23-5, Accounting and Financial Reporting in Uncertain Times: Considerations for Navigating Macroeconomic and Geopolitical Challenges (September 15, 2023)

While each factor on its own poses challenges in the application of accounting standards, the convergence of these factors significantly increases the level of complexity involved and, therefore, the amount of effort needed to develop significant accounting estimates, such as the valuation of receivables, inventory, investments, property and equipment, leased assets, goodwill, and intangibles. In addition to the many potential impacts on accounting estimates, the factors can also have more direct accounting implications. For example, as interest rates rise, debt covenant violations may increase, which could call for an evaluation of debt classification and going concern considerations, among others. Furthermore, given the current environment, companies may also need to reevaluate their foreign currency exposures, the effectiveness of hedging relationships, and — while generally considered rare — the potential need to change a foreign entity’s functional currency as a result of significant changes in economic facts and circumstances.

In light of the changing macroeconomic and geopolitical environments, companies should also be mindful of the considerations below related to risk assessment, internal controls, and SEC disclosures.

At the highest level, addressing this changing environment means revisiting risk assessments to ensure that management has identified new risks or changes in existing risks, including fraud risks, that are affecting the company. For example, management might consider the following:

• If management mitigated its exposure to foreign currency fluctuations by denominating more of its transactions in a particular currency, has it unwittingly changed the functional currency of the related business? Alternatively, if management mitigated its foreign currency exposure by expanding its hedging program, has it adequately considered counterparty risk, especially given the concerns about the banking sector?
• If management changed or diversified its suppliers in response to supply chain constraints or geopolitical concerns, has this supplier change increased the company’s exposure to foreign currency fluctuations and, if so, is that appropriately disclosed in the company’s financial statements and SEC filings?
• Which of the current macroeconomic and geopolitical factors, or combination of factors, affect the overall risk of fraud either at an entity level or with respect to specific risks within the entity’s existing accounting and reporting structure?

In addition, organizations that use or are considering using generative artificial intelligence (GenAI) in accounting and financial reporting should carefully consider the potential risks associated with this technology. GenAI models can be biased and inaccurate, and they may not be able to capture all the nuances of the current business environment. Therefore, organizations may need to revise their processes and controls to mitigate these risks.

While many of the changes outlined above are one-off occurrences, others have a clear recurring impact. For instance, when the inflation rate was lower, companies may have been successful in passing on minor cost increases to their customers so that cost changes may not have had a substantial impact on margins. However, customers may now be more resistant to price increases and therefore companies may face difficulties in passing on significant cost increases to their customers. Pressure to increase margins may instead lead companies to explore cost-saving initiatives such as layoffs and restructuring activities, which can create new accounting, reporting, and fraud risks.

A common example of changing the frequency of when a control is performed is an interim goodwill impairment analysis in response to a triggering event. However, there are other circumstances in which the frequency of a control may need to be changed, even if it is not called for by accounting standards. For example, if an entity is experiencing significant cost increases, management should consider whether to only update the standard cost of inventory annually or to do it on a more frequent basis. If management instead relies on its process for capitalizing variances, it should assess whether (1) that process adequately considers the fact that some costs are relatively stable while others continue to undergo significant change and (2) the analysis should be disaggregated by product line, cost type, or other unit to ensure a reasonable allocation.

Beyond the design of a control, it is also important to think about how controls operate in a changing environment. Processes such as developing a forecast for use in an impairment analysis and reviewing that forecast may need to be modified when many of the factors discussed above come together. For example, a global entity may encounter very different economic circumstances in different geographies, with some countries experiencing deflation and others experiencing significant inflation. The company’s consideration of inflation will necessarily be affected by the degree of inflation in the geographies in which the company operates, and a one-size-fits-all approach will not fit every company. In addition, since interest rate changes will affect the weighted-average cost of capital used in a discounted cash flow analysis, management should consider whether tightening credit has had an impact on debt-to-equity ratios. Even if a company is projecting solid profitable growth, its ability to grow could be challenged by labor availability in a tight labor market.

Management should consider the above factors, among others, in the preparation and review of forecasts and should challenge whether historical results and relationships continue to be indicative of future projected results. It should also consider potential fraud risks and schemes related to pressures resulting from interest rate changes, since such pressures could affect the company’s forecasts and ability to meet targets for key performance indicators.

The MD&A section of an SEC registrant’s filing supplements the financial statements by providing information about the registrant’s financial condition, results of operations, liquidity, and critical accounting estimates, including:

• Material quantitative and qualitative impacts on the registrant’s historical results of operations, financial condition, and liquidity.
• Material known trends, events, or uncertainties that have had or are reasonably likely to have a material impact on the registrant’s financial condition, results of operations, or liquidity. Such disclosures can give investors an “early warning” about risks such as (1) when and under what conditions charges may be incurred in the future and the potential magnitude of such charges, (2) when revenue growth or profit margins may not be sustainable because of underlying economic conditions, or (3) when the registrant may be unable to comply with debt covenants or may have other liquidity issues.
• Material impacts on liquidity, including a discussion of a registrant’s working capital or other cash flow needs, anticipated changes in the amount and timing of cash generated from operations, the availability of other sources of cash along with potential limitations associated with accessing such sources, and the possible ramifications of the registrant’s inability to meet their short- or long-term liquidity needs.
• Material critical accounting estimates, which may include early-warning disclosures to highlight the uncertainty associated with material estimates including (1) the key assumptions used in the registrant’s most significant estimates and (2) the sensitivity of such estimates to changes that could reasonably occur as events continue to develop.

The SEC also expects registrants to continually evaluate whether they need to update their risk factor disclosures and to explain their disclosures about key assumptions used in significant estimates and the sensitivity of such assumptions. Registrants may need to scrutinize their disclosure of risk factors, results of operations, liquidity and capital resources, and critical accounting policies to ensure that such disclosures reflect the challenges the company may face in the current macroeconomic and geopolitical environment.

In summary, a registrant should discuss in its MD&A all relevant material quantitative and qualitative impacts of the current environment on its business. MD&A disclosures are typically included in a Form 10-K or Form 10-Q; however, because of the rapidly evolving current environment, registrants sometimes may also file current reports on Form 8-K to update investors on the current and potential future impact of such events on their business.