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Forecasting in Q4: There Is No One-Size-Fits-All

Deloitte's Eric Knachel explains how to address forecasting challenges, COVID-19-related adjustments, remote work, and more.

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FEI Daily spoke with Eric Knachel, senior consultation partner in the Professional Practice Group at Deloitte & Touche LLP. Knachel leads Deloitte’s revenue recognition subject-matter team and provides guidance to audit practitioners and companies on complex financial accounting and reporting issues involving revenue recognition. We asked him about how to address forecasting challenges, COVID-19-related adjustments, and remote work.

FEI Daily: What issue do you regard as most challenging for companies as they close the 4th quarter?

Eric Knachel: Forecasting continues to be the single most challenging area for most companies in the COVID-19 environment. In fact, during a survey we conducted in October on accounting and financial reporting issues, nearly one-half – 47% – of more than 9,500 respondents polled said forecasting will be the biggest accounting and reporting challenge in the fourth quarter and beyond.

For many of the companies that have been negatively affected by COVID-19, we’ve observed them developing forecasts that use pre-COVID-19 results as an initial target – and then after that point, the resumption of “normal growth” assumptions. 

While that may seem logical, companies should be asking themselves whether achieving pre-COVID-19 results in the near term is reasonable, or whether they are facing a “new normal” likelihood that the existing economic environment continues. Or, alternatively, has there been a permanent shift in their business models?

It is also worth noting some companies have leveraged historical data from the 2008–2009 financial crisis as a benchmark to project their recovery.

Companies should exercise caution in determining the extent to which the financial crisis is comparable to the current environment given the fundamental differences between the two economic periods. For example, the current economic environment presents issues around supply chain disruption, change in customer behavior, workforce adjustments, and industry-specific impacts, which were not necessarily present during the last financial crisis.

The bottom-line: there is no one-size-fits-all approach to addressing the forecasting challenges that exist currently and companies should be deliberate and strategic in their approach.

FEI Daily: Non-GAAP metrics remain a topic of interest. Are you seeing an increase in COVID-19-related adjustments and what are the driving factors to include or not include non-GAAP COVID-19-related adjustments?

Knachel: Before addressing specifics around non-GAAP trends, it’s important to take a step back and consider the context around non-GAAP information, which is to communicate and provide information to shareholders. And communication with shareholders in the current environment is neatly summarized in one word – transparency! 

In the last 2 quarters, we observed an increasing number of companies providing non-GAAP metrics that included COVID-19-related adjustments. However, notwithstanding this trend, we are aware of some companies that chose not to provide non-GAAP metrics either because of concerns regarding (1) judgments related to which COVID-19-related costs were in fact “unusual or incremental,” or (2) concerns about creating potential negative comparisons in future periods to the extent that certain COVID-19 related costs become part of the company’s future cost structure. Still, in other instances, companies determined that their potential COVID-19-related non-GAAP adjustments were immaterial.

It’s worth noting, however, that in a number of instances in which non-GAAP metrics were not used, we did see companies provide a description of COVID-related costs or transactions. When we did see COVID-related non-GAAP adjustments, many of them were related to activities that are often included in more typical non-GAAP metrics, such as impairments or restructurings, but those activities were described as being caused by or related to COVID-19.

To a lesser degree, we also observed COVID-19-related adjustments that were described as incremental employee compensation or benefits, and incremental expenses associated with cleaning, sanitation or similar types of costs.

So, as we progress in this reporting quarter, and companies now have the benefit of seeing whether competitors did or did not provide non-GAAP metrics, it will be interesting to see to what extent non-GAAP metrics are used. 

FEI Daily: With so many companies still having a significant portion of their workforce working remotely, has this given rise to new or increased concerns around internal controls?

Knachel: In a word, yes – concerns are higher now since working remotely has a direct impact on internal controls.

Throughout the onset of COVID-19 and shutdown orders, regulators have been emphasizing that the requirement for an effective system of internal controls has not changed. Simply put do not lose sight of what is required versus what might become “normal” or what others might be doing. Just because others may be doing something, and it might be considered “common” under the circumstances doesn’t mean it’s compliant with the requirements for effective internal controls. 

Here’s the big picture for internal controls. Consider all the changes undertaken since COVID-19, such as working remotely, and how a company may have changed the way it operates. Now think about some of the areas that could create issues as they relate to a company’s internal controls in the current environment. For example,

Are there manual controls?

Are there controls that were designed to operate through in-person meetings?

There are three areas receiving a lot of attention right now as it relates to internal controls.

First is physical inventory counts. Many companies have restricted or limited access to their facilities, with approaches varying based on the nature of inventory and the regulatory environment. A question that comes up with some level of frequency right now is the use of video technology, which has met some skepticism with U.S. regulators but has been better received in other markets, and this makes coordination with advisors critical to ensuring everyone is on the same page.

The second area is segregation of duties. Job responsibilities in many companies have shifted as a result of furloughs, terminations, or changes in processes themselves. As such, its important companies have a systematic process in place to monitor changing duties so nothing falls between the cracks. In many instances the internal control process that existed in February/early March, may no longer align to today’s roles and responsibilities. Companies need to ensure that they are evaluating the design of controls in this new environment.

Finally, we have cybersecurity. For many organizations, the number of people working remotely now is huge compared to past practices. Simultaneously, we are seeing the volume of cyber attempts increase because remote operations create more opportunities for bad actors. We have seen situations in which someone gains access to an employee’s account in order to give a colleague fraudulent instructions, such as transferring funds. Given that the primary source of communication is most often e-mail, the environment simply presents more opportunity when people can’t just walk down the hall and say, “this seems unusual.”

Again, bottom line: with all the challenges, companies need to stay focused on internal controls.

FEI Daily: I’ve heard many companies have modified different contractual arrangements. Is this consistent with what you have seen and if so, what are some of the common or trending types of modifications you are seeing?  

Knachel: I’m not surprised by what you’ve heard. Contract modifications of all sorts of arrangements have been common. In recent months, we have seen an increased level of activity related to stock compensation plans and awards. In many instances the ongoing impact of COVID-19 has made previously established performance targets largely unattainable. And so, we have seen some companies modify awards to revise performance targets. Others have modified the strike price of stock options and extended the exercise period for awards.

Regardless of the specific action taken, modifications of stock awards can lead to a host of accounting challenges and consequences. For example, when revising performance targets, companies need to be mindful that the performance conditions are sufficiently objective and determinable; otherwise, an award may not be considered “granted,” leading to variable and potentially increased expense to be recorded.

FEI Daily: Anything else you would like to emphasize as companies progress in their year-end closing cycle?

Knachel: I would emphasize the need for robust disclosures. While disclosures are always important, the uncertainty surrounding the economic landscape creates increased importance of telling investors what assumptions a company is using to make its estimates, in addition to describing the estimates themselves. Many companies may have had unusual transactions during the year – such as restructurings, furloughs, government assistance (e.g. monies received under the CARES Act), insurance recoveries, etc. A company will want to clearly describe unusual or “one-off” transactions and the related accounting treatment and financial statement presentation.