How natural disasters impact financial reporting

By Cyril Jasmin B. Valencia

First Published in Business World (9/8/2014)

Typhoons, heavy monsoon rains and even earthquakes frequently result in damage to both lives and property. In the aftermath of such calamities, companies will need to take stock of the extent of the damage and how to report its financial impact. In this column, we provide guidance on the accounting requirements that a company should consider in its financial reports in relation to the effects of natural disasters.

Asset Impairment

The most common impact of disasters is damage to property. Because of this, an asset’s performance may be affected and asset impairment may occur. Management should perform impairment testing to determine if the company should recognize a loss by writing down the asset’s carrying value. Indicators of impairment may include a significant adverse change in the extent or manner in which an asset can be used, damage to its physical condition, or a significant decrease in the market price of the asset. Such impairment may be a direct or indirect result of the natural disaster.

Examples of direct results are toppled cell sites and electric posts or flooded manufacturing facilities, the carrying values of which require direct write-offs. Examples of indirect effects are business disruptions resulting from the inability of current suppliers to meet the company’s demands as these suppliers were also affected by the natural calamities. Companies may consequently have to find an alternative supplier outside the location or country to fulfill its commitments. This could result in higher operating costs. If such a disruption is expected to be prolonged, this may result in lower than expected cash flows from the use of the asset and may, therefore, result in its impairment.

Financial institutions lending to affected companies should also revisit their receivables portfolio or collateralized assets. They should consider whether such receivables or assets are still collectible or recoverable given that the borrowing company’s ability to pay may have been negatively impacted by the disaster.

Insurance Claims

More often than not, companies ensure that they are protected from losses by taking out insurance policies. When natural disasters strike and the companies have estimated the amount of damage or impairment resulting from these disasters, a question arises on how they will recognize the proceeds or claims, if any, from such insurance policies.
Determining the losses should be independent of the assessment of any compensation that can be covered by an insurance policy. If the company expects to recover its losses through insurance after the reporting period in which the losses occurred, the loss should be recognized when incurred, notwithstanding the expected insurance recovery. For example, when inventories are destroyed, these assets should be written-off, regardless of whether the losses can be recovered from an insurance policy or if there are plans to replace the inventories.
Although Philippine Accounting Standards (PAS) 37 Provisions, Contingent Liabilities and Contingent Assets does not define the point at which the compensation becomes a ‘claims receivable’, the standard requires that reimbursement from insurance claims should be recognized as a separate asset only when it is ‘virtually certain’ that proceeds will be received. PAS 37 does not define ‘virtually certain’ but it has a higher threshold than probable. In practice, ‘virtually certain’ has been interpreted as being at least 95% likely to occur. Given that it usually takes time to determine which losses will be recovered through the insurance policy, and that this will require close coordination and agreement between or among the parties involved, there should be sufficient evidence to prove the ‘virtually certain’ assessment.

If receiving the proceeds is only probable, PAS 37 prohibits the recognition of the related asset but requires disclosure in the financial statements. Such an asset (referred to as a ‘contingent asset’) should be assessed continually if it has already met the recognition threshold of the accounting standard and, thus, can be recognized as an asset.

Obligations and Restructuring Costs

Companies will also need to consider additional obligations resulting from natural disasters such as the obligation to repair damage to the environment. Business restructuring may also result from such disasters. This may include sale or termination of a line of business, closure of a certain branch, relocation of an office to another area, or even a change in management.

There are expected costs for these activities and PAS 37 has specific guidance on timing of recording these additional obligations and restructuring costs. As a general rule, costs from restructuring can be recorded in the books if all these criteria are met, namely: (1) there is a present obligation, which can either be legal or constructive; (2) it is a result of a past event and; (3) in respect of which a reliable estimate can be made of the probable cost. Companies should carefully analyze if the costs will meet these criteria before recognizing the same in their books.

Future Losses

Companies may also incur future losses from a natural disaster. Examples of future losses are additional costs from a decision to outsource capacities due to the destruction of facilities or to provide additional benefits to its employees who have suffered personal damage. It is important to remember that future operating losses and costs that do not meet the definition of a liability are not recognized until they have been incurred.

Onerous Contracts

Companies will also need to assess if the disaster will give rise to onerous contracts. Onerous contracts are those where the unavoidable costs of meeting the related obligations under the agreement exceed the economic benefits expected to be received from it. Such an excess should be recognized as a provision (liability). The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it.

For example: Take an entity that leases a warehouse adjacent to its manufacturing facility. Due to a recent typhoon, the manufacturing facility became inoperable and will have to be closed. The lease for the adjacent warehouse continues for the next three years but can be cancelled for a certain penalty. The provision required in the books therefore will be the lower of the discounted lease payments for the next three years and the penalty for cancellation.
It is important, therefore, that when a natural disaster occurs, contracts should be reviewed to determine if there are any special terms, such as force majeure, that may relieve a company of its obligations.

In one way or another, damage wrought by natural disasters may have an impact on a company’s financial reports. Thus, it is important that companies should have the ability to assess and record, in a timely manner, such an impact. Moreover, as the adverse effects could be significant, companies should also consider how these financial consequences will be communicated to their stakeholders.

Cyril Jasmin B. Valencia is a Partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.