Appreciating Depreciation

From an accounting perspective, it is generally quite clear that when an asset is destroyed as a result of a peril (for example, fire or flood) the depreciation on that asset ceases. This, in turn, results in the depreciation expense being saved by the insured.

But what happens when an asset is not damaged? Should depreciation on those assets be considered a saved expense?

Depreciation is a non-cash expense used to allocate the cost of an asset over its useful life (most assets lose their value over time and must be replaced once reaching the end of their useful life). There are four principal causes of depreciation:

•functional – asset declines in productivity or service over time;

•physical – asset deteriorates due to environmental factors over time;

•technological – asset become obsolete from improved technology; and

•economical – asset devalues as a result of economic factors.

Now consider how things might play out when there is a fire involving an insured who owns and operates a small stamping business with two major assets: an extravagant rotating sign – which has a useful life of 10 years based on the gradual deterioration from weather – out front of the business that the insured depreciates using the straight-line method (depreciation is charged uniformly over the life of an asset); and a stamping machine that has an estimated useful life of 100,000 stamped widgets that the insured depreciates using the units of production method (depreciation is charged based on the actual usage of the asset).

Assume a fire occurs at the insured’s premises. The building is destroyed, including the stamping machine, but the sign remains undamaged. As a result of the fire, the business is unable to operate in any capacity for 12 months.

It is clear that since the stamping machine was totally destroyed, any depreciation that would have been incurred on the machine would be saved. But would it be appropriate to consider any depreciation saved on the undamaged sign?

Alternatively, what if an uncontrolled truck drove off the road, destroyed the sign and went through the building, but the stamping machine was undamaged? Since the sign was totally destroyed, any depreciation on the sign would be saved, but would it be appropriate to consider any depreciation saved on the undamaged stamping machine?

In assessing whether or not depreciation is saved on an undamaged asset, the following key questions must be asked: What is the depreciation driver and method of depreciation? Has the useful life of the asset been extended as a result of the loss?

POSSIBLE OUTCOMES

With regard to the fire at the stamping business, the sign is being depreciated based on its expected useful life of 10 years due to its gradual deterioration from the environment. If the business was not operating for 12 months, the sign would continue to be exposed to the same weather conditions and would need to be replaced at the same time irrespective of whether or not the business was operating. On this basis, it would not be fair to the insured to calculate depreciation savings since there has not been an extension to the useful life of the asset.

Conversely, if the stamping machine was not damaged by the rogue truck piling into the building, would the useful life of the asset have been extended if the business was closed for 12 months? Generally, the answer would be yes.

The method of depreciation for the stamping machine is the number of units produced, and if the business ceased operating, no units would be produced. Further, since the machine would be able to produce the lost units after the business recommences, the useful life of the machine has effectively been extended.

It has been argued that the actual depreciation savings takes place subsequent to the resumption of operations and that the savings to the insured is the time value of money associated with the purchase or replacement of the machine in a future period.

To illustrate this point, consider that a machine is purchased at Year 1 for $4,000, the units of production depreciation method is used, there is 1,000 average units produced annually, the total life in number of units is 4,000, and the salvage value is nil (see upper chart to left).

Although depreciation is not incurred in the year of the incident, the depreciation, in effect, has been deferred by one year. On this basis, an argument can be made that the depreciation is not saved, but the extension of the useful life of the asset has caused the deferral of the purchase of a new machine, which would result in a savings based on the time value of money related to the investment in a new machine.

However, what happens if the insured decides to increase production after operations resume? If so, the purchase of the new machine may occur at the same time as if there had been no incident, which would result in no savings to the insured.

Another issue to consider with that approach is it does not consider any future depreciation charges incurred by the insured on the purchase of the new machine. Given these issues, it begs the question: What is the proper approach?

This approach is based on the argument that even though the replacement of the undamaged asset may be deferred, the insured will incur annual depreciation charges on either the existing undamaged machine or a newly acquired machine.

As such, if the insured has no production activity during the year following the incident, the insured has saved a year’s worth of depreciation (see lower chart on page 51).

PARTIAL SAVED DEPRECIATION

All scenarios are not so black and white as in cases where an asset is depreciated either entirely on time or usage. Consider, for example, a scenario involving a flood at a gravel pit operation. The entire operation is shut down, although, the dump truck remains undamaged.

When the truck is not in use, it sits in the gravel pit and gradually deteriorates from its exposure to the environment; when it is being used for production, it depreciates more quickly from wear and tear. In this situation, it appears the truck will have a portion of its useful life extended from a decrease in use.

That said, would it be fair to the insured to consider 100% of the depreciation on the dump truck saved knowing that the vehicle is subject to gradual deterioration from its exposure to the environment? In theory, this would not indemnify the insured since the dump truck will depreciate over time as well as depreciate by use.

The question then arises: What is the appropriate portion of saved depreciation? Although, the answer requires professional judgment and a solid understanding of case-specific facts, in general, one should consider the following non-exhaustive list when estimating the depreciation saved on an undamaged asset:

What is the primary and secondary driver of depreciation?

How long would the useful life of the asset be extended without any use?

Are there market comparables to determine annual change in market value for assets with similar condition?

Does the insured have any comparable assets that were purchased and disposed of that may provide insight into the impact of time versus usage?

Is the asset subject to technological obsolescence that would require the insured to periodically purchase a new replacement asset irrespective of usage?

Below is a chart depicting various possible outcomes. Given that depreciation of an undamaged asset can result in various outcomes, careful consideration of case-specific information is necessary to truly indemnify the insured following a loss.