Compliance in Focus: Financial Reporting in Times of Economic Crisis - Minimizing Risk in Accounting Judgments and Estimates

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June 18, 2020

As a result of the COVID-19 pandemic, U.S. public companies face significantly increased challenges, and legal risks, relating to their accounting and financial reporting. This is especially so in the realm of judgment and estimates, which are used in a wide variety of important accounting areas – e.g., valuation of assets, recognition of revenue and losses, and setting of reserves for losses and expenses – but which are notoriously difficult to make in the face of great uncertainty.

Sagar Teotia, Chief Accountant of the U.S. Securities and Exchange Commission, has acknowledged the difficulties in navigating complex accounting issues during the current economic crisis, but has also made clear that “[during] these challenging times, investors and other stakeholders need high-quality financial information more than ever.” Steven Peikin, Co-Director of the SEC’s Division of Enforcement, recently stated the issue more pointedly: “Previous economic downturns proved that stresses on the financial conditions of issuers may raise the risk to investors from financial statement and issuer disclosure frauds.”

Enforcement actions over the past decade by both the SEC and the U.S. Department of Justice have demonstrated that management’s exercise of judgment in an environment of uncertainty is no defense to charges if a judgment or an estimate is based on insufficient evidence or clearly unreasonable assumptions or methodologies. Management of public companies and recognized “gatekeepers” – particularly audit committees and independent auditors – need to pay particular attention to accounting judgments and estimates during these difficult times and take steps to avoid the issues that have led to SEC and criminal charges in the recent past.

Practical Lessons for Management and Audit Committees

Management should take proactive and diligent steps to ensure – and to document – that its judgments and estimates are based on reasonable methodologies, data and assumptions. For example, management should:

  • employ methodologies and criteria that are widely accepted by financial and accounting professionals for the financial metric in question and utilized by other companies in the same industry under similar circumstances;
  • ensure that projections of future business results are based on the best available current business and economic information and reasonable (and typically conservative) future-looking assumptions; 
  • when relying on an appraisal or other outside report, ensure that the report is current and meets the company’s internal criteria for reliability; and
  • maintain clear and accessible documentation reflecting these steps and all other pertinent information supporting the judgment or estimate.

Audit committees should, as part of their financial reporting oversight responsibilities:

  • ensure that management sets an appropriate “tone at the top”;
  • ensure that management maintains robust internal controls over financial reporting, including controls around judgments and estimates such as those recommended above;
  • ensure that the auditors are provided with all of the information and records they seek and are given access to all management and other company personnel with whom they wish to communicate;
  • ensure that the auditors are free to fully test and scrutinize management judgments and estimates, including the underlying methodology, data and assumptions; and
  • maintain open lines of communication, and full and frank discussion, between the auditors and the audit committee.

We explore these issues in depth in a broader article published by the NYU Compliance & Enforcement blog, which can be found here.