Financial Reporting in Uncertain Times for Local Governments
While the health and safety of employees, constituents, and customers is the main priority during the novel coronavirus (“COVID-19”) pandemic, financial reporting can help provide transparency and consistency in these uncertain times. Today’s ever-changing environment will have a significant impact on governmental financial statements and many local governments may encounter financial reporting effects of this pandemic that are not normally dealt with. The Governmental Accounting Standards Board (“GASB”) has created an Emergency Toolbox to provide a quick reference to authoritative guidance to address some of these challenges and we will highlight some of these technical topics.
It is important to remember the basics to ensure that the receipt of new revenues such as the Cares Act funding is recorded in the proper period. GASB states that revenues are recognized in the fund financial statements in the accounting period in which they become susceptible to accrual— that is, when they become both measurable and available to finance expenditures of the fiscal period.
Fair Value Measurement
Fair value is an estimated exit price at which an asset is sold or a liability is transferred between market participants at the financial reporting date in current market conditions. Since fair value is market-based, rather than an entity specific measurement, the impact of COVID-19 on fair value will depend on the severity of the pandemic and the volatility in financial markets at the financial reporting date. Although valuation techniques should be consistent between periods, a change in historical techniques may be appropriate in these uncertain times. Valuation techniques should be based on the market approach, the cost approach, or the income approach and should maximize the use of observable inputs while minimizing the use of unobservable inputs. When preparing financial statements, fair value disclosures should include the assessments and judgements made by the preparer that could influence the decisions of the users of the financial statements. These can include whether or not the pandemic is being considered in evaluation of fair market value, the basis for selecting assumptions and inputs used, and the related sensitivities at the reporting date.
Social distancing guidelines and quarantine measures put into place to stop the spread of COVID-19 have caused economic threats such as office closures, reductions in services, and construction delays or stoppage, all of which could be considered an impairment indicator. A capital asset is considered impaired when its service utility has declined significantly and the event driving the decline in service utility is outside the normal lifecycle of the asset. The question is whether the impairment is permanent or temporary. Social distancing guidelines and quarantine measures may start to relax as governments enter into a phased recovery, but the new normal may not be the same as it was prior to the pandemic. The more the current environment is uncertain, the more important it is for the preparer of financial statements to provide detailed disclosure of the assumptions taken, the evidence on which those assumptions are based, and the impact of any changes in key assumptions.
Local governments affected by the COVID-19 outbreak may experience cash flow challenges as a result of disrupted operations, higher operating costs, or lost revenues. They may need to obtain additional financing, amend the terms of debt agreements, or obtain waivers if they no longer satisfy debt covenants. In such cases, management will need to consider whether any changes to existing contractual arrangements represent a substantial modification or potentially a contract extinguishment.
Additionally, if localities are unable to get a waiver for debt covenants, prior to any default, preparers of financial statements should consider how a potential breach of covenants could affect the timing of repayment and how it affects the classification of the debt in the financial statements. If a breach occurs on or before year end, and the breach allows the lender to demand repayment within 12 months, the liability would be classified as current. If a breach occurs after year end, it should be disclosed in the financial statements, but financial statements would not typically be adjusted. In either case, a breach of covenants could also affect the government’s ability to continue as a going concern and information about any actions taken by the government to address the breach during the year or subsequent to yearend should be disclosed to provide a better understanding of the impact of the breach on the government.
Revenue and Expense Recognition
Certain budgetary relief efforts government entities have implemented in response to cash flow challenges, such as delaying payments or accelerating future revenues, will not have the same impact on the accrual or the modified-accrual financial statements, as those expenses have already incurred and accelerated revenues might not have been earned.
Some entities might also consider selling receivables or future revenues to help cash flows or to repay debt. The valuation of those receivables and any corresponding allowance for doubtful accounts may need to be scrutinized more than normal. Historical client payment behaviors might not represent today’s uncertain times with businesses dealing with lost revenue, disrupted supply chains, and significant volatility in financial markets. When assessing the collectability of accounts receivable, management may want to consider credit risk characteristics including customer’s industry and location (particularly how COVID-19 has impacted that industry and location), the customer’s past-due status, and other relevant factors.
Prepares of financial statements are required to evaluate whether there is substantial doubt that their entity can continue as a going concern for at least the next 12 months from the date of auditors report included in the financial statements. Circumstances that may indicate a substantial doubt that a government may not be able to continue as a going concern include negative trends, financial difficulties, internal matters, and external matters. In light of the current crisis, some governments might experience financial difficulties (default on financing agreements, restructuring of debt or new methods of financing, or sale of assets), as well as internal matters (labor difficulties or union contracts) and external matters (sustainability of key programs, loss of key taxpayer or customers). The potential for a substantial doubt about an entity’s ability to continue as a going concern will vary significantly depending on the severity of the outbreak and the circumstances for each government. Depending on how the pandemic and economy look when financial statements are prepared, there likely will be a need to disclose the impact of the pandemic on the government entity and the judgements made in preparing those financial statements. Those disclosures might also be referenced in an Emphasis of Matter paragraph the auditors reports.
GASB Statement No. 95, Postponement of the Effective Dates of Certain Authoritative Guidance
The GASB issued Statement No. 95 Postponement of the effective dates of Certain Authoritative Guidance in May 2020 to provide temporary relief to governments during this pandemic by postponing the effective dates of other GASB Statements that originally were effective for periods beginning as early as June 30, 2018. The most significant impact is delaying of Statement No. 84 Fiduciary Activities by one year and Statement No. 87 Leases by 18 months.
We will continue to monitor developments and share updates related to financial reporting in these uncertain times. If you have further questions, please contact us.