Six Theses on the Impact of COVID-19 on Financial Accounting and Auditing

COVID-19 is already having an economic impact on companies – from additional limits on production to trade and travel restrictions. The economic effects of the Coronavirus have additional consequences for accounting and for the auditing of the financial statements and management reports of affected corporations. Prof. Dr. Jürgen Ernstberger, Full Professor for Financial Accounting at the TUM School of Management, is currently giving two seminars on the effects of COVID-19 on financial accounting and auditing. The following six theses highlight some of the (potential) effects.

We won’t see reliable information on the Coronavirus impact before the quarterly reports Q1.

The consequences of the pandemic are not yet reflected in the financial statements for the fiscal year 2019, which are currently being issued. Financial statements are strictly based on the balance sheet date and events/information up to the balance sheet date. As of December 31, 2019 (which is the balance sheet date for most companies), there were no major effects of the pandemic. Only the so-called supplementary report briefly discusses effects. The pandemic, therefore, shows the importance of frequent interim reporting, e.g. quarterly financial reports, for the timely reporting of new developments. In these reports, companies have to disclose for the first time reliable and comprehensive figures on the (short-term) effects of Corona on the financial situation. Prior to the pandemic, quarterly financial reports have been heavily debated, because interim disclosure of financial figures may foster myopic management incentives.

Some firms refrain from forecasts, which is not a good idea.

At the current analysts’ conferences, companies are transparent when it comes to the current financial situation. Important factors are liquidity (“cash is king”), access to credit lines, and a solid equity ratio. The situation is different when it comes to forecasts. Many companies refrain from issuing quantitative forecasts or even any forecasts. Others at least address different potential pandemic scenarios. Shareholders and stakeholders are of course aware that a “reliable” estimate is impossible and that it is even harder to determine probabilities for different scenarios. Nevertheless, investors expect transparent communication on how the management believes things could go on. Even though companies are currently not required to publish quantitative forecasts, prior research shows that silence is usually interpreted negatively.

The pandemic will spur the digitalization in auditing and trigger modified audit opinions.

The annual financial audit of financial statements by the statutory auditor is more difficult during the current pandemic. For the first time, auditors could not conduct on site reviews and remote audits require external access to the companies’ ERP systems. The Corona crisis will certainly accelerate the current efforts to digitalize the audit process. Here, all accounting records could be examined using intelligent algorithms to detect conspicuous patterns that indicate errors or even fraud. During the pandemic, auditors must take a closer look at whether the company can continue its operations (without insolvency) for at least 12 months. If not, the auditor has to provide a (modified) going concern opinion. A modified opinion is also necessary if there are obstacles to the audit because evidence could not be obtained to a sufficient extent (e.g., due to travel restrictions).

Profit warnings are rampant but do not provoke negative market reactions.

According to a study by EY, the number of profit warnings from listed companies in Germany more than doubled during the first quarter 2020 compared to first quarter 2019. According to the study, a total of 77 profit or revenue warnings were issued in the first quarter of 2020, whereby 80 percent explicitly refer to COVID-19. Meaning that management had to admit that it was no longer able to meet the previously made forecasts due to the pandemic. It is interesting to note, however, that the share price reaction to the profit warnings was only moderately negative (on average approx. -3 percent). This is probably due to the fact, that in the current highly volatile market, company-specific news is taking a back seat and negative expectations have already been factored in. It is obvious to investors that, with a few exceptions (e.g. producers of medical equipment or e-commerce firms), all companies are more or less negatively affected by Corona.

Virtual annual general meetings are controversial but they are here to stay.

On site annual general meetings, i.e. a discussion of the Management Board and Supervisory Board with all shareholders, are currently not possible. While 9 DAX30 companies postponed their general meetings later and two have already held them before the lockdown, 19 announced an online general meeting. The virtual general meetings were made possible by an emergency act of the German government. Under the law, it is also possible for management boards to order that questions from shareholders must be submitted at least two days in advance. These are then answered in a live stream, whereby the Management Board also decides how to answer which questions. This means that direct confrontation through shareholder speeches is no longer possible. However, virtual shareholder meetings also provide the opportunity to involve more shareholders who would otherwise have found the journey too expensive.

The Coronavirus could make financial statements implode.

The consequences of the Corona pandemic for future financial statements could be dramatic. Some experts have repeatedly warned that some financial statements are ticking time bombs. They could now implode in the crisis. What many do not know: financial statements according to the International Financial Reporting Standards (IFRS), which are applied by virtually all listed firms in Europe and many other jurisdictions, are strongly influenced by future expectations compared to historic cost. One example is goodwill: It arises as a mere residual difference in business combinations and is based on positive expectations about future synergies from a business combination. In the DAX30 alone, these are reported as assets tantamount to approx. 317 billion euros. Now, if expectations are heavily revised, or more precisely reduced, this could lead to high losses because of goodwill impairments. The same applies to multiple other items, like financial instruments measured at market, i.e. fair, values. Additionally, this effect could be exacerbated by strategic earnings management of firms. Research shows that managers use crises to strategically “tidy up” their statement of financial position. Managers increase write-downs and blame it on the crisis. Although a large part might be due earlier mismanagement. This so-called big-bath accounting enables them to report higher profits (or lower losses) in the near future at the expense of higher losses right now. Overall, we might see dramatic losses in future annual reports but only a part of them are due to the Corona pandemic.

Prof. Dr. Jürgen Ernstberger’s research interests include financial accounting, auditing, corporate social responsibility and corporate governance. He explores the effects of financial reporting on business decisions, current developments in auditing, and sustainability and corporate social responsibility reporting.  In 2014, he was appointed Full Professor of Financial Accounting at the TUM School of Management.

Prof. Jürgen Ernstberger

The post Six Theses on the Impact of COVID-19 on Financial Accounting and Auditing appeared first on Technical University of Munich – School of Management.