Depreciation due to Deterioration of Plants & Machines

Depreciation It is the usual wear and tear caused by the normal working of any asset, its use is liable to a certain amount of deterioration despite the care and attention bestowed on its maintenance and preservation.

Physical depreciation is broken down into curable and incurable

Curable Depreciation

The following input for machinery under consideration by technical personnel of clients helps in estimating curable depreciation.

(i) Did the equipment undergo major repair or reconditioning?

(ii) Did the equipment undergo capability test?

(iii) What is the present condition in terms of production rate and accuracy vis-à-vis the original at the time of purchase?

Curable depreciation is fixable by refurbishing, rebuilding of the equipment

Physical Incurable Depreciation

Physical depreciation is caused from age, wear and tear, fatigue, exposure to the elements or lack of maintenance. Overall physical depreciation is caused more by use rather than age.

A visual inspection can help to assess present condition of the machine

General Upkeep:

If an equipment is well-maintained during its service life and is expected to operate longer with lower costs, its value may be higher than expected for a machine of its age.

Dirt, dust, and other contaminants can interfere with lubrication and cause abrasive wear on the surfaces of the rotating equipment. This can also lead to increased friction, leading to increased heat, and damage to seals, bearings, and other components. Contamination can also lead to corrosion and oxidation, which can cause parts to degrade and fail prematurely. Additionally, contaminants can interfere with the flow of fluids, cause bearing failure, cause pressure spikes, block lubricant pathways, and reduce equipment efficiency.

Observed deterioration (also known as the 0 – 100% method)

 Lump sum figure of depreciation can be adopted as given below:

 Condition                                                        Depreciation %

New (N)                                                            0 - 5

Excellent (E)                                                    6 - 10

Very Good (VG)                                              11 - 20

Good (G)                                                         21 - 50

Fair (F)                                                            51 - 70

Poor (P)                                                           71 - 90

Scrap (S)                                                          91 - 100

If upkeep and maintenance are high, then the effective age will be lower than the actual age and conversely if upkeep and maintenance have been low then the effective age will be greater than the actual age.

As one of the important obsolescence factors considered by the cost approach, physical deterioration influences the conclusion of value.

Reference Document: STANDARDS ON VALUATION OF PLANT, MACHINERY AND EQUIPMENT; Publisher: Centre for Valuation Studies, Research & Training Association, India

 The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

Taking benefit of Insurance Valuation for Asset Management

Fixed assets represent the largest item on Company's insurance budget– especially in capital-intensive industries like manufacturing, power generation, oil & gas.

While completing a property insurance appraisal, the findings can also be useful for fixed asset management as both require a physical inspection of the fixed assets inventory.

When it comes to insurable values, accuracy is vital to avoid excess insurance premiums on ghost assets.

An insurance appraisal will consider a total replacement cost of all the fixed assets and buildings. This would also include expensed assets below the capitalization threshold.

The purpose of an asset management system, or asset system, is to keep track of the equipment and inventory vital to the day-to-day operation of the business.

The only reliable way to verify and validate the fixed asset information is to conduct a physical inventory. Eliminate assets those have been lost, stolen, or unusable but are still listed as an active fixed asset in the system and also inclusion of new assets upon purchase

From insurance point of view, this means their balance sheets match up with their records, and assets that have been loaned, lost or stolen are timely identified and excluded from insurance premium. Companies not effectively managing their assets typically lose considerable amounts of time and money.

Without an accurate, real-time, organized system for tracking assets, it will be difficult to plan timely preventive maintenance of the important machines.

The benefits of an asset management system include :

·        To track and manage an asset’s entire lifecycle, from initial acquisition to periodic maintenance to phase-out from inventory

• To monitor asset use and make improvements.
• to implement preventive maintenance and routine inspections, thereby preventing expensive repairs and downtime.
• To maximize equipment lifecycles and staving off early replacements
• Reduced waste and increased profitability
• In obtaining better residual value while selling off machines due to functional or economical obsolescence

An asset management record may contain details like purchase date, serial number, manufacturer, model, lifecycle cost including maintenance and repair, present value, number of each type of fixed asset, locations, and estimated lifespans.

Such record provides a picture of the present conditions of the machineries and also help companies prepare for the future. Based on facts, they can make decisions about the assets they will need in the coming year. Subsequently, they can avoid under or over-stocking assets and manage their resources responsibly. Asset management optimizes an asset's operational performance during its lifespan and aims to keep these assets running profitably for as long as possible.

The decision to repair or replace an asset depends upon various factors, including the type of asset, age, wear and tear, and role in the production line. To decide between repairing and replacing an asset, a management company must compare its current value and the repair costs. If repair costs are less than the value of equipment, it is best to get it repaired. However, when the repair costs exceed the value of equipment, it is better to replace it.

 The above interpretations are absolutely personal in nature and are not binding on any individual/ organization in particular.

 

CONCEPT OF DEPRECIATION IN INSURANCE VALUATION

The following paragraphs are being reproduced from the Book: CONCEPT OF DEPRECIATION IN INSURANCE VALUATION, which may be valuable for fixing residual life of the insured fixed assets.

Although I tried my best to recover the source/origin of this publication, I could not trace this so far. However I find the concept very useful while assessing old but satisfactorily usable machines, 

"The depreciation being provided by the Insured in his books of account in line with what is permissible under Income Tax regulations, need not necessarily be considered as an appropriate basis for computing the insurable value of capital assets.

Insurance is concerned with actual intrinsic loss of useful working life deducted due to real wear and tear, and not the notional amounts deducted from the reducing balances, for the purpose of Income Tax and Balance Sheets.

Maximum Depreciation: (Residual Value concept)

Suppose a machine is 18 years old and is still giving satisfactory performance and almost the rated output. Assuming that we ascribe a life of 20 years to this machine, the total depreciation will touch 90%, at 5% per year. This is not fair if the machine is still giving satisfactory production, because of good maintenance. In such case, where it can be established that the standard of maintenance is good, it is enough if the maximum depreciation is levelled off at 75%. Thereafter, the ‘Residual Value Concept’ will take over.

Surely, after 15 years, when we reach a total depreciation of 75%, the machine is not a mere scrap. If it is still working well, it will at-least have a ‘Residual Value’ of 25% applied on its present replacement cost.

In some industries including all Petro-Chemical complex, where very high standard of renewals and maintenance is a must for safe operation of the plant; where there is a full fledged maintenance department, staffed with qualified engineers; where regular periodical maintenance shutdowns are taken to completely overhaul and check the entire Plant and Machinery; where the industry concerned maintains adequate spares to replace worn out items as and when needed – in such cases, it has to be conceded that the Plant is in excellent condition at all times; depreciation could be at a lower level provided there is satisfactory evidence of such a high standard of maintenance.

However, where it is evident that the Plant and Machinery have been ‘worked to death’ they are in a highly worn out condition with no renewals/replacements having been carried out as per maintenance norms then the maximum depreciation can be taken even upto 95%; the balance 5% representing practically the ‘Scrap Value’ of the machinery.

In the case of nonworking obsolete old machines lying in the factory, their value should be worked out only on the basis of their weight as metal scrap.

It will be seen from the above that, unless the valuation and depreciation exercises are carried out appropriately, serious distortions will result. The escalation and depreciation formulae shown in the above two tables should not be followed blindly for all cases.

Wherever they are found unsuitable necessary modifications should be made suitably.

In the case of capital assets other than plant and machinery, such as furniture, fixtures, office equipment, the same consideration as explained above would normally apply.

The depreciation being provided by the Insured in his books of account in line with what is permissible under Income Tax regulations, need out necessarily be considered as an appropriate basis for computing the insurable value of capital assets.

Insurance is concerned with actual intrinsic loss of useful working life of a deducted due to real wear and tear, and not the notional amounts deducted from the reducing balances, for the purpose of Income Tax and Balance Sheets.

Maximum Depreciation : (Residual Value concept)

Suppose a machine is 18 years old and is still giving satisfactory performance and almost the rated output. Assuming that we ascribe a life of 20 years to this machine, the total depreciation will touch 90%, at 5% per year. This is not fair if the machine is still giving satisfactory production, because of good maintenance. In such case, where it can be established that the standard of maintenance is good, it is enough if the maximum depreciation is levelled off at 75%. Thereafter, the ‘Residual Value Concept’ will take over.

Surely, after 15 years, when we reach a total depreciation of 75%, the machine is not a mere scrap. If it is still working well, it will at-least have a ‘Residual Value’ of 25% applied on its present replacement cost.

In some industries including all Petro-Chemical complex, where very high standard of renewals and maintenance is a must for safe operation of the plant; where there is a full fledged maintenance department, staffed with qualified engineers; where regular periodical maintenance shutdowns are taken to completely overhaul and check the entire Plant and Machinery; where the industry concerned maintains adequate spares to replace worn out items as and when needed – in such cases, it has to be conceded that the Plant is in excellent condition at all times; depreciation could be at a lower level provided there is satisfactory evidence of such a high standard of maintenance.

However, where it is evident that the Plant and Machinery have been ‘worked to death’ they are in a highly worn out condition with no renewals/replacements having been carried out as per maintenance norms then the maximum depreciation can be taken even upto 95%; the balance 5% representing practically the ‘Scrap Value’ of the machinery.

In the case of nonworking obsolete old machines lying in the factory, their value should be worked out only on the basis of their weight as metal scrap.

It will be seen from the above that, unless the valuation and depreciation exercises are carried out appropriately, serious distortions will result. The escalation and depreciation formulae shown in the above two tables should not be followed blindly for all cases.

Wherever they are found unsuitable necessary modifications should be made suitably.

In the case of capital assets other than plant and machinery, such as furniture, fixtures, office equipment, the same consideration as explained above would normally apply".

The publication has not been originated by me. I have come across this publication while undergoing self-study sessions for IBBI Valuation Examination.

Above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular. 

 

Why Plant & Machinery Valuation Matters:

Followings are the reasons why plants and machineries are needed to be appraised periodically:

1. Financial Reporting:

Accurate valuation ensures that assets are reported correctly on the balance sheet, impacting depreciation, taxation, and overall financial health. 

2.               2    Insurance and Risk Management:

Accurate machinery and equipment appraisal assists in reducing any financial losses. It eliminates the impact of loss or theft by enabling to secure sufficient insurance coverage for plant & equipment.

Furthermore, knowing the depreciation rate of assets enables to anticipate their declining value and plan accordingly, reducing the financial burden of future replacements.

3. Investment Decisions:

Valuations are essential for making informed decisions about investments, acquisitions, and disposals of machinery. Accurate valuations enable to make informed choices when buying or selling equipment. Knowing their true market value will help negotiate the best price. 

4. Fundraising:

Accurate valuations are crucial for securing loans or attracting investors, as lenders and investors rely on the value of assets as collateral. 

5. Mergers and Acquisitions:

Valuations are vital in determining the fair market value of machinery during mergers and acquisitions. 

6. Asset Management:

By understanding the value of machinery, companies can optimize its utilization, maintenance, and replacement, maximizing return on investment. By tracking the value of assets over time, one can monitor their performance and make informed decisions about their economic lifespan and replacement. 

This allows to maximize the return on investment of machinery and equipment while ensuring their continued functionality and productivity.

Note: Point 1, 4 &5 are better to be left on Company’s Chartered Accountants.

 

The above interpretations are absolutely personal in nature and are not binding on any individual/ organization in particular.

 

INSURANCE OF CNC MACHINES UNDER ELECTRONIC EQUIPMENTS INSURANCE

CNC machines & machining centers are widely used for precision machining of automotive and other engineering components. These machines are generally covered under Machinery Insurance policies for sudden unforeseen breakdowns.

Option to insure under either MB or EEI Policy

CNC Machines preferably should be insured under EEI Policy as EEI provides much wider coverage in comparison with MB Policy

Note – Where it is not feasible to give a breakup of values for minor electronic equipment (non-metallic items) which were integral to various machines, eg CNC Machines, wherever such CNC Machines are insured, the Insured can have option to cover the same either under MB or EEI policy.

In India, a CNC machine, due to its significant electronic components, is typically covered under an Electronic Equipment Insurance (EEI) policy rather than a standard Machinery Breakdown (MB) policy, meaning it should be included in your EEI coverage to ensure protection against damages or breakdowns related to its electronic parts and systems. 

All Electronic equipment like Computers, Medical, Biomedical, Micro- processors; Audio/Visual equipment including the value of Systems Software may be covered under Electronic Equipment Policy. The term equipment shall also include the entire computer system consisting of CPU, Keyboards, Monitors, Printers, Stabilizers, UPS, System Software etc.

Cover granted under E.E.I policy are virtually against all insurable perils namely fire, RSMD, Terrorism, Flood, Storm, subsidence, Earthquake, accidental breakdown while at work or rest, electrical damage, faulty manipulation, dropping, falling impact etc.

OTHER FEATURES: If the insured want to opt out fire and allied perils cover, a premium reduction in rate is offered based on the coverage.

SUM INSURED: Sum Insured shall be equal to the cost of replacement of the insured property by new property of the same kind and same capacity, which shall mean its replacement cost including freight dues and customs duties, if any and erection costs. The sum insured of the equipment insured under this section shall include the value of ‘System Software’.

PROHIBITION TO ISSUE MB POLICY ON ELECTRONIC EQUIPMENT- Unless otherwise specifically provided for in MB Guide Rate, no machinery breakdown policy should be issued on Electronic Equipment like Computers, Medical, Bio-medical, Micro processors, Audio-visual equipment which must be covered under EEI Policy only.

Loss or damage sustained during transit and any loss/damage attributable to transit shall be excluded under both Machinery Breakdown and Electronic Equipment Policy

An Electronic Equipment Insurance (EEI) policy in India would cover an industrial CNC machine against a wide range of damages, including electrical breakdowns, mechanical failures, fire, theft, accidental damage, and even damage caused by faulty operation, essentially providing comprehensive protection for the machine's functionality due to unforeseen events; the key is to ensure the CNC machine is specifically listed as covered under the EEI policy. 

Key points about CNC machine coverage under EEI:

• Specific coverage:

EEI policies generally cover damages caused by electrical surges, short circuits, faulty operations, accidental impacts, fire, theft, and natural calamities to the electronic components of a CNC machine. 

• Separate policy needed:

While some minor electronic parts integrated into a standard machine might be covered under an MB policy, for comprehensive protection of a CNC machine, a dedicated EEI policy is recommended. 

• Consult with insurer:

Always check with insurance provider to clarify the exact coverage details for specific CNC machine to ensure it is appropriately included within the EEI policy. 

The above interpretation is absolutely personal in nature and is not binding on any individual or organization in particular.

 

Valuation of Tangible Fixed Assets For Insurance Purpose:

Tangible fixed assets are long-term assets with a physical presence that are held by a company to support its operations and generate economic benefits over multiple accounting periods. These assets are not intended for sale in the ordinary course of business

For insurance coverage, accurate valuation of tangible fixed assets need consideration for depreciation, potential obsolescence, and the need for repair or replacement option in the event of a damage.

Valuation of tangible fixed assets assists in determining insurance coverage and replacement costs, ensuring proper risk management and asset protection.

There are two methods of Fire insurance coverage in India for determining the appropriate value of a loss under commercial fire insurance.

1.     Indemnity: best described as compensation for a loss sustained, and all contracts of property insurance are referred to as contracts of indemnity.

The intension of a party to the contract is that the insured, on the happening of an insured event, will be placed by the insurer, in the same pecuniary position that the insured occupied immediately before the event. This is subject to any limitations which may have been agreed and written into the contract!

Replacing "like for like”

In other words, if an item of equipment which was 5 years old was damaged beyond repair insurers would be liable to indemnify the insured based on the value of an item of a similar age and condition. Depreciation will be considered.

An important point to note that balance useful life calculation for depreciation calculation of the insured property may significantly differ from that of financial reporting standard. 

2.     Reinstatement Value Condition Clause:

Reinstatement cost, often termed as the 'replacement cost', an alternative method of settlement, refers to the amount of money needed to rebuild or restore a property back to its original state after it has been damaged or destroyed, without considering its age or condition prior to the damage. In other words depreciation is not considered in the claim value calculation.

Reinstatement value claims are only valid if the damaged property has been repaired or replaced. The sum insured depends on the replacement value of the damaged property or asset.

Re-instatement Cost Method:

Apart from Fire insurance, Sum insurance for Engineering Insurance policies like Machinery Insurance, Electronic Equipment Insurance, Contractor’s Plant & Machinery Insurances are mandatorily R.I Value based.

The valuation of tangible fixed assets using the reinstatement cost method involves determining the value of an asset based on the cost of replacing it with a similar new asset at current market prices. This approach assumes that the value of an asset is equivalent to the cost of acquiring or constructing a new asset of similar utility.

The replacement cost method is particularly useful when the asset being valued is unique or custom-built and does not have readily available market comparable. R.I. basis of valuation provides insights into the costs of replacing the assets and helps businesses understand the potential investment required to obtain a similar asset.

An insurance reinstatement value assessment is totally independent of the market value of a property.

 Valuation Process

The process typically begins with identifying the specific assets to be valued and gathering relevant information such as purchase records, maintenance history, and any appraisals or assessments previously conducted, and type of insurance policy needed.

The frequency of performing valuations of tangible fixed assets varies depends on several factors. Generally, it is recommended for companies to conduct valuations periodically or whenever significant changes occur, such as acquisitions, disposals, or major capital investments.

Valuing tangible fixed assets can pose several challenges. One common challenge is determining an accurate indemnity/fair market value, especially for unique or specialized assets with limited comparable market data.

Assessing depreciation and obsolescence accurately can also be challenging, as it requires a thorough understanding of the asset’s condition, usage, useful life, and technological advancements.

Additionally, valuation challenges may also arise from changing market conditions, inflation, economic uncertainties, or discrepancies in data availability.

Higher valuations may result in increased insurance premium while lower results in inadequate coverage for the assets in case of any mishap.

The above interpretation is absolutely personal in nature and is not binding on any individual/ organization in particular

 

Measure of Betterment in Reinstatement Basis of Claim Settlement

When dealing with commercial property claims most often the basis of settlement is reinstatement. is important the issues related to betterment are understood.

A contract of fire insurance is fundamentally one of indemnity, since its object is to make good, within the limits of the amount of insurance, and subject to terms and conditions of the policy, the actual loss sustained and nothing more.

An insurance policy providing reinstatement cover is basically a contract of indemnity. The addition of the reinstatement basis of settlement provides a means by which an indemnity will be calculated.

By definition, ‘Reinstatement value’ is the cost necessary to replace, repair, or rebuild the insured property to a condition substantially the same as, but not better or more extensive than, its condition when new provided the reinstatement is actually carried out.

In other words, damaged / destroyed / irreparable property to be replaced by new property of “the same kind or type but not superior to or more extensive than the insured property” and the monetary claim to be allowed on value as new basis without deducting depreciation.

An insurance policy covers the insured’s financial interest in the subject matter of the cover, not the item itself. So, if the damage to the item in question causes the insured no financial loss, there is no indemnity to consider, and reinstatement is an irrelevance.

Policy does not only insure property itself, but also the insured’s interest in the property and measurement of loss is the extent of such interest in property damaged or destroyed by an insured peril.

If a warehouse is destroyed, a building of modern steel frame may cost less to construct in comparison with the old one with brick walls and internal columns construction. By reinstating the property using modern methods, the insured’s financial interest is protected as the final result is an asset at least as valuable with equal utility than that which was lost.

In a situation where rectification works have improved a property or asset in some way (i.e. it is larger, newer or has an improved specification), the insurer will often claim that betterment has been obtained and that a deduction should be made in any award of damages.

There are three common examples of financial benefit obtained following rectification: -

·        The property or asset is improved, either because the replacement specification is enhanced,

·        The available products are superior, or

·        The lifecycle and maintenance requirements are improved.

For an award of damages to be reduced for betterment it is necessary to show that the claimant has received some form of financial benefit or advantage.

This same principle applies to machinery and contents – the insured’s financial interest in an item is whatever it does, not the machine itself.

Computers may be an excellent example, given the fact that new equipment is generally better and cheaper than the original. It would seem impractical to spend money on procuring an out-of-date specification of computer when, for far less, a more efficient and faster computer can be obtained. today.

It is the functionality that is important, but that can of course include reliability, quality and the like as all these things are relevant.

The basic principle remains however that the machine is the current equivalent in terms of its functionality – same capacity, output, quality of product, etc. as the original.

Comparison has to be made between the latest and the old machinery with regard to following aspects to assess for the deduction due to betterment.

▪ Higher output / productivity 

▪ Lesser manpower requirement 

▪ Lesser fuel consumption and operating cost 

▪ Additional range of function / compactness of machine, etc. 

If only an improved replacement can be obtained (the computer being a typical example) as the current nearest equivalent of the damaged machine, a suitable deduction will be made for the inherent improvements.

The following invaluable Publication has been referenced for this article:

“Reinstatement Basis of Settlement Practical Problems in Adjusting Losses by the CILA Property Special Interest Group”

The above interpretation is absolutely personal in nature and is not binding on any individual/ organization in particular.