what? Flu season starts up again in October." So we have all of that pressure.

Even though we're gathering a lot of information and we're seeing a lot more skepticism and cynicism, we're at least more communicative of all the pressures and trying to manage those pressures. We don't know everything, but we have a pretty good handle of it. We have a pretty good handle of what we have. We just don't know how to resolve it. That's really where we're going.

What has been the effect here in the area of subsequent events?

[Newhard] The subsequent events concept in financial reporting is that ... and this has always been the complaint about financial statements. Financial statements are history reports. This is what happened last year, some time in the past. So, by the time it comes out, it's not fresh. It's not simultaneous. We're certainly aware of that in so many different things.

What we're saying is by the time we issue the report, perhaps certain things we've learned from other things that might be good for people to know. When companies were doing their December year-ends, and if they were getting their publicly ... let's say they were public companies that were filing with the FCC in February. It was not an issue.

In February, it was still the typical flu thing. Be careful of all that, get your flu shot, and life goes on. So, some of the disclosures were of subsequent events of this coronavirus has come from the Asia area and looks like it's ... we don't know. We don't have any idea but we don't think it's going to be too significant.

Well, that's what we were saying in February, and once companies got into March, completely different tone. Financial statements that are going out now, that subsequent events note is humongous. In a quarterly report, J & J Snack Foods talked about things shutting down and what the impact was. It was incredible. They said, "Government shutdowns curtailed the food service venues." We all know what's happened to the restaurant and food industry. They say that's two-thirds of their business. Two-thirds of all their revenues come from the food service venues that were shut down.

It's hard to wrap your head around that, saying, "Hey, we did billions of dollars of revenue last year. We may have lost two-thirds of that." That's what the subsequent events ... even though we say, "Shouldn't everybody be aware that this is serious right now?" We have to do our due diligence and say, "Listen, these are the things that are happening."

The good news is it doesn't change anything that we did last year. Last year's already done. But we often look at last year. What's the old saying? Those who don't learn from history are doomed to repeat it? Well, most people think based on whatever happened last year, we're going to repeat that, plus 5% growth, or 2% growth, or whatever else.

There aren't many companies that are going to say, "Whatever we did in 2019, we're going to be a bigger year in 2020." Now, we're worried about how far will we fall? That's the pressure. People look to CPAs to be ... sorry for those CPAs listening to this who aren't football fans, but we're going to be that safety in football, the last line of defense to make sure nothing bad happens, that nothing gets out of hand. We can't predict. It's a lot of pressure on not only the companies but certainly on the auditors and the CPAs that are doing the financial statements about how enormous the implications could potentially be to the business.

What about the area of asset impairments? Does the significance look like it's going to be as much there?

[Newhard] It's certainly going to be rather significant because people respond in different ways. And we have different rules for different parts of the balance sheet. But in terms of equipment and real estate, if you remember back after the economic banking failure back in 2008, parts of the United States had real estate values drop anywhere from 30% to almost 60% in the southwest. Those are huge, and if they don't recover quickly that write-down has to occur. That could potentially rise to a level of a permanent situation.

Now, other asset impairments, we look at the main assets. We have equipment, and equipment is based on fair value. What is that value? How we look at equipment is future expected cash flow. Well, if sales are going to drop, if productivity is going to drop, then utility of those assets is going to drop. Therefore, it's going to be worthless.

To bring it a little more closely to home, at least for me, I had my copier company call me and say, "We're going to upgrade you to the newest version, the highest technology copier," because the companies are so desperate to make another transaction that they're going to replace your three-year-old copier with the latest technology at a lower price. That's how desperate they are to make a sale.

So that's a trickle-down effect. As some people start dropping their prices to make a sale, the value of all those assets drop, and then you have inventory. We've heard the stories in our own commonwealth of tens of thousands of livestock that had to be euthanized because there's not people to manage them, to take care of the farms, to feed the chickens, all those different things.

All of these types of things impact impairment, and, frankly, the other item is receivables. It's certainly close to our hearts and we bill for our services. That's one thing. Now, can our clients afford to pay us? Or can any businesses that actually provide services, are they going to get paid, let alone in a timely manner? Are they ever going to get paid?

So those are all the different things that impact impairment that we're dealing with. Again, we all wish we had that crystal ball. But we don't.

I can't tell you how many pieces I've seen on revenue recognition and the struggles that CPAs have had in acclimating to the rules. Does coronavirus make that process even more difficult? Is there even more that people have to deal with in the area of revenue recognition?

[Newhard] It does. It affects a lot because the entire cost structure changes. Revenue is based on the expected prices, and, as we say, a lot of people are dropping their prices to try to compete at any cost. We also know usually for a company to be more profitable, they have to increase sales. But, as sales start to drop 10, 20, 30%, but they still have the same overhead, they still have all the same warehouses. They still have all the same people. They have all the trucks and equipment, and the debt on all those. That puts that much pressure on that revenue and being predictive about that revenue.

Now the new standard has a lot of interesting attributes. But one of the concepts is revenue can only be recognized if you are reasonably certain of collecting all of the money. That's the first problem.

Let's take an industry like the construction industry, pretty big industry in our country. Most construction contracts have what's called a variable aspect. There's an incentive of some kind or some bonuses. There's bonuses in all types of aspects in those providers. That's based on meeting certain time deadlines. A lot of people may have, in 2019, said, "Oh my God, we have about $1 million worth of bonuses by completing on time, or early, these long-term construction contracts." They anticipated that and they included that in their revenue calculations in 2019.

Now, how many construction companies say, "Yeah, we're going to finish our projects on time?" Some of them just started going back to work within the last couple days here in May. There's a lot of those things that we estimated in 2019, and this is that area where estimates is huge, because we were much more optimistic about the future four or five months ago.

Now, we are significantly more pessimistic that we're not reasonably certain that we're going to achieve anything as well as we did in the past. So all those contracts, all those arraignments, all those models that CVS has for what they sell in the aisles, will have to be reevaluated based on the new information and the new cost structure because ultimately the goal is to make a profit. It's going to be really, really challenging for many to do that.

One of the areas that needs to be disclosed in financial statements is possible risks and uncertainties to the business being audited. What's the effect that COVID-19 is having there?

[Newhard] This is one where we could probably get somebody to write a 14-page feature for the article for the magazine. What we have here is a number of things. This is a lot of things coming together. The first thing is, as a profession, the audit is something that's significantly unique to our profession that we do. The one area that we've had the most problem with, or at least the most criticism, is in this thing called risk assessment, not being sensitive enough to the risks on our audits. That was when things were good.

Now what happens is we have this crisis. What happens is this crisis is the most perfect Bermuda Triangle, no pun intended, for the fraud triangle. The fraud triangle is about when you have these three components. You have pressure. Well, do we have pressure? Oh yeah. Places aren't opening up. People are losing jobs. People who are ... even executives are taking 20, 30, 40% pay cuts and certainly are expected to go to work in situations. My daughter works for a nonprofit and they have numerous retirement adult centers, which are being hit tremendously. She's got to manage people who have to go through this, which is the ground zero of a lot of the virus.

So you have all of this pressure, and meanwhile you're still having people laid off. Sales are dropping, so you have pressure. You have less people. Well, that means you have less controls. You have more people doing other people's jobs and there's less oversight. Now there's opportunity for fraud. There's openness. We don't have checks and balances. We have people doing remotely, people having access, nobody seeing who's coming and going, what might be the impact there. You have those types of situations.

Then you have this rationalization is the third point. Wow, we're seeing that huge. Everybody that we interact with says, "Hey, we want some free money. The government should be giving me stuff, should be taking ..." And when we see somebody gets something and we don't, then we start saying, "Well, I have to level the playing field. I'm getting screwed. I'm getting cheated,” whatever else. You have this rationalization.

So while we always have had these three components in any situation, every one of these is triggered. When these conditions exist, you basically have total fertile ground for fraud. The fraud risk goes out the window. You have all of this risk, and, I already mentioned, uncertainties. We don't know if companies are going to turn around.

I look at all the restaurants around me and I wonder, will they ever open up again? What will they ever look like? How will they recover? I think in Pennsylvania, it was just within the last few days, the governor came out about trying to give some moratorium on anybody foreclosing for at least 60 days if they're behind on their mortgage payment. But you look at the landlords or the mortgage holders, if they're not collecting, how do they pay their creditors? It's a trickle-down effect.

There's a lot of stuff, a lot of uncertainty here. One of the things that we're supposed to do is when we say there's uncertainty and we can quantify that, well, now we might have to book more liabilities on the company's financial balance sheets, which then makes a bleak financial statement look even more bleak. It's a real Catch-22 here, and some companies see risks and uncertainties so dire, they may not be auditable because basically if you don't have controls, we can't audit a company unless we look at every transaction. There's a lot of pressure there with those aspects and internal controls are going to be crapped out here.

How does this entire situation affect the auditor's role to report on an organization's status as a going concern? What is the larger picture on that?

[Newhard] Well, the larger picture to that is that this whole ... the going concern issue has been a train that has been maintaining momentum, and there's been more and more pressure. As a matter of fact, it actually became a generally accepted accounting principal in 2015. It went into effect, that management must assess their ability to continue as a going concern, which in itself can be challenge because if they say, "Hey, you had a lot of negative stuff going against you. What's your plan? How are you going to turn this around? How are you going to make sure?"

Now, we're going to have to be even more skeptical, more, I hate to say, cynical, when management comes back and says, "Yes, we are a retailer and we're going to come back because malls are going to be big again. We're going to have a bigger presence,” and this, that, and the other thing. Meanwhile, you see J Crew just filed for bankruptcy, and a number of other retailers, and so on. We have to have that critical mind as auditors and say, "Really? Do we believe that management is going to attract more?"

I mean Amazon had already established itself this past Christmas as more people bought ... not just Amazon but everybody. It was the biggest retail sales, online sales, in our history this past Christmas. There were no restrictions of us going anywhere. If anybody that's in a retail-type of business is saying, "Yes, we're going to recover. We're optimistic. We're going to be able to do this," you've got to say, "Really? How do you plan to do that?"

We're going to have to be looking in the mirror too. Is our cynicism or our objectivity being impaired? Are we too likely to want to believe our clients? Or are we so pessimistic of things that we're predisposed to thinking, "No, you're not going to come back. You'll never be Sears. You'll never be what you used to be." Well, that one's already in the books. We know that that's gone.

But we see that model in a lot of other type of industries and that takes it a step further because everything that we've known about industries, CPAs are required to have a great knowledge of the industry before we can audit that entity. Well, how are those industries going to change? Will it ever be the same? Maybe a home builder will be the same. But service businesses, certainly, are going to be different.

So we have to take all of this into consideration to say, "Hey, if you did a billion dollars in revenues last year, and that's what you need to exist going forward, prove to me that you can get back to a billion dollars in revenue or that you can shrink your costs enough to not have the tsunami just come right over you and wipe the company out."

Then again, we are all quite fearful of this litigious society. So, as CPAs, we don't want to be overoptimistic and have it come back and bite us, and have us being sued because we didn't put the warning on the financial statements that this company was at risk.

Can you give us a general idea of how much of an impact you think changes brought on by COVID are going to have on auditors? Whether it is a major shift in their work process? Whether it means while we're going through COVID, or even when it's a little bit in the rear view? What is that effect going to be?

[Newhard] We always try to find this balance between over-auditing and under-auditing, not doing enough work or doing overkill. Well, the argument going forward is going to be it’s almost impossible to over-audit because you're not going to have that certainty. I just took in a webinar and they basically said every audit firm is going to have to say, "Forget the budget. We can't worry about going over budget. We just cannot fail to do enough work."

No matter how long it takes, we have to do enough work, enough testing, enough examining, enough tracing, all these other kinds of things, to the extent that we can even do it. Because obviously, there's a lot of things that we do in audit steps that are walk-throughs, seeing the facility, seeing the operations, look at how they interact, seeing the controls in place. It's not optimal situations. We can't do walk-throughs. We can't physically be there. You can't just say, "Hey, can you take your laptop there, put on the video cam, and let us watch remotely as you walk around," as you visit 200 different Walmarts to see what the operations are like or whatever it might be.

Everything is going to take that much longer. It's going to be a lot of pressure on the CPA firms to get all the work done. If you have ... we talk about busy seasons, whether you're an auditor or tax, taking 60-, 70-, 80-hour workweeks. Well, if you had those same client loads and everything's going to take 30% longer, and there's only so many things that you can do.

A CPA's got to get to the point where we've accumulated enough "evidence" that we're comfortable issuing our auditor report. That threshold for comfort level has changed dramatically from what it's been in the past. Audits are going to be huge and basically everybody is going to be looking at those financial statements and what we convey in those, whether they be audits, reviews, even compilations, what is the CPA doing to provide some level ... and I hate to use this term, I really do, because we hate it as a profession … but everybody who looks at the financial statements is going to be looking for what level of “comfort” they can get from the CPA.

On the other side, if we go in there and we do a financial statement, and we say, "Listen, we're Chicken Little CPAs and the sky is falling on this business," then the banks are going to pull their loans and all the rest of the stuff. The company will probably fail, and then they'll turn around and sue us to say, "You did fear-mongering." There's all that, and it's really hard to remain totally objective in such a highly emotional situation where you have tens of thousands of Americans dying. Not just Americans, everywhere across the globe.

So the audit world is going to be crazy-intense to try to complete those. God forbid, I'm glad I'm not a peer reviewer because I'd hate to be the person to come in next year and then criticize a CPA. There's a lot there. It's pretty much every item in FASB, all of our standards which cover everything on the balance sheet from cash and cash equivalents to stockholder's equity. Almost everything on that balance sheet is going to be somewhat at risk or require expanded disclosure in the footnotes.