A rough guide to depreciation and its role as part of a prolongation claim
We recently wrote about the different types of claim that commonly arise on construction projects, including what happens when a project is running late (prolongation claim). This is a particularly common area of issue, and within itself can be sub-divided into a catalogue of causes. One of the potential categories of damage (otherwise known as a head of claim), that a contractor may consider including as part of any prolongation claim, is depreciation.
What is a claim for depreciation?
A claim for depreciation is designed, to compensate a party for the decline in value of, for example, plant and equipment as a result of a delay. Depreciation is really an accounting method of allocating the cost of an asset over its useful life, thereby estimating the asset’s decline in value over time. It may not represent real cashflow. The nature of the damage suffered by depreciation is as an indirect or consequential loss, if it is just an accounting exercise but it becomes real money when a projects finances or results relate to how that exercise has been applied. This is important as some construction contracts specifically exclude indirect or consequential losses from being recoverable. In such cases, the depreciation claim needs to explain how the sums claimed are direct and very real.
What does legal precedent say about depreciation as part of a prolongation claim?
Some guidance as to how this sort of claim came about can be found in the English case of Sunley and Company Limited v Cunard White Star, limited. In that case, the plaintiffs (Sunley) were contractors who had a contract to level an aerodrome on Guernsey. They had machinery which they needed to transport to the island and the defendant (Cunard) were engaged to perform that function.
As part of the contract, Cunard was to transport the machinery from Sunley’s yard to the dock to be loaded onto the Staghound on 12 November 2937. Cunard used a subcontractor to do this, however the subcontractor did not provide a large enough truck. By the time the subcontractor sourced a larger truck and transported the machinery to the dock, the Staghound had sailed leaving the machinery on the Beryl which reached Guernsey approximately a week late. Sunley claimed for, amongst other things, depreciation of the machinery for the week it was delayed. (One trusts that there was a much larger claim at stake, and this was just a minor heading).
Methods of determining depreciation as part of a prolongation claim
In the Sunley case, the court used a straight line method of determining the deprecation. It is one of two methods that are broadly used: the straight line (or prime cost) method and the diminishing value method.
The straight line method assumes a uniform reduction in the value of the plant being depreciation over an expected lift. The diminishing value method on the other hand assumes a greater reduction at the beginning of the period, reducing down until such time as the plant is scrapped or written off.
In accounting, standard practices are written down in GAP, for example, and where this is applied, that should be followed. In jurisdictions not under GAP, the contractor should follow that which his own accountants are following to be consistent with the claim. The rest of this article follows such principles as GAP was clearly not deployed.
An example of the effect of the straight line or prime cost method against the diminishing value method can be seen if we assume a plant value of £100,000 and an economic life of 10 years (10% p.a.). The results can be graphed as follows:
With this in mind, when examining such an issue, the court may consider that if the plant or profit earning machinery was lost or destroyed due to an accident then the owners would be entitled to the residual value. This principle can be applied to depreciation as well in that the item is considered to be lost or destroyed for the period of the delay. The court may then go on to consider whether or not the machinery was suffering from wear and tear during the period of delay or if it was idle and therefore not suffering a loss of value to the same degree as if it were being used. If it was idle the court may consider that the depreciation value may be reduced accordingly.
For example, if they decide the original value of the machinery was £4,500 and that it had an expected life of three years, using a straight line method of depreciation that equates to £29 per week. If the machinery was delayed for a week, the loss would be considered as £29. However, the court may also adjust this because the machinery was stood idle during this week, so the actual wear and tear and reduction in the value of the machinery would not be as much as if it were actually being used, so the court may reduce the award to £20.
Of course, this is a simple explanation for the principle whereby depreciation can be considered as part of a prolongation claim, and in reality, things can be a little less cut and dry. If you are concerned about a claims notice or potential area of concern and would like to speak to our team, you can contact us any time by following the link below.