After the Flood

Few calls a CPA receives are more urgent: A client phones to say that last week’s torrential rain storms caused flooding, destroying everything in her company’s ground floor office. She is out of business. To make an insurance claim, she needs to recreate certain financial records. Can you help?

Your response: “Of course I can help; relax.” The client offers her thanks, and as you put down the phone, you begin to review the steps for filing an insurance claim in your head-first, property damage; second, loss of income. This article describes how a CPA can help this client and many other small business clients like her who suffer damage to their businesses due to floods, fires or similar disaster.

PROPERTY DAMAGE:
RECORDS RESTORATION
To help the client above make her insurance claim, you check your files to see whether her company had given you all of its property records. A fat file reveals documentation for the last 10 years-more than enough to satisfy most insurers.

What if the client made the mistake of keeping all property records herself? Hopefully, she also kept a backup copy, or had maintained off-site computer files. If necessary you can obtain copies of the client’s business tax returns from the Internal Revenue Service. The returns should show a correct and indisputable property listing on depreciation schedules that can be used in making an insurance claim.

It’s important for the client and his or her advisers to remember that damaged property valuation ultimately is subject to the provisions of the client’s insurance policy. But the skill with which the client negotiates with his or her insurance company also is important.

BUSINESS INTERRUPTION INSURANCE
A business interruption insurance policy is intended to do for the insured what the business itself would have done had no loss occurred-provide income. A business owner frequently adds such coverage to an existing property policy by endorsement. A typical policy pays a business owner for the actual loss of business income resulting from the necessary suspension of operations while damage is repaired.

DOCUMENTING LOSS OF INCOME
Documenting the income that is lost in a business disaster so a client can make a claim under his or her business interruption insurance policy is more complicated than substantiating a claim for lost property. Four basic factors figure into the loss-of-income equation.

1. Projected net income. How much would the business have earned in the period since the disaster occurred.
2. Operating expenses not incurred. Expenses nullified by the disaster.
3. Income earned since the disaster, if any.
4. Extraordinary expenses incurred as a result of the disaster.

Projected net income. For the CPA to assist the client in projecting how much income the business would have earned, the loss period must be known. The disaster is the first day of this period, which ends when the business is back to normal . Of course, back to normal isn’t always easy to calculate. If the client owns a retail business, for example, it may take some time for customers to switch to a new location. Even if a business has not recovered within a policy-specified period of time, the insurer may not be obligated to cover the loss if the policy limits the amount of coverage.

Once the loss period has been estimated, the CPA can calculate projected net income. The starting point is the prior year’s tax returns. The CPA should make adjustments for atypical revenue or expenses, as well as any unusual changes in the business (growth, decline, new products, salary level changes). The CPA should be sure to make a list for the insurance adjuster of all the assumptions he or she made in preparing the pro forma financial statements, along with the justification for those adjustments.

Expenses not incurred. The projected net income calculated above is reduced by normal operating expenses that would have been incurred had the disaster not happened. Again, prior-year tax returns are helpful in determining normal operating expenses if, for example, staff members have been laid off as a result of the disaster-thus reducing wage expenses-or a plant stops operating, decreasing utility costs. The CPAs next step is to compare the actual operating expenses (if the business is still partially functional) with normal expenses. The difference would reduce the loss of income claim.

Postdisaster income. Income earned by the business after the disaster reduces the client’s loss-of-income claim. To keep track of this, CPAs should impress on their clients the importance of keeping good records.

Extraordinary expenses incurred. Extraordinary expenses incurred by the business as a result of the disaster increase the loss-of-income claim. Clients may incur significant costs while trying to mitigate damages to their businesses. These costs-for renting temporary office space, replacing inventory, using different suppliers or outsourcing certain tasks-reduce the entity’s normal profit margin. They may be covered by either the property damage or loss-of-income policy provisions.

TALKING TO THE INSURANCE ADJUSTER
In most cases, the insurance adjuster is more likely to question the loss-of-income claim than he or she is to question the property damage claim. Once the above calculations are completed, CPAs and their clients can expect the adjuster to question projection assumptions. CPAs should be prepared to defend them as reasonable with some form of substantiating evidence, and to have available documentation for significant expenses incurred since the disaster.

One caveat: The CPA should be careful not to include extraordinary costs such as site cleanup or employee overtime in both the property damage and loss-of-income claims. Doing so may cause the adjuster to think the claims have been artificially inflated.

PREVENTING A LOSS
What can a CPA do-before disaster strikes-to make sure his or her clients won’t have to scramble to get their business back on track in the event of fire, flood or similar calamity? The checklist on page 41 lists some key questions CPAs should go over regularly with their clients to make sure they are prepared for the worst.

CPAs also can prompt their clients to review their business insurance needs on a regular basis. Having the right business interruption coverage can make the difference between keeping a business alive and forcing it to close its doors forever. Because CPAs typically are very familiar with their clients’ business operations, they are in an excellent position to determine what types of insurance are appropriate and how much coverage is necessary.

PEACE OF MIND
For CPAs, helping a client present his or her insurance claims professionally provides that client with peace of mind at a time when it is in very short supply. Even more important, CPAs can offer true peace of mind by assuring clients that the business insurance they maintain is sufficient to protect them from virtually any disaster.