How to Determine the Correct Depreciation Reserve
It is one of the most creative and unique financial instruments for managing a vehicle fleet. The open-end terminal rental adjustment clause (TRAC) lease has been a staple in the fleet industry for decades. However, sometimes the basic principles of the TRAC lease are misunderstood.
A basic tenet of accounting is to match expense with the period in which it occurs. Open-end TRAC leases enable fleet managers to do so, but only if the various terms used in the lease are understood and applied correctly.
The first step in creating a proper depreciation reserve is to know and understand the various components of the open-end TRAC lease. These components are often (wrongly) used interchangeably.
First, what is a TRAC? It is merely a clause stating that, at the point when the lessee has decided to terminate the lease of a particular vehicle, the following occurs:
- The lessor causes the vehicle to be sold.
- If the proceeds exceed a predetermined value, the excess is returned to the lessee.
- If the proceeds fall short of that predetermined value, the lessee makes up the difference to the lessor.
Thus, the “terminal rental adjustment” is one of three things: nothing (where the proceeds are exactly the same as the value), an additional lease payment by the lessee (where the proceeds are less than the value), or a credit back to the lessee (where the proceeds exceed the predetermined value).
Several primary terms are used in any discussion of the depreciation component of a TRAC lease.
- Amortization: This is the rate at which the principal of a loan is reduced to zero over the loan period. In the case of a TRAC lease, vehicle cap costs are amortized over some period of months, in equal increments, toward the goal of matching the unamortized amount at replacement with the vehicle’s market value.
- Depreciation: Depreciation is simply the difference between the original cost of a fixed asset and the proceeds from the sale of the asset. Depreciation, therefore, cannot be determined until after the asset is sold. Often called “actual depreciation.”
- Depreciation Reserve: In a TRAC lease, each month’s payment contains a repayment of principal — a portion of the original cost — similar to the repayment of a loan. These payments accumulate into a reserve for the anticipated depreciation of the vehicle when it is finally sold.
- “Book Value”: A vehicle’s socalled book value in a TRAC lease is simply that portion of the cap cost that remains after amortization payments have been paid. Also called the “unamortized” book value. Resale proceeds are applied against this value, to determine the terminal rental payment under the TRAC.
The TRAC: How Does It Work?
In a majority of fleet leases, “predetermined value” is agreed upon at inception, when the lessee and lessor agree upon the rate at which the original cost (“capitalized cost”) of the vehicle is reduced, or amortized. In theory, this is the rate at which the actual (market) value will decline over time, so that at the point when the vehicle is sold, the remaining value matches the vehicle’s actual value on the open market. In effect, a portion of each lease payment is set aside — “reserved” — to cover the depreciation that inevitably occurs as the vehicle ages and mileage accumulates. Example A illustrates how a TRAC lease works.
Assume that the cap cost of the vehicle is $20,000. The lessee (fleet) has a replacement policy that states vehicles are replaced at 36 months or 70,000 miles, whichever occurs first. The vehicle in question will drive 2,400 miles per month; thus, under the policy, it is anticipated that it will be replaced after 29 months in service (having reached the 70,000 mile criterion before the 36-month limit). Further, the fleet anticipates that at that point, the vehicle will have a market value of $8,400. Ideally, then, the lease (predetermined) value, against which the actual sale proceeds will be applied, should be $8,400, after 29 lease payments are made. The open-end TRAC lease accomplishes this by amortizing the original cap cost at a rate such that at replacement, the unamortized (book) value reflects the market value:
Cap Cost: $20,000
Amortization rate: 50 months (2 percent per month)
Replacement: 29 months
Monthly amortization: $400 ($20,000/50=$400)
Depreciation reserve: $11,600 ($20,000/(29X$400)=$11,600)
Unamortized (book) value: $8,400 ($20,000 - $11,600 = $8,400)
If the fleet planning in example A is correct, the vehicle will be sold, and the proceeds, $8,400, will be the same as the unamortized value, and the TRAC will result in no further exchange of funds between lessee and lessor. The purpose, therefore, of the TRAC lease is to provide fleets with a mechanism by which they may have the flexibility of ownership in a lease transaction, flexibility that includes residual risk. Returning, once again, to the accounting principle that expense should be recognized in the period in which it occurs, the goal of reserving for anticipated depreciation is to match, as accurately as possible, the amortization of the original cost with the actual depreciation the vehicle incurs.
That “matching” goal sometimes becomes obscured in routine, as fleets and lessors lock themselves into one rate of amortization for the entire fleet. Any fleet widely dispersed geographically will necessarily see similarly dispersed vehicle usage: high-mileage vehicles in sparsely populated areas, lower-mileage vehicles in urban areas or in difficult weather and topographical conditions. A time/mileage replacement policy results in vehicles replaced at varying times, and varying market values. The use of a single amortization rate to reserve for depreciation cannot meet the accounting goal of expense/period matching.