The economic consequences of the COVID-19 pandemic on businesses have yet to be fully comprehended by the business community. With many businesses being forced to close either due to government shutdown orders or simply due to a lack of customer base in light of quarantines, the effects can be long-term and detrimental to businesses that simply cannot afford to shut their doors.
During these difficult times, many insurance carriers are not covering claims for these interruptions. Although business interruption insurance typically covers losses resulting from disaster-related damage (i.e., fires, theft, etc.), many carriers are denying claims related to COVID-19. Some businesses have filed lawsuits against their carriers, while state legislatures are fighting to mandate certain coverage. Like most questions during such an uncertain time, the issue of business interruption insurance will unfold as we continue to go through this pandemic.
Several carriers have stated their policies do not cover coronavirus-related business interruption claims. To date, a number of states have introduced legislation1 that would require insurance companies to cover claims for business interruptions due to COVID-19.
The intent of the outline below is to provide a reference framework for forensic accounting practitioners who may be called upon by a client or their insurance adjuster to assist in preparing a business interruption claim (“BI claim,” or “BIC”).
I. What Is a Forensic Accountant?
- "Forensic"- that which is acceptable before the trier of fact.
- Must have an understanding of a "dispute environment" which exists in the context of an insurance claim.
- Generally, the insured's accountant is not qualified to address many of the issues that are present in these matters:
i) they may be conflicted for lack of independence/objectivity because they prepared the books and records,
ii) due to their lack of familiarity with insurance contracts,
iii) due to the potentially adversarial nature of coverage disputes, or
iv) unaware of the potential fraud issues.
- Must be experienced through education, training, experience, certification and prior case work and/or testimony.
- Background check: criminal and professional record must be clean.
II. Purpose of Assignment – Why Do I Need a Forensic Accountant?
- Preparation of Calculation of Losses from Business Interruption.
- Rebuttal of carrier’s expert:
- Data underlying calculation
- Mitigation expenses
III. Overview of the Process
- Business interruption insurance typically covers the insured (policy holder) for losses resulting from disaster-related damage (i.e., fires, theft, etc.)
- The insured will retain a public adjuster to quantify the costs of physical damage to the property:
- Most often used after natural disasters, fires, etc.
- The adjuster will retain a forensic accountant to prepare the related loss due to the temporary closure or diminution of the business.
- The forensic accountant will prepare the BI claim for submission to the insurance carrier
- In the event that the claim is contested or rejected by the insurer, standard policies have a dispute resolution mechanism, or one is provided for by state law (called arbitration or appraisal):
- Evidence and testimony are presented by forensic accountants (called appraisers) representing:
- The insured
- The insurer
- The calculations of the respective parties’ BI claims, and the underlying data will be examined and debated.
- The proceedings are administered, and decided by, a neutral appraiser, called an umpire.
- In the event the dispute between the insured and the insurer remains unresolved, counsel will be retained and the matter will go to state court for disposition.
- Depending on the jurisdiction, the same forensic accountant may provide testimony in the matter.
IV. Insured's Books and Records
- Must be true and accurate.
- Areas of concern:
- Cash income
- "Off the books" employees
- Self-constructed assets and betterments
- Potential fraud issues - general ledger v. tax returns
- Presents an ethical conundrum:
- If the books that form the basis for the claim present lost income significantly in excess of what the tax returns would have presented, the Insurer may raise this issue.
- Client then transitions from being a Plaintiff in an insurance coverage case to being a defendant in a tax fraud case.
V. Mechanics of the Calculation
- Conceptually similar to preparing a damage claim, subject to the terms of the Insurance Policy.
- Depending on the business, 3-5 years of books and records:
- General Ledger
- Tax Returns
- Identify continuing v. discontinued expenses for the business during the period of restoration.
- Continuing expenses:
- Salaries of key employees
- Discontinued expenses:
- Raw Materials purchases
- Freight/delivery costs
- Trending v. Averaging of Sales and expenses for projections:
- Depending on seasonality of the business, use:
- Same period prior years
- Imputed growth rates (CAGR, linear regression, etc.)
- Rolling averages
VI. Basic Business Interruption Calculation Framework
Add Net Sales Projected
Less Cost of Goods Sold (COGS)
Equals Gross Profit
Less Selling, General & Administrative (SG&A) or Operating Expenses (OpEx)
Less Interest & Taxes
Equals Net Income
Add Continuing Expenses and Adjustments
Equals Total Estimated Business Interruption Amount
VII. Types of Claims and Potential Issues
- Business interruption projections:
- Retail businesses
- Restaurants (key employees)
- Validity and accuracy of books and records v. tax returns.
- Valuation of self-constructed improvements and betterments.
- Valuation of businesses:
- Diminution in enterprise value should be reconciled to amount of damages.
Documents to request
- Policy documents and all riders and amendments
- General ledger
- Trial balance
- Cash receipts and disbursements register
- Payroll registers
- Bank statements
- Credit card statements
- Tax returns
- For self-constructed assets, receipts for materials and labor
1 More States Introduce COVID-19 Business-Interruption Bills, April 16, 2020, Claims Journal.