All parties involved in a business income (BI) loss claim, adjusters especially, must have a basic command of financial accounting concepts to ensure that the policyholder is properly indemnified for his or her loss.
To fairly value a business income loss claim, for instance, an adjuster must understand how a policyholder captures economic transactions on financial statements.
Financial accounting focuses on the reporting of an entity’s financial position and results of operations. The two general reports serving these functions are the balance sheet and income statement1, respectively. Under generally accepted accounting principles (GAAP),2 financial statements record assets and liabilities at their cost; revenue when earned; and expenses when incurred. If these accounting principles are followed, then the balance sheet will truly reflect the policyholder’s assets, liabilities, and owner’s equity at the date of the report. Whereas, its income statement will reflect revenue, expenses, and net profit over a certain time period.
A business income loss calculation measures the policyholder’s lost profit during a period of interruption. Therefore, the claims handler focuses his or her attention on the income statement, as it records and reflects revenue, expense, and resulting net profit.
Accounting vs. Insurance Terminology
The insurance policy is a contract that provides a guideline to indemnify the policyholder for its loss. The policy language typically lists various financial and other records, which may be used to calculate a business income loss. To properly measure a business income loss it is essential to understand how economic transactions are recorded on the policyholder’s financial statements (GAAP vs. other method), and the difference and similarities between accounting and insurance terminology.
An income statement may be recorded on a cash basis, accrual basis, or other basis of accounting. If transactions are recorded on a cash basis, then revenue is not recorded until it is collected and expenses are not recorded until paid. If they are recorded on an accrual basis (GAAP), then revenue is recorded when earned; expenses are recorded when incurred.
The accrual basis of accounting will provide a more accurate reflection of the actual business activity during a certain period of time, as it matches revenue earned to its related costs and expenses incurred. As the business income loss calculation measures the difference between expected profit and actual profit earned during the period of interruption, an income statement prepared on an accrual basis of accounting would be the preferred method of accounting for those analyzing a business income loss. However, as previously noted, many policyholders’ income statements are not prepared on an accrual basis. Therefore, a conversion of the non-accrual income statement to an accrual basis is needed to properly calculate a business income loss.
Listed below are various accounting terms that may be found on an income statement, and comparable insurance terms that may be found in a business interruption (BI) policy:
- Gross sales (accounting) are the total of all sales earned before deduction for sales returns and allowances and discounts.
- Gross sales (insurance) are the total of all sales earned before deduction for sales returns and allowances and discounts.
- Net sales (accounting) are the gross sales less returns and allowances and sales discounts.
- Net sales (insurance) are the gross sales less returns and allowances, bad debts, commissions, royalties, and freight out.
Gross Profits, Gross Earnings
- Gross profit (accounting) for mercantile business is the net sales less cost of goods sold. For manufacturing business the gross profit is the net sales less direct costs (materials and direct labor) and factory overhead (manufacturing).
- Gross earnings (insurance) for mercantile business are the net sales less cost of goods sold. For manufacturing business gross earnings are the net sales value of production plus all other earnings from business operation, less cost of raw stock sold and services purchased from outsiders that do not continue under contract.
- Fixed expenses (accounting) are operating expenses that do not vary directly with the volume of business (sales and/or production). Examples may include insurance, rent, administrative salaries, and interest. Some income statements may segregate fixed expenses from variable expenses; whereas, others will categorize all expenses together as operating expense.
- Continuing expense (insurance) examples include officer and key employee salaries, administrative expenses, advertising, office expenses, and other fixed overhead. A significant difference from fixed expense is that continuing expenses reflect only the portion of the fixed expense that continues to be incurred during the interruption period. Some fixed expenses, such as administrative salaries, advertising, rent and utilities, may decrease or discontinue during an extended period of interruption.
- Variable expense and costs (accounting) are expenses that vary directly with sales and or production volume. Examples include direct labor, direct materials, sales commissions, credit card bank fee charges, and certain overhead costs.
- Semi-Variable expense and costs (accounting) are expenses that have a fixed and variable component. Examples are utilities, tools, supplies, and maintenance.
- Non-Continuing expenses (insurance) are expenses that do not continue to be incurred during the period of interruption. These are typically variable expenses but may include some fixed expenses during an extended period of interruption.
- Direct labor (accounting) is labor directly utilized in the production of a product. This cost is typically located in the cost of goods sold section of an income statement.
- Ordinary payroll (insurance) is payroll costs, including payroll taxes and other related benefits, for hourly employees who are not considered key employees. These expenses may diminish or discontinue during an extended period of interruption.
- Net profit (accounting) is net sales less cost of goods sold and operating expenses. The net profit may be reported at both before and after income tax.
- Net profit (insurance) is net sales less cost of goods sold and operating expenses. The net profit typically noted in the business income coverage is the net profit before income tax.
The preparer of a business income claim needs the skill to translate a policyholder’s operational activity, as reflected on its financial statements, to the terms and conditions of its insurance policy coverage. Therefore, the preparer must understand the business income coverage and take the time to occupy accounting.
1 The income statement may also be known as the profit and loss statement; statement of revenue and expenses – income tax basis; and many other descriptive names.
2 Many if not most financial statements prepared for small businesses and/or businesses in certain industries do not reflect GAAP for various reasons.