17-6, Financial Reporting Implications of Disasters (September 20, 2017; Updated October 17, 2018)

U.S. GAAP on property, plant, and equipment and the impairment or disposal of long-lived assets in ASC 3601 requires entities to test a long-lived asset or group of assets for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable (see ASC 360-10-35-21). For example, the impact of a disaster may cause entities to assess the recoverability of long-lived assets in accordance with ASC 360-10-35-21 because there may be any of the following:

• “A significant decrease in the market price of a long-lived asset (asset group).”
• “A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition.”
• “A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.”
• A significant decline in the asset’s (or asset group’s) capacity to generate income or cash flows such that forecasts demonstrate continuing losses.

The impact of a disaster may trigger the need to test an entity’s finite-lived intangibles (e.g., customer relationships, patents, copyrights) for impairment. Entities should apply the recognition and measurement provisions in ASC 360-10-35-17 through 35-35 when reviewing finite-lived intangibles for impairment (see ASC 350-30-35-14). Thus, the analysis of finite-lived intangibles is not different from the analysis of long-lived assets discussed above.

The impact of a disaster also may trigger the need to test an entity’s indefinite-lived intangibles for impairment. ASC 350-30 requires that entities test indefinite-lived intangible assets for impairment annually or more frequently when an event or change in circumstances indicates that it is more likely than not that the asset is impaired. An entity may first perform a qualitative assessment to determine whether it is necessary to perform the quantitative impairment test. Such a test would consist of a comparison of the fair value of an intangible asset with its carrying amount, and an impairment would be recognized for the amount, if any, by which the carrying amount exceeds the fair value.

As a result of a disaster, an entity may need to test goodwill for impairment. Entities are required to test goodwill for impairment annually or more frequently in certain circumstances (this re-quirement is similar to the guidance on other indefinite-lived intangibles and includes an optional qualitative assessment). Specifically, an entity should test goodwill for impairment when an “event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.”

A disaster may lead to circumstances in which the utility of inventory on hand is impaired by damage, deterioration, obsolescence, changes in price levels, or other causes. Whether the impairment is caused by physical destruction or an adverse change in the utility of the inventory, entities should assess whether an inventory impairment or write-off is required in accordance with ASC 330-10-35-1A through 35-11 as appropriate, which address adjustments of inventory balances to the lower of cost or market.

Receivables from entities affected by a disaster should be evaluated for collectibility. Entities may incur additional write-offs of receivables deemed uncollectible or may be required to establish additional reserves on receivables.

Creditors are required to evaluate loans for collectibility and assess whether a loan is impaired, which occurs when, on the basis of current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement (see ASC 310-10-35-16). In a disaster event, debtors experiencing operational declines, especially declines in cash flows and liquidity, may not be able to make principal and interest payments in a timely manner. This may lead to impairment of such loans on the creditor’s books, because it may become probable that contractually specified cash flows will not be collected.

Declines in the market value of securities or impairments as a result of defaults, bankruptcy, or both should be considered in the evaluation of whether investments are other-than-temporarily impaired. ASC 320-10-35-17 through 35-37 and SEC Staff Accounting Bulletin Topic 5.M, “Other Than Temporary Impairment of Certain Investments in Equity Securities,” provide guidance on evaluating whether an impairment is other than temporary.

Under certain finite insurance contracts, an entity pays a premium, approximating the amount of expected losses, into an account held with the insurer. If the cost of losses turns out to be less than the premium, the carrier gives back the difference to the insured; if the losses turn out to be greater, the insured pays an additional premium to the insurer. The main advantage of these types of finite insurance contracts is the transfer of timing risk and not necessarily underwriting risk.

Retrospectively rated insurance contracts provide for changes in future contractual cash flows (including premium or settlement adjustments) or changes in the contract’s future coverage on the basis of contract experience. A critical feature of such contracts is that part or all of the retrospective rating provision is obligatory; thus, the retrospective rating provision creates for each party to the contract future rights and obligations as a result of past events. As detailed in ASC 720-20-25-15, an insured should recognize “a liability to the extent that [it] has an obligation to pay cash (or other consideration) to the insurer that would not have been required absent experience under the contract.” Significant damages caused by an unforeseen event, such as a disaster, may indicate that a liability has been incurred under retrospective rating provisions. Similar issues should be considered for single-year retrospectively rated insurance contracts with respect to interim reporting periods.

In a mutual insurance company, the members pay premiums that are pooled to cover the losses incurred by all members of the mutual company. If the mutual company is required to cover large, unexpected losses, it may demand additional premiums from all members or it may increase premiums over subsequent years. By analogy to ASC 720-20-25-15, entities with a contractual obligation requiring the insured to pay the additional premiums, even if the policy is canceled, have most likely incurred a liability that should be recognized. Therefore, entities not directly affected by an event may be indirectly affected by the requirement to recognize a contractual obligation for additional premiums.

ASC 610-307 and ASC 605-40 provide guidance on the accounting for involuntary conversions of nonmonetary assets (such as property or equipment) to monetary assets (such as insurance proceeds). This guidance requires recognition of a gain or loss on an involuntary conversion of a nonmonetary asset to a monetary asset that is measured as the difference between the carrying amount of the nonmonetary asset and the amount of monetary assets received. An involuntary conversion is considered to have occurred even if an entity reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets. Insurance recoveries, including resulting gains and losses, should be classified in a manner consistent with the related losses (i.e., generally within income from continuing operations).

With respect to the timing of recognition of insurance recoveries, an entity should apply ASC 450-30-25-1 and AICPA Technical Practice Aids, TIS Section 5100.35, “Involuntary Conversion — Recognition of Gain,” for recoveries in connection with property and casualty losses; the entity should apply ASC 410-30-35-8 through 35-12 for recoveries in connection with environmental obligations. In general, insurance recoveries that will result in a gain should not be recognized until realized.

Business interruption insurance differs from other types of insurance coverage in that it is designed to protect the prospective earnings or profits of the insured entity. That is, business interruption insurance provides coverage if business operations are suspended because of the loss of use of property and equipment resulting from a covered loss. Business interruption insurance coverage also generally provides for reimbursement of certain costs and losses incurred during the reasonable period needed to rebuild, repair, or replace the damaged property. Certain fixed costs incurred during the interruption period may be analogous to losses from property damage and, accordingly, it may be appropriate to record a receivable for amounts whose recovery is considered probable. We encourage entities to consult with their independent auditors in connection with their evaluation of whether a receivable may be recorded for expected insurance recoveries associated with fixed costs incurred during the interruption period. Lost revenues or profit margin are considered a gain contingency and should be recognized when earned and realized. Because of the complex and uncertain nature of the settlement negotiations process, this generally occurs at the time of final settlement or when nonrefundable cash advances are made.

An entity that purchases insurance from a third-party insurer generally remains primarily obligated for insured liabilities; however, the entity should carefully evaluate the insurance contract and applicable laws. Under U.S. GAAP, claim liabilities should not be presented in the balance sheet net of related insurance recoveries unless the requirements of ASC 210-20 are met. The general principle of that guidance is that net presentation (“offsetting”) of assets and liabilities is appropriate only when a right of setoff exists. ASC 210-20-45-1 states that a right of setoff exists when the following four conditions are met:

ASC 230-10-45-16(c) indicates that proceeds of insurance settlements should be classified as operating cash flows except for recoveries “that are directly related to investing or financing activities, such as from destruction of a building.”

Some past disasters have caused natural gas leaks and leaks from oil storage tanks, damage to underground containers holding potentially toxic materials, and other environmental damage. Entities should assess whether the damage results in additional exposure to environmental remediation liabilities. ASC 410-30-25 provides guidance on recognizing environmental remediation liabilities.

Not all clean-up costs will represent an environmental remediation liability or have to be accrued. ASC 410-30-25-1 refers to ASC 450, which clarifies that a liability would be recognized when evidence indicates that a liability has been incurred as of the date of the financial statements and the amount of this liability can be reasonably estimated. Given the nature of environmental remediation obligations, the “probable” criteria triggering recognition are presumed to have been met when (1) litigation has commenced or a claim or an assessment has been asserted on or before the balance sheet date or (2) commencement of litigation or assertion of a claim or an assessment is probable on the basis of available information (see ASC 410-30-25-4(a)) and it is probable that this litigation, claim, or assessment will be unfavorable (see ASC 410-30-25-4(b)). Making such a determination in light of the uncertainty that is often associated with a disaster may be extremely difficult. In addition, rubble of damaged buildings and equipment or leaked toxins may never result in litigation or another remediation liability under a law or statute. Clean-up costs, other than those that create an obligation in accordance with ASC 410-30 or that result in other litigation requiring an accrual in accordance with ASC 450, should not be recorded until incurred (i.e., when the clean-up takes place), even though such expenses could be triggered by the disaster event.

An entity may forecast operating losses for a certain period after a disaster. Such losses may result from clean-up and repair costs directly attributable to the event. Other losses may be indirectly related to the event, such as those resulting from declines in customer demand or disruptions in the supply chain. Future operating losses do not meet the definition of a liability, nor do they qualify for accrual under ASC 410-30 or ASC 450. Such losses should be reflected in the period in which the related costs are incurred.

Upon designation of a cash flow hedge, entities must assert that the occurrence of the forecasted transaction is probable in accordance with ASC 815-20-25-15. Entities should consider whether occurrence of the forecasted transaction is still probable after a disaster. If occurrence of the forecasted transaction is no longer probable, hedge accounting should be discontinued. However, ASC 815-30-40-4 and 40-5 indicate that related gains and losses in accumulated other comprehensive income should only be immediately reclassified to earnings if it is probable that the forecasted transaction will not occur by the end of the originally specified period (as documented at the inception of the hedging relationship) or within an additional two-month period thereafter.

Entities should consider the risk of counterparty default with respect to their derivative and hedging portfolios. In accordance with ASC 815-20-35-15, if the likelihood that the counterparty will not default ceases to be probable, the hedging relationship ceases to qualify for hedge accounting because the hedging relationship is no longer expected to be highly effective.

ASC 815-10-15-22 through 15-51 provide guidance on the normal purchases and normal sales exception. If it is no longer probable that a contract will not settle net and result in physical delivery, the contract generally no longer qualifies for the scope exception for normal purchases and normal sales. If the contract no longer meets the scope exception, it should be recorded on the balance sheet at its current fair value and marked to fair value on an ongoing basis.

Entities may be committed to lease agreements for property that has been destroyed or has permanently lost its function because of damage resulting from a disaster. ASC 420 requires that if an operating lease is not terminated and the associated asset has no future economic benefit, the entity must recognize a liability as of the cease-use date at fair value, determined on the basis of the remaining lease rentals, reduced by estimated sublease rentals that could be reasonably obtained for the property, regardless of whether the entity intends to enter into a sublease (see ASC 420-10-25-13 and ASC 420-10-30-8). A liability for costs to terminate a contract before the end of its term must be measured at fair value when the entity terminates the contract (see ASC 420-10-25-12 and ASC 420-10-30-7).

A lessor and lessee may decide to modify the terms of a lease agreement as the result of a disaster. In such situations, entities should consider the guidance in ASC 840-10-35-4, which requires lessees and lessors to analyze lease modifications (other than lease renewals or extensions) to determine whether substitution of the modified provisions for the original lease provisions at the inception of the lease would have resulted in a different lease classification at the inception of the lease.

For sublet assets, ASC 840-20-25-15 states that “[i]f costs expected to be incurred under an operating sublease (that is, executory costs and either amortization of the leased asset or rental payments on an operating lease, whichever is applicable) exceed anticipated revenue on the operating sublease, a loss shall be recognized by the sublessor.” Similarly, ASC 840-30-35-13 states, “The original lessee (as sublessor) shall recognize a loss on a direct financing sublease if the carrying amount of the investment in the sublease exceeds the total of rentals expected to be received and estimated residual value unless, as sublessor, the original lessee’s tax benefits from the transaction are sufficient to justify that result.”

One-time termination benefits provided to current employees that are involuntarily terminated under the terms of a benefit arrangement that, in substance, is not an ongoing benefit arrangement would be accounted for in accordance with ASC 420. In general, the obligation associated with the one-time termination benefit should be recognized as of the “communication date,” as detailed in ASC 420-10-25-8, and measured at fair value in accordance with ASC 420-10-30-5. The communication date is defined as the date on which the plan of termination meets all the criteria in ASC 420-10-25-4 and has been communicated to employees.

ASC 420 does not apply to termination benefits to be paid to terminated employees that are part of a substantive preexisting ongoing employee benefit plan. Such benefits should be accounted for in accordance with other guidance, such as ASC 715-30, ASC 715-60, ASC 712, or ASC 710.

Entities offering a voluntary termination benefit to employees in an effort to reduce their workforce should consider the guidance in ASC 712-10-25-1, which indicates that a liability and loss generally should be recognized “when the employees accept the offer and the amount can be reasonably estimated.”

Unconditional promises to give are recognized at fair value in the period in which the promise is made. Conditional promises to give are recognized when they become unconditional (i.e., when the conditions are substantially met). A conditional promise to give is considered unconditional if the possibility that the condition will not be met is remote.

Contributions to certain organizations are not deductible for income tax purposes, resulting in a permanent tax difference that increases an entity’s effective tax rate. In certain limited circumstances, donations of nonmonetary assets may be recorded at carrying value for book purposes but at fair value for tax purposes, thereby creating a permanent tax difference. These permanent differences should be reflected in the entity’s quarterly and annual income tax provisions. However, ASC 740-270-30-6 requires that, at the end of each interim period, an entity “make its best estimate of the effective tax rate expected to be applicable for the full fiscal year.” Therefore, the entire tax impact will not necessarily be reflected in the quarter in which the contribution occurs (particularly when a disproportionate amount of contributions is made in a single interim period).

A significant event, such as a disaster, may cause a company to reassess its need for a valuation allowance against deferred tax assets (DTAs). A DTA is reduced by a valuation allowance if, on the basis of the weight of positive and negative evidence available, it is more likely than not that some portion or all of a DTA will not be realized (under ASC 740). Whenever negative evidence is present, the determination of the amount of the valuation allowance needed to reduce the DTA to an amount that is more likely than not to be realized depends on the existence of positive evidence supporting the future utilization of the DTA. One form of positive evidence may be the existence of deferred tax liabilities (DTLs), which would result in future taxable income upon reversal; however, a significant event resulting in financial losses may also result in the loss of such DTLs because of asset impairments or write-offs. Another significant form of positive evidence is an estimate of future taxable income. Generally, discontinued operations, cumulative effects of accounting changes, extraordinary items, and even certain nonrecurring items are not indicative of an entity’s ability to generate taxable income and may be excluded from projections. However, unusual loss allowances, poor operating results caused by an economic downturn, operating losses attributable to a change in the focus or directives of a subsidiary or business unit, and, by extension, poor near-term and projected operating results caused by a disaster, whether related to operations in the affected area or outside it, are generally not considered nonrecurring in the forecasting of taxable income and therefore generally are considered in such projections. Thus, a significant disaster could potentially lead a company to conclude that it may not generate sufficient results in the future to realize its existing DTAs and to therefore determine that a valuation allowance and related disclosures are required.

Companies should also reassess the continuing propriety of transfer pricing arrangements between a parent and a subsidiary. The average profitability of benchmark companies underlying the most recent transfer pricing analyses may change, triggering a disconnect between expectations set by regional tax authorities and the modified margins achieved through transfer pricing.

Any potential shift in earnings between foreign entities or jurisdictions may also affect regional cash needs, and management may determine that foreign earnings that it had not planned to repatriate to the United States may now be required to meet debt service requirements or other cash needs of the U.S. parent company. Although these foreign earnings may have been subject to U.S. tax under the Tax Cuts and Jobs Act of 2017, entities may still be subject to additional income tax on foreign investments (e.g., withholding taxes or state income taxes) and should consider whether they need to record any deferred taxes on outside basis differences in foreign investments.

All of the items noted above may affect a company’s interim accounting for income taxes. The estimated annual effective tax rate applied to year-to-date earnings in interim periods should take into account all changes to forecasted earnings and book-tax differences affected by the event, including changes in the company’s ability to use certain state or foreign tax attributes, its need for a valuation allowance, transfer pricing changes, and its ability to avoid additional U.S. or foreign withholding taxation on earnings of subsidiaries that it plans to repatriate to the United States. Certain significant events may result in losses or permanent book-tax differences during the period that are considered significant, unusual, or extraordinary under ASC 740 and therefore may warrant treatment as discrete items to be excluded from the calculation of the esti-mated annual effective tax rate. In addition, a disaster may result in a significant loss carryforward in a certain jurisdiction that will require a full valuation allowance or may result in an operation for which management cannot develop reliable estimates. The tax effects of significant unusual or infrequently occurring items should be treated as discrete and excluded from the calculation of the annual effective tax rate.

In some cases, an entity may incur such substantial losses or experience such significant liquidity concerns that the entity’s ability to continue as a going concern is called into question. In connection with the preparation of financial statements for each annual and interim reporting period, ASC 205-40 requires an entity’s management to evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the interim or annual financial statements are issued (or available to be issued when applicable). The evaluation (1) is based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued and (2) initially cannot take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued. ASC 205-40 requires an entity to make disclosures in the annual and interim financial statements when events and conditions are identified that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the financial statements are issued. Such disclosures are required even when management’s plans alleviate such doubt about the entity’s ability to continue as a going concern. If these plans do not alleviate substantial doubt about the entity’s ability to continue as a going concern, in addition to the required disclosures, management must make a statement in the notes to the financial statements indicating that there is substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the annual or interim financial statements are issued.

Independent auditors also have a responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern in connection with their audits of the annual financial statements. PCAOB Auditing Standard No. 2415, Consideration of an Entity’s Ability to Continue as a Going Concern, and AICPA Professional Standards AU-C Section 570, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern,” provide independent auditors with guidance on making this evaluation. In addition, in connection with an independent auditor’s review of interim financial information performed in accordance with PCAOB Auditing Standard No. 4105, Reviews of Interim Financial Information, or AICPA Professional Standards AU-C Section 930, “Interim Financial Information,” the independent auditor should perform interim review procedures (e.g., inquiries) related to (1) whether the going concern basis of accounting is appropriate, (2) management’s evaluation of whether there are conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern, (3) management’s plans to mitigate conditions or events that raised substantial doubt about the entity’s ability to continue as a going concern, and (4) the adequacy of the related disclosures in the interim financial information. Further, if a public company is filing a registration statement that requires the auditor to reissue its opinion on the most recent annual financial statements, the auditor may need to consider the ramifications of a disaster on the entity’s ability to continue as a going concern.