Reporting Update July 2011, 11RN-001 Accounting considerations related to Natural Disasters Key points: Key accounting issues arising out of the earthquake, include accounting for: impairment assessments and valuation of assets compensation rights for damaged or destroyed assets and lost revenue/profits The earthquakes in Christchurch and other recent natural disasters have resulted in loss of life and have caused wide-spread damage and destruction to property and civic infrastructure. Many entities have been directly impacted by these events and many others have been indirectly impacted through business relationships they have with affected entities. There are a number of difficult financial reporting issues that have arisen as a result of these events. This paper highlights some of the key financial reporting considerations. Background Entities with reporting periods ending on or after the date the Christchurch earthquake occurred will need to consider the accounting impact in their financial statements. For example, an entity with a 30 June 2011 year end, impacted by the earthquake in February 2011 should consider the following: provisions for onerous contracts, subsequent events disclosures breaching loan covenants, hedge accounting and going concern assessments. items of property, plant and equipment (PP&E) and inventory damaged or destroyed compensation rights for damaged or destroyed items of PP&E, inventory and lost revenue/profits resulting from the earthquake costs of restoring, purchasing or constructing new items of PP&E other considerations including the need to recognise provisions for onerous contracts, the potential for breaching loan covenants, the accounting for future losses, clean up costs, impact on hedge accounting and going concern assessments.
July 2011, 11RN-001 2 Subsequent events disclosures Entities with a reporting period before the earthquake occurred i.e. a balance date prior to 31 January 2011, will need to consider whether any subsequent events disclosure should be provided in the 31 December 2010 financial statements. Those entities preparing interim financial statements prior to 31 January 2011 should also consider these disclosures. NZ IAS 10 Events after the Reporting Period requires the disclosure of material non-adjusting events. In our view, the earthquake would be regarded as a non-adjusting event to the extent it occurred after the reporting period and before the financial statements were authorised for issue. These entities will need to consider the impact of the earthquake on their financial statements and if the impact is considered material, should provide the following subsequent events disclosure: the nature of the event an estimate of its financial effect or a statement that such an estimate cannot be made. If the impact of the earthquake occurred after the reporting period, but affected the going concern presumption then this is an adjusting event under NZ IAS 10 and the financial statements should be adjusted if the going concern assumption is no longer appropriate. Example: Subsequent events disclosure Subsequent to balance date, but prior to the signing of these financial statements, Christchurch was struck by a severe earthquake. There is significant damage to the Christchurch CBD where the company is located and operates. While there has been damage to the building and other assets, it is unknown as to the extent of that damage and when staff can return to the building. This event will cause disruption to our business and it is not known how much damage has been done to the property or how long the business will have to operate without premises. The Company has put in place plans to deal with clients and staff and to continue business. At the current time, the Directors' consider that they are adequately insured to cover any losses arising from damage to buildings and other assets. Property, plant and equipment (PP&E) Items of PP&E damaged or destroyed in the earthquake will potentially be impaired or need to be written off. When accounting for damage to PP&E, the key factor is whether the asset will be demolished as a consequence to the earthquake. Certain items of PP&E may have been damaged to such a degree that it is necessary to permanently withdraw the asset from use. For example, if the asset is to be demolished, and there are no future economic benefits arising from the asset. If only a part of an asset is damaged, then the damaged part should be derecognised, even if it had not been separately depreciated. Any gain or loss is recognised in profit or loss for the difference between the net proceeds received, if any, and the carrying amount of the asset. In our view, the impact of the earthquake, for example physical damage to assets and reduced revenue forecasts, will be an indicator of impairment. Impairment of items of PP&E must be recognised in accordance with NZ IAS 36 Impairment of Assets. NZ IAS 36 requires an impairment test to be performed when there is an indicator of impairment. The damage caused by the earthquake may also result in the need to reassess the residual values and useful lives of items of PP&E. NZ IAS 16 Property, Plant and Equipment requires the impairment and derecognition of PP&E and any potential compensation claims relating to PP&E to be treated as separate economic events and accounted for separately. Therefore, it is not appropriate to net the events off and not record an impairment loss because there is an insurance claim related to the same impaired asset. These economic events should be accounted for separately and in the period in which they occur. Separate consideration of the events may mean that a loss from the impairment of PP&E is recognised in a reporting period before the compensation claim is recognised.
July 2011, 11RN-001 3 Intangible assets and goodwill NZ IAS 36 requires goodwill and any intangible assets with an indefinite life to be tested for impairment annually and to the extent to which an impairment indicator exists. Finite life intangible assets already put into use need to be tested for impairment when there is an indicator of impairment. As noted above, in our view the impact of the earthquake is an impairment indicator triggering the requirement for an impairment test to be performed in accordance with NZ IAS 36 for these assets. Consequently, capitalised IT systems, capitalised development costs and goodwill/other intangibles attached to impacted businesses may be impaired as a result of the earthquake. Inventory Any damaged inventory must be measured at the lower of cost and net realisable value in accordance with NZ IAS 2 Inventory with any write down recognised in profit or loss. Any insurance claim for damaged inventories must be recognised separately to the write down. Measuring value after the earthquake There are various challenges and valuation difficulties in valuing damaged assets such as buildings and inventory and investment properties. Under IFRS, when measuring fair value, the asset is assessed in its present condition. For example, NZ IAS 40 Investment Property specifies the fair value of investment property shall reflect market conditions at the end of the reporting period and that fair value is time-specific as of a given date. It also states that the fair value of investment property does not reflect future capital expenditure that will improve or enhance the property and does not reflect the related future benefits from this future expenditure. Therefore, the fair value of properties, as reported in entities financial statements, must reflect their current state at the end of each reporting period. This will also impact PPE valuation under NZ IAS 16 and related impairment under NZ IAS 36. Notwithstanding such technical difficulties, there are often practical difficulties in gaining access to assets to assess the values required for financial reporting, whether that is fair value or net realisable value. Financial assets The recoverability of financial assets may also be directly or indirectly impacted by the earthquake. For example, an entity should assess the collectability of trade receivables, loans or mortgage receivables from businesses directly impacted by the earthquake. An entity should also consider whether any loan or mortgage facilities secured with assets that have been damaged by the earthquake are impaired, e.g. mortgage receivables and personal loans secured by property, vehicles or other personal belongings. Disclosure of impairment losses, to the extent significant should be provided in accordance with NZ IAS 1 Presentation of Financial Statements, NZ IAS 36 and NZ IAS 39 Financial Instruments: Recognition and Measurement. Compensation from third parties Certain entities may have insurance policies under which they will be compensated for damage to an item of PP&E, other assets or lost revenue/profits caused by an earthquake. The question as to whether an entity is covered under its insurance policy for damages to non-financial assets and for loss of revenue/profits is one of fact and will depend on the specific terms of the insurance policy. Additionally, recognition of any insurance proceeds receivable will require evaluation of coverage in a given situation as well as an analysis of the ability of an insurer to satisfy the claim. Legal advice should be sought if uncertainty exists regarding the validity of a claim. NZ IAS 16 includes guidance on compensation under insurance contracts for the impairment of PP&E and requires compensation for the loss or impairment of PP&E to be recognised in profit or loss when the compensation is receivable. In order to consider whether an insurance claim is receivable, factors to consider include whether entity has insurance cover and whether a present claim exists. However, no specific guidance exists in relation to insurance contracts that
July 2011, 11RN-001 4 compensate the holder for a loss event related to other assets (excluding items of PP&E such as inventory) or lost revenue/profit. In our view, income related to the compensation for damaged PP&E, other assets or lost revenue/profits should be recognised when the damage giving rise to any loss or impairment has occurred and the entity has an unconditional contractual right to receive the compensation. That is, in our view such compensation from third parties should be recognised when it is virtually certain that the compensation will be received. This is consistent with the guidance in IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Assessment as to whether the compensation is considered virtually certain will depend on the specific facts and circumstances, for example, the type of insurance policy an entity holds, the specific terms of the insurance contract and the certainty around whether the entity is covered for earthquakes. Contingent asset disclosure may be appropriate in circumstances where the entity is unable to recognise the compensation. Therefore it is possible that recognition of the loss or impairment may occur at a different point, and even in a different reporting period, from the recognition of the compensation. To the extent to which entities receive earthquake compensation from the government, they will need to consider the application of NZ IAS 20 Accounting for Government Grants and Disclosure of Government Assistance if the entity is considered a "profit oriented". For public benefit entities guidance can be found in the NZICA Not-for-Profit Guide, or IPSASB 23 Revenue from Non-Exchange Transactions. Subsequent expenditure, including acquisition of replacement assets As a result of the earthquake, an entity may incur costs in relocating assets or installation of assets at a more suitable location. Subsequent expenditure on an item of PP&E is recognised as part of its cost only if it meets the general recognition criteria, that is, it is probable that future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably. The damage caused by the earthquake may also result in the need to reassess the residual values and useful lives of items of PP&E. The standard requires that the recognition of costs as part of the carrying amount of an item of PP&E ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management. Ordinarily, costs of relocating or reorganising part or all of an entity's operations are not included in the carrying amount of an item of PP&E. However, to the extent an item of PP&E cannot operate in the manner intended by management, for example, because the premises has been damaged by the earthquake, then in our view, it may be possible to capitalise these costs. However, in these circumstances it will be necessary to consider whether any previously capitalised installation or transport costs should be derecognised. To the extent to which the relocation is temporary in nature, immediate expensing of the relocation costs to initially relocate the asset and subsequently move it back at a later date is likely to be appropriate. Prior to reaching a conclusion entities will need to consider the specific facts and circumstances to which the costs relate. Expenditure incurred to acquire safety or environmental equipment may be recognised as a separate item of PP&E if it enables the future economic benefits of other assets to be realised, even though the expenditure itself does not give rise directly to future economic benefits. Costs of the day-to-day servicing of PP&E are recognised in profit or loss as incurred, while the cost of replacing or rebuilding PP&E should be recognised when the asset is acquired or rebuilt by the entity. Other considerations Onerous contracts Under NZ IAS 37, an onerous contract is one in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under the contract. The recent earthquake may result in certain contracts becoming onerous, for example the lessee of a building damaged by the earthquake who is still required to pay the lease payments despite being unable to use the premises. The present obligation of an onerous contract is required to be immediately recognised and measured as a provision. Furthermore, entities should consider the impact of any specific contract provisions which may come into effect as a result of the earthquake, for example,
July 2011, 11RN-001 5 lease agreements, take or pay contracts, or the ability to honour minimum supply obligations. However, the existence of "force majeure" clauses within contracts should be considered when assessing whether the contract is onerous. Loan covenants Impairments and derecognition of assets as a result of the earthquake could impact financial position ratios specified in loan covenants. Breach of loan covenants will need action by the entity to secure a waiver. If a waiver is not obtained before the reporting date, then debt will need to be classified as a current liability, even if a waiver has been obtained by the time the financial statements have been authorised for issue. Depending on the nature of the breach and when it was rectified, disclosure in the financial statements may also be necessary under NZ IFRS 7 Financial Instruments: Disclosures. Future operating losses and clean up costs Expected future operating losses as a result of the earthquake, even if probable, are not provided for unless they relate to an onerous contract. Similarly, future expected costs of clean up would not meet the definition of a provision until the clean up is performed and the costs incurred. Disclosure of costs incurred, to the extent significant should be provided in accordance with NZ IAS 1. Hedge accounting The impact of the earthquake on an entity's hedging strategies and the consequent impact on an entity's ability to continue to apply hedge accounting needs to be considered. If a forecast transaction is no longer highly probable prospectively, the entity should cease hedge accounting. If it is still probable that the transaction will occur, the net cumulative gain or loss recognised in other comprehensive income (OCI) during the effective period of the hedge continues to remain in equity until the expected transaction actually occurs. However, if it is no longer probable that the transaction will occur within the original time period or relatively short period thereafter, then any cumulative gain or loss on the hedging instrument recognised in OCI should be reclassified to profit or loss immediately. For example, an entity was hedging its exposure to USD from sales expected to occur in May 2011. Due to the damages to the infrastructure of the entity, it is no longer highly probable that these sales will occur however, it may still be probable that the entity will resume operations and hence meets its May sales target. In this case, whilst the entity will cease applying hedge accounting prospectively, any cumulative gain or loss recognised in OCI during the effective period of the hedge continues to remain in equity until the sale actually occurs. If however, the entity no longer expects to resume its operations until the end of the year, the May 2011 hedged forecast sales are no longer probable. In this case any cumulative gain or loss recognised in OCI must be immediately reclassified to profit or loss. Going concern Financial statements are normally prepared on the assumption that an entity is a going concern and will continue operation for the foreseeable future. If significant doubt exists as to whether an entity can continue to operate in the foreseeable future as a result of the damage caused by the earthquake, then the going concern assumption may no longer be appropriate. This assessment may be necessary even though the entity was impacted by the earthquake after the reporting date. Where the financial statements are prepared on an other than going concern basis, the basis must be disclosed in the financial statements. Preparation of financial statements on an other than going concern basis will also have recognition and measurement impacts on assets and liabilities that may need to be considered. Where the going concern assumption is still appropriate but material uncertainties exist in relation to the ability of the entity to continue as a going concern, specific disclosure should be provided. (Refer to DPP Bulletin Issue B0914 Preparation of financial statements using a non-going concern basis, October 2009).
July 2011, 11RN-001 6 Held-to-Maturity Securities Entities that are affected by a natural disaster may decide to sell or reclassify investments that were previously classified as held-to-maturity. Determining whether a sale of a held-to-maturity security is likely does not call into question an entity s intent to hold other securities to maturity as this will depend on the specific facts and circumstances. Impacts of reduced profitability In addition, entities impacted by the earthquake may need to consider whether the impact on profitability will affect their ability to: recover other assets recognised in the financial statements such as any deferred tax assets associated with temporary differences and tax losses meet any debt covenants NZX and continuous disclosure obligations Certain entities may be concerned about their ability to meet their current reporting deadlines and may wish to seek relief from the NZX or the Companies Office. To the extent an entity believes they will not be in a position to meet filing deadlines, we suggest that they contact the Companies Office directly. Entities should also consider their continuous disclosure obligations to the extent to which the impact of the earthquake is expected to have a material impact on the entity's share price. Statement of cash flow disclosures An entity may also need to consider how earthquake expenses and related insurance recoveries are disclosed in the statement of cash flows. For example, earthquake expenses for minor repairs and maintenance for PP&E and insurance receipts for business interruption should be shown as separate items in the operating cash flows section. Any insurance recoveries for property, plant and equipment should be classified as investing cash flows, even if the insurance proceeds are not used to replace the PP&E. Judgment may be required in classifying insurance recoveries where one receipt from an insurer covers both business interruption and damage to PP&E. Additional disclosures Entities should provide additional disclosures to enable users of the financial statements to evaluate the financial effects of the natural disaster and related events. These may include: The nature and amounts of losses recognised as a result of the natural disaster and the amounts of any related insurance recoveries; A description of contingencies from the event that have not yet been recognised in the financial statements but that are reasonably expected to impact the entity s financial statements (e.g. future losses and costs and probable future insurance recoveries); Amount of the exposure to credit loss and how that risk was evaluated; Potential loss of customer base and the related revenue recognition; Major disruptions in supply chain that impact inventory; Any significant uncertainties in the amounts recognised in the financial statements; The accounting policy on the treatment of impairment losses and insurance recoveries in the financial statements.
July 2011, 11RN-001 7 Further information If you would like to discuss the accounting implications discussed in this paper in greater detail, please contact your regular KPMG advisor or KPMG Accounting Advisory Services. kpmg.com/nz 2011 KPMG, a New Zealand partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved. Printed in New Zealand. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. TM Rugby World Cup Limited 2008. All rights reserved.