All parties involved in a business income (BI) loss claim,adjusters especially, must have a basic command of financialaccounting concepts to ensure that the policyholder isproperly indemnifiedfor his or her loss.

To fairly value a business income loss claim, for instance, an adjuster mustunderstand how a policyholder captures economic transactionson financial statements.

Financial accounting focuses on the reporting of an entity'sfinancial position and results of operations. The two generalreports serving these functions are the balance sheet and incomestatement¹, respectively. Under generally accepted accounting principles (GAAP),²financial statements record assets and liabilities at their cost;revenue when earned; and expenses when incurred. If theseaccounting principles are followed, then the balance sheet willtruly reflect the policyholder's assets, liabilities, and owner'sequity at the date of the report. Whereas, its income statementwill reflect revenue, expenses, and net profit over a certaintime period.

A business income loss calculation measures the policyholder'slost profit during a period of interruption. Therefore, the claims handler focuses his orher attention on the income statement, as it records and reflectsrevenue, expense, and resulting net profit.

Accounting vs. InsuranceTerminology

The insurance policy is a contract that provides a guideline toindemnify the policyholder for its loss. The policy languagetypically lists various financial and other records, which may beused to calculate a business income loss. To properly measure abusiness income loss it is essential to understand how economictransactions are recorded on the policyholder's financialstatements (GAAP vs. other method), and the difference andsimilarities between accounting and insurance terminology.

The Basis of Accounting

An income statement may be recorded on a cash basis, accrualbasis, or other basis of accounting. If transactions are recordedon a cash basis, then revenue is not recorded until it is collectedand expenses are not recorded until paid. If they are recorded onan accrual basis (GAAP), then revenue is recorded when earned;expenses are recorded when incurred.

The accrual basis of accounting will provide a more accuratereflection of the actual business activity during a certain periodof time, as it matches revenue earned to its related costs andexpenses incurred. As the business income loss calculation measuresthe difference between expected profit and actual profit earnedduring the period of interruption, an income statement prepared on an accrual basisof accounting would be the preferred method of accounting for thoseanalyzing a business income loss. However, as previously noted,many policyholders' income statements are not prepared on anaccrual basis. Therefore, a conversion of the non-accrual incomestatement to an accrual basis is needed to properly calculate abusiness income loss.

Listed below are various accounting terms that may be found onan income statement, and comparable insurance terms that may befound in a business interruption (BI) policy:

Sales

• Gross sales (accounting) are the total of all sales earnedbefore deduction for sales returns and allowances anddiscounts.
• Gross sales (insurance) are the total of all sales earnedbefore deduction for sales returns and allowances anddiscounts.
• Net sales (accounting) are the gross sales less returns andallowances and sales discounts.
• Net sales (insurance) are the gross sales less returns andallowances, bad debts, commissions, royalties, and freightout.

Gross Profits, Gross Earnings

• Gross profit (accounting) for mercantile business is the netsales less cost of goods sold. For manufacturing business the grossprofit is the net sales less direct costs (materials and directlabor) and factory overhead (manufacturing).
• Gross earnings (insurance) for mercantile business are the netsales less cost of goods sold. For manufacturing business grossearnings are the net sales value of production plus all otherearnings from business operation, less cost of raw stock sold andservices purchased from outsiders that do not continue undercontract.

Tallying Expenses

• Fixed expenses (accounting) are operating expenses that do notvary directly with the volume of business (sales and/orproduction). Examples may include insurance, rent, administrativesalaries, and interest. Some income statements may segregate fixedexpenses from variable expenses; whereas, others will categorizeall expenses together as operating expense.
• Continuing expense (insurance) examples include officer and keyemployee salaries, administrative expenses, advertising, officeexpenses, and other fixed overhead. A significant difference fromfixed expense is that continuing expenses reflect only the portionof the fixed expense that continues to be incurred during theinterruption period. Some fixed expenses, such as administrativesalaries, advertising, rent and utilities, may decrease ordiscontinue during an extended period of interruption.
• Variable expense and costs (accounting) are expenses that varydirectly with sales and or production volume. Examples includedirect labor, direct materials, sales commissions, credit card bankfee charges, and certain overhead costs.
• Semi-Variable expense and costs (accounting) are expenses thathave a fixed and variable component. Examples are utilities, tools,supplies, and maintenance.
• Non-Continuing expenses (insurance) are expenses that do notcontinue to be incurred during the period of interruption. Theseare typically variable expenses but may include some fixed expensesduring an extended period of interruption.
• Direct labor (accounting) is labor directly utilized in theproduction of a product. This cost is typically located in the costof goods sold section of an income statement.
• Ordinary payroll (insurance) is payroll costs, includingpayroll taxes and other related benefits, for hourly employees whoare not considered key employees. These expenses may diminish ordiscontinue during an extended period of interruption.

Counting Profits

• Net profit (accounting) is net sales less cost of goods soldand operating expenses. The net profit may be reported at bothbefore and after income tax.
• Net profit (insurance) is net sales less cost of goods sold andoperating expenses. The net profit typically noted in the businessincome coverage is the net profit before income tax.

The preparer of a business income claim needs the skill totranslate a policyholder's operational activity, as reflected onits financial statements, to the terms and conditions of itsinsurance policy coverage. Therefore, the preparer must understandthe business income coverage and take the time to occupyaccounting.

¹ The income statement may also be known as theprofit and loss statement; statement of revenue and expenses –income tax basis; and many other descriptive names.

² Many if not most financial statements prepared forsmall businesses and/or businesses in certain industries do notreflect GAAP for various reasons.