The coronavirus (“COVID-19”) pandemic has left the entire world in an unprecedented time of change. The uncertainties relating to the duration of the outbreak, disruptions in supply chain and clinical development, the reality of adjusting to digital health options, and the necessity of building patient confidence in a safe environment have had a significant impact on the healthcare & life sciences companies.
Additionally, COVID-19 has imposed a huge burden on the corporate ecosystem by affecting the wellness of employees and interrupting normal business operations. The effect on the overall economy and financial markets have created volatility and unforeseen challenges for many companies in the industry. As if that isn’t enough to keep leaders up at night, there are also several accounting considerations stemming from COVID-19 that will need to be analyzed during the remainder of the year.
Impairment of Long-lived Assets and Goodwill
Entities are required to perform impairment tests annually or when a triggering event has occurred. The COVID-19 outbreak has had a significant effect on the health and life science companies, potentially leading to many types of internal and external impairment triggers. A few key examples of triggers include:
- Significant decreases in the market value of assets;
- Decrease in the extent or manner the asset is being used (idle facility space previously utilized for elective surgeries or pharmaceutical R&D and reduced capacity due to ‘social distancing’ and fear of patient safety, to name a few);
- Current period operating loss coupled with a history of losses;
- Decrease in customer or patient demand;
- Supply disruptions leading to inability to meet demand; and
- Decreased selling prices and/or profit margins.
Unfortunately, a decline in market capitalization that is consistent with declines experienced by others within its industry is not a sufficient argument against the existence of a triggering event.
Property, plant and equipment can also be impacted by temporary or permanent closures, reduced operating hours, mandated reduced occupancy capacities, supply and demand disruptions, and various other challenges during this time. For some entities, only certain locations are affected while others have seen a more pervasive impact, so judgment will be required to identify the assets at risk, and to what extent grouping the assets for a test is appropriate. Impairment testing for these assets is sometimes based on internal business projections where underlying assumptions should be consistent with those used in other tests discussed above, if applicable, while other assets have the best indication of value by market observations such as appraisals or similar sales.
Inventory, Production and Purchase Commitments
Life sciences companies may have new considerations relating to inventory valuation due to COVID-19. Decreases in customer demand may lead to an increase in stock levels where obsolescence or slow-moving allowances will require renewed analysis. The price of raw materials and other inputs may have sudden and substantial decreases indicating that previous purchases at higher cost levels may be at risk of a write-down as well.
Conversely, other entities may be experiencing higher input costs for materials and inputs that are now in high demand due to changing demands in markets. As such, there are many accounting considerations as a result of this outbreak to ensure that inventory is recorded at the lower of cost or net realizable value that require more detailed discussions between accounting and operation departments within entities.
Manufacturers of medical devices, lab equipment, pharmaceuticals, etc. may be experiencing abnormal production patterns — some are experiencing idle facilities while others are running at higher rates than normal to meet higher demand for critical items. Entities should only capitalize overhead costs that are based on a ‘normal capacity’ assumption, which considers production over a period, including planned maintenance downtime. Entities experiencing unusually high inventory turnover rates should ensure any excess overhead is expensed as incurred and not capitalized into inventory. Changing the assumption of what ‘normal capacity’ is should be consistent with other business and accounting projections, such as those used in the goodwill and long-lived impairment analysis discussed above.
Leases
Under the historic lease guidance of ASC 840, capital leases are subject to ASC 360 impairment guidance discussed in the long-lived asset section above. Under the new lease guidance of ASC 842, right of use assets also generally follow the ASC 360 impairment guidance. Certain software products provide a convenient approach for determining right of use impairments while others require a manual work-around.
Some leases contain ‘force majeure’ clauses that call for changes in lease payments. These changes may lead to treatment of rent abatements as variable lease payments if the duration of the abatement is uncertain. If lease payments are revised in the absence of a ‘force majeure’ clause, then entities should follow lease modification accounting guidance.
Accounting for Income Taxes
Entities experiencing downturns in their business with significant deferred tax assets (“DTA”) recorded may need to reassess their valuation allowance. Business projections used for DTA analysis should be consistent with those used for other operational or accounting purposes (goodwill and long-lived asset impairment discussed above), so close communication of the financial model assumptions is important across management teams. ASC 740 requires entities to consider all currently available information for DTA valuation purposes (including data subsequent to the balance sheet period end).
Many jurisdictions have proposed or enacted changes in tax law to help provide relief to businesses and individuals during these challenging times. Rates used in the provision for income taxes though must be based on rates enacted during the reporting period, and not based on mere proposals or laws enacted subsequent to period end.
Health and life science leaders should be mindful of the classification of government relief to ensure any assistance is appropriately classified as income tax, other tax or a government grant.
Debt Covenant Violations and Waivers
Entities that violate their debt covenants within a reporting period should reclassify any outstanding long-term balance to a current liability. Entities can continue the long-term classification if a debt covenant violation waiver is received and valid for at least one year after the period end, and if the entity can conclude that it is not probable of violating the same or another covenant within one year of the period end balance sheet date.
Revenue Recognition
Under accounting guidance, a sales contract does not exist unless its collectability is probable. Healthcare providers may need to evaluate whether its current and new patients have lost access to insurance due to lay-offs or furloughs and do not have the ability to pay on their own. Similarly, life sciences companies will need to assess its customer base for collectability issues. When receipt of payment is in question at the time of or close to a transaction, revenue should not be recognized until all performance obligations have been fulfilled by the entity and the concern over collectability has been lifted, or the agreement is terminated, and any consideration received to date is nonrefundable.
Customers facing financial difficulties may seek concessions with pricing or discounts from prior balances. Such concessions should be treated as variable consideration and may have a significant impact on revenue recognition under current standards.
Ongoing Concern
Current accounting guidance requires management to evaluate whether there are conditions that raise substantial doubt about the entity’s ability to continue as an ongoing concern. The COVID-19 pandemic presents numerous potential indicators as discussed above, along with ongoing uncertainty of the general economic outlook coupled with individual entities’ financial position and liquidity. Management’s evaluation should consider all information available through the date the financial statements are to be issued, and not just as of the reporting period end balance sheet date.
The forward-looking period for this purpose is one year after the date the financial statements are to be issued or are ready to be issued. It is important to ensure that cash flow projections, closures, cost cutting measures, asset sales and other data points are consistent with the various analysis covered in the areas discussed above as these types of plans may trigger additional accounting considerations.
If negative conditions are identified, additional disclosures may be required, regardless of whether those conditions are mitigated by management’s analysis.
How Cherry Bekaert H&LS Experts Can Help You Navigate These Complexities
Cherry Bekaert and our leading professionals in healthcare and life sciences can help organizations navigate complex accounting issues brought on by COVID-19 and adapt to the constant changes. Please contact Chris Rux or Chase Wright to discuss these and related topics further.
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