Accounting alert 2011/02 - Accounting for the impacts of natural disasters
Considerations for financial reporting at 30 June 2011
During the past twelve months, the globe has faced a number of significant natural disasters. The extreme rainfall events in Queensland, Victoria and other parts of Australia have caused substantial damage. Bush fires have raged in Western Australia. Earthquakes have devastated Christchurch and Japan.
In addition to causing the tragic loss of life, disasters can result in widespread damage to and destruction of property and the disruption of business activity to varying degrees in affected regions and, in some cases, parts of the rest of the world.
A number of financial reporting implications can arise as a result of a disaster. Set out below are some financial reporting considerations for entities that may have been directly or indirectly affected by these events or others which may occur. The implications discussed are not intended to be all-inclusive or exhaustive, but rather a starting point for thinking about issues that might arise.
Are natural disasters an adjustable event?
For entities with balance dates before the disaster event
The disaster event is a non-adjusting event where the financial reporting period ended before the event, but audited financial statements were not produced before the event.
AASB 110 Events after the Reporting Period requires note disclosure for all material non-adjusting events, including the nature of the event and an estimate of its financial effect or, where the effect is not known, a statement that an estimate cannot be made.
However, where an entity is determined to be not a going concern after balance date, but before signing the financial statements, the financial statements will need to be adjusted to a basis other than going concern.
For entities with balance dates after the disaster event:
The financial impact of the disaster event should be included in the financial statements where the financial reporting period ends after the -disaster, including any potential going concern issues.
In addition to the above, material impacts may also require disclosure under continuous disclosure and similar rules.
Potential impairment of assets
Entities may need to consider impairing damaged property, plant and equipment or other assets. They will also need to account for related compensation as a separate economic transaction. Treatment of compensation (e.g. insurance proceeds, grants or donations) is discussed below.
Inventory is carried at the lower of cost and net realisable value in accordance with AASB 102 Inventories. Net realisable value is the estimated selling price, less estimated costs of completion and estimated costs to make the sale.
Entities will need to consider whether net realisable value has now fallen below cost, especially if the inventory is damaged or selling prices have declined. In some other cases, suppliers of materials and other needs in reconstruction or whose products become more scarce due to competitors being affected, may need to reverse previous net realisable value write downs.
Investment property will need to continue to be measured at fair value, reflecting market conditions at the end of the reporting period (AASB 140 Investment Property).
In some extreme cases, entities may be considering whether it is possible to determine fair value reliably. In periods where there is an absence of current prices in an active market, entities (and the appointed independent valuers) will need to consider information about fair value from other sources, including current market prices for properties of a different nature, condition or location, recent prices in less active markets (with adjustments) or discounted cash flow projections.
Entities which already use the fair value model under AASB 140 must continue to do so. They cannot revert to the cost basis, which is only available on initial recognition where there is evidence that fair value cannot be reliably determined on a continuing basis.
|Property, plant and equipment||
Assets that are unable to be repaired will need to be derecognised in their entirety other than scrap value.
Assets that are damaged (but will be repaired) may be impaired. They will need to be assessed in accordance with AASB 136 Impairment of Assets. Entities will need to consider the recoverable amount of assets individually, unless the asset does not generate cash inflows that are largely independent of other assets in which case it will be considered as part of the cash generating unit (CGU) to which it belongs.
Impairment and CGUs is a complex area, requiring careful consideration. While damage may be obvious, entities with significant headroom in their CGU impairment testing may not need to provide for any impairment if the asset is expected to be repaired and will continue to be used within the CGU (as this is not permitted).
This may be more prevalent where entities include operations in a disaster affected area and other locations in the same CGU.
|Goodwill and intangible assets||
Goodwill and indefinite life intangibles are tested for impairment annually, and finite life intangibles are tested whenever there is an indication of impairment.
Changes in expected profitability and cash flows will impact on the determination of recoverable amount, and entities will need to consider carefully the application of AASB 136 in this area.
Recoverable amount is the higher of fair value less costs to sell and value in use.
Entities may need to make substantial changes to their previous value in use model, to reflect the disruptions to the economy in affected areas and revised expectations of profitability and cash flows.
In the event that a goodwill impairment loss is recognised, it cannot be subsequently reversed.
|Investments in other entities||
Investments in other entities may be impaired if those entities are also affected by natural disasters. The measurement and treatment of any impairment is dependent on the type of investment and the policy adopted for that investment.
As with goodwill and intangible assets above, entities may find that the models used to determine fair value (for investments carried at fair value) or recoverable amount (e.g. for equity accounted investments or investments carried at cost) need to be updated for significant changes in facts in circumstances.
|Debtors and receivables||
Many entities may have cash flows and profitability which are not directly negatively impacted, but may have customers that are affected. Even if customers are not based in an affected area, they might have customers or business operations facing difficulties as a result of the disasters. This may have a flow-on effect on the recognised amount of doubtful debt allowances.
Entities will need to consider appropriate doubtful debt allowances, in accordance with AASB 139 Financial Instruments: Recognition and Measurement. This requires entities to estimate future cash flows, discount that cash flow (at the original effective interest rate), and then compare that to the current receivable balance in order to determine if the provision level is adequate.
Changes in the fair value of any collateral that is expected to be called on should also be considered, particularly if it is physical property and based in the affected area.
|Financial instruments measured at fair value||Financial instruments measured at fair value must continue to be measured on this basis. Careful consideration of whether recent transactions represent fair value may be required in some cases, particularly if markets are thinly traded for particular instruments affected by the event.|
In some cases it may be difficult to determine fair value less costs to sell, value in use, or net realisable value (as appropriate). Careful consideration will need to be given to arriving at appropriate carrying amounts for assets, and affected entities will need to disclose clearly the judgements, estimates and assumptions made.
Treatment of compensation
Compensation (e.g. insurance proceeds, grants or donations) should be treated as a separate economic transaction from any impairment event. Entities will need to consider when to recognise compensation, and also the amount to recognise.
Insurance cover may be a contingent asset, rather than a receivable, until the point at which cover is confirmed, e.g. by an insurer.
Insures may choose to meet some costs directly and entities in effect receive a “make-good” service from the insurer. In such a scenario it may be difficult for entities to determine the cost actually incurred by the insurer in restoring damaged assets. In any event, the compensation received or receivable should be recognised at an estimate of its fair value.
The facts and circumstances of the insurance arrangement will also influence the timing of recognition of any insurance revenue. If, for example an entity is entitled to reimbursement of costs actually incurred by the entity in repairing a building, then that insurance revenue would be recognised as repair costs are incurred. If however, an agreement obligates an insurer to repair or replace a building, the facts and circumstances may suggest that the insured entity could recognise the insurance revenue/receivable immediately.
Once the repair of impaired property, plant and equipment carried at cost has been completed, an entity may be able to reverse its impairment provision. However, this should not result in the asset value being greater than the carrying value before impairment unless the “repair” has resulted in additional economic benefits (such as an extended useful life). Any excess of the fair value of the insurance proceeds over the amount which can be capitalised may represent compensation for repairs and maintenance expenses.
The costs incurred by the entity or the insurer to replace property, plant and equipment which was unable to be salvaged (and accordingly was written off) can be fully capitalised, provided it meets the criteria for capitalisation in AASB 116 Property, Plant and Equipment.
In the case of business interruption insurance or loss of profits insurance, it is obviously important that entities carefully document their losses to increase the chance of a successful insurance claim. When to recognise compensation will depend on the facts and circumstances of the insurance arrangement, but must not be before losses have actually been incurred. Entities will need to consider the likelihood of the claim being accepted by the insurer, and the amount to recognise may require some degree of estimation.
If a government grant is received then for-profit entities will need to consider AASB 120 Accounting for Government Grants and Disclosure of Government Assistance. The accounting treatment is dependent on the terms of the grant, so careful consideration will need to be given to the facts and circumstances of each grant.
Government grants are recognised as a receivable when there is reasonable assurance that the entity will comply with the conditions of the grant, and the grant will be received. They are then recognised in profit or loss on a systematic basis over the periods in which the entity recognises as expenses the related costs for which the grants are intended to compensate. Grants related to assets may be treated as deferred income, or deducted against the carrying amount of the asset.
Grants that are receivable as compensation for expenses or losses already incurred, or for the purpose of giving immediate financial support with no future related costs, shall be recognised in profit or loss in the period they become receivable.
Where interest-free or below-market loans are received from governments, recent changes to AASB 120 require such loans to be measured in accordance with AASB 139 and a government grant recognised for the difference between the initial carrying value of the loan and the amount received.
Onerous lease provisions
Entities will need to consider whether any lease (or other) contracts at balance date are onerous contracts under AASB 137 Provisions, Contingent Liabilities and Contingent Assets. An onerous contract arises when the unavoidable costs of meeting the obligations under the contract exceed the benefits expected to be received under it.
It may be an indication that a lease contract is onerous where an entity is required to continue to pay lease costs for premises that it does not intend to, or is unable to occupy for a period of time (in some cases the entity may not be required to pay rental where the premises is damaged). This may include where:
- For the period of repair an entity has leased, and is using, alternative premises
- An entity has entered into an agreement for a long term lease of alternative premises, whilst still continuing to lease the damaged or unusable premises
- An entity does not intend to re-open for business from the current lease premises.
It is important that entities consider the expected benefits over the lease term as a whole, rather than just the near future.
Environmental and similar liabilities may arise due to natural disasters. For instance, gas leaks and leaks from storage tanks, underground containers containing potentially toxic materials caused by an event may give rise to remediation and clean up obligations, legal claims or other similar liabilities.
Such obligations should be recognised as liabilities where they meet the requirements of AASB 137 Provisions, Contingent Liabilities and Contingent Assets.
However, AASB 137 does not permit the recognition of a liability for future operating losses that might be incurred (other than onerous contracts) as a result of having to suspend or curtail operations, or for other reasons.
Similarly, restructuring costs or termination benefits arising as a result of post-event restructuring decisions can only be recognised where they meet the stringent criteria for recognition under AASB 137 or AASB 119 Employee Benefits.
Hedge accounting requirements under AASB 139 Financial Instruments: Recognition and Measurement permits a hedging relationship to qualify for hedge accounting only if a number of conditions are met.
Amongst other requirements, hedges must be assessed on an ongoing basis and determined actually to have been highly effective throughout the reporting periods for which they are designated. Forecast transactions must be highly probable and any ineffectiveness must be recognised in profit or loss.
Unforeseen events such as natural disasters may impact the application of these requirements. For instance, a natural disaster may halt or restrict production, prevent an entity from delivering its product to customers, trigger force majeure clauses, impact customers and suppliers and so impact on assessment of the hedge item meeting the highly probably test. Any of these outcomes may impact effectiveness of hedging relationships and result in additional volatility in profit or loss. High ineffectiveness may preclude hedge accounting.
Accordingly, entities with hedging programs in place for affected operations need to consider carefully the hedge accounting requirements of AASB 139.
Entities will need to consider whether their loan covenants are breached as a result of the disaster, for example asset write downs may impact balance sheet ratios prescribed in the loan agreement.
Entities need to fully understand the terms of their financing agreements and to discuss any issues that arise with their lenders as soon as possible, to ensure any necessary covenant waivers are in place by balance date. If covenant waivers are not in place by balance date, loans will need to be classified as current.
Entities will need to consider whether any additional liabilities need to be recognised in relation to guarantees given. The accounting for guarantees can be complex: :
- Guarantees are initiailly recognised at fair value
- Subsequent measurement is based on the higher of:
- The amount determined under AASB 137 Provisions, Contingent Liabilities and Contingent Assets (when it is probable that the guarantee will be called on, the entity recognises a provision for the present value of the best estimate of the amount required to be paid), and
- The amount initially recognised less, when appropriate, cumulative amortisation in accordance with AASB 118 Revenue.
There are numerous other considerations that may arise in certain circumstances. For instance, deferred taxes may be affected by changes in expected profitability or changes in expectations as to the recovery or settlement of assets and liabilities (including the repatriation of amounts from subsidiaries), or circumstances surrounding employee benefit plans, share-based payment plans and similar arrangements may change and impact the resultant accounting.
For entities affected by natural disaster events, careful consideration of the ‘flow on’ financial reporting impacts is therefore required.
In the interests of transparency, affected entities should ensure all relevant disclosures required by accounting standards are considered. For instance, AASB 101 Presentation of Financial Statements requires disclosure of the nature and amount of material items of income and expense, and significant judgements and estimation uncertainties made in the preparation of the financial statements. Various other standards mentioned above also have particular disclosure requirements which may be triggered by the event or its consequences.