a briefing note from michael whitton of edwin coe llp - CILA/The ...

A BRIEFING NOTE FROM MICHAEL WHITTON OF EDWIN COE LLP
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DEPRECIATION – A MISSED OPPORTUNITY
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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 2010. 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 2007. 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 2006.
2. 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:
(i)
(ii)
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
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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:
(i)
(ii)
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:
(i)
(ii)
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.
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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:
(i)
(ii)
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.
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(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:
(i)
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.
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(ii)
(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 2012
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