Natural disasters Asset impairments

Natural disasters Asset impairments contains an explanation of the accounting considerations a reporting entity faces when operations are affected by a natural disaster. A combination of impairments of assets and insurance coverage for property damage and business interruption.

Impairment of assets

If an entity determines that the events resulting from a natural disaster have triggered impairment indicators, an impairment test must be performed in accordance with IAS 36 Impairment of Assets for the respective asset(s) and/or cash-generating unit(s). Indicators of impairment as a result of a natural disaster could include: Natural disasters – Asset impairments

  • Observable indications that the asset’s value has declined during the period significantly more than what would be expected as a result of the passage of time or normal use
  • Significant changes with an adverse effect on the entity have taken place during the period, in the technological, market, economic or legal environment in which the entity operates or in the market to which an asset is dedicated. For instance, a decline in customer demand in markets because of a change in operating forecasts, damaged reputation resulting from the disaster, and a change in regulation for safety measures for natural disasters by the government causing additional costs to the entityNatural disasters Asset impairments
  • Similarly, significant changes have taken place, in the extent to which, or manner in which, an asset is used or is expected to be used. For instance, termination of operations because of restriction for entering the area where facilities are located, due to flood, liquefaction, nuclear pollution, etc.
  • The carrying amount of the entity’s net assets is more than its market capitalisation. For instance, natural disasters may lead to decreasing stock prices, which again may indicate that the carrying value of the entity’s net assets is higher than its market capitalisation
  • Evidence of obsolescence or physical damage of an asset. For instance, in many cases an effect of natural disasters is that property, plant and equipment is damaged.

Asset impairments may be indicated as a direct or indirect result of the disaster. For example, damage to a manufacturing facility located in the affected region would be a direct indicator. A jump in operating costs at a facility outside the affected region, resulting from the replacement of a supplier in the region with a more costly supplier elsewhere, may be an indirect indicator. The likelihood of a supply interruption or an increase in costs being an indicator of impairment and triggering an impairment depends on the significance and duration of the expected change. Short-term, temporary disruptions are not necessarily indicative of an impairment for assets with a long-term remaining useful life.

The complete destruction of a non-current asset results in the derecognition of that asset as opposed to an impairment. That is because the complete destruction of an asset means that the asset will be disposed of or removed, and no future economic benefits are expected either from its use or disposal. Entities consider accruing decommissioning costs when evaluating the consequences of damage to assets in the disaster. Estimates of the amount and timing of future cash flows may have changed if the asset has been impaired or destroyed, which could affect the carrying value of the asset. Refer to Decommissioning obligations for guidance on accounting for decommissioning costs. Natural disasters – Asset impairments

Decisions about the recognition and measurement of losses are made independently of those relating to any compensation that might be a receivable from an insurance policy.

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Insurance coverage for property damage and business interruption

The basic intent of property damage and business interruption coverage is to repair or replace damaged property and to reimburse the insured for lost profits and continuing costs. However, the insured may find that it doesn’t want to—or can’t—repair or replace the property “as was.” Some reasons may include:

  • Building codes have changed since original construction. Natural disasters Asset impairments
  • It is impractical or inefficient to rebuild the previous design. Natural disasters Asset impairments
  • Operations can be enhanced—changed, expanded, or minimized—by making significant changes. Natural disasters Asset impairments
  • The damaged location can more effectively be consolidated into or moved to another location. Natural disasters Asset impairments

The basic property insurance policy allows the insured to be reimbursed for costs to repair or replace the damaged assets and the business interruption impact for the time required to repair or replace “with due diligence and dispatch.” Typical policy wording is as follows:

Property Damage

In the event of such damage or destruction, the Company shall pay the actual expenditure incurred in repairing or replacing the damaged property. The term “replacement cost” as used here means the cost to repair or replace lost or damaged property with property of comparable value and quality on the same or another site, and used for the same purpose, without deduction for depreciation, deterioration, or obsolescence.

Business Interruption

In the event of such damage or destruction, the Company shall be liable for the actual loss sustained by the Insured resulting directly from such interruption of business, but not exceeding the reduction in Gross Earnings … less charges and expenses which do not necessarily continue during the interruption of the business, for only such length of time as would be required with the exercise of due diligence and dispatch to rebuild, repair, or replace such part of the property as has been damaged or destroyed. Natural disasters Asset impairments

Property Damage and Business Interruption Illustrations

Let’s look at a hypothetical situation. Tylake Corporation owns a manufacturing plant located in Des Moines, Iowa, that produces dizaphones. The plant suffers a fire that destroys the entire plant. Natural disasters Asset impairments

Scenario 1: Rebuild the Property as It Was before the Incident

Tylake rebuilds the plant as it was before the incident a cost of $1 million. The time to complete repairs is 6 months. What is Tylake entitled to under its property policy?

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Tylake is entitled to the $1 million that it incurred to complete repairs. It is also entitled to the business interruption losses incurred during that 6-month period of time.

Scenario 2: Rebuild “As Was,” but Comply with “Code Upgrades”

Although Tylake’s management is willing to replace the plant as it was before the incident, new building codes written after original construction must now be adhered to, for an additional cost of $200,000. What is Tylake entitled to? Natural disasters Asset impairments

The insured’s policy will dictate the amount of coverage that is provided. While the standard ISO CP 00 10 “Building and Personal Property Coverage Form” provides coverage for the increased costs incurred to comply with the enforcement of new building codes, it also places a cap on the amount of such coverage. Many companies craft customized (manuscript) policies which either expand or do not limit the amount of such coverage. Typical wording for this type of policy is as follows:

Increased Cost of Construction

In the event of physical loss or damage covered hereunder that causes the enforcement of any law or ordinance in effect at the time of loss regulating the construction, repair or use of property … this Company will be liable for the increased cost of construction. Natural disasters Asset impairments

With this type of coverage, most policies typically require that the code upgrade be in place before the incident occurred. For example, after some of the recent hurricanes, local authorities made changes to code requirements after the incident. Costs incurred to meet such code upgrades may not be recoverable.

Assuming that Tylake’s policy had code upgrade wording such as that shown above, and that the new building codes were written prior to the incident, Tylake should be entitled to recovery of the total cost incurred, including the costs incurred to meet the new codes, or $1,200,000.

Scenario 3: Comply with “Code Upgrades” that Extend the Time To Complete Repairs

When code upgrades are required, it often means that the time to complete the repairs is longer. Tylake is happy to hear that the cost of the code upgrades will be reimbursed under its property policy. But it also finds that the time to rebuild the plant will take longer in order to adhere to the code upgrades. Instead of completing the repairs in 6 months, it will take 8 months to complete the repairs and meet the new code requirements. What is Tylake entitled to?

The standard ISO CP 00 30 “Business Income (and Extra Expense) Coverage Form” states that “”period of restoration” does not include any increased period due to the enforcement of any ordinance or law that regulates the construction, use or repair, or requires the tearing down of any property.” For this reason, most companies that have manuscript policies which cover the increased costs of construction due to code upgrades (as discussed in Scenario 2 above) typically also have manuscript policies that provide for the period of interruption to reflect the increased time to adhere to the code upgrades. Typical wording is as follows:

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Increased Cost of Construction

This policy also covers any increase in the Business Interruption and extra expense loss arising out of the additional time required to comply with state law or ordinance. If Tylake’s policy has code upgrade wording similar to the above, the additional time required to comply with the code upgrades should be covered.

Scenario 4: Don’t Rebuild

Tylake decides not to rebuild the damaged plant at all. What is Tylake entitled to? Natural disasters Asset impairments

Most policies state that the insured must take a reduction for depreciation if they decide not to rebuild and to “cash out” on the policy. Typical wording is as follows:

Actual Cash Value

If within one year, the process of repairing, rebuilding, or replacing the property has not begun, then the value of the property will be the Actual Cash Value. The term “Actual Cash Value” as used here means the Replacement Cost with deduction for depreciation, deterioration, or obsolescence.

If the insured’s policy includes wording similar to that above, and it decides not to complete the repairs, it would be entitled to the $1 million, less a factor to reflect the physical deterioration or depreciation of the property. Natural disasters Asset impairments

When the repairs are not made, the insured is typically entitled to business interruption losses incurred for the estimated time that it would have taken if repairs were indeed made. Natural disasters Asset impairments

Scenario 5: Make Significant Enhancements

Tylake decides to make significant enhancements to the plant rather than to rebuild it as it was before the incident. Instead of repairing the plant for $1 million, it intends to spend $2 million to enhance the facility. The time to complete repairs is expected to take 9 months rather than the 6 months that was expected if the facility was repaired as it was. What is Tylake entitled to? Natural disasters Asset impairments

When a significant loss occurs, the insured should determine if repairing the damaged asset as it was before the incident makes good business sense—from an operational and financial perspective. In this scenario, Tylake should be entitled to the $1 million cost to rebuild the plant as it was before the incident and should be entitled to business interruption losses for the 6 months that that it would have taken to rebuild the facility to as it was before the incident.

Natural disasters Asset impairments

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