Question

Describe the GAAP rules for involuntary conversion of PPE to include how any gains or losses are calculated.

Answer 1

Natural disasters like storms, floods, and fires can have a significant impact on tangible property. Companies often have questions about how to account for the effects of property damage caused by natural disasters under U.S. generally accepted accounting principles (GAAP). Organizations should carefully consider nonmonetary asset conversion and related insurance accounting as they account for the impact of a natural disaster on their properties.

Nonmonetary asset conversion

When a nonmonetary asset, real property, is involuntarily converted to a monetary asset, cash to repair or replace, the effects of that conversion must be recognized under ASC 605-40, Revenue Recognition – Gains and Losses. Companies that have already adopted ASC 606, Revenue from Contracts with Customers will find the same guidance in ASC 610-30, Revenue Recognition — Other Income — Gains and Losses on Involuntary Conversions.

An assessment is needed to ascertain the extent of the damage when determining the appropriate accounting treatment and if the event qualifies as an involuntary asset conversion.

• If only repairs and maintenance (R&M) are needed to bring the asset back to its original condition, then costs incurred to repair the damage are expensed. Insurance proceeds related to the R&M, if received during the same accounting period, are recognized as an offset to the expenses incurred.
• If the real property, or a component thereof, needs to be replaced, then a different approach is taken. The asset basis related to the damaged real property is determined and written off as a loss on disposal. Accumulated depreciation associated with the damaged and disposed asset is also written off as a loss on disposal. Next, costs incurred to replace the damaged real property are capitalized and placed into service as appropriate. Depreciation on the new asset is recorded according to the placed in service date and useful life of the new asset. Insurance proceeds, if received during the same accounting period, are recorded as a gain. Finally, the loss on disposal is net with the gain from insurance proceeds to reflect an overall net casualty loss or gain as presented on the income statement.

In both instances, for repairs or replacements, if the amount of insurance proceeds to be received cannot be determined until a subsequent period, the loss is still recognized when incurred. The determination of whether to recognize a loss is made without regard to any expected recoveries from insurance. A loss and a gain may be shown in separate years depending on timing of the involuntary conversion and when insurance claims are considered fixed and determinable, or received. Additionally, insurance proceeds are not recorded as receivable until the amount is fixed and determinable as evidenced by final acceptance and approval from the insurance company. Any anticipated proceeds in excess of recognized losses are considered a gain and are subject to the guidance in ASC 450-30, Contingencies — Gain Contingencies. These gains may not be recognized until all contingencies related to the insurance claim are resolved.

Other considerations

(Learn about additional accounting impacts from natural disasters in our related article.)

1. Insurance proceeds must be accounted for on a property-by-property basis rather than aggregated using a portfolio approach.
2. Companies may incur other losses indirectly related to a natural disaster. For example, a company may anticipate having operating losses for a period of time after a natural disaster due to misplaced tenants or due to an overall decline in the economy. These future operating losses should not be recognized until the losses are incurred as they do not meet the definition of a liability.
3. Business interruption insurance policies can cover either short-term temporary relocation costs or lost revenue. Evaluating these polices often requires careful analysis and judgment. Recovery of temporary relocation costs should be treated like recoveries of property and casualty losses and would be recognized when the insurer settles the claim for at least the amount of the costs incurred to date. However, anticipated reimbursements for lost revenue would follow the considerations required to evaluate a gain contingency. These contingencies would not be resolved and recognized until they are final and received from the insurer.
4. Companies will also need to consider whether impairment indicators are present after a natural disaster. ASC 360, Property, Plant and Equipment outlines potential indicators and tests for impairment. If impairment indicators are present then an impairment analysis is required. ASC 360 also provides guidelines for real property disposed of in a manner other than by sale to be classified as held and used until disposal (i.e., abandonment). Also, full destruction of the asset is effectively a disposal which results in the full write-off of the asset rather than impairment.

Example scenario: Storm damage to property

A storm caused minor flood damage to the first floor of a building as well as major damage to the roof. The flood damage only required drying equipment and replacement of carpeting to restore the affected parts of the first floor back to their original condition. However, the damage to the roof caused the replacement of the entire roof. The following figures and estimates were provided by management:

Item

Amount

Cost of drying equipment

$5,000

Cost of new carpeting

$10,000

Insurance proceeds - flood damage

$5,000

Damaged roof – cost basis

$65,000

Accumulated depreciation - damaged roof

$12,000

Replacement cost - new roof

$80,000

Insurance proceeds - roof replacement

$50,000

Assuming the insurance proceeds were received before year-end, the following entries would be recorded and the following net casualty loss would be recognized:

Item

Debit

Credit

Record R&M costs for flood damage

Debit: R&M - Flood

$15,000

Credit: Cash

$15,000

Record insurance proceeds related to flood claim

Debit: Cash

$5,000

Credit: R&M - Flood

$5,000

Remove basis of destroyed roof

Debit: Loss on disposal

$53,000

Debit: Accumulated depreciation

$12,000

Credit: Roof

$65,000

Record insurance proceeds related to roof claim

Debit: Cash

$50,000

Credit: Gain on proceeds

$50,000

Record cost of new roof

Debit: Roof

$80,000

Credit: Cash

$80,000

Net loss calculation

Loss on disposal

$(53,000)

Gain on proceeds

$50,000

Net casualty loss

$(3,000)

Now assume the insurance proceeds for only the flood damage were received before year-end, and the insurance proceeds for the roof replacement were not yet fixed and determinable as of year-end. The following entries would be recorded and following net casualty loss would be recognized:

Item

Debit

Credit

Record R&M costs for flood damage

Debit: R&M - Flood

$15,000

Credit: Cash

$15,000

Record insurance proceeds related to flood claim

Debit: Cash

$5,000

Credit: R&M - Flood

$5,000

Remove basis of destroyed roof

Debit: Loss on disposal

$53,000

Debit: Accumulated depreciation

$12,000

Credit: Roof

$65,000

Record cost of new roof

Debit: Roof

$80,000

Credit: Cash

$80,000

Net loss calculation

Loss on disposal

$(53,000)

Gain on proceeds

$0

Net casualty loss

$(53,000)

As shown above, the full $53,000 of loss would be recognized. A gain would be recognized in the subsequent year if the insurance proceeds for the roof replacement claim were then approved and received.

Financial statement disclosures

Financial statement disclosure requirements are addressed based on the nature of the material financial item being disclosed (e.g., asset impairments or casualty loss). For example, when a casualty loss is recognized, a description of the facts and circumstances leading to the loss are needed. The amount of the disposal and loss, and where they are reported on the financial statements, are also required. If impairment is present, ASC 360-10-50 will govern the disclosures which require a description of the impaired assets and the facts and circumstances leading to the impairment as well as the amount of the impairment loss and how fair value was determined.

A subsequent event disclosure may be required when a natural disaster occurs after year-end and the company has not yet issued their financial statements. The company will likely need to consider disclosing the nature of the event and an estimate of its financial effect, or a statement that such an estimate cannot be made.

Conclusion

Accounting for impacts from natural disasters can be complex. Determining how to accurately account for the various pieces may require additional assistance. We recommend organizations affected by natural disasters consult with their accounting advisors to ensure accurate accounting and financial statement disclosures.