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DEPRECIATION
Should Depreciation be Calculated on Mileage, a Time Basis, or a Combination of the Two ? S.T.R. Discusses This Question and Deals With the Method Used by Income-Tax Assessors TOGETHER with interest on capital outlay, depreciation is a matter which always gives rise to controversy. Some operators insist that depreciation on a vehicle should be calculated on a time basis, spreading it evenly over a period of two to 10 years, whilst others agree with me that the correct way to calculate it is on a mileage basis.
My view is that depreciation is the rate at which a vehicle wears out, and as it wears out in proportion to its mileage its depreciation should be assessed at so much per mile. But I think it can be said that although it may be logical to calculate depreciation on mileage, it is more convenient and easier to assess it on a time basis.
There is a third school which holds that depreciation should be calculated partly on a time basis arid partly on mileage. It considers that without some provision for depreciation according to time it is not possible to make any allowance for obsolescence, pointing out that a vehicle doing a small annual mileage will be obsolete long before it is worn out. That cannot be denied, and in compiling the figures for "The Commercial Motor" Tables of Operating Costs I took obsolescence into account, notwithstanding that I placed depreciation amongst the running costs, assessing it on a mileage basis, and not the standing charges.
The matter is further complicated because the income-tax authorities have a way of measuring depreciation, or wear and tear as they call it, which differs from any of those just mentioned. Before dealing with a practical method of allowing for depreciation, I shall delineate the Income Tax Authorities' method and demonstrate its impracticability as a means for the operator.
To understand this subject it is necessary to go back a little to the war when, in acknowledgment of the difficulties under which the haulage contractors were operating, a• special allowance was made in respect of vehicles operated by A licensees. The income-tax allowance in respect of wear and tear of vehicles was fixed at 25 per cent, per annum on the diminishing value of the vehicle plus one-fifth of that allowance. On the face of it that appears to be an
allowance of 30 per cent, per annum, but actually it was not. The 25 per cent, allowance was on the diminishing value and the one-fifth did not have any effect on that diminishing value.
For further elucidation let us refer to Table I which gives the allowance for wear and tear as assessed in those years. For the first year a vehicle valued at £750 was granted an allowance of 25 per cent., £187 10s., plus one-fifth of that, £37 10s., making a total of £225.
Only the £187 10s. was deducted from the original value to diminish the value for the second year's assessment. In the second year there was again the 25 per cent. of £562 10s., which is £140 12s., plus one-fifth of £140 12s., £28 2s., making a total of £168 14s. The reader should pursue his investigation of this tax to the end, when in the seventh year the allowance is only £10. That brings the total of allowances up to £750, the original value of the machine.
It should be appreciated that income-tax allowances are never permitted to exceed the original value of the vehicle
to which they apply. If an operator retained this £750 vehicle for a seventh year he would have been given no allowance thereafter on account of the wear and tear.
However, this stage was never reached, because there came into force the Income Tax Act of 1945, which con siderably altered the allowances for wear and tear. This Act provided an initial allowance for new and used buildings or plant purchased in that or subsequent years for use-in trade and industry. Motor vehicles were included under the heading of plant. The original annual allowances for wear and tear were altered inasmuch as the extra one-fifth was eliminated.
25 25 Per Cent. for Wear and Tear
The allowance for wear and tear in respect of all classes of motor vehicle was made 25 per cent, per annum on the diminishing value. In addition there was an initial allowance of 20 per cent, of the amount paid for new or used vehicles purchased during 1945 and subsequent years (in certain circumstances vehicles purchased in 1944 also), so that in the first year in which the vehicle was purchased the buyer was able to make entry in his statement of business expenses 20 per cent. plus 25 per cent, of the amount spent on the vehicle, a total of 45 per cent.
The object of this grant was to encourage operators to purchase new machinery. As is usual with Government grants there was a snag, inasmuch as it was two years after the time of expenditure before the operator received any benefit. He made a return of the amount spent one year that credited to his next year's assessment and he received the benefit when paying his tax in the following year.
How this arrangement worked out is shown in Table II. Again I have taken a vehicle costing £750. The allowance is seen to be first the 20 per cent. of the initial outlay, which is £150, plus 25 per cent, wear and tear allowance, £187 10s., a total of £337 10s. in the first year. But the whole of that £337 10s. is deducted from the original £750 to arrive at the diminishing value of the vehicle for the purpose of assessment in the next year. How this affected the allowance may be realized by appreciating the fact that in the first year the allowance was £337 10s., whereas in the second year it was only £103.
Lower in the Long Run Now here is a curious point. According to Table 1, the operator in seven years received allowances equal to the original value of the machine, but according to Table II there was still £41 to go before that value was reached at the end ofethe ninth year, and in fact the value of the machine never reaches zero. In seven years the operator would, under the old scheme, have received allowances of £750. In seven years under the new scheme he would have been allowed only £676 10s., notwithstanding the fact that in the first year he received £337 10s.
In this year's Finance Act there is provision for that 20 per cent. vehicle allowance to be increased to 40 per cent. The object is still to encourage the purchase of new plant, and how this will work out in practice when the Act is implemented is shown in Table III.
There is a further point of interest in the new Finance Act so far as depreciation allowances are concerned. In future, depreciation may be calculated on a straight-line basis and not on the diminishing value. Instead of subtracting the amount allowed from the value of the vehicle each year it will be permissible to depreciate the vehicle over an agreed period of years, the depreciation allowance being the same for each year. At the time of writing, no decision has been come to as to the allowance or the number of years over which a vehicle will be depreciated.
c 16 It is generally understood, however, that there will in the first place be an allowance of one-tenth of the initial amount as residual value. The straight-line depreciation will then be calculated in such a way that the total allowances will be nearly the same as they would have been acdording to the old method.
This means, maybe, that there will first be the initial allowance, which I take it will be 40 per cent, of the original amount of £750, so that the initial allowance will be E300, as in the example in Table 111. That leaves a total of £450 from which must be deducted 10 per cent., £45, leaving £405. It seems likely that the period of depreciation will be at least seven years, so that the annual allowance will be approximately £58.
Cannot be Used to Assess Rates The point I would like to make here before proceeding to discuss the other methods of dealing with depreciation is that it is impracticable to use these wear-and-tear allowances as a basis for calculating costs for assessing rates for new vehicles and fares for passenger vehicles. Taking Table TI, provision for wear and tear in the first year is .£337 10s. and in the ninth year £141 10s. The operator assessing his costs on the basis of the allowance made in the first year would be at a loss during subsequent years long before the ninth year was reached, so that whereas it is essential for operators to know how income tax allowances
are calculated, it is of no use for them to attempt to use these figures to indicate the amount of the item depreciation in the operating costs of their vehicles,
For the purpose of estimating cost and, from that) assessing rates and fares, the operator requires figures which do not fluctuate from year to yea,r but continue at an even rate throughout the life of the vehicle. Three methods of arriving at such figures are set out in Table IV.
The first of these is the method used in compiling "The Commercial Motor" Tables of Operating Costs. It is assumed that the initial selling price of the vehicles is £750. From that is first deducted the cost of a set of tyres, £100.
Life of 180,000 Miles
Next it is necessary to assume the probable life, a period of use at the end of which it will be uneconomical to run the vehicle. In this case the period is assessed on a mileage basis and assumed to be 180,000 miles. It is further assumed that £50 is obtained for the vehicle when sold. That is its residual value and that amount must be deducted from the £650, the cost of the vehicle less tyres, That gives £600 as the net amount on which depreciation must be calculated. Dividing £600 by 180,000 we get 0.8d. per mile: 'that is the basic figure for depreciation, but can only be applied if the vehicle runs not less than 36,000 miles per annum.
If the mileage does not reach that 'figure there must be some additional allowance for obsolescence. That allowance is made by adding 5 per cent, to the basic figure for every 1,000 miles per annum less than 36,000. Thus if the vehicle runs only 32,000 miles per annum, that is 4,000 less than 36,000, we must add four times 5 per cent., that is 20 per cent., to 0.8d., Which gives us 0.96d.-the figure set down in Table IV.. The figures for the other mileages are calculated in the same way. The Road. Haulage Association in its Interim Report of Rates and Charges Committee takes time as a basis for calculating depreciation and assumes a life of five years. It is equivalent in the present case to £120 per year. In Table IV I have converted that £120 per year into a cost per mile for different annual mileages. It will be doted that this has the effect of making the depreciation cost high for the mileage of 10,000 per annum, but in my opinion unduly low for the high mileage of, say, 48,000 or 60,000.
The National Association of Furniture Warehousemen and Removers uses a method which in effect combines those shown in the first and second columns. Half the depreciation is based on time, the other half on mileage. In that way the figures set out in the third column are achieved. Here again the depreciation allowance is in my view too little for high mileage figures, but as furniture vans do not attain such mileages the method should be perfectly satisfactory in its application to such vehicles. There is not a great deal of difference, except as regards those high mileages, between "The Commercial Motor" method and the N.A.F.W.R. method.
In Table V I show the amounts of depreciation per annum brought about by the application of these three methods and in Table VI I give the years of life which correspond to these figures. In next week's article I will deal further with this matter. S.T.R. •