A BRIEFING NOTE FROM MICHAEL WHITTON OF EDWIN COE LLP DEPRECIATION A MISSED OPPORTUNITY

Transcription

1 A BRIEFING NOTE FROM MICHAEL WHITTON OF EDWIN COE LLP DEPRECIATION A MISSED OPPORTUNITY 1. The appeal in Synergy Health (UK) Limited v- CGU Insurance Plc (t/a Norwich Union) and Others arose in relation to a Judgment of Mr Justice Flaux dated 19 October The case related to a claim against Synergy s insurers for damages in respect of loss and damage sustained in a fire at its premises at Dunstable on 3 February At those premises, Synergy maintained a linen management facility, washing and preparing linen for use by the NHS. It was insured against material damage and business interruption losses but insurers declined to indemnify Synergy on the grounds of material non disclosure and/or misrepresentation in failing to correct a representation that a burglar alarm would be installed by the end of The Judge found that there had been non disclosure/misrepresentation but that the insurers had failed to establish the relevant inducement i.e. the Judge was not persuaded that it would have made any difference to the insurers. 3. As to the quantum of the business interruption loss, there was agreement between the parties save in relation to two issues. The first related to increased cost of spare parts which is not relevant for the purpose of this note. The second issue related to the treatment of depreciation on the damaged plant and machinery. Depreciation was not treated in the same way after the fire as it was before the fire. Therefore it was argued by the insurers that there was a saving of the depreciation expense which had to be taken into account because the saving reduced the loss that Synergy suffered. 4. In summary, the basis of the Judge s findings was that: As a matter of principle, the fact that during the indemnity period a deduction for depreciation ceased to be made, meant that there was a saving which ought to be brought into account when quantifying the business interruption losses; As a matter of construction of the policy, although the saving provision referred to savings in respect to such of the charges and expenses of the Business payable out of Gross Profit as may cease or be reduced in consequence of the incident and depreciation was not actually paid or payable, the meaning of payable out of Gross _1 1

2 Profit was not limited to a literal interpretation of payable but embraced the sort of charges or expenses which would ordinarily be deductible from Gross Profit. 5. The Judge gave permission to appeal on 17 November 2010 because in his view: The appeal had a real prospect of success; and The point relating to depreciation was one which had troubled the insurance industry for some time and on which an authorative ruling from the Court of Appeal would be welcome. At its heart, the issue was whether or not depreciation, which in the ordinary course of business: Is treated as an annual expense of the business, recorded in the profit and loss accounts; and Shown in the balance sheet as a reduction in the asset value of the company; should be treated as a saving (i.e. as actually not having been incurred) because after the fire, depreciation was not shown in the management accounts as it had been before the fire. The business was not operative from the fire damaged premises for a period of 10 months after the fire and the insurers claimed that, since depreciation was not shown in the management accounts for that period, that represented a saving and should be deducted from the increased cost of working for which Synergy was entitled to an indemnity. 6. The policy wording was relatively standard and, after the usual provisions for calculating the reduction in Turnover and increase in cost of working, concluded with: less any sums saved during the Indemnity period in respect of such of the charges and expenses of the Business payable out of Gross Profit as may cease or be reduced in consequence of the incident. 7. It was Synergy s case that depreciation is an accounting means of recognising, on an annual basis, the amortised cost of plant and machinery, the cost of which has been incurred at an earlier time. The total cost of purchase is not set off against turnover in the year of purchase but spread over the expected useful lifetime of the plant and machinery and recorded as an annual expense to reflect the fact that the profit is derived from the use of plant and machinery which has an expected lifetime of X years. The cost is actually incurred on the acquisition of the plant and machinery _1 2

3 8. Damage to the plant and machinery makes no difference to the fact that the cost of the plant and machinery has already been incurred or to the fact that, whatever that cost was, it is then treated in the accounts as being depreciated annually until the end of its useful life by which time the full cost of the plant and machinery will have been set off against the gross profit made by Synergy. 9. In the case of plant and machinery which is not damaged, the end of its working life will mean for the whole of the period of the expected use of the plant and machinery. In the case of plant and machinery which is damaged so as to be written off, it will be brought to an unexpected and premature end of its working life by that damage. The residual value of the equipment in the accounts (after earlier depreciation) has to be dealt with. 10. If the useful working life of the plant and machinery is brought to an abrupt end it becomes valueless and the whole of its remaining value is depreciated in one operation or written off (rather than continuing to depreciate on a straight line basis). Thus the depreciation which would have occurred in normal circumstances over the 10 month period following the fire, has in fact been absorbed within the write off of tangible fixed assets. This also includes the write off of the remaining cost in the profit and loss account and the write down of the remaining value in the balance sheet. Far from being saved, therefore, the depreciation has been incurred. 11. Another way of analysing the treatment is that the depreciation charge has to be accelerated to accommodate the change from the plant and machinery being expected to have a continuing working life and diminishing value for several years with depreciation being taken annually and it unexpectedly reaching the end of its working life when a one off depreciation charge of the remaining balance of the value of the plant and machinery is taken to deal with the unexpected loss of value. 12. Accordingly, Synergy s principal arguments against the Judge s finding that depreciation should be deducted as a saving were: That the true characteristic of depreciation is an accounting entry recording, as a charge or expense, a proportion of the cost price of assets which have already been acquired. That the charge or expense is generally calculated by taking the cost price of the asset and dividing that price by the number of years of useful working life the asset is projected to have _1 3

4 (iii) (iv) (v) (vi) (vii) That the cost price or the liability for the cost price having been incurred, the process of spreading the cost across many years (amortising) is continued until there is a total reduction in value, either by the plant and equipment reaching the end of its working life or being unexpectedly brought to the end of its working life. The more usual treatment of the cost of the plant and equipment where the plant and equipment has come to the unexpected and premature end of its useful working life, is to write off the undepreciated cost of the damaged assets in the profit and loss account and to reflect the write down of the residual value of the asset in the balance sheet. That is what happened in this case. The depreciation, which might have been expected to be ongoing for years over the useful lifetime of the plant and machinery, was accelerated and an appropriate element of the value of tangible fixed assets was written off as a result of the fire. The expected annual depreciation for plant and equipment in its undamaged state, was in fact included within the sum written off. The expected annual depreciation would have represented a write down of part of the residual value of the plant and equipment (which came to be damaged), whereas the actual write off represented a write down of the whole of the residual value. The partial write down (the norm) and the whole write down (the exception) were different only in scale, but otherwise were the same, since each represented a reduction in the value of the same equipment. The result was that the depreciation actually charged in the accounts as a result of the damage, was very much greater than the depreciation which would have been charged if there had been no damage. Far from there being a saving, the depreciation charge or expense was greater than it would have been. 13. In relation to the Judge s finding that the meaning of the words payable out of Gross Profit included depreciation because the word payable should be construed broadly so as to give it the meaning of a charge or expense, Synergy s principal arguments were: That it was wrong to find that payable was to be construed as meaning a charge or an expense because depreciation is an accounting entry which recognises the spreading of cost which has already been paid or incurred and the reduction in value of the plant and equipment over its lifetime. Depreciation is not the payment of anything. Depreciation is not paid to anybody. It is not paid anywhere. Payment occurred when the plant and equipment was bought _1 4

5 (iii) The cost of acquisition which had been incurred (and the value which had been acquired) was not the subject of separate repeated transactions involving the payment of money, which were reflected in the accounts according to whether the plant and equipment could be used. The cost, having been incurred, was spread over a period of time, and whether the plant and equipment was damaged or undamaged, that cost (and the reduction in value of the plant and equipment) was to be reflected in the accounts as an accounting entry, either as an annual deduction or, as a write off if the circumstances required. The cost or its accounting treatment did not cease, merely because the equipment was no longer useable. In no sense could that accounting entry be regarded as a saving, merely because the plant and equipment was no longer usable. Depreciation is different from other charges and expenses in the Profit and Loss account, which are commonly taken as savings, because it cannot be realised. Other savings (electricity, soap powder etc.) are costs which the insured does not pay and are therefore deducted from the increased cost of working and from the claim. That is a neutral adjustment for the insured. However, depreciation savings cannot be realised in the same way, with the result that if such savings are deducted, the insured suffers an unjustified loss in the assessment of the quantum of the claim. Conclusion 14. Sadly for the insurance industry, the appeal settled and these arguments were never aired in open court. The settlement was on terms of a payment to Synergy for whom continuing the appeal became commercially pointless but the payment was of sufficient magnitude to indicate how insurers anticipated the Court of Appeal would decide the matter. Michael Whitton Partner Edwin Coe LLP Sponsors of the Claimant SIG January _1 5