Quarterly Reporting From Quarantine: Looking Back and Looking Forward during COVID-19
As the first quarter earnings season kicks off over the next few weeks, public companies need to figure out how best to describe the effects of the novel coronavirus (COVID-19) crisis on their business, both in their historical results for the first quarter of 2020 and on their prospects going forward. For some companies, conducting the historical assessment may be hindered by the inability to access records or conduct investigations in shuttered facilities, the challenges of conducting complex impairment analysis with incomplete information or assessing the strength of internal controls in a remote work environment. For most companies, however, the forward-looking analysis will be far more daunting. A scatter-shot of government policies and stimulus programs, coupled with uncertainty and mixed messages about when and how the economy will reopen, make accurate predictions about the short- and long-term effects of COVID-19 practically impossible. Over the past few weeks, numerous companies have withdrawn their 2020 guidance, and companies may be tempted to provide generic disclosures or avoid forward-looking disclosure entirely in their quarterly reporting.
Recognizing companies’ tendency to struggle with thoughtful forward-looking disclosure in times of uncertainty, the SEC Chair Jay Clayton and Director of the Division of Corporation Finance William Hinman released a public statement on April 8, 2020 (the “Clayton/Hinman Statement”) urging companies to address the company-specific effects of COVID-19 and provide meaningful forward-looking information in their upcoming quarterly reports and earnings releases. The SEC called on companies to “provide as much information as is practicable regarding their current operating status and their future operating plans under various COVID-19 mitigation conditions,” including detailed disclosure related to liquidity positions, received or anticipated government financial assistance, expected financial resource needs and measures taken to protect worker and customer health and safety. The SEC acknowledged that historical information may be relatively less significant for this quarter and stated that company disclosures should cover: “(1) where the company stands today, operationally and financially, (2) how the company’s COVID-19 response, including its efforts to protect the health and well-being of its workforce and its customers, is progressing, and (3) how its operations and financial condition may change as all our efforts to fight COVID-19 progress.” The SEC also encouraged companies to avail themselves of the safe-harbors for forward-looking statements and assured companies that the SEC “would not expect to second guess good faith attempts to provide investors and other market participants appropriately framed forward-looking information.”
As the SEC stated so succinctly, this quarter’s “earnings reports and related investor and analyst calls will not be routine.” For most companies, preparation of their report on Form 10-Q for the first quarter of 2020 will require a much more nuanced and robust analysis than normal. The following section outlines some key recommendations, considerations and resources.
Consider the breadth of potential COVID-19 business impacts and how to reflect those impacts throughout the Form 10-Q.
When drafting this quarter’s Form 10-Q, companies should aim to take a holistic approach to disclosing the various ways COVID-19 has impacted, or may impact, their business and operations. Operational disruptions such as (i) remote staffing, (ii) manufacturing challenges, (iii) supply chain delays, and (iv) delivery issues are just some of the difficulties that companies are facing. Companies should review the line items in their financial statements and determine to what extent COVID-19 and current market conditions might affect the major functional areas within the business going forward.
Management’s Discussion and Analysis (MD&A), as discussed in more detail below, should discuss events, trends or uncertainties that are reasonably likely to have a material effect on a company’s financial condition, liquidity or results of operations, or that would cause reported financial information not to be necessarily indicative of its future financial condition or results of operations. To the extent operational disruptions have or are reasonably likely to have a material effect on a company, they should be described in MD&A so that investors can adequately understand the impacts that such disruptions may have on future results.
Emphasize forward-looking disclosures in MD&A.
The Form 10-Q MD&A must include information that a company believes to be necessary for readers to understand and assess material changes in the company’s financial condition and results of operations. The SEC’s recent public statements have stressed the importance of forward-looking disclosures in the quarterly filings for the most recent quarter, and have described factors companies should consider with respect to the potential effects of COVID-19 on a company’s results of operations, liquidity and capital resources. The Clayton/Hinman Statement requests that companies “strive to provide, and update and supplement, as much forward-looking information as is practicable is driven by three primary considerations: (1) the information will benefit investors, (2) market digestion of the information will benefit the company, and (3) the broad dissemination and exchange of firm-specific plans for addressing the effects of COVID-19 under various scenarios will substantially contribute to our nation’s collective effort to fight and recover from COVID-19.”
The Clayton/Hinman Statement also discusses the broad recognition of the need for a transition to forward-looking health and welfare strategies, and states that, even though producing forward-looking disclosures may be challenging during these times of uncertainty, it is a challenge worth taking on. The Clayton/Hinman Statement emphasized that companies should consider discussing time frames for current COVID-19 social distancing guidelines and other mitigation-related requirements and scenarios, and companies receiving financial assistance, whether under the CARES Act or other federal or state programs, should disclose the nature, amounts and effects of such assistance if it has materially affected, or is reasonably likely to have a material future effect upon financial condition or results of operations. In addition, as discussed in greater detail in our prior release, companies should also consult the Division of Corporation Finance’s Disclosure Guidance Topic No. 9 (“Disclosure Guidance Topic No. 9”) for an illustrative list of topics that each company should assess in considering the effects of COVID-19, summarized below.
The SEC has acknowledged that investors are not the only ones who are interested in how companies will adjust their affairs in the collective fight against COVID-19, and broad and extensive coordination across workers, firms, investors and governmental officials will be critical to successfully emerge from this fight, and the exchange of forward-looking information is essential to that coordination. However, given the high level of uncertainty regarding the severity, scale and duration of the COVID-19 pandemic, it is not clear that companies will be able to provide at this time detailed forward-looking information, particularly given the potential litigation risk.
COVID-19 Topics to Consider for Form 10-Q Disclosure
- How has COVID-19 impacted your financial condition and results of operations?
- How has COVID-19 impacted your capital and financial resources, including your overall liquidity position and outlook?
- How do you expect COVID-19 to affect assets on your balance sheet and your ability to timely account for those assets?
- Do you anticipate any material impairments, increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on your financial statements?
- Have COVID-19-related circumstances (i.e., remote work arrangements) adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures, and if so, how and what changes have you made to your systems and controls?
- What challenges have you experienced in your business continuity planning and do you foresee any material resource constraints?
- Do you expect COVID-19 to materially affect the demand for your products or services?
- Do you anticipate a material adverse effect of COVID-19 on your supply chain, distribution or the relationship between your costs and revenues?
- Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?
- Are travel restrictions and border closures expected to have a material impact on your ability to operate and achieve your business goals?
For example, certain of these topics were covered by Halliburton in its recent earnings release:
COVID-19 Pandemic and Market Conditions Update: The COVID-19 pandemic and related economic repercussions have created significant volatility, uncertainty, and turmoil in the oil and gas industry. Oil demand has significantly deteriorated as a result of the virus outbreak and corresponding preventative measures taken around the world to mitigate the spread of the virus. In the midst of the ongoing COVID-19 pandemic, the Organization of Petroleum Exporting Countries and other oil producing nations (OPEC+) were unable to reach an agreement on production levels for crude oil, at which point Saudi Arabia and Russia initiated efforts to aggressively increase production. The convergence of these events created the unprecedented dual impact of a global oil demand decline coupled with the risk of a substantial increase in supply. While OPEC+ agreed in April to cut production, downward pressure on commodity prices has remained and could continue for the foreseeable future.
These events have negatively affected and are expected to continue to negatively affect Halliburton’s business. Demand for the Company’s products and services is declining as its customers revise their capital budgets downwards and adjust their operations in response to lower oil prices. In addition, Halliburton is facing logistical challenges, including border closures, travel restrictions and an inability to commute to certain facilities and job sites, as the Company provides services and products to its customers. The Company is also experiencing inefficiencies surrounding stay-at-home orders and remote work arrangements.
Given the dynamic nature of these events, Halliburton cannot reasonably estimate the period of time that the COVID-19 pandemic and related market conditions will persist, the extent of the impact they will have on the Company’s business, liquidity, consolidated results of operations and consolidated financial condition, or the pace of any subsequent recovery. The financial results for the first quarter of 2020 reflect some of the reduced activity experienced towards the latter part of the quarter in various locations around the world. For the remainder of 2020, the Company expects a further decline in revenue and profitability, particularly in North America.
Review and update financial projections and significant judgements and estimates that go into the financial statements.
In the current environment of uncertainty, it is especially difficult to make accounting estimates. On April 3, 2020, the Office of the Chief Accountant (OCA) issued a public statement stressing the need for high-quality financial information; stating that “the proper functioning of our capital markets depends on a regular supply of high-quality financial information that enables investors, lenders, and other stakeholders to make informed decisions.” In light of the evolving status of COVID-19, companies should review and update required disclosure of judgments and estimates in areas such as fair value and impairment considerations, leases, debt modifications or restructuring, hedging, revenue recognition, income taxes, going concern, and subsequent events and adoption of new accounting standards (specifically, the new credit losses standard).
The SEC allows companies with a reasonable basis for the underlying assumptions to include projections of future economic performance in their filings. While some assumptions may have been reasonable in the early stages of the COVID-19 pandemic, the recent economic downturn, decline in financial markets, and other company-specific effects need to be considered when reevaluating financial line items. Additionally, the current volatility of financial markets and resulting future uncertainty may impact key assumptions and sensitivities used in financial forecasting.
United Airlines’ recent earnings release included the following example of one type of such disclosure:
Special charges. During the three months ended March 31, 2020, the Company recorded $63 million of special charges, primarily associated with a $50 million impairment for its China routes. The Company conducted impairment reviews of certain intangible assets in the first quarter of 2020, which consisted of a comparison of the book value of those assets to their fair value calculated using the discounted cash flow method. Due to the COVID-19 pandemic and the subsequent suspension of flights to China, the Company determined that the value of its China routes had been impaired.
Consider how COVID-19-related mitigation activities may have materially changed internal and disclosure controls and related procedures.
As briefly summarized above, the SEC notes in Disclosure Guidance Topic No. 9 that COVID-19-related circumstances may have an effect on companies’ internal control over financial reporting and disclosure controls and procedures. The SEC identifies remote work arrangements as one such circumstance, however, others may include facility closures, lack of or delays in access to necessary external expertise and internal resources being redirected to COVID-19-related mitigation activities, including business continuity planning. While these circumstances and others may not rise to the level of materially affecting or being reasonably likely to materially affect a companies’ internal control over financial reporting, companies should be thoughtful in considering whether they address any mitigation activities in disclosures regarding their internal and disclosure controls and related procedures.
Be thoughtful about liquidity and quarterly going concern disclosures.
In determining required or appropriate liquidity disclosure, companies need to evaluate their ability to meet upcoming cash needs in both the short and long term. Particularly in times of uncertainty, merely stating that a company has adequate resources is insufficient, and companies should address known trends and uncertainties, including those relating to COVID-19, related to cash flows, capital resources, capital requirements or liquidity. As briefly touched on above, Disclosure Guidance Topic No. 9 highlighted some questions companies should specifically focus on with respect to liquidity considerations, including:
- Has your cost of or access to capital and funding sources, such as revolving credit facilities or other sources changed, or is it reasonably likely to change?
- Have your sources or uses of cash otherwise been materially impacted?
- Is there a material uncertainty about your ongoing ability to meet the covenants of your credit agreements?
- If a material liquidity deficiency has been identified, what course of action has the company taken or proposed to take to remedy the deficiency? Consider the requirement to disclose known trends and uncertainties as it relates to your ability to service your debt or other financial obligations, access the debt markets, including commercial paper or other short-term financing arrangements, maturity mismatches between borrowing sources and the assets funded by those sources, changes in terms requested by counterparties, changes in the valuation of collateral, and counterparty or customer risk.
- Do you expect to disclose or incur any material COVID-19-related contingencies?
Companies should consider providing investors with additional disclosures regarding the sources and the terms of liquidity; access to new sources of liquidity, including government aid; and efforts to reduce costs. Companies are also required to prepare an assessment of their presumed ability to continue as a going concern, which should include identifying the relevant conditions and events that raise substantial doubt about the company’s ability to continue as a going concern – both quantitative and qualitative information should be considered.
DuPont’s recent earnings release provides a good example of a summary of steps taken to enhance the company’s liquidity position:
Capital Discipline and Liquidity
Due to the uncertainties presented by COVID-19, DuPont has implemented a number of proactive measures to enhance its already strong liquidity position and improve working capital.
- Entered into a 364-day $1.0 billion revolving credit facility, replacing the $750 million revolving credit facility that was set to expire in June 2020.
- Secured a $2.0 billion 364-day delayed-draw facility ensuring its ability to meet the November 2020 maturities; the company may elect to replace this facility via the capital markets.
- Delayed certain capital investments.
- Idled production at several manufacturing sites, predominantly production plants within the Transportation and Industrial segment due to the current global automotive environment.
Revisit non-GAAP financial measures and explain to investors any COVID-19-related adjustments.
In Disclosure Guidance Topic No. 9, the SEC reminds companies of their obligations under Item 10 of Regulation S-K and Regulation G, as well as the Commission’s recent Guidance on Management’s Discussion and Analysis of Financial Condition and Results of Operations, with respect to the presentation of non-GAAP financial measures. The SEC states that companies should:
- Highlight why management has made any adjustments to non-GAAP financial measures or performance metrics to adjust for or explain the impact of COVID-19.
- Where a GAAP financial measure is not available at the time of the earnings release because the measure may be impacted by COVID-19-related adjustments that may require additional information and analysis to complete, consider reconciling a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results.
- The provisional amount or range should reflect a reasonable estimate of COVID-19 related charges not yet finalized, such as impairment charges.
- If a company presents non-GAAP financial measures that are reconciled to provisional amount(s) or an estimated range of GAAP financial measures, it should explain, to the extent practicable, why the line item(s) or accounting is incomplete, and what additional information or analysis may be needed to complete the accounting.
- In filings where GAAP financial statements are required however, including on Forms 10-K or 10-Q, companies should reconcile to GAAP results and not include provisional amounts or a range of estimated results.
- Remember that a non-GAAP financial measure should not be disclosed more prominently than the most directly comparable GAAP financial measure or range of GAAP measures.
- Remember that the SEC does not believe it is appropriate for a company to present non-GAAP financial measures or metrics for the sole purpose of presenting a more favorable view of the company. Companies should only report COVID-19-related adjustments in non-GAAP measures to the extent such measures are used in reporting financial results to boards of directors.
Update risk factors and safe harbors to address COVID-19-related company-specific risks.
We expect that almost all companies should review and update their risk factor disclosures in their first quarter 10-Q. Many companies filed their Forms 10-K during the infancy of the COVID-19 pandemic and now need to update those disclosures in their Forms 10-Q to reflect the new reality. As touched on above, the SEC has emphasized the need for detailed discussions of current liquidity positions and expected financial resource needs under various COVID-19-related mitigation conditions. In particular, the following types of risk factors should be reviewed: business continuity and availability of liquidity, supply chain disruptions, inability of key personnel to perform their duties, actions taken by governmental authorities, employee relations, cyberattacks/data security, and market volatility.
As companies complete their reviews of their risk factors, it is important to remember that the SEC holds a very strong view that presenting a risk that has already had a material negative effect on the company as a potential future risk is misleading, and the SEC’s Division of Enforcement brought two actions in 2018 involving disclosure of existing conditions as hypothetical risks. Companies may have presented certain risks in their Forms 10-K as hypothetical that now, as a result of the COVID-19 pandemic, are current conditions likely to have a material impact on the company. In addition to presenting any new risks emerging related to the COVID-19 pandemic and related market volatility, risks that have materialized or begun to materialize should no longer be presented as hypothetical risks.
Companies should also update cautionary statements and disclaimers regarding forward-looking statements to include COVID-19-related company-specific risks that could affect actual results in both the Form 10-Q and earnings or press releases as appropriate.
For an example of detailed company-specific risk factors regarding COVID-19, see Levi Strauss’s Form 10-Q, filed with the SEC April 7, 2020, which includes the following COVID-19-related risk factor, among others:
The novel coronavirus disease (or COVID-19) pandemic is expected to have a material adverse effect on our business and results of operations.
The COVID-19 pandemic has negatively impacted the global economy, disrupted consumer spending and global supply chains, and created significant volatility and disruption of financial markets. We expect the COVID-19 pandemic to have a material adverse impact on our business and financial performance. The extent of the impact of the COVID-19 pandemic on our business and financial performance, including our ability to execute our near-term and long-term business strategies and initiatives in the expected time frame, will depend on future developments, including the duration and severity of the pandemic, which are uncertain and cannot be predicted.
As a result of the COVID-19 pandemic, and in response to government mandates or recommendations, as well as decisions we have made to protect the health and safety of our employees, consumers and communities, we have temporarily closed a significant number of our stores globally. We may face longer term store closure requirements and other operational restrictions with respect to some or all of our physical locations for prolonged periods of time due to, among other factors, evolving and increasingly stringent governmental restrictions including public health directives, quarantine policies or social distancing measures. In addition, many of our customers, including significant customers in our wholesale and franchise distribution channels, have closed many of their stores, which will adversely impact our revenues from these customers and franchisees. As a result, we expect our financial results to be materially adversely impacted.
In addition, consumer fears about becoming ill with the disease may continue, which will adversely affect traffic to our and our customers’ stores. Consumer spending generally may also be negatively impacted by general macroeconomic conditions and consumer confidence, including the impacts of any recession, resulting from the COVID-19 pandemic. This may negatively impact sales in our stores and our e-commerce channel and may cause our wholesale customers to purchase fewer products from us. Any significant reduction in consumer visits to, or spending at, our and our customers’ stores, caused by COVID-19, and any decreased spending at stores or online caused by decreased consumer confidence and spending following the pandemic, would result in a loss of sales and profits and other material adverse effects.
The COVID-19 pandemic also has the potential to significantly impact our supply chain if the factories that manufacture our products, the distribution centers where we manage our inventory, or the operations of our logistics and other service providers are disrupted, temporarily closed or experience worker shortages. We may also see disruptions or delays in shipments and negative impacts to pricing of certain components of our products.
As a result of the COVID-19 pandemic, including related governmental guidance or requirements, we also have recently closed many of our corporate office and other facilities, including our corporate headquarters in San Francisco, and have implemented a work from home policy for many of our corporate employees. This policy may negatively impact productivity and cause other disruptions to our business.
Consider whether updates are needed to legal proceedings disclosure.
Item 103 of Regulation S-K requires disclosure of material, non-ordinary course, pending legal proceedings to which a company is a party or of which any of its property is subject. Examples of litigated matters that may be invoked in connection with COVID-19 include breaches of contract (including credit facilities and other debt documents), shareholder litigation (including “stock drop” and 10b-5 lawsuits), employment matters, force majeure clauses and, for upstream and midstream companies in the oil and gas industry, takeaway commitments. It is important to note that more than just lawsuits must be disclosed under Item 103, for example arbitrations, court orders and administrative hearings could also trigger disclosure, and although mediation is not a formal legal proceeding, disclosure may be appropriate even if not literally required based on the dictionary definition or commonly understood meaning of legal proceeding. In addition, while threatened litigation does not automatically trigger disclosure, proceedings that are known to be contemplated by government authorities and pending proceedings that involve claims for damages that exceed 10% of the current assets of the company are still generally required to be disclosed. Any material bankruptcy or similar proceeding must be described regardless of amount. To the extent a company is party to any disclosable proceeding, either by private parties or governmental authorities, the company will need to disclose (1) the name of the court or agency in which the proceedings are pending, (2) the date instituted, (3) the principal parties thereto, (4) a description of the factual basis alleged to underlie the proceeding and (5) the relief sought.
Calculate filing deadlines.
The SEC has issued an order conditionally extending the temporary 45-day grace period for registrants affected by COVID-19 to file Exchange Act reports that would have otherwise been due between March 1 and July 1, 2020. To qualify for the extension, the registrant must be unable to meet a filing deadline due to circumstances related to COVID-19 and must submit a current report explaining its particular circumstances and why the relief is needed for each periodic report that is delayed. To take advantage of the extension, a company must furnish a Form 8-K or Form 6-K by the original Form 10-Q filing deadline. For additional information on the SEC’s order, click here.
Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.