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June 17, 2020 09:00 AM

Commentary: COVID-19 demands investors read financial statements very carefully

Julie Bell Lindsay and Sandra Peters
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    Julie Bell Lindsay and Sandra Peters
    Julie Bell Lindsay and Sandra Peters

    The first quarter of the public company reporting season gave investors a glimpse of COVID-19's economic impact on company performance. As investors prepare for the second-quarter reporting season to begin in July, one thing that's certain is that there's a lot of uncertainty.

    Public companies, auditors, regulators and investors are confronting how they must manage, report and assess an array of complex assumptions and judgments during an unprecedented global emergency. In this environment, effective corporate financial reporting can help investors make well-informed, confident investment decisions.

    As representatives of the investment and auditing professions, here are five things we think investors should keep in mind when evaluating financial information provided by public companies.

    Past performance will not be future performance

    Past performance has never been a guarantee of future performance. That statement is even more true during an economic crisis impacting a wide array of sectors and industries.

    COVID-19 has reshuffled the deck. Companies providing essential services may flourish, those representing discretionary spending may struggle, and some companies on the brink of bankruptcy may even use the crisis to restructure and come out of the crisis stronger than ever.

    Just because a company performed well in the most recent quarter doesn't mean it will in the remaining quarters in 2020, or even possibly in 2021. No one knows over what period the economic recovery will emerge.

    Balance short-term solvency with long-term prospects

    In recent weeks, we have seen going-concern disclosures emerging from high-profile companies such as Norwegian Cruise Line, and we have also seen Chapter 11 bankruptcy filings from high-profile clothing retailers such as J. Crew and Neiman Marcus. These disclosures and filings may continue to worsen as the effects of the pandemic continue.

    Company going-concern disclosures should not be surprising. Because of the current environment, companies are laser-focused on balancing immediate cash needs with expected cash inflows. These analyses involve assumptions and judgments which, when combined with longer-term analyses required in, for example, goodwill impairment tests, necessitate management applying assumptions and judgments in a very uncertain environment. When management concludes there is a substantial doubt that the company can continue as a going concern, the company is required to disclose this.

    Auditors, in evaluating whether the financial statements are presented in conformity with generally accepted accounting principles, will assess management's going-concern evaluation. In addition to considering management's evaluation, auditors are also required to assess whether the company can continue as a going concern using their own judgments and, if applicable, include them in the auditor's report if there is substantial doubt.

    Obviously, company disclosures about solvency are extremely important in this environment. Investors should consider what they can glean from these disclosures, not only about asset impairments, including goodwill, but the level of company fixed vs. variable costs. The latter is especially important to assess a company's ability to bridge over the next 18-plus months toward projections of, hopefully, a more normal future.

    Focus on future performance

    Without a crystal ball, predicting future performance and evaluating forward-looking forecasts will remain a challenge for everyone in the financial reporting ecosystem. With this uncertainty in mind, the Securities and Exchange Commission recently said it does not expect to second-guess good-faith attempts by public companies to provide forward-looking information, and it reiterated a long-standing position of not objecting to company well-reasoned judgments and estimates. Arguably, the same should apply to the auditors' exercise of judgment, so long as it is made in good faith and sound application of auditing standards.

    Investors should seek to balance the fact that accurate estimates are difficult during times of uncertainty with the fact that they're the best estimates management and the auditor have at this time.

    This economic crisis continues to evolve

    This is not the first economic crisis investors have faced in recent history. Similar to previous crises, we will learn more about the economic impact of COVID-19 on public companies as time passes.

    In fact, we're at only the early stages of assessing the impact. The conclusion of the March 31 financial reporting period reflected only a few weeks of COVID-19's financial impact and management's estimates of its future performance at such time.

    The financial reporting period ending June 30 will provide investors with additional information on the economic impact companies are experiencing, from a historical and updated future perspective. It will almost certainly bring about more questions as well. In these times of uncertainty, fundamental analysis is essential but possibly impossible.

    Professional skepticism is critical

    The uncertainty brought by COVID-19 may compel investors to continue to seek additional information on public companies' current financial performance and longer-term value, beyond traditional financial reporting. To meet this need, public companies may release additional information outside of audited or auditor-reviewed SEC filings to provide additional context around their financial statements. This includes information on ESG practices to highlight their company's social commitment and response to COVID-19, especially employee health and work environments.

    Investors should carefully consider whether the company-prepared information they are using for decision-making has been independently evaluated by an auditor. In many instances, the information will be outside the traditional realm of auditor responsibility.

    As knowledgeable investors recognize, this is a challenging time for even the best-managed companies. The difficulties experienced to date in financial reporting will likely continue during the remainder of the year as we learn more about the economic impact of the pandemic. Investors should be thoughtful about the mix of information they are relying on to make decisions, including the assumptions and judgments going into that information and the level of auditor involvement.

    Notwithstanding these challenges, investors should have confidence that the financial reporting ecosystem of public companies, auditors and regulators is designed to equip them with the information needed to make sound investment decisions. Those decisions will play an essential role in our economic recovery.

    Julie Bell Lindsay is the executive director of the Center for Audit Quality and Sandra Peters is head of financial reporting policy for the CFA Institute. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.

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