January 2008, Fleet Financials - Feature
How to Determine the Correct Depreciation Reserve
By Staff
Making the Adjustments
What then might a fleet manager do when faced with resale data as
outlined? This example is a calculation for a vehicle in the second category of resale:
Cap Cost: $20,000
Reserve rate: 2 percent (50 months, or $400/month)
Time in service: 20 months
Total reserve: $8,000 (20 X $400 = $8,000)
Unamortized value at resale: $12,000 ($20,000 - $8,000 = $12,000)
Resale proceeds: $9,800
TRAC adjustment: $2,200 to the lessor ($12,000 - $9,800 = $2,200)
The original value of the vehicle is clearly not being amortized at a rate that properly reflects the vehicle’s actual market depreciation rate. If the fleet manager adjusts the reserve rate to, say 40 months, the calculation is the following:
New reserve rate: $500/month ($20,000/40 months = $500)
New total reserve: $10,000 ($500 X 20 months = $10,000)
New TRAC adjustment: $200 credit to the lessee ($10,000 - $9,800 = $200)
By making this adjustment, the fleet manager has considered the faster rate of actual depreciation on these vehicles and increased the rate at which the reserve is accumulated. The result is an unamortized value that more accurately reflects the vehicle’s actual market value at termination. This will avoid the large cash flow outward at lease end, facilitate budgeting, and better match the realization of the expense to the time in which it occurs (making the company’s auditors more comfortable with the transaction).
It is, of course, impossible to tune the reserve rate so finely as to approach an average zero TRAC adjustment. Nor is it necessary. The vagaries of the used-vehicle marketplace make this accurate of an adjustment nearly impossible. A brief discussion with the company’s auditors or the accounting department will familiarize the fleet manager with an acceptable level of TRAC adjustment. Achieving an adjustment within $500 each way, for example, seems more acceptable than adjustments of thousands of dollars and more reflective of the actual timing of the expense.
There is, of course, a downside, and it is based in the time value of money. In the example provided, those vehicles for which the reserve rate amortizes the value too slowly (to match the market) would suffer a $100/month “hit” in cash flow, as the remedy increasing the rate increases the monthly depreciation reserve (and thus the lease payment) by that amount. Further, the TRAC adjustment is made 20 months after the inception of the lease, in dollars less valuable than they would be at inception.
The effect would be limited, however, as the additional reserve would similarly be discounted over time. At any rate, the purpose of the TRAC isn’t to maximize cash flow or delay the booking of expense. It is to allow the fleet to recognize the expense as it occurs, while retaining the flexibility to do so for vehicles of widely varying usage.
Establishing the Policy
In the sample fleet described, vehicle usage differs, resulting in a number of different results when the TRAC adjustment is made. Justifying a single reserve rate for the entire fleet therefore becomes difficult.
Most of the issue lies in mileage. The faster mileage accumulates, the more quickly a vehicle is replaced under the time/mileage policy and its value declines in the open market. It then becomes incumbent upon the fleet manager, after reviewing the data, to adjust the reserve rates for different classes of vehicles.
In the example provided, the 50 month/2-percent per month rate is acceptable for more than half the fleet (250 units sold). For the 200 whose mileage accumulates more quickly, a reserve rate of 40 months (2.5-percent per month) reduces the original value more accurately, and the existing TRAC adjustment average of $2,200 is reduced to $200.
The third class of vehicle, those whose mileage accumulates more slowly, and whose time in service is lengthened, can be viewed as exceptions, and treated on a case-by-case basis. If the exceptions are consistent, the reserve can be adjusted so that less is reserved each month, and the unamortized value is higher at replacement.