Depreciation savings can represent a significant area of disagreement during the claims process. Resource, time and money are often spent on negotiations that can hold up settlement of a claim. This could be avoided by the inclusion of a basic clause in the policy.
Depreciation is simply an allocation of historic cost. It is a theoretical accounting treatment with its origins in the matching concept. The cost of an asset is spread across its useful life to match the cost with the revenue which it generates over its useful economic life, therefore an amount is charged to the profit and loss account annually.
The real position is that an asset is purchased and either the cash is handed over in full or credit is arranged. Either way, the asset is effectively paid for, in full, when purchased.
The definition according to the Financial Reporting Standard 15 (FRS 15) states:
'The fundamental objective of depreciation is to reflect in the operating profit the cost of use of the tangible fixed asset (ie the amount of economic benefits consumed by the entity) in the period'
Having reached a conclusion on the first part, the question arises whether, if an asset is destroyed and depreciation ceases in the accounts, depreciation should be recognised as a saving, and therefore reduce the business interruption insurance claim.
The insurance claim
A theoretical allocation of cost can never constitute a saving if it ceases. A price has already been paid in full for the asset at the date of purchase, so, even if no depreciation appears in the accounts, there is no real saving.
Likewise, if the depreciation charge on the replacement asset increases, this would not be included as an additional cost in the claim. It is not an additional cost, as the company itself has not paid for the asset.
Mitigation of loss
If a machine is lost in an incident and another machine is used to mitigate the loss, then - as a result of the additional use and harder working of that asset - the economic life of that asset is reduced. Therefore the depreciation charge on that machine should be increased to reflect its change of use.
However, this would never be claimed as an increased cost, for logical reasons, even if the policy wording was not clear on the issue, which it is. This further supports the statement that depreciation should not form a saving.
Actual cash position
A simple example is to think of it as a bank account position. The asset is purchased and paid in full; the asset is lost and a claim made under the policy; the asset is then replaced using the insurance proceeds and therefore usually at no extra cost to the company. There is no saving, and no additional cost.
It does not matter what is recognised in the accounts; it is the actual position that should be recognised. This is the case in other sections of the business interruption insurance claim. For example:
- Increased costs of working must be actual additional costs incurred
- Gross profit is calculated using actual variable costs, irrespective of how it appears in the financial statements of the business. Any theoretical allocation of costs, such as those under a standard costing system, is replaced with actual cost.
Shouldn't the principle be followed in all areas of the policy?
If the definition of depreciation was money being set aside for replacing assets, there might have been a case for depreciation savings under the actual cash position argument. But this is not what happens, therefore there is no case.
The premium is paid on the basis that depreciation is a fixed/standing charge. Savings in fixed charges are recognised if cash is actually saved, for example, rent and rates. If depreciation is to be recognised as a saving, the policy and premium should be adjusted accordingly.
Policies do not expressly deal with the recognition of depreciation as a saving, and as mentioned, clarity must be sought on the issue to avoid the need for negotiation. The decision should not be left to chance, or the negotiation skills of claims representatives. Even if it is not in the name of clarity, it is more advantageous to deal with the issue up front. A possible depreciation clause is shown below. Marsh recommends its inclusion in a policy:
'It is understood and agreed that in consideration of the business interruption values developed with the inclusion of depreciation as a fixed and continuing expense, and the premium paid on those values, that depreciation on those assets affected by a loss recoverable under this policy shall be payable as a fixed and continuing expense as part of the business interruption portion of the claim. This shall have no further effect on the deductible, limits or other policy terms and conditions contained in the policy.'
Other than the principles identified above, there are other reasons why depreciation charges should not be used in a calculation of loss.
To depreciate or not to depreciate is not the question, as a tangible asset must be depreciated. However, what the method of depreciation is, should be the questions, as it will determine the potential depreciation saving. If one company has straight line depreciation, and another reducing balance, the former would be penalised in its insurance claim depending where the asset is in its economic life.
Also, what if the economic life is understated, or the company use old assets, with the asset fully written off? No depreciation would be charged therefore none would be saved.
Revaluation of an asset will also increase depreciation, but the increase in value has not actually been received. There is no real increase in charge to the insured. If a saving is calculated it would be artificially high.
For tax purposes, depreciation is added back to profit for the calculation of tax, as the method of depreciating an asset can differ significantly between firms. Instead, capital allowances are used: often 100% of the asset is taken in the first year. This further supports the theoretical nature of depreciation.
- Caroline Woolley is vice president, forensic accounting and claims services, Marsh, www.marsh.co.uk