Depreciation – Is it really a saving? Michael Whitton

Depreciation – Is it really a saving?Michael Whitton

Introduction

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

Damage to the plant and machinery makes no difference to: The fact that the cost of the plant and machinery has

already been incurred 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 gross profit

In the case of plant and machinery which is not damaged In the case of plant and machinery which is damaged

The depreciation charge is accelerated

What is Depreciation?

Part of the Synergy Group providing laundry and related services to the NHS

Substantial modern laundry facility in Dunstable Commercial combined policy 30 April 2006 to 29 April

2007 On 3 February 2007 the Dunstable laundry was

substantially damaged by fire The basis of the defence Synergy made a secondary claim of breach of duty

against the brokers

Synergy – The Facts

The relevant wording

“Gross profit/Estimated gross profit – the insurance under this item is limited to loss of gross profit due to (a) reduction in Turnover and (b) increased cost of working and the amount payable as indemnity thereunder shall be:

a) In respect of reduction in turnover …

b) In respect of an increase in cost of working ...

Less any sum 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.”

How Synergy dealt with depreciation in respect of plant and machinery at Dunstable pre fire

How depreciation was dealt with post fire

Did the fact that depreciation was not shown in the management accounts for Dunstable post fire represent a saving to be deducted from the increased cost of working

The Depreciation Issue

Experts’ reports on behalf of both parties Synergy’s position

Depreciation represents an accounting entry to write off the cost of fixed assets over a period of time – it does not represent cash flow

As stated in the policy, savings represent “the charges and expenses of the business payable out of gross profit”

Depreciation is fundamentally different from other items taken as savings

Reduced use of machinery at Dunstable was counterbalanced by increased use at other facilities

There was no saving because £2.841 million was written off in Synergy’s audited accounts due to fire damage

Synergy was entitled to an indemnity on a new for old basis. Applying a depreciation saving had the effect of reducing it to an indemnity policy

The Evidence

The fact that when depreciation is deducted from the financial accounts, it is referred to as a depreciation charge or expense

Depreciation is deducted from gross profit and therefore is payable out of gross profit

If depreciation ceases and no depreciation saving is taken then net profit is higher than that achieved but for the incident and additional profit would be generated

In arriving at the net profit in the management accounts at Dunstable, no depreciation on plant and machinery was charged from February to November 2007

In relation to other heads of claim, accounting profit, not cash flow is considered so there is no reason why the word “payable” would have a strict cash sense in respect of savings

The Evidence – The Defendants position

The Honourable Mr Justice Flaux held as follows:- Synergy ceased making a deduction in its accounts for

depreciation of plant and machinery at Dunstable after the fire. The Defendants submit that if Synergy does not give credit for what might be described as the cessation of depreciation for the period until new machines were installed and depreciation resumed in subsequent accounting periods, Synergy will recover an indemnity for more than its actual loss in respect of business interruption. This is for the simple reason that, had the fire not occurred, Synergy could not have earned its gross profit (by reference to which any indemnity under the business interruptions section of the policy is calculated) without having the use of the machines, in respect of which a sum for depreciation would be deducted from the gross profit in each accounting period.

The Judgment

It seems to me that, as a matter of principle, this analysis is unanswerable and plainly correct. On that basis, to the extent that, during the Indemnity Period, the deduction in respect of depreciation ceased to be made, that was a saving against what would otherwise have been the charges and expenses of Synergy’s business. It follows that, in principle, that saving should be offset against any claim under the business interruption section of the policy, unless the wording of the policy requires some different conclusion.

The Judgment cont’d

Synergy submits that credit does not have to be given against its business interruption claim for any saving in respect of depreciation, on two grounds which it submits are the consequence of the correct construction of the policy. First it is submitted that if it was intended that the “sum saved during the Indemnity Period in respect of … the charges and expenses of the Business” in the closing phrase of the provision quoted above was intended to include savings in respect of depreciation, the provision could and would have said so. Reliance is placed upon the fact that in other provisions of the policy where it is intended that depreciation should be taken into account express reference is made to depreciation [reference to the definition of Gross Profit].


It does not seem to me that this point has any real force for two reasons. First, given that the definition of gross profit itself contemplates a deduction for depreciation, it would be very odd if the savings made during the indemnity period which would reduce gross profit but for the insured event, somehow excluded a matter which, because of the insured event was no longer a deduction from the gross profit. Second it seems to me that there is no reason for the closing phrase of the insuring provision to expressly identify a saving in respect of depreciation as a saving in respect of the charges and expenses of the business any more than any other saving.


More formidable is the second ground upon which Synergy submits that any saving in respect of depreciation does not have to be brought into account upon the true construction of the policy. This is that depreciation is simply not a charge or expense “payable” out of gross profit within the meaning of the provision. Synergy submits that the word “payable” connotes something that would be “paid” to somebody whereas depreciation is never paid in that sense. Rather it is an accounting exercise that spreads the cost of assets over a number of years.


The Defendants seek to counter that argument by contending that the correct approach to the provision is that it is unlikely that the word “payable” was used with the intention of only requiring certain types of saving to be deducted from any claim so that other types of saving did not have to be deducted, with the consequence that the insured recovered more than a full indemnity. Rather the likelihood was that “payable” was used not as a word of limitation but because the sort of expenses which would ordinarily be deductible for this insured’s business such as electricity and washing powder would be “payable” in the ordinary sense.


Although the Defendant’s construction stretches the word “payable” somewhat, it seems to me that it is to be preferred to Synergy’s construction which leaves the saving in respect of depreciation out of account. My principal reason for that conclusion is that it seems to me that, as a matter of principle, a policy should be interpreted as providing an indemnity for the loss suffered not for more than such an indemnity. Of course if the wording is incapable of any other construction, a court might be driven to the conclusion that something in excess of the full indemnity was intended, but given the unlikelihood and unreasonableness of such a conclusion, the court should not arrive at it unless no other conclusion is possible.


It seems to me that Synergy’s construction would lead to that unreasonable conclusion, but that construction is not inevitable if “payable” is given a purposive meaning. Synergy sought to counter the suggestion that it would otherwise recover more than a full indemnity by contending that depreciation had not in fact been saved because it had been accelerated due to the write off of damaged assets following the fire. The short answer to that point is that, on the basis that the policy has responded (as I have found it must), the insurers will have indemnified Synergy for the cost of replacement of the machines on a reinstatement basis meaning that Synergy is better off to that extent.


Furthermore, in my judgment the word “payable” does not have as inflexible and narrow a meaning as that for which Synergy contends. I agree with Mr Southern [counsel for the brokers] that, whilst accountants might not ordinarily refer to depreciation being payable, in accounting terms depreciation is a charge or expense deducted from gross profit to arrive at net profit and to that extent, as Ms Rawlin said, something payable out of gross profit. Thus an accountant would understand why a saving in depreciation was a saving in respect of charges and expenses of the business payable out of gross profit. Accordingly, in my judgment, Synergy has to deduct from its business interruption claim the savings it has made in respect of depreciation.


The Judge was wrong to find that depreciation should be deducted as a saving because:-

The true characteristic of depreciation

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

The cost price or the liability for the cost price having been incurred, the process of spreading the costs across many years (amortising) is continued until there is a total reduction in value

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

The Appeal - The first ground of appeal

In this case the depreciation was accelerated

The expected annual depreciation for plant and equipment in its undamaged state was in fact included within the sum written off

The result

The judge was wrong in his reasoning in paragraph 6(i) above

The judge was also wrong to find that Synergy was bound to give credit for the cessation of depreciation for the period until new machines were installed and depreciation resumed in subsequent accounting periods, for otherwise Synergy would recover an indemnity for more than its actual loss in respect of business interruption

The Appeal - The first ground of appeal cont’d

In finding (see 6(ii) above) that to the extent that the deduction in respect of depreciation ceased to be made, was a saving in respect of what otherwise would have been the charges and expenses of Synergy’s business, overlooked or ignored and failed to find that: The charges and expenses of Synergy’s

business would have reflected the annual deduction in value of those assets

Such a reduction in value (and more) has occurred as a result of the end of the useful life of the assets being accelerated

The second ground of appeal

Depreciation was accelerated as a consequence of the fire and appeared as a charge or expense in

Synergy’s accounts in the year of the fire and was described as a write off of tangible fixed assets The Judge’s reasoning in this respect was based on a misapprehension that the deduction for depreciation ceased to be made Whilst the management accounts were relied on as demonstrating an absence of a depreciation charge for the 10 month period after the fire, in fact as the audited accounts revealed, the depreciation charge was incurred

The second ground of appeal - cont’d

The Judge was wrong to find (see 6(vii) – (ix) above) that the depreciation was “payable out of gross profit”. The policy of insurance only required a deduction for such savings to be made when such savings were in respect of a charge or expense which was payable out of gross profit

There were two reasons why the judge concluded that “payable out of gross profit” was to include depreciation

Construing the word “payable” broadly so as to give it the meaning of a “charge” or “expense” deducted from gross profit, gives the word “payable” a purposive meaning

Since insurers will have provided an indemnity by replacement of the machines on a reinstatement basis, Synergy would be more than indemnified if the saving in depreciation were not deducted

The third ground of appeal

The Judge was wrong to find that payable should be construed to mean “a charge” or “an expense”

The cost of acquisition which had been incurred (and the value which had been acquired) was not the subject of repeated transactions involving the payment of money which were reflected in the accounts according to whether the plant and equipment could be used

Further, 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

The third ground of appeal - cont’d

It was also wrong to find that there would be more than an indemnity once the machines and equipment had been replaced in accordance with the indemnity to be provided by the insurersInsofar as it can be said that there is over compensation because old equipment is replaced with new equipment, that is the inevitable consequence of the cover being provided on a new for old basis

The third ground of appeal - cont’d

The appeal was settled

Why?

What happened next?

Ongoing uncertainty

Verba chartarum fortius accipiuntur contra proferentem

Claims against brokers?

The future

Questions

Michael Whitton

Litigation Partner

e: [email protected]

t: +44 (0)20 7691 4000

f: +44 (0)20 7691 4177

Contact details

Unravelling Settlement AgreementsNicola Maher

Entered into by the parties to a dispute

Records the terms agreed

Conclusively determines the elements in dispute

Binding upon the parties

Specie of general contract – subject to the usual principles of contract law

Can a party later assert that it is not bound by what appears to be a binding contract?

Settlement Agreement

Incapacity

Duress or undue influence

Misrepresentation

Mistake

Grounds for Unravelling

A contract entered into by a person without the requisite capacity may be voidable

The following categories may lack contractual capacity:

Aged under 18

Lacking mental capacity; and

Intoxicated – e.g. by alcohol or otherwise

For example, a contract concluded with a drunkard may be invalid where he was unable to understand the nature and effect of the transaction; it must be more than the “merriment of a cheerful chap”

Gore v Gibson (1845) 13 M&W 623; Pitt v Smith (1811) 3 Camp 33

Incapacity

A contract which has not been entered into freely and voluntarily may be voidable

Duress includes: Actual or threatened violence to a person

(Barton v Armstrong [1976] AC 104); Actual or threatened violence to property

(Maskell v Horner [1915] 3 KB 106) ; and Economic duress (North Ocean Shipping Co.

Ltd v Hyundai Construction Co. Ltd [1979] QB 705)

Duress and Undue Influence

Undue influence includes: Improper pressure applied so that a party is

prevented from exercising free and independent judgment; and

Taking advantage of a position of trust and confidence

Royal Bank of Scotland v Etridge (No.2) [2001] UKHL 44

Duress and Undue Influence - cont’d

A contract may be rescinded where one party has entered into it in reliance of a material false statement

The statement can be: fraudulent, negligent or innocent

It must induce the other party to enter into the agreement

Not every false statement will give rise to a claim (e.g. a mere contention or statement of position)

Often difficult to establish on the facts

Misrepresentation

Kyle Bay Ltd (t/a as Astons Nightclub) v Underwriters Subscribing under Policy No. 019057/08/01 [2007] EWCA Civ. 57;

Primus Telecommunications plc v MCI Worldcom International Inc. [2004] EWCA Civ. 957

Misrepresentation

A contract may be vitiated by a common mistake – e.g. a shared and fundamental misunderstanding as to the state of affairs giving rise to the contract

Great Peace Shipping Ltd v Ttsavliris Salvage (Int) Ltd [2002] EWCA Civ. 1407;

Associated Japanese Bank (International) Ltd v Credit du Nord SA [1989] 1 WLR 255;

Mistake – Common Mistake

A contract will be void by common mistake if:

The parties have entered a contract under a shared and self-induced mistake as to the facts or law affecting the contract

Under the express or implied terms of the contract neither party is taken as taking the risk of the situation being as it really is

Neither part is responsible for or should have known of the true state of affairs, and;

The mistake is so fundamental that it makes the “contractual adventure” impossible or makes performance essentially different to what the parties anticipated.

Mistake

Incorrect facts must generally relate to the nature and/or validity of the contract (as opposed to the mere details, even if they are significant details)

Brennan v Bolt Burdon [2005] 2 QB 303;

Bell v Lever Bros. Ltd [1932] AC 161;

Mistake - cont’d

Where there is a common mistake in the written the terms of the contract, the court may intervene to rectify it

Mutual mistake – i.e. both parties mistakenly believe the contract gives effect to their common intention; either party may seek rectification of that term

Unilateral mistake – i.e. one party mistakenly believes that the contract gives effect to the agreement reached, but the other party is aware of the true position and takes advantage of this; rectification is only available in limited circumstances

Mistake - Rectification

E.g. Joscelyne v Nissen [1970] 2 QB 86;

Youell v Bland Welch & Co. [1992] 2 Lloyd’s Rep 127;

Mutual Mistake – requires common intention between the parties together with some outward expression of accord

Mutual Mistake

Thomas Bates Limited v Wyndham’s (Lingerie) Ltd [980] EWCA Civ. 3

For rectification of unilateral mistake One party must have an erroneous belief as to the

terms of the document; The other party must be aware of the omission or

inclusion of such a terms and be aware that it was a mistake;

He must have omitted to draw the other party’s attention to it;

The mistake must be one calculated to benefit him.

Unilateral Mistake

George Wimpey UK Ltd v VI Construction Ltd [2005] EWCA Civ. 77;

The relief of rectification for a unilateral mistake is of “drastic nature”

Unilateral Mistake

Questions

Nicola Maher

Litigation Partner


t: +44 (0)20 7691 4069

f: +44 (0)20 7691 4090

Contact details

Construing BI Policies: Art or Science?Roger Franklin

Absence of specific BI case law due to:

Settlement

Market agreement

Construing BI Policies

Synergy Health (UK) Ltd –v- CGU Insurance

“the needs of the many outweigh the needs of the few”

Construing BI Policies cont’d

The Ordinary meaning of Words

“The ascertainment of the meaning which a document would convey to a reasonable person

having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the

contract”.

Investors Compensation Scheme Ltd –v- West Bromwich Building Society


Basic Principles Previous interpretation Decisions from other jurisdictions Ordinary meaning Business like interpretation Avoid absurdity Departure from ordinary meaning of words Trade usage Inconsistency and/or ambiguity


The Insuring Clause“The Insurer agrees (subject to the terms… of this policy) that if… any building or other property used by the Insured at the Premises for the purpose of

the Business be accidentally lost, destroyed or damaged during the period of insurance… and in

consequence the Business carried on by the Insured at the Premises be interrupted or

interfered with then the Insurer will pay to the Insured… the amount of loss resulting from such

interruption or interference provided that…”


The Material damage Proviso

“…..at the time of the happening of the loss destruction or damage there shall be in force an insurance covering the interest of the Insured in the property at the Premises against such loss

destruction or damage and that… etc.”


“….any building or other property…”

What amounts to property?

Ruapehu Alpine Lifts Ltd –v-State Insurance Ltd

(1998) 10 ANZ Insurance cases 61 -64


“… any building or other property or any part thereof used by the Insured at the Premises, or as provided herein, for the purposes of the Business be destroyed or damaged by:

Accidental loss or damage covered by the Insured’smaterial damage policy affected with state.

Boiler and/or economiser explosion on the Premises or elsewhere.

Earthquake, geothermal activity or volcanic eruption.

(all such loss, damage or destruction being hereafter termed “damage”) and the Business carried on by the Insured be in consequence thereof interrupted or interfered with.” [Emphasis added.]


“and in consequence the Business carried on by the Insured at the Premises be interrupted…”

McMahon’s Tavern Pty Ltd –v- Suncorp Metway Insurance Ltd [2004] SASC 237


“In consequence of….”

The proximate cause, which is the event, whether peril or exception, which, in all the circumstances prevailing at the time, led inevitably to the loss in question.


“Occasioned by….”

Loss is occasioned by a peril if there is a sufficient connection, not in the case of causation, but of coincidence in time and space.


“Damage arising directly or indirectly from…”

The Direct cause has been held to be the proximate cause. By implication, ‘indirectly caused’ refers to something less proximate.


“Arising out of…..”

Wider than ‘directly or indirectly caused by’


“…covering the interest of the Insured in the property..”

Glengate – KG Properties v Norwich Union Fire Insurance Society Limited [1996]


Conclusions

Questions

Roger Franklin

Litigation Partner


t: +44 (0)20 7691 4044

f: +44 (0)20 7691 4090

Contact details

Documents

Depreciation – Is it really a saving? Michael Whitton