Accounting in Times of the Pandemic – Financial Reporting and Regulatory Issues

Accounting in Times of the Pandemic –  Financial Reporting and Regulatory Issues

Accounting is critical for corporate transparency in such times of high uncertainty. Investors, politicians, and society at large are in need of trustworthy information. At the same time, numerous actors take part in producing, distributing, and processing accounting information: from the bookkeeper who enters transactions, via corporate accountants and managers deciding about reporting policies, to financial auditors checking the financial reports, and public regulators setting the accounting rules. The number of actors involved is mirrored by the number of functions that accounting information fulfills. They inform investors on the capital market, serve to evaluate the performance of corporate management, are used to calculate taxes, etc. It is hence not surprising that events as important as the coronavirus (COVID‑19) pandemic affect such a complex system. These effects play out on different levels, impacting individual firms, regulators overseeing them, and governments taking important policy decisions.

Practical difficulties

The coronavirus pandemic creates a complex situation affecting financial markets and virtually all industries in a way that was unimaginable by accounting standard setters. This creates various pressing problems. First of all, going concern becomes an issue for an increasing number of firms: in a time of uncertainty, it is hard for companies to forecast going concern for at least 12 months. Second, assets and liabilities measurement becomes more difficult. How does one account, e.g., for petroleum on stock when oil prices turn negative? Another issue is how to deal with rent concessions that are negotiated by parties of lease contracts in an economic situation that puts many firms in danger of not being able to fulfill their payments. The large accounting firms are obviously pools of expertise and are devoting considerable resources to providing guidance to their clients. At the same time, standard setters and regulators are working on delivering temporary simplification for complex issues.

Earnings management incentives

Firms will also face substantial incentives to engage in creative accounting in order to camouflage their true economic situation. On the one hand, many firms will be tempted to try sitting out the crisis and waiting too long before writing off troubled assets in the hope that the situation recovers before the next balance sheet date. On the other hand, governments worldwide are going to hand out unprecedented amounts of money in the form of stimulus packages. Firms will want to position themselves as potential recipients of that money, and financial reports will be affected. Prior evidence suggests that firms attempt to lower their reported profits when seeking government aid from foreign competition or, on the other hand, avoid regulatory attention. Given the magnitude of the expected economic downturn, further diminishing reported profits may not be the most likely accounting outcome. Under such circumstances, firms may rather be tempted to understate the extent of their difficulties in order to convince the government that they are worthy recipients of public money.

Regulatory Issues

Regulatory bodies overseeing corporate financial reporting typically aim to make accounting reports reflect a true and fair view of the economics of the reporting firm. In order to protect creditors, a conservative bias is sometimes considered desirable as an overstatement of the firm’s situation is seen as more harmful than an understatement. However, particularly during economic crises, governments sometimes conclude that a conservative approach to reporting an already dire situation may be too much. A prudent valuation of firms’ assets may imply that total assets are valued lower than total liabilities – forcing the firm into bankruptcy. While accounting decisions do not change a firm’s fundamentals, temporarily overvaluing assets may buy the firm some time. Empirical evidence shows that regulators have repeatedly turned a blind eye on such behavior or even encouraged it. One study finds that the US Securities and Exchange Commission (SEC) imposes fewer enforcement actions on firms in states exhibiting high unemployment – interestingly in particular during election years and if a state’s senator sits on the SEC’s oversight committee. In Japan, the Ministry of Finance simultaneously introduced new rules on accounting or deferred tax assets and allowed their inclusion in regulatory capital during the financial crisis of the late 1990s – in effect allowing banks to meet regulatory capital thresholds when other sources were depleted. Finally, in the European Union, politicians successfully pressured the IASB, the global accounting standard setter (a non-EU body whose standards applied in many countries all over the globe) into changing the rules of reclassification of financial instruments in reaction to the 2008 financial crisis. As such, accounting regulation is the product of market and political forces.

Conclusion

The current coronavirus pandemic is undoubtedly a massive challenge for our society. It remains to be seen whether the regulatory environment provides the necessary resilience against some of the adverse effects, and which accounting systems offer the needed flexibility in these uncertain times. Principles-based accounting standards, for example, may lead to different and more adaptable outcomes relative to rule-based standards. It is also not clear whether the pandemic will have permanent effects on firms’ financial statements. For research, this creates an exciting opportunity to contribute to our understanding of how the pandemic affects the various actors in our economy and how it changes the world of accounting as we know it today.

Roland KönigsgruberRoland Königsgruber, Professor of Finance and Accounting, FAIRR Research Centre, SKEMA Business School - University Côte d'Azur, France

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Benedikt FrankeBenedikt Franke, Professor of Finance and Accounting, FAIRR Research Centre, SKEMA Business School - University Côte d'Azur, France

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Marco GhittiMarco Ghitti, Professor of Finance and Accounting, FAIRR Research Centre, SKEMA Business School - University Côte d'Azur, France

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