Business Consequences of Natural Disasters

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Background

The latest flood and storm disasters in Brisbane Queensland have had a destructive and far-reaching economic effect. Many companies and households are direct victims of the flood disaster.

This is despite other companies feeling the indirectly effect through business relationships they have with those firms and households directly affected. These economic effects raise accounting issues that require critical and close evaluation.

During December 2010 and January 2011, vast areas of Brisbane were subject to extreme flooding that resulted in extreme damage of both residential and commercial properties.

The major effects that spread across Brisbane remind everyone about the destructive effects that natural disasters can cause on local communities. This results in not only significant social impact, but also a regional and national economic impact that affects business entities of all types and size.

Accounting Issues Arising From Natural Disasters

Like all other companies affected by the floods that hit Brisbane, Milley Ltd was a major casualty of the floods. The floods destroyed the offices and warehouses that lead to the loss of stocks held at that time and machinery.

Several accounting issues arose from these destructions suffered. These include how to account for the items of inventory destroyed, and accounts receivable that relate to companies that suffered damage during the storms.

The ability of Milley Ltd to meet contracts to supply books was substantially dented by the destruction of inventory, a question of how to account for lost business arises.

Destroyed property, plant and machinery need an immediate replacement. Cleaning up costs that will be incurred in May 2011 and government assistance received are issues that need to be accounted for in the annual financial statements.

The recognition, measurement and disclosure issues for each of the six items listed above are the subject of my subsequent discussion in detail. At the end, there are recommendations in relation to recognition, measurement and disclosure of each of the six items under review.

Inventory

Any spoiled inventory must be valued at the lower of cost and net realizable value in harmony with AASB 102 Inventory with any write downward recognized in profit or loss.

Since the completely damaged stock is no longer in a saleable, state and must therefore be written off. On the other hand, the inventory, which was not completely damaged and is available for sale at the discounted value, ought to be used in estimating the net realizable value.

Compensation form insurers should not be considered in determining net realizable value as this is considered as a separate event Therefore, management should approximate the net realizable amount of their stock as at reporting date that is 31 March 2011 based on the most dependable evidence existing according to Brimson (2010).

Disclosure may be essential where the worth has changed after reporting date of 31 March 2011.

Collectability of Accounts Receivable

An impairment test should be carried out to check if the accounts receivable have been impaired. Customers directly affected by the floods may be incapable of settling the balances outstanding or may require renegotiating payments conditions, therefore necessitating the need for an impairment assessment.

Management ought to assess whether trade receivables with businesses directly impacted by the floods are by any chance recoverable. Additionally, management should assess the likelihood of reversing losses incurred.

Further, management should also evaluate whether any facilities secured with resources that have been destroyed by the storm are impaired.

Disclosure of impairment losses, to the significant level must be provided in agreement with AASB 101 Presentation of Financial Statements, AASB 136 and AASB 139 (Elaine, 2011).

Implications of Supply Contracts Not Fulfilled

Careful analysis of supply contracts is essential to whether there are any ‘force majeure’ provisions relieving the firm of prospective onerous contracts.

An onerous contract is an agreement under which the inevitable costs of fulfilling the obligations under the contract surpass the economic benefits projected in it.

Inevitable costs under a contract are the net cost of exiting the agreement that is the lower of fulfilling the supply contract and cost of exiting. If no such provisions exist, an appraisal will be required as to whether the estimated economic benefits (e.g., the profit from supplying books under the contract) are less than the obligatory costs of the contract, over the period of the agreement.

Disclosures are required for any possible onerous contracts existing where ‘force majeure’ provisions do not exist as noted by Brimson (2010). This is quite critical to ensure that proper standards in financial reporting and to meet the stakeholders expectations.

Items of Property, Plant and Equipment Destroyed or Damaged That Need To Be Replaced

Items of property, plant and equipment that suffered destruction in the floods will potentially be impaired or call for to be writing off. Impairments of items of property, plant and equipment ought to be recognised in harmony with AASB 136 Impairment of Assets.

AASB 136 stipulates that an impairment test should be performed when there is a sign of impairment (Elaine, 2011). The impact of the recent storm disasters, for example physical damage to assets and inventory and reduced revenue forecasts, will be a pointer of impairment.

The business has experienced considerable decline in production and the capability to meet customers’ demands and contracts has been impeded. All of these affect an entity’s future profitability and indicate impairment (Brimson, 2010).

Certain items of property, plant and equipment in the warehouse and offices were damaged to such an extent that it is essential to withdraw the asset from productive use permanently.

If only a component of an asset is damaged, then the damaged element ought to be derecognized, even if it had not been individually depreciated. Any gain or loss is recognized in profit or loss for the variation between the net earnings received, if any, and the carrying amount of the equipment.

The destruction caused by the floods may also result in the need to reassess the residual values and economic useful lives of items of property, plant and equipment.

Because of the floods, the company incurred costs in relocating assets to and putting in place of assets at a more appropriate location (Elliot and Elliot, 2004).

The above treatment should align itself with the internationally set standards in accounting. The expectations of the stakeholders are a point of consideration but should not be the major area of consideration as it may detract the accountants’ expectations.

Subsequent expenditure on items of property, plant and equipment is recognised as part of its cost only if it fulfills the general recognition condition, that is, it is probable that future economic benefits related with the item will flow to the company and the expenditure of the item can be measured reliably.

The standard stipulates that the recognition of costs as part of the carrying amount of an item of property, plant and equipment ceases when the item is in the location and state required for it to be able of operating in the way planned by management (Weetman, 2007).

Usually costs of relocating or reorganizing a section or all of an entity’s operations are not included in the carrying amount of an item of property, plant and equipment.

Conversely, to the extent that an of item property, plant and equipment cannot operate in the way planned by management because the buildings have been destroyed by the floods, then the costs should be capitalized (Elaine, 2011).

However, in these situations it will be essential to consider whether any earlier capitalized setting up or transport costs should be derecognized.

To the level to which the relocation is temporary in nature, direct expensing of the relocation costs to originally relocate the asset and subsequently shift it back at a later date is likely to be suitable.

Prior to arriving at a conclusion management will need to consider the facts and circumstances to which the costs relate. Costs incurred to acquire safety or environmental assets may be recognised as a separate item of property, plant and equipment if it makes it possible for the future economic benefits of other assets to be realized, even though the cost itself does not result directly to future economic benefits.

Expenditure of the day-to-day servicing of equipments is recognised in profit or loss as incurred, while the expenses of replacing or rebuilding property, plant and equipment ought to be recognised when the asset is acquired or rebuilt by the company as reliably noted by Alexander (2002).

Cleaning Up Costs That Will Be Incurred In May 2011

There is no provision for anticipated future operating losses because of the storm, even if probable, unless they relate to an onerous contract.

Likewise, future estimated costs of cleanup would not fulfill the conditions of a provision until the cleanup is undertaken and the expenses incurred.

Disclosure of expenses incurred, to the significant level ought to be provided in harmony with AASB 101.Provisions are only recognised where the company has a present obligation that is it is likely that an outflow of resources is necessary to settle the obligation; and a dependable financial approximation can be made.

It is expected that it will take weeks, if not months, for the company to appropriately assess and repair damages to the destroyed offices and warehouse. Clean-up activities do not reflect the effects of the destruction caused before the financial year end year end of 31 March 2011, but rather reflect subsequent events to repair the damage in May 2011.

There will be no liability until such time those events occur. Consequently, a liability for these expenses ought not to be recognised at 31 March 2011; to the degree, such events have not taken place until after that date.

Disclosure of the best estimation of expenses probable to be incurred to clean up the destruction should be made (Elaine, 2011).

Government Assistance to Be Received

To the degree to which the company receives flood assistance from the government, it will be required to consider the applications of AASB 120 Accounting for Government Grants and Disclosure of Government Assistance. Income related to the reimbursement for destroyed property, plant and equipment, other assets or lost earnings or profits ought to be recognized when the destruction-giving rise to any loss or impairment has occurred and the company has an unconditional contractual right to get the reimbursement (Elaine, 2011).

That is such assistance from the government should be recognised when it is virtually certain that the assistance will be expected. Contingent asset disclosure may be suitable in conditions where the company is unable to recognize the asset.

Thus, it is likely that recognition of the loss or impairment will occur at a different point, and even in a different reporting period which is 31 March 3011, and the government assistance will be received and recognised after this period.

Closely related to government assistance is insurance. Since the company is covered under its insurance policy for damages to non-financial assets and for loss of revenue and profits, a careful analysis of the specific terms of the insurance policy should be done in evaluating whether compensation is expected.

Legal advice ought to be sought if doubt exists concerning the validity of a claim. AASB 116 provides guidance on reimbursement under insurance contracts for the impairment of property, plant and equipment and requires compensation for the loss or impairment of property, plant and equipment to be recognised in profit or loss when the payment is receivable (Elaine, 2011).

Conversely, no definite guidance exists in relation to insurance agreements that compensate the company for a loss event related to other assets or lost earnings and profit.

Reference List

Alexander, D. (2002) Principles of Emergency planning and Management. Harpended: Terra Publishing.

Brimson, J. A. (2010) Activity Accounting: An Activity-based Costing Approach. London: John Wiley and Sons.

Elaine, E. (2011) Intermediate Financial Accounting. Australia, Sydney: John Wiley and Sons.

Elliot, B. & Elliot, J. (2004) Financial Accounting and Reporting. London: Prentice Hall.

Weetman, P. (2007) Financial and Management Accounting: An Introduction. Chicago: Prentice Hall.

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