CMA Intermediate · Financial Accounting

Insurance Claim for Loss of Stock and Loss of Profit

An insurance claim for loss of stock or profit recovers a fire loss from the insurer. First find the stock or profit lost, then apply the average clause if the policy is underinsured, then cap the claim at the policy amount. Finally, record the claim and any salvage in the books.

What this chapter covers

This chapter deals with what a business can recover from an insurance company after a fire or similar event destroys stock or stops trading. It has two claims. The loss of stock claim recovers the value of goods destroyed. The loss of profit claim, also called the consequential loss claim, recovers the profit and standing charges lost while the business was disrupted.

The work is mostly computation in a fixed order. You first rebuild the stock at the date of the loss from the last balance sheet figures, using trading account items up to the date of the fire. Then you deduct what was saved to get the loss, apply the average clause if the sum insured is less than the value of stock at the date of fire, and limit the claim to the policy amount. The loss of profit claim follows a similar pattern with its own measures: standard turnover, short sales, rate of gross profit, the indemnity period and its own average clause.

This chapter connects to the rest of the paper through trading and profit and loss accounts, gross profit ratios, and the journal entries for claims receivable and loss written off. Students who are comfortable with stock valuation and ratios find it quick to score here.

Questions from this chapter are numerical and follow a repeatable pattern, so they are among the more predictable questions in the paper. A steady approach gives you step marks even if one figure is wrong, and the MCQs test the average clause and the rule that the claim cannot exceed the policy amount. Time spent here pays back because the method rarely changes, only the data does.

Insurance Claim for Loss of Stock and Loss of Profit: topics in the order to study them

1Insurance Claims Basics and Average ClauseYou need the idea of sum insured, value at risk and underinsurance before any calculation makes sense.
2Loss of Stock Claim ComputationIt applies the average clause to a concrete figure and builds the stock-at-date-of-fire statement you will reuse.
3Loss of Profit (Consequential Loss) ClaimIt uses the same logic with extra terms such as turnover, short sales and standing charges, so it is easier after stock claims.
4Accounting Treatment of Claims and SalvageIt closes the loop by recording the claim, salvage and loss in the books once you know the amounts.

How to prepare Insurance Claim for Loss of Stock and Loss of Profit

Treat this chapter as a method to be drilled, not a theory to be read. Aim to solve each type in a clean, repeatable layout.

Read the basic terms once: sum insured, policy amount, salvage, underinsurance and average clause. Write each in one line in your own words.
Learn the average clause formulas for stock and for loss of profit, and test them on three or four small numbers until you can state when each applies and when it does not.
Practise the stock-at-date-of-fire statement first: stock at date of fire = opening stock + purchases + direct expenses − cost of sales. Cost of sales is sales (net of returns) less gross profit at the given rate, with special items adjusted separately. Only then deduct stock saved (salvage) to get the loss. Use a fixed layout every time.
Solve loss of profit questions in this order, one step per line. (1) Find the short sales and the rate of gross profit = (net profit + insured standing charges) ÷ turnover × 100. Loss on short sales = rate × short sales. (2) Deduct savings in insured standing charges during the period of disruption. (3) Add increased cost of working, limited separately by the policy limit (a proportion of the gross profit saved by the extra spending). (4) Apply the average clause factor to this net adjusted loss. The factor = policy amount ÷ (rate × adjusted annual turnover), where the rate uses net profit plus insured standing charges only. If the factor is below 1, reduce the claim in that ratio. Standing charges that are not insured are left out of the rate and are not recovered. (5) Cap the result at the policy amount.
Practise the journal entries for claim receivable, salvage and loss to profit and loss account. Check that debits equal credits.
Finish with mixed questions under time limits, then attempt the MCQs on the average clause and the claim limits.

Common mistakes in Insurance Claim for Loss of Stock and Loss of Profit

Applying the average clause when the sum insured is equal to or more than the value at risk
Fix: Compare sum insured with value at risk first. Apply the clause only if the sum insured is lower.
Forgetting to cap the claim at the policy amount
Fix: Make 'compare with policy amount' a last step in your layout every time.
Using sales instead of cost when rebuilding stock
Fix: Deduct gross profit at the given rate from sales (net of returns) to get cost of sales before computing stock at the date of fire. Adjust special items, such as goods at a different profit margin or goods sent on approval, separately.
Treating all expenses as insured standing charges in the loss of profit claim
Fix: Include only the charges the question says are insured, and add them to net profit to get the gross profit basis.
Using the net stock after salvage as the denominator in the average clause
Fix: Find stock at the date of fire first and keep it as the denominator. Deduct salvage only to get the loss in the numerator.
Ignoring salvage or stock saved in the entries
Fix: Record salvage as a separate entry and take the remaining uncovered loss to profit and loss account.
Writing only the final figure without working
Fix: Use a labelled layout with each step shown so that a small slip costs only one step.

Last-day revision: Insurance Claim for Loss of Stock and Loss of Profit

The claim can never exceed the policy amount.
The average clause applies only when the sum insured is less than the value of stock at the date of fire.
Stock at the date of fire = opening stock (last balance sheet) + purchases (net of returns) + direct expenses − cost of sales.
Loss = stock at the date of fire − stock saved (salvage).
Deduct stock saved/salvage from the stock at the date of fire to get the loss, then apply the average clause: claim = net loss × sum insured ÷ value of stock at the date of fire.
The denominator is the stock at the date of fire before deducting salvage. The loss in the numerator is after salvage.
Sales (net of returns) are converted to cost of sales by deducting gross profit at the given rate. Special items, such as goods sold at a different profit margin or goods sent on approval, are adjusted separately. Stock is valued at cost.
Loss of profit claim, in order: (1) loss on short sales = rate × short sales, where rate = (net profit + insured standing charges) ÷ turnover; (2) deduct savings in insured standing charges; (3) add increased cost of working, limited separately by the policy limit; (4) apply the average clause factor to the net adjusted loss; (5) cap at the policy amount.
The savings in insured standing charges are deducted from the loss on short sales, not from the final claim after the average clause.
For loss of profit, the average clause compares the policy amount with (rate of gross profit × adjusted annual turnover). Adjusted annual turnover is the turnover of the 12 months immediately before the date of damage, adjusted for expected trends. Clause factor = policy amount ÷ (rate × adjusted annual turnover). If it is below 1, the net adjusted loss is reduced in that ratio. Uninsured standing charges are left out of the rate and are not recovered.
Short sales are the standard turnover less actual turnover in the indemnity period.
The indemnity period limits how long the loss of profit is paid for.
Record the claim as a receivable and the uncovered loss as a charge to profit and loss account.
Show every step in the answer, because step marks are awarded.

Insurance Claim for Loss of Stock and Loss of Profit practice questions

Insurance Claim for Loss of Stock and Loss of Profit in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Insurance Claim for Loss of Stock and Loss of Profit: frequently asked questions

What is the average clause in insurance claims?

It is a condition that reduces the claim when the property is underinsured. For stock, if the sum insured is less than the value of stock at the date of fire, the insurer pays only that proportion of the net loss. For loss of profit, the policy amount is compared with the rate of gross profit applied to the adjusted annual turnover. The rate is (net profit + insured standing charges) ÷ turnover, so uninsured charges are left out. The clause factor is policy amount ÷ (rate × adjusted annual turnover), and it applies only if the policy is lower.

How do I find the stock lost in a fire?

Start with the last balance sheet stock and add purchases and direct expenses up to the date of the fire. Deduct cost of sales, found by deducting gross profit at the given rate from sales (net of returns). Adjust any special items separately. The result is the stock at the date of fire. Then deduct stock saved to get the loss.

What is a loss of profit or consequential loss policy?

It compensates the business for profit lost because trading was disrupted, usually after a fire. It typically covers the lost net profit and the insured standing charges that continue during the indemnity period.

Are MCQs asked from this chapter?

Yes, they can be. Section A has 15 MCQs of 2 marks each, and this chapter suits short questions on the average clause, the policy limit and the claim formula. There is no negative marking, so attempt every one.