In the aftermath of recent natural disasters including Hurricanes Irma and Maria, this BDO Puerto Rico Flash Report is intended as a resource for the related financial reporting issues. The Financial Accounting Standard Board (“FASB”) accounting guidance differs by the type of loss, but companies should bear in mind that the losses are generally reflected in the accounting period of the natural disaster, independent of any potential insurance proceeds, which are accounted for separately.
Asset Impairment and Contingent Losses
As a result of natural disasters many assets may be destroyed, damaged or impaired. When considering if impairment exists, an entity should first determine the condition of the asset. If an asset is destroyed, it should be written off as an expense. Otherwise, an impairment may be required. Assets potentially affected include receivables, inventories, intangible assets, and goodwill.
Receivables and Loans
Receivables and loans from entities impacted by natural disasters might be at risk for collectability. Receivables and loans are subject to ASC 310 and ASC 450-20. In addition, baking and financial institutions should consider the effects of the hurricanes will require a change in the evaluation and determination of the allowance for loan and lease losses (“ALLL”).
Companies should evaluate their inventories for damages or obsolescence caused by the effects of the hurricanes. ASC 330 states that a departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference shall be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market. Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs.
Indefinite-Lived Intangible Assets
Indefinite-lived intangible assets are addressed under ASC 350-30-35. They are tested for impairment annually, or more frequently if events or circumstances indicate the asset might be impaired, by comparing the fair value of the assets to their carrying amount.
Property, Plant and Equipment and Finite-Lived Intangibles
Companies should evaluate their property, plant and equipment held for use for damages and losses caused by the hurricanes. In addition, they should evaluate finite-lived intangibles to determine if their carrying amounts may be recovered in the future. Both property, plant and equipment held for use and finite-lived intangibles should be evaluated based on the requirements of the ASC360-10, that requires the test for recoverability whenever events or circumstances indicate that the carrying amount of the asset group may not be recoverable. If the asset group is not recoverable, its carrying amount is reduced to its fair value.
Indefinite-lived intangibles, including Goodwill should be evaluated for impairment based on the guidance provided by the ASC 350. This guidance requires an impairment test to be performed when a triggering event occurs that may result in impairment (e.g., when an event or change in circumstance indicates that the carrying amount of a long-lived asset may not be recoverable). In the event of a natural disaster, such as a hurricane, companies should assess whether a triggering event has occurred. Goodwill impairment is tested last, at the reporting unit level.
Liabilities related to natural disasters are addressed by ASC 450-20, in the absence of other GAAP (see discussion of “Exit Activities” below). A liability should be accrued by a charge to income if it is probable that it has been incurred at the financial statement date and the amount of the loss can be reasonably estimated. This includes, for example, the costs of repairs and maintenance that are not capitalized.
Following a natural disaster an entity may choose to sell or terminate a line of business, close the business activities in a particular location, relocate the business activities from one location to another, make changes in the management structure, or undergo a fundamental reorganization that affects the nature and focus of operations. All of these items represent exit activities accounted for under ASC 420, Exit and Disposal Cost Obligations.
Temporary Differences and Deferred Income Tax Liabilities
Book recognition of reserves, accruals and impairments would likely impact the measurement of temporary differences and related deferred income taxes under ASC 740. Careful consideration of deferred income taxes including the valuation allowance is required in the period that book losses, reserves and impairments are recognized.
Balance Sheet Presentation
Asset impairments and liabilities related to natural disasters should be recognized independent of any related insurance recoveries. Liabilities are usually shown gross.
Income Statement Presentation
ASC 225-20-45-16 states a material event or transaction that an entity considers unusual, infrequent or both is reported as a separate component of income from continuing operations.
An involuntary conversion is the exchange, or conversion, of a nonmonetary asset (e.g., fixed assets) to monetary assets such as insurance proceeds. To the extent the cost of a nonmonetary asset is less than the amount of monetary assets received, the transaction results in a gain. This is true even if the insurance proceeds are reinvested in replacement nonmonetary assets, such as new equipment.
As mentioned previously, impairment losses are generally accounted for separate from any related insurance. With respect to accounting for insurance proceeds, GAAP includes the following guidance.
Natural disasters often cause disruptions in operations which result in losses. These losses are often covered by business interruption insurance and should be accounted for separate from other insurance proceeds. When losses incurred can be reasonably estimated and recovery is considered probable a receivable may be recorded. However, the amount recorded should not be greater than costs incurred to date. Therefore, proceeds for lost profits are treated as a contingent gain and typically recorded at the settlement date.
Cash Flow Statement Presentation
Since insurance proceeds are classified based on the nature of the insurance coverage rather than the intended use of the proceeds, amounts received for business interruption, inventory losses and operating lease assets are presented as operating activities. If insurance proceeds are received for the loss of property, plant and equipment, they should be presented as investing cash flows.
Debt covenant compliance
After the hurricanes, some companies may confront significant liquidity issues that could trigger to a none-compliance with its debt covenants. In addition, financing arrangements may be backed or collateralized by assets that were destroyed or damaged. In either case, an event of default may be triggered. An event of default affects the classification of debt on the balance sheet even when a waiver or debt modification has been granted by the lender; therefore, debt classification should be evaluated when a company has obtained a waiver or has modified a debt covenant prior to the balance sheet date in order to comply with the covenant.
Natural disasters can cause environmental contamination that can trigger a liability for environmental remediation costs. These types of costs should be recorded in accordance with the requirements of the ASC 410-30. In addition, the effects of natural disasters could give rise to certain assets retirements obligations, which are related with legal obligations associated with the retirement of a tangible long-lived asset that should recorded in accordance with the requirements of the ASC 410-30.
Other Accounting Considerations
Natural disasters affect many aspects of a business. Additional consideration should be given to items such as debt, investments (including debt and equity securities, equity and cost method investments and investments in joint ventures), going concern, subsequent events, environmental remediation obligations, fair value estimates, and stock compensation.
In addition, entities should disclose the material event or transaction that gave rise to an unusual or infrequent loss, as described in ASC 225-20-45-16. Entities should also consider disclosures about risks and uncertainties in ASC 275-10-50. Further, natural disasters may trigger incremental disclosures for SEC reporting purposes.
Ryan Marín, CPA
Partner Assurance Services
787-754-3999 Ext. 2011
Wallace Rodríguez Parissi, CPA
Partner Assurance Services
787-754-3999 Ext. 2279
Juan José Díaz, CPA, CFE
Partner Assurance Services
787-754-3999 Ext. 2201
Cristian Rivera Torres, CPA
Senior Manager Assurance Services
787-754-3999 Ext. 2106