Accounting for the COVID-19 Crisis

by Marco Trombetta, Professor of Accounting and Management Control at IE Business School.

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The coronavirus has clearly generated an immense economic crisis. But, how immense is “immense”? An important task at the moment is to quantify as precisely as possible the magnitude of the crisis. This is an area where accounting can play a role.

For example, it is important to try to estimate how many companies will survive the crisis. Obviously, this will depend on the overall duration of the social distancing measures that have nearly halted global economic activity. However, it also depends on each company’s financial situation before the crisis.

Since we all hope that this crisis will be temporary, one crucial aspect to assess is companies’ capacity to face short-term financial obligations with their current and projected levels of liquidity. Short-term liquidity analysis depends crucially on a fundamental source of information: the company’s financial statements. Financial accounting information and annual reports are crucial sources of information for quantifying the economic dimension of the crisis.

Thanks to the widespread availability of accounting figures in digital formats for a vast number of companies worldwide, plus the use of established financial statement analysis and valuation techniques, we can perform liquidity and bankruptcy simulations for different scenarios in a relatively short period of time.

These analyses can be very helpful in guiding public policy interventions. Antonio De Vito and Juan Pedro Gómez of IE University have already produced one such study and used it to evaluate the relative merits of tax deferrals versus bridge loans as tools to help companies survive the crisis.

During and after the crisis

Moreover, during and (hopefully) after this major economic crisis, investors and other public and private stakeholders will monitor the financial performance of companies in order to make their economic choices. Again, financial accounting information will be a crucial source of information for these decisions. Hence, in addition to existing (pre-crisis) accounting figures, the figures produced and published during and after the crisis will also be important.

Financial accounting numbers are not produced on a cash flow basis. Profit is not simply the difference between cash in and cash out. Instead, these figures are produced on an accrual basis. Because of this feature of the financial accounting process, we have some discretion with regard to how to report an organization’s overall economic performance on a periodic basis.

In other words, the hard facts about a company can be “accounted”—i.e. narrated in the financial statements—in various alternative and reasonable ways. Two classic examples of this characteristic of financial accounting are depreciation and provisions.

The depreciation chapter

Depreciation is the accrual-based representation of the cost of an investment over the course of its economic life. If a company pays one million euros in cash to acquire a piece of equipment that is expected to be in use for 10 years, the company’s accounts will not register the entire million as an expense in the current period. Instead, the cost will be spread out over the 10 years through depreciation.

How do we spread it? We have a few options. We could do it linearly (i.e. the same amount every year) or on an accelerated (i.e. more at the beginning and less at the end) or delayed basis (i.e. less at the beginning and more towards the end). The principle that should govern this choice is the so-called “matching” principle: the recognition of costs should follow the recognition of revenues.

One of the consequences of the COVID-19 crisis is a dramatic (but hopefully temporary) decrease in revenue for many companies. Hence, following the matching principle, companies could slow down or even temporarily stop the depreciation of their long-term assets and restart it once revenues start flowing in again. This reduction in depreciation would allow companies to mitigate the effect of the crisis on their reported profit for 2020 and possibly attenuate the perceived gravity of the crisis for investors and stakeholders. There is plenty of empirical evidence that reported profit plays a crucial role in determining investor and stakeholder behavior.

Attention to provisions

Provisions are another area where accrual-based accounting discretion could be used. A provision is basically the anticipated recognition of expected future losses. If a company knows that it is very likely to suffer a loss in the future, it is supposed to anticipate the recognition of this loss on its income statement as early as possible.

In this case, given the exceptional and (hopefully) temporary nature of the COVID-19 crisis, we could allow companies to temporarily reduce the level of the provisions recognized in 2020 for future losses and ask them to re-increase them later on when revenues should be up again. This measure would also attenuate the effect of the crisis on short-term reported profits.

In short, the gravity of the economic crisis prompted by COVID-19 will be reflected in the accounting numbers produced by companies. Hence, it is crucial to reflect carefully on how we “do the numbers” for this crisis!