Navigating the Accounting Impact of Weather-Related Disasters

Recent hurricanes and other extreme weather events along the southeastern U.S. have caused significant devastation, with widespread damage to businesses, infrastructure and livelihoods. As these events unfold, businesses must also grapple with the financial and accounting implications of natural disasters.

Understanding the accounting ramifications of such events is critical for organizations with assets or customers in affected areas. Below, we explore key considerations for businesses navigating these challenges, from asset impairments to insurance recoveries.

Identifying Triggering Events: A First Step in Asset Impairment

When a natural disaster impacts a business’s operations, the first step in evaluating its financial implications is identifying whether a “triggering event” has occurred. A triggering event suggests a decline in the fair value of assets below their carrying value.

The occurrence of a natural disaster, even if short-term, can trigger asset impairment tests, especially if a business experiences a significant drop in revenue. This is particularly relevant for businesses with most of their revenue concentrated in a single geographic area or customer base. For example, losing 80% of revenue, even temporarily, may indicate that assets are impaired, necessitating an immediate evaluation of their fair value.

Assessing Goodwill and Intangible Asset Impairments

Goodwill, tested for impairment annually unless the private company alternative is available and elected, may require an interim assessment as a significant weather event could be a triggering event. For businesses directly affected, the likelihood of impairment increases. Businesses can normally perform a qualitative goodwill test, but bypassing this step and opting for a quantitative assessment may be a more efficient approach in the wake of a disaster. This test evaluates whether the carrying value of goodwill exceeds its fair value and can result in an impairment charge if necessary.

Similarly, indefinite-lived intangible assets, such as non-amortizing trademarks, must be tested annually or when a triggering event occurs. Unlike goodwill, these tests are based on the fair value of individual assets, and private company alternatives do not apply. Businesses must reassess the fair value of these intangible assets, which may be impacted by a loss of customers or operational disruptions.

Evaluating Finite-Lived Tangible and Intangible Assets

Natural disasters can physically damage or destroy assets, but they can also affect future cash flows. Businesses must conduct a three-step process to assess impairment:

1. Identify a Triggering Event: The disaster serves as a triggering event but may manifest in different ways. For example, potential asset impairments could arise from physical damage, a change to the manner and extent the assets are used, reduced production levels, or anticipated customer losses negatively impacting projected cash flows.
2. Determine Recoverability: Assess whether the asset group’s carrying value is recoverable by evaluating the most up-to-date projected undiscounted cash flows. This could involve considering multiple potential outcomes and weighing cash flows based on various recovery scenarios.
3. Measure Impairment: If the carrying value exceeds the recoverable amount, the impairment must be measured using fair value estimates. This involves comparing the asset group’s fair value to its carrying value with any deficit recognized as an impairment loss.

It’s important to note that when an asset is destroyed — even if the rest of the asset group passes the recoverability test — it must be written off entirely.

Receivables and Inventory: Reassessing Value and Collectability

Severe weather events can significantly impact the collectability of receivables, especially if customers are located in the affected areas. Businesses must consider whether they need to increase reserves or write off certain receivables. The Current Expected Credit Loss (CECL) standard requires assessing credit losses collectively, grouping receivables that share similar risk characteristics. If a natural disaster significantly changes the risk profile of certain receivables, they should be removed from the group and assessed individually.

Inventory located or sold in affected areas also demands attention. For companies using the last in, first out (LIFO) or retail inventory method, inventory impairments are assessed using the lower of cost or market approach. For other methods, impairments are determined based on the lower of cost or net realizable value. Businesses must also consider whether inventory has been physically destroyed or its value has diminished due to its perishable nature, lower demand or lower margins resulting from the disaster.

It’s important to note that abnormal overhead costs — either from idling a production plant or unusually high expenses incurred from renting backup equipment, power generators or temporary facilities — should not be included in inventory production costs. Instead, these abnormal costs are expensed as incurred.

The Role of Deferred Tax Assets and Debt Covenants

Following a natural disaster, companies must determine if the weather event impacts their deferred tax assets (DTAs) valuation analysis. The likelihood of realizing DTAs is based on the company’s ability to generate future taxable income. Suppose a disaster impacts the company’s future profitability. In that case, it may no longer be able to meet the “more likely than not” threshold for realizing those assets, potentially necessitating a change to the valuation allowance.

Debt is another area that can become a challenge after a weather event. Companies may struggle to meet their debt covenants or, worse, face default due to disruptions in revenue. If a company is in default as of the reporting date or expects to default within a year, it may need to reclassify its debt from non-current to current. Additionally, companies with cross-default provisions in their debt agreements may face broader financial repercussions if a default triggers a series of other defaults across multiple agreements.

Insurance Recoveries: Managing Expectations

One area where companies can potentially mitigate their financial losses is through insurance recoveries. When it comes to insurance recoveries, there are many judgments involved, including not only whether the loss event is covered by insurance but also which accounting model applies to the fact pattern. The expected insurance recovery may fall under the loss recovery model, the gain contingency model or both. Property and casualty insurance typically covers physical damage, while business interruption insurance compensates for lost profits during recovery. However, accounting for these recoveries depends on the coverage type and the certainty of the payout.

Insurance proceeds for physical damage are generally accounted for under the loss recovery model, with recoveries recognized when it is probable that it will be received. Any amount exceeding the recorded loss falls under the gain contingency model and is not recognized until receipt is realized or realizable, which is when substantially all uncertainties around the recovery have been resolved.

On the other hand, business interruption insurance covers losses not yet incurred — such as projected future profits lost during recovery. These recoveries are also accounted for under the gain contingency model and recognized only when receipt is virtually certain. This requires confirmation from the insurance provider that the event is covered and that the payout amount has been finalized.

Going Concern and Lease Considerations

Businesses affected by natural disasters may face liquidity challenges, raising questions about their ability to continue as a going concern. Management must assess whether the company can meet its obligations for the 12 months generally following the financial statement issuance, considering factors such as disrupted operations, reduced cash flows and impacts on debt covenant compliance.

Lease agreements may also be affected by natural disasters. Businesses might terminate leases or negotiate rent concessions, which triggers the lease modification accounting rules. Depending on whether changes to a lease are part of the original contract or a modification, companies may need to remeasure lease liabilities and right-of-use assets, potentially resulting in a gain or loss.

A Path Forward After the Storm

The financial consequences of natural disasters can be complex, extending well beyond the immediate physical damage. As businesses rebuild and recover, they must navigate various accounting challenges — from asset impairments to debt compliance and insurance recoveries.

At CBIZ, our accounting professionals are here to help with the expert guidance you need to stay financially resilient through any storm. Connect with us today.