Carbon Credit Accounting: Considerations for Environmental Credits
Accounting for Natural Disasters: Impairment, Insurance, and More
Hurricane Ian. Relentless wildfires in the west. Floods, earthquakes, and drought. As much as we hate to say it, we're not lacking for natural disasters these days, and relief doesn't appear to be on the horizon.
From an accounting and finance perspective, natural disasters obviously impact businesses as well, where data, inventory, and company property all face potential peril when a force majeure strikes. Of course, the safety of those affected should always come first. But as soon as the immediate crisis is over, attention quickly shifts to disaster recovery and reconstruction. That’s why we’re taking a moment to discuss the significant accounting and disclosure-related matters companies may face after a natural disaster.
Common Accounting and Disclosure Implications of Natural Disasters
Your company's recoverability hinges on knowing your balance sheet like the back of your hand, as well as the myriad potential outcomes you may face as a business owner. It's not enough to smile and hope for the best—it takes action and preparation to secure your business' future which, like it or not, can be a daunting task, even for companies with a herd of CPAs on staff.
US GAAP defines impairment as a situation where the carrying amount of the asset or asset group exceeds its fair value. In other words, if you see possible declines in the carrying values of your assets after an "event," you must evaluate those assets for impairment. This is true whether it's a tangible or long-lived asset – as covered in ASC 360 – or an intangible asset – as covered in ASC 350.
Companies might have to determine if a natural disaster has resulted in asset impairment like, for example, if buildings, equipment, or other assets are lost or damaged. In other cases, supply chain disruption or losing an important client may greatly impact a company's operations or financial performance.
Potentially impacted assets include:
- Goodwill and other intangibles
- Deferred taxes
When determining impairment, the accounting standards state you must distinguish between property damage – and other damaged assets – and those whose value is affected by changes in future cash flows due to the disaster.
If a tangible asset is partially or totally lost, you must write it down or at least revisit its useful life. On the other hand, a test for impairment may be necessary for assets affected by changes in cash flows.
The guidance also gives a specified order for assessing those potential impairments:
- Working capital (accounts receivable, inventory, investments)
- Indefinite-lived intangible assets
- Finite-lived assets (fixed and intangible)
Goodwill Impairment and Other Intangible Assets
According to ASC 350, testing for impairment of intangible assets must occur at least once a year in any scenario. Impairment testing for goodwill and other intangibles with indefinite useful lives – that you aren't amortizing – also occurs whenever a “triggering event” – an event or condition that indicates an asset “is more likely than not” impaired decreased below their carrying values – takes place.
Since a disaster will very likely qualify as a triggering event and, therefore, you'll need to conduct an impairment assessment when one occurs, regardless of when you last performed one.
Insurance Considerations Related to Natural Disasters
For financial accounting purposes, you should have procedures in place to guarantee accurate long-term asset valuation on your financial statements. Because, like it or not, there are several varieties of natural disasters that don't give fair warning. Thus, constant vigilance and preparation are essential. Enterprise risk management (ERM) programs can be invaluable to companies facing the physical and financial impacts of a natural disaster.
Business Interruption Insurance
ERM programs often include business interruption coverage. This type of insurance pays for lost profits and other expenses incurred when a firm must shut down some or all of its activities due to a significant event.
To see how a business interruption might impact your business, rock-solid forecasting will help estimate the lost profits accurately. And it goes without saying that reliable, supportable forecasting is entirely reliant on clean, timely, accurate data. Insurance carriers will also go through those forecasts and data sets with a fine-toothed comb to make sure it's reasonable for reimbursement.
The claims process often includes both property & casualty insurance as well, with your insurance coverage handling the cost of replacing a damaged or destroyed asset. Alternatively, the insurance company may reimburse you for the asset's cash value, which is equal to the asset's value immediately before the loss.
Before deciding on a type of insurance, you should evaluate the cost of the premiums in relation to your organization's level of risk tolerance. As a result of inflation and technological advancements, the cost of creating an asset today is probably significantly higher than when it was first built. Therefore, replacement value policies can be incredibly beneficial for businesses that rely heavily on physical assets, like manufacturing companies.
Inventory is an area that straddles both property and business interruption insurance. Since inventory is a physical asset, property insurance will almost certainly cover it. But the cost of replacing lost inventory also impacts the company's profit margins. Thus, business interruption claims will include those lost or impacted margins.
Insurance Recovery Proceeds
When a company's insurance policy pays out proceeds, the accounting falls under ASC 610-30. This standard looks at the involuntary conversion of a nonmonetary asset – like property – to a monetary asset like cash. To the extent the cost of the nonmonetary asset differs from the monetary assets received, a company realizes a loss or, if proceeds exceed the recorded loss, it's accounted for as a gain contingency. In either case, you would not record any receivable until it’s certain you’ll receive the proceeds.
Simply put, the receipt of the proceeds from the claim is an entirely different transaction from the purchase of the replacement asset, even if a company uses the proceeds to purchase the new asset.
Other Accounting Impacts Related to Natural Disasters
Once you've got your ducks in a row with insurance and replacing company property, there are still other pieces of the accounting puzzle to put into place. When a disaster strikes, there are a variety of potential impacts above and beyond potential disruptions to operations, including:
- Exit and disposal activities
- Asset retirement
- Environmental obligations
Exit and Disposal Activities
The guidance covers activities related to exit and disposal in ASC 420. Exit actions might involve a variety of expenditures, including contract terminations, facility closures, and restructuring plans.
Related exit and disposal costs may include:
- The sale or closure of a business line
- The termination of company operations in a specific location
- Relocating business operations from one place to another
In the event a disaster occurs, we hope, of course, there are no significant injuries or loss of life. However, the company could still suffer substantial damages. In such a case, business owners and leadership can opt to sell or even abandon some assets.
While restructuring can take on different meanings in different contexts, it has a specific connotation around the impact of a natural disaster on a company. Most obviously, a full or partial business closure could cost many people their jobs.
In these cases, a company would hopefully be able to compensate the people affected. From an accounting perspective, when a one-time employee termination benefit plan satisfies certain requirements and has been disclosed to the employees, the liability for all those costs is recorded and is relieved as the benefits are paid out.
The criteria for employee termination benefits – essentially severance plans – include:
- Management's support and commitment to the plan
- Identification of the impacted personnel and the anticipated completion dates
- Details of the benefits to be provided
- Actions demonstrating the plan will not likely be dramatically amended
Should a natural disaster destroy or damage the environment surrounding the business, the company may be held responsible.
Many large-scale operations, such as manufacturing plants or materials processing companies, may have legal obligations associated with the remediation of pollution, as detailed in ASC 410.
Perhaps more top-of-mind, however, are the clean-up costs associated with common disaster-related environmental issues. If a storm, earthquake, or other disaster compromises dangerous materials maintained at a facility – think chemical leak or oil spill – it could result in significant costs to the company.
The expense simply to contain and fix the environmental damage may total millions or even billions of dollars. And that might not even include the costs associated with public relations catastrophes, as we've seen with BP and the Exxon Valdez over oil spills in the last few decades.
Whether due to flood, fire, hurricane, or other disasters, sudden financial or physical damage or destruction to a business can be devastating. And to be honest, we've only scratched the surface here, leaving potentially critical topics like going concern and subsequent event disclosures for other discussions, not to mention far deeper dives on accounting for insurance proceeds and the like.
Suffice it to say, a comprehensive enterprise risk management program and accurate, timely, transparent financial reporting will be essential in keeping your company active and ready to bounce back in critical situations. And, of course, if any of this makes your head spin even just a bit, our resident technical accounting gurus here at Embark are always ready to lead you to higher ground.