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.
