Subsequent events and corona virus | China Accounting Blog | Paul Gillis

Subsequent events and corona virus

On Wednesday, the SEC said that it had asked accounting firms to keep an eye on the impact of the corona virus on audit quality, since it had caused personnel disruptions in China and Hong Kong. SEC Chairman Jay Clayton said in a joint statement with the PCAOB chairman: “How issuers plan and respond to events as they unfold can be material to an investment decision, and we urge issuers to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable.”

Because most US-listed Chinese companies have a calendar year end and because the impact of the virus is mostly in 2020, the important accounting question is what should be recorded or reported in the 2019 financial statements that will be released sometime in 2020.   

I believe the most important accounting guidance is found in reporting of subsequent events. There are two types of subsequent events. 

The first type consists of those events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and affect the estimates inherent in the process of preparing financial statements.  Type 1 events require the year-end financial statements to be adjusted to report the impact of the events, even when they partially occur after year end. 

The second type consists of those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date. These events should not result in adjustment of the financial statements. The events may be of such a nature that disclosure of them is required to keep the financial statements from being misleading. 

For example, companies sometimes face lawsuits.  Accounting rules say that a company must accrue for potential lawsuits based on the probability that a claim will be made and a loss will be incurred.  So, a company that is sued in December 2019 must accrue the expected loss in 2019.   The accrual is based on the best estimate of the loss (often 0).   So, if the company had recorded an estimated loss of $20 million as of December 31, 2019 what should it record if the lawsuit is settled for $30 million in March, 2020?  Because the lawsuit was known at December 31, 2019, the settlement in March is a type 1 subsequent event.  The $30 million settlement must be recorded in the December 31 financial statements resulting in a $10 million additional charge in 2019.  

However, if the lawsuit was unexpectedly filed in January 2020 and settled in March 2020, the settlement is not recorded on the financial statements as of December 31, 2019 but rather in March 2020 because it is a type 2 subsequent event.  The financial statements for December 31 would disclose that settlement if significant, but the amount recorded as of December 31 to settle the lawsuit would be determined on the best estimate of the claim and its probability of loss  (zero in this case since the company was unaware of the potential suit. This assumes financial statements are issued after March.

I believe that the virus is a type 1 subsequent event requiring it be reflected on the December 31 financial statements. On 31 December 2019, the Wuhan Municipal Health Corporation alerted China's CDC, who notified the World Health Organization. I expect some will argue that this is a type 2 event, since the virus was not widely known until 2020.  

The accounting implications of the corona virus will be significant.  Many companies will face adverse business results due to the shutdown of much of the economy.  Many companies may not survive, since they do not have the resources to weather this storm.  Accountants will need to determine whether they should issue going concern opinions, expressing their concern that the company may not survive. Going concern issues are typically resolved on subsidiaries of multinational companies through the issuance of a support letter from the parent company which assumes the parent has sufficient resources to survive the crisis. 

Even when there is no going concern issue because the company is adequately capitalized, the issue of whether to accrue corona virus related losses in 2019 or to report them in 2020 is important. There are two significant components to this:

Most companies will have done little business in January and February, 2020 first because of the normal Chinese New Year holiday and then because of mandatory closures related to the virus. Companies, however, are required to continue to pay employees. Should losses related to the virus be accrued as of December 31?  The event that caused the loss began in 2019.  By the time that financial statements are issued (April or later) the amount of loss can likely be determined. 

Secondly, each company must determine in the preparation of 2019 financial statements if any assets are impaired. Any impairment is recorded as an expense. Of particular concern will be intangible assets such as goodwill. Many Chinese companies have considerable goodwill on their balance sheet due to acquisitions. Goodwill is typically tested for impairment by looking at future cashflows from the related business. Those cash flows have been altered by the virus, and potentially significantly enough that goodwill must be impaired.  

I think it would be useful if accounting standard setters or the Emerging Issues Task Force would issue guidance as to the application of the subsequent event rules to the facts of the corona virus. 


Update:


PwC has decided the virus is a type 2 subsequent event, requiring disclosure but not recording in the 2019 accounts.  They appear to have reached this conclusion on the assumption that at December 31 we have inadequate evidence of person to person transmission and further evidence in 2020 provides no new information about the situation at December 31.  I am not sure that is accurate, given the notices to the WHO, but it will be a popular position. 

If a building caught fire on New Year's Eve in 2019 and the fire department was called before midnight, but the building mostly burned down after midnight, should it be written off in 2019 or in 2020?  I seriously doubt PwC would argue for 2020.





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