This year’s current accounting issues panel at the Conference was moderated by Adam Brown (BDO) and comprised several accounting firm professionals, including KPMG Partner Dan Langlois.
Inflationary pressures, rising interest rates and the potential for a recession were drivers of the discussion. Langlois cautioned that current economic trends will increase the complexities of applying some accounting principles and may require more resources than the financial reporting function has needed in the past.
“Preparers should be mindful that this year-end reporting season is not ‘business as usual’. Challenges posed by the current economic environment – like rising interest rates, inflation and uncertainties in future cash flows – may require additional attention in asset impairment analyses and other accounting areas requiring significant judgment.”
— Angie Storm, KPMG Deputy Chief Accountant
Langlois noted companies could face goodwill impairment in Q4, although all panelists were quick to caution that it is not just goodwill that might be at risk of impairment, but also tangible and other intangible assets. Certain fact patterns may be particularly susceptible to impairment in the current environment, such as little headroom in prior assessments and recent acquisitions that are separate reporting units.
Preparers should be asking themselves:
- if and how their business has been impacted by a prolonged decrease in their share price and the impact on impairment testing;
- whether management’s projections are consistent with expectations in the current environment;
- how their business has been impacted by inflation;
- whether there are other financial challenges their customers may be facing, and the possible impacts on demand; and
- how the rising interest rate environment impacts discounts rates used in impairment testing and in fair value calculations more broadly.
Panelists mentioned several key issues to address.
Sequencing of impairment testing
Before testing goodwill for impairment, preparers need to test other assets in the following order:
1. the carrying amount of assets not in the scope of Topics 350 or 360 (e.g. working capital assets);
2. indefinite-lived intangible assets;
3. long-lived assets.
Impact of increased interest rates
Angela Newell (BDO) commented on the impact of rising interest rates on the fair value of certain assets when a discounted cash flow (DCF) analysis is used to determine that fair value. Because the Federal Reserve has increased interest rates this year, the risk-free rate that is used as an input in the DCF analysis will increase. The higher discount rate will translate into lower fair values.
Step 0 vs Step 1
A company’s financial reporting function should consider whether a ‘Step 0’ qualitative assessment of goodwill or indefinite-lived intangibles is appropriate given the current environment. Langlois pointed out that this is a matter of judgment based on a company’s facts and circumstances.
Given the current uncertainty presented by inflation, rising interest rates, depressed share prices and other factors, it may be difficult to qualitatively conclude that it is ‘more likely than not’ that the fair value of a reporting unit or indefinite-lived intangible asset exceeds its carrying amount. This is especially true as the length of time since the last quantitative test was performed increases, or if there was not significant headroom at the time.
Read more in KPMG Handbook, Impairment of nonfinancial assets.
Revenue recognition / receivables
Susan Mercier (Grant Thornton) and other panelists discussed how revenue recognition and accounting for receivables may be affected this filing season by current economic conditions. They spoke about several issues in particular that could have a financial reporting impact.
Inability of customers to pay
Mercier discussed the common example where a company may continue to sell goods or services to a customer and enter into new contracts while the customer is having trouble settling its existing and outstanding receivables for past orders.
Newell explained that typically in these situations a portion of the existing receivable is forgiven. This leads to a broader analysis of whether the forgiveness is a writeoff of bad debt or a price concession in a new contract, each of which results in different accounting treatment.
Read more in KPMG Handbook, Credit impairment.
Reassessment of revenue contracts
A company may have initially characterized a contract as a revenue contract under Topic 606 because it determined it was probable that it would collect substantially all of the expected consideration under the contract (a criterion for ‘passing Step 1’ under Topic 606). However, changing economic conditions may indicate that the ‘probable’ threshold can no longer be met, leading to the contract being recharacterized. In this situation, the recognition of any revenue would occur later than it otherwise would if Step 1 had been passed.
Read more in KPMG Handbook, Revenue recognition.
Newell pointed out that revenue contract modifications from changes in price or scope are common in the current environment.
Depending on the specific facts and circumstances, this could result in accounting prospectively for the modification as a separate contract, accounting for the change on a cumulative catch-up basis, or a mixture.
Read more in KPMG Handbook, Revenue recognition.
Langlois commented that noncash consideration, such as warrants, in a revenue contract require special attention and can result in significant income statement volatility.
Newell and Mercier discussed the issues and pitfalls to changing incentive-based compensation plans to adjust for lowered sales and financial projections. For example, if a company cancels awards, it may have to accelerate any unrecognized compensation cost at the cancellation date.
Mercier encouraged companies to develop a plan for a cancellation and reissuance, and fully analyze the accounting treatment before canceling an award, to avoid a surprise and often punitive outcome.
Read more in KPMG Handbook, Share-based payment.