As Florida residents and business owners who are still recovering from Irma well know, hurricanes are large-scale, destructive events that can inflict damage over a large area with little warning. Thousands have perished in storms in the 21st Century alone and billions of dollars of damage have been incurred. Understandably, much of the focus around hurricanes is safety and getting through the hurricane itself and the weeks after a hurricane.
However, in the aftermath of a hurricane or other significant natural disaster, it is also important to consider the financial reporting implications of such extreme events at period end, as the effects can be substantial. Once safety is assured, begin considering what steps to take to appropriately capture the effect the hurricane has had on your operation, and also to be ready for period-end reporting. We have broken down post disaster recording considerations into five steps, as a way to consider addressing GAAP and GAAS issues.
- Develop an expectation of what could have happened.
- Inquire of appropriate personnel.
- Consider the effects the disaster will have on various assertions/assumptions and consider additional procedures on areas such as:
- Valuation of receivables
- Inventory lower of cost or net realizable value considerations;
- Impairment of Property, Plant, and Equipment
- Insurance proceeds and gains/losses
- Consider the appropriateness of disclosures in the financial statements.
- Be ready for possible additional audit procedures to be performed by your financial statement auditors.
Implementation of the Five Steps
1. Develop an expectation of what could have happened
- Developing an expectation can help identify the scope of possible financial reporting issues and also identify issues that may not have come to light yet internally
- Consider the nature of the disaster and how it affected the reporting entity (noting that not everyone may have realized all the effects)
- Some thoughts may include:
- Was there flooding that may have damaged inventory and Property, Plant, and Equipment?
- Were there high winds that may have damaged inventory and the roof of the building?
- Was there a loss of power that may have caused significant damage (such as perishable inventory spoiling due to lack of power for refrigeration)?
- Was the damage so extensive to the local area that the entity will have trouble collecting receivables?
2. Inquire of appropriate supervisory and line personnel
- It may be helpful to inquire of non-financial personnel to understand the operational nature of how the hurricane has affected a business.
- Some thoughts may include:
- What was damaged in terms of facilities?
- What was damaged in terms of inventory?
- How does the entity intend to collect receivables?
- Has there been any looting or other acts of civil disorder that affect the entity?
- Will the entity be able to resume operations?
- Will the entity be able to sustain itself for a year beyond the date that the financial statements have been issued?
- Is there insurance for business interruption and for damage to property?
3. Consider the effect the disaster will have on various assertions/assumptions and consider additional procedures on areas such as:
Valuation of receivables
- Due to the hurricane, customers may be slower, or less likely to pay, making previous assumptions on collectability of accounts receivable (such as aging strata, payment history, etc.) invalid
- An entity might not have the resources to collect receivables, thus making collection a less likely possibly in certain cases
- In order to maintain good customer relations, the entity might offer a customer an incentive such as debt forgiveness (which may require additional entries to reflect this)
- Be aware that the estimate of the allowance as to the ability of people to pay (and the value of any underlying collateral) may be lower than previously expected
- Consider if the evidence is sufficient in regards to the determination of the allowance (this may end up being an audit issue as well)
- Subsequent collections may be important evidence as to collectability (however, if the receivables are long term notes, then the amount of subsequent collections may be limited, but could enter into a delinquency analysis)
Inventory “lower of cost or net realizable value” considerations
- Due to the disaster, the net realizable value of inventory may become lower than cost due to damage from issues such as:
- Spoilage (from loss of electrical power and/or lack of attention)
- Civil unrest
- Does the entity have support for determination as to lower of cost or net realizable value (often inquiry, and what management thinks, often will not be sufficient for auditors)
- Consider comparable entities and market data to determine if inventory should be written down
- Consider also the needs of the immediate community
- For example: perhaps the hurricane destroyed 75% of the vehicles in an area; the auto dealerships in the area will likely be able to sell a large amount of inventory (provided it is not damaged) – in this case, there may be significant subsequent collections to support the amount of a write down (if any)
Impairment of Property, Plant, and Equipment (“PPE”)
- Consider performing a physical inspection of the Property, Plant, and Equipment to note hurricane damage (develop an expectation before doing so). There may be portions of buildings, or whole buildings, which are no longer there or are beyond repair.
- Property, Plant, and Equipment is not typically carried at fair value, thus there may be fluctuations in value at different points of time and no impairment may be required. However, there is a 2-step impairment test to possibly consider. Due to the disaster, the triggering event may have occurred which would necessitate the 2-step impairment test under US GAAP (including ASC 360-10-35-7)
- Compare the undiscounted cash flows from the use and eventual disposition of the property to the carrying amount
- If the carrying amount is more, than write down the Property, Plant, and Equipment to fair value
- Below is a sample analysis that assumes a 3-year useful life with no value at ultimate disposition
- When the auditors are testing the two-step impairment test, the auditors will likely challenge the inputs and may request support (lease agreements, etc.)
Insurance receivable considerations
- Consider if criteria for revenue recognition has been met in order to record an insurance receivable
- Obtain sufficient evidence that the amount exists and is collectible
- Is there correspondence from the insurer to support the amount to be paid?
- Just because there is a policy in effect, does not necessarily mean every loss will be covered by the insurer
- Consider if the insurer is solvent (consider public company, statutory filings, as well as publicly available information such as reputable news reports). If the insurer is not solvent, the insurance proceeds may never be received or be received late and at a discounted amount.
Insurance proceeds considerations
- The presentation of insurance proceeds on the statement of cash flows was recently clarified by the FASB and is most succinctly expressed in FASB ASC 230-10-45-21B which indicates:
- “Cash receipts resulting from the settlement of insurance claims, excluding proceeds received from corporate-owned life insurance policies and bank-owned life insurance policies, shall be classified on the basis of the related insurance coverage (that is, the nature of the loss). For insurance proceeds that are received in a lump-sum settlement, an entity shall determine the classification on the basis of the nature of each loss included in the settlement.”
- Business interruption and inventory insurance claim received:
- Operating cash flow
- Property, Plant, and Equipment claim received
- Investing cash flow
- Business interruption and inventory insurance claim received:
Insurance Gain/Loss Considerations
- Often, insurance received from property damage will result in a gain for book purposes (the coverage amount can be in excess of the net book value being removed)
- For US GAAP, Property, Plant, and Equipment is written down through earnings and the insurance proceeds are in earnings as well. For US GAAP, the insurance proceeds typically do NOT reduce the basis of Property, Plant, and Equipment (i.e., the entry is not debit Cash and credit Property, Plant, and Equipment)
- Note this may be different than tax treatment
- After a disaster, to encourage customers to keep coming back, an entity might offer sales incentives. Such incentives may require accrual and/or disclosure for items such as future benefits to the customer in exchange for a purchase now, such as:
- “…buy a computer with us now and we will give you additional service free for 2 years”
- “…we do not have vehicle inventory now because of the hurricane, but if you agree to buy from us in the future, we will pay for a rental vehicle now”
- Additional literature in the FASB that may be applicable:
- Multiple element guidance
- Product warranty guidance
Going concern considerations
- Due to the disaster, and related circumstances, consider if there is significant doubt the entity will be able to sustain itself for a reasonable period of time (at least 1 year beyond the balance sheet date for US GAAP)?
- Does sales demand still exist and is it sufficient?
- Is the entity able to meet the demand for its goods/services?
- Was the area the reporting entity operates adversely affected?
- The various factors in US GAAP (ASC 205-40) and US GAAS (AU-C 570) or PCAOB (AS 2415)
4. Consider the appropriateness of disclosures in the financial statements
- The financial statements should provide sufficient disclosure as required under the financial reporting framework (US GAAP, IFRS, etc.).
- Consideration may be given to items such as the following:
- Risks associated with customers and the area the entity operates
- Risks associated with the final amount and/or collection of insurance claims
- The possibility that Property, Plant, and Equipment impairment may not be completely identified until a subsequent period
- Risks associated with the fact the entity is depending on business interruption insurance to sustain operations
- Risks associated with the fact that the entity is depending on its source of material, inventory, sales, etc. from areas and/or companies adversely affected by a disaster
5. Be ready for possible additional audit procedures to be performed by your financial statement auditors
Keep in mind that a disaster such as a hurricane, and the related direct and indirect effects on an entity, may require a change in audit approach and procedures which may not have been necessary previously
How MBAF Can Help
In the aftermath of a hurricane or other disaster, you may be facing more than merely physical damage as your business tries to recover. With our years of expertise in providing post-disaster advice, we can help you through the above steps and considerations relative to your specific business, and damage/loss you may have incurred.
In addition, we also provide the following specific “post-disaster” services:
- Consulting on the application of GAAP
- Assistance with preparing for financial statement audits
- Business valuations
- Business interruption cases
- Help prepare insurance claims
- Disaster tax planning
- Loss of profit claims
We wish that everyone remains safe for the remainder of Hurricane Season, and we remind you, that we are here to help with disaster preparations and recovery in any and all ways that we can.
Understanding how to prepare and recover from natural disasters can be complex. If you would like to benefit from our expertise in these areas, or if you have further questions on this Advisory, do not hesitate to contact our Assurance Specialists, or call us at 1-800-239-1474.