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How to Handle a Loss of Business Income

By Marcine Johnson, CPA
December 1, 2019
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Good records that detail everything from discounts to inventory valuations are key to insulate your organization from business income loss.

 

Catastrophe can strike at any moment. For a small business, the impact of such an event could be devastating, and it’s important to be prepared for potential events. Consider an interior design company that has leased business space for warehousing, offices, and an improved leasehold in the space to showcase finished flooring, tile, kitchen counters, and appliances for viewing by walk-in clients, other interior designers, and home builders for show houses and commercial projects.

 

 

This company had two specific divisions: (1) sales of “showroom merchandise” supported by two employees five days a week at the leased space where merchandise was replaced as sold and (2) long-term projects with special-order merchandise using the showroom merchandise for browsing and real-time appeal. This enabled the company to buy at the specially provided discounts on the same merchandise by having a “showroom.”

 

In the past, there had been a flood in the building. It had caused minor damage to the merchandise and was cleaned up within hours. The issue causing the flood was a clogged drainage pipe. The landlord agreed to pay for damages and agreed in writing (via emails) to repair pipes to prevent accumulation of debris and to annual maintenance. This was covered in emails and not in a modification or an addition to the lease, which was subject to automatic renewals of two years after an initial five-year lease commitment.

 

After six years without any flood damage, the area experienced a heavy downpour for two days. The building was flooded, with water reaching as high as 12 inches. This flood damage wasn’t cleaned up for two weeks due to delays by the landlord. Moisture wicked up into all furnishings and inventory on the floor. All damages were photographed immediately, showing the debris piled up on the drainage pipe, the level the water reached, mud in the space, and dehumidifiers put in place to try to prevent mold.

 

LIMITS OF A FLOOD RIDER

 

It would appear that the course would be simple enough: File a claim with the insurance provider to cover damage to merchandise using the “flood rider” put into place when the first flood had occurred. Though the designer did have the right type of coverage for this potential damage, the insurance provider denied the claim, stating that the landlord was responsible for recovery due to neglect of property protection. In other words, the landlord was liable for failing to maintain the drainage pipes and keep them clear of debris. The claim was then filed with the landlord’s insurance company.

 

The design company had pictures to show proof of loss. It had the calls notifying the landlord of the damage and notification at this time that the call was being recorded. The landlord had admitted to failing to do promised and required maintenance, and there was an inventory report showing valuation. The company had lost all access to the “showroom” immediately after the flood and until the lease was canceled a year later.

 

The landlord’s insurance company denied the claim, and the design company disputed the denial with a lawsuit. According to the insurance company, there were three things at issue.

(1) Who was responsible to protect the building from flood and pay for any damages?

(2) What was the value of the damaged inventory? The insurance company requested three values of inventory: replacement cost, fair-market value, or aged inventory value.

(3) What was the loss of business income to include?

The definition of business income for insurance is “revenues minus expenses.” The design company was asked to provide revenues, expenses, and tax returns, and those hadn’t been financially segmented prior to the flood. The coverages, inventory valuation, and proof of income were challenged by the insurance company.

 

Though the design company lost access to the showroom, it continued to pay two employees with the expectation that the lawsuit would be settled soon. There was no written documentation from vendors stating that a showroom was required to ensure purchasing discounts. As the claim kept being denied and the lawsuit dragged out, presenting loss of business income covered more and more time after the flooding.

 

One division no longer existed. The showroom merchandise had had annual revenue of $300,000. This was now gone, and there were costs associated with two employees and rent for another 12 months paid to the landlord without access according to the terms of the lease, security, and building operational costs for these 12 months. Therefore, the business was faced with revenues of $0 and expenses of $94,460 for a net loss of $94,640 vs. $205,360 net income for this business division prior to the flood (see Table 1).

 

 

Having lost the entire showroom, the design company focused on doing more long-term projects (proposal to completion could take three years). This line of business provided substantially more in revenue and net bottom line. The improved net income started showing up in the 12 months after the flood and increased each year for three years while the lawsuit was ongoing.

 

As a result of the better income due to the change in business model vs. a loss of business income, the lawsuit was settled for less than the book inventory value. Some would say the business owner was tenacious in staying in business and pursuing a much tougher avenue for revenue. Others suggested the owner was doing much better and therefore was seeing no business loss.

 

WRITE IT DOWN

 

Either way, what was lost had an impact on the future of the business as it wouldn’t be able to continue to purchase merchandise at a showroom discount, jeopardizing future projects and the expected income. The settlement didn’t cover replacement cost of inventory and buildout of a new showroom/warehouse, which was required by vendors as implied but not written.

 

It’s essential to have discounts and responsibilities put in writing and supportable inventory valuations (remove obsolete or write-down aged inventory values and have document support for identifiable traits of inventory, such as color or finishes) and to segregate your business operations if they’re significantly different (in this case, showroom revenue and expenses with walk-in business vs. long-term project revenues and expenses). The key to preventing loss of income: Keep good records, and have it all in writing.

 

Marcine Johnson, CPA, is president of Accounting & Tax Advisory Services Inc. Her service with IMA includes membership on the Global Board of Directors and the Small Business Committee, as well as dean emeritus of IMA’s Leadership Academy. She can be reached at marcine@atasinfo.com.
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