Should You Set a Depreciation Reserve to Reflect a Strong Resale Market?

It is one of the most important tasks fleet managers have: setting the proper depreciation reserve for fleet vehicles. Depreciation reserve (or amortization) will be the foundation of much of the flow of funds that fleet vehicles generate, and determine the impact of those flows on budgets.

The basis for setting a depreciation reserve is an economic one. And, under normal circumstances, it can be consistent for each type of usage.

But, what is the impact of the resale market on the decision? Should fleet managers consider current markets when setting a reserve for vehicles that won’t hit that market for two or three years? 

Getting Down to Basics

Understanding the importance of setting the right depreciation reserve rate begins with reviewing the basics. Too often, such terms as depreciation, amortization, and depreciation reserve are used interchangeably; however, they should not be. Here are some simple definitions:

• Depreciation: The difference between the original cost of an asset and the proceeds from its sale. 
• Amortization: The regular reduction of that original cost to reflect the reduction in actual value as the asset is used.
• Depreciation reserve: The amount set aside during the amortization process.

For most mid-size and larger fleets, the lease of choice is the open-end, terminal rate adjustment clause (TRAC) lease, where a vehicle’s original value (cap cost) is reduced at a rate (amortization rate) that is agreed upon by the lessor and lessee. This process reserves funds to cover the anticipated actual depreciation of the vehicle when sold. 

The concept is a simple one: The lease is intended to provide the economic benefits of owning while qualifying as a lease. A rate of depreciation reserve should, ideally, reflect as closely as possible the actual rate anticipated. That is, when the vehicle is ultimately sold, the unamortized asset value (book value) should match as closely as possible what the resale proceeds are. 

The goal is to keep “gains” and “losses” (adjustments where proceeds are either less than, or greater than, that book value) to a minimum, resulting in a relatively even flow of funds. 

Fleet managers (and lessors) use a number of criteria to determine the proper rate of depreciation reserve. These points include how the vehicle is equipped, what the make/model is, what the anticipated mileage will be at replacement, and at what rate that mileage will accumulate. Even geography (where the vehicle will be sold) is a factor to consider when projecting future values.

Not all of the factors are predictable — vehicles are moved from territory to territory and driver to driver, affecting mileage and condition, as well as the timing and geography of the sale. 

Thus, the amortization rate is set so that, at the point when the vehicle is sold, the depreciation reserve most closely reflects the market value of the vehicle and the actual depreciation of the asset. 

While it may seem to be nitpicking to draw a careful distinction between these terms, it is important to do so to thoroughly understand the process.

Understanding Resale Markets

Fleet managers are well aware that there really is no monolithic “used-vehicle market.” Not unlike stocks and commodities, the market for the sale of used cars, trucks, vans, and SUVs is multifaceted and dependent upon a wide variety of factors, including:

Time: Resale markets are seasonal. Most fleet managers know that fall and spring markets are generally the strongest, while winter and summer markets are the weakest. Fall markets take advantage of the new model-year (a vehicle sold during a new model-year introduction has provided the full value of the previous year), and spring markets lead into the summer driving season. Winter markets are weak, due to holidays and bad weather, and summer drivers have already purchased vehicles for vacation driving in the spring. 

Channels: There are multiple channels available to sell used vehicles, including retail, private sales, auctions, wholesalers, and brokers. Fleet managers also know that the strongest and most readily available market is a driver/employee market. Different vehicles, in different condition, with varying mileage and equipment require a fleet manager to know what market will return the most, and thus choose the right rate of amortization.

Condition/Mileage: Obviously, the value of any asset being sold will depend upon its condition or how “used” it is. Vehicles are certainly no exception.  Fleet vehicles, on the whole, tend to be relatively late model, high-mileage vehicles, well maintained, and include a moderate level of equipment. 

These and other considerations are important in determining the right depreciation reserve rate. 

Using Strong Markets as a Catalyst

Again, as with any commodity, markets for sale rise and fall due to a number of external and internal forces. Veteran fleet managers know this occurs, and generally try to set up amortization schedules accordingly. Whether or not a strong resale market should be a catalyst for changing depreciation reserve can be addressed in looking at what the consequences might be.

There are three possible scenarios in setting a depreciation reserve:

• Scenario 1: The reserve under-amortizes the vehicle cost. In other words, the cap cost has not been reduced enough to bring the book value at time of replacement down to market value.
• Scenario 2: The reserve amortizes the cap cost down to a book value that accurately reflects the market value at replacement.
• Scenario 3: The reserve reduces the vehicle cost too quickly, resulting in a book value that is significantly lower than market value at replacement. 

Only scenario No. 2 reflects the proper use of a depreciation reserve, where book value reduction reflects market value depreciation, and depreciation expense is booked in the period in which it occurs.

Let’s now look at what the financial consequences of over- or under-amortizing would be. 

Since flows of cash reflected in a fleet lease occur over a period of time (two to three years, maybe more), the only way to properly measure these scenarios is via present value. Using basic assumptions, here are the financial results: 

• Original cost: $20,000
• Time in service: 30 months
• Resale proceeds: $7,000

In the first scenario, we’ll assume the amortization rate is 50 months, or 2 percent per month. 

After the 30 months in service, this would result in a reserve of $12,000 ($20,000 / 50 x 30), and an unamortized book value of $8,000 ($20,000-$12,000). 

The resale proceeds of $7,000 would result in a net TRAC payment of $1,000 — in other words, the vehicle was under-amortized. 

The overall depreciation reserve cash flow consists of 30 equal $400 outflows, followed by a $1,000 outflow upon sale.

Scenario No. 3 over-amortizes. Assume a rate of 40 months, or 2.5 percent per month. The 30 months of $500 reserve payments would total $15,000. After resale proceeds of $7,000, this results in a TRAC credit of $2,000.

Under-amortizing will reduce cash outflows during the lease, but require a large ($1,000) outflow after the unit is sold.

Over-amortizing will increase outflows while the unit is in service, with a larger ($2,000) outflow upon sale. 

Now we can apply the present value concept to both scenarios. In scenario No. 1 (under-amortizing), $400 each month for 30 months totals $12,000.

Using an annual discount rate of 3 percent (the discount rate is arbitrary, but should be both realistic and the same for both scenarios), the present value of the stream of outflows is $11,816.

In other words, if $11,816 were to be placed in an interest bearing account at a 3-percent annual rate, in 30 months it would be worth $12,000. 

The final TRAC payment of $1,000, made 30 months from today, again discounted at 3 percent, is worth $956, making the total present value of the scenario $11,816+$956 = $12,771, vs. the gross value of $13,000. 

In scenario No. 3, the monthly reserve payment is $500, making the present value over 30 months at the same discount rate of 3 percent is $14,770 (vs. $15,000 undiscounted).

The final $2,000 inflow (excess of proceeds over unamortized value) would be worth $1,912 today.  Thus the full net outflow would be $14,770-$1,912 = $12,858.

Using these assumptions, over-depreciating results in a net present value of $87 cost to over-amortizing.

The purpose of this exercise is to show first what effect the amortization rate has on the total flows of cash, and second what the net present value cost of over- or under-amortizing might be. 

Amortizing to a Current Market

Using two amortization rates, the net present value result from over- and under-amortizing a fleet unit is clear. Keep in mind the same effect can be seen when using the same rate, if the resale proceeds differ.

The impact of a strong resale market on both amortization rate and net present value cost can be illustrated in two ways: first, by leaving the rate the same and accepting a larger TRAC credit adjustment at resale, or, second, by factoring the strong market into the reserve and changing the rate accordingly. 

Let’s assume that the $20,000 vehicle, which normally would bring a 40-percent (of cost) residual at sale, now brings a strong 55-percent return. The fleet manager would normally amortize the unit at a 50-month rate to match the reserve to the 40-percent market. 

Here is how the in/outflows would look:

• Proceeds: $20,000 x 0.55 = $11,000
• Booked reserve: $400 x 30 months = $12,000
• Unamortized value: $20,000 - $12,000 = $8,000
• TRAC adjustment: $11,000 - $8,000 = $3,000 credit

Keeping the reserve rate at 2 percent per month results in an outflow of $400 per month for 30 months and replacement at an unamortized value of $8,000. 

When the vehicle is sold for $11,000 (55 percent of cost), the TRAC adjustment is a $3,000 credit back to the lessor.

Now, apply present value to these flows:

• Reserve flows: $400 per month outflow over 30 months = $11,816 (present value)
• TRAC adjustment: $3,000 inflow 30 months in the future = $2,869 (present value)
• Present value of all cash flows: $11,816 - $2,869 = $8,947

Now, what if the fleet manager decided to change the amortization to incorporate the strong residual market (55-percent value retention)? To do so, the reserve rate would be lowered from 2 percent per month to 1.5 percent per month. The new cash flows would be as follows:

• Proceeds: $20,000 x 0.55 = $11,000
• Booked reserve: $300 per month = $9,000 over 30 months
• TRAC adjustment: $0

Changing the reserve rate to factor in a stronger resale market, where the reserve booked equals the resale value results in a total cash flow made up only of the monthly reserve, e.g., 30 x $300 = $9,000. Finally, the present value of this new, lesser flow would equal $8,862.

In the assumed scenario, where the fleet manager adjusts for the strong market by setting a lesser reserve rate results in a present value cash flow $85 less ($8,862 vs. $8,947) than it would have been had the adjustment not been made. 

Does it Matter?

Clearly all of the aforementioned formulas are based on assumptions: original cost, resale proceeds, chosen depreciation reserve rates, discount rates for present value, etc. But, you have to ask yourself two important questions: What are the concepts behind setting reserve rates? And, what is the effect of setting those rates to consider a strong resale market?

The previous examples have illustrated how present value provides the clearest picture of the effect of over- or under-amortization, and what the results would be if a fleet manager chose to alter a standard rate in recognition of a stronger resale market. 

The basis for depreciation reserve is to attempt, as best as is possible, to reflect the actual market depreciation; that is, ideally there would be no TRAC adjustment needed when vehicles are sold.

Might there be other scenarios where a fleet manager’s actions are taken in response to a spike in the resale market? 

In short, yes. Fleet managers, by necessity, track used-vehicle markets carefully, if for no other reason than depreciation being the single greatest fixed cost they manage.

Resale markets, being what they are (commodity markets), can be volatile, and sometimes a fleet manager might be tempted to “shortcycle” vehicles; that is, replace them prior to reaching normal replacement policy. 

If, for example, the depreciation reserve rate is set for replacement after 30 months, but the fleet manager sees that at 24 months the market has spiked and the unamortized balance can be obtained if sold then, the vehicle is turned over early. 

This would not, of course, change the reserve rate; however, it would be an action taken in response to a strong market. But, this should be only be done after carefully considering other factors that can upset the concept, including:

• The new replacement vehicle might cost more than the vehicle being replaced.
• Interest rates may have risen, as well as the lease.
• The replacement may occur at a time when a new model-year is imminent, and, thus, the new vehicle will experience model-year depreciation on the market sooner than planned.
• Higher lease payments and/or a spike in market depreciation due to model-year turnover can very quickly consume any savings achieved through shortcycling a unit due to a strong market.

The Bottom Line

On a present value basis, there is not a great difference between using an existing reserve rate and changing it to reflect a strong resale market ($85 in the aforementioned example). For a very large fleet, however, that is replacing hundreds or thousands of vehicles, $85 per unit can add up, but that is only if the market is the same at replacement (percentage of retained value) as it was when the decision was made. 

On the positive side, even if this is the case, the present value of the under-amortization that results isn’t all that substantial (one way of reducing even that is by keeping units in service for a few months longer if necessary).

All in all, it’s up to the fleet manager to decide whether the relatively modest benefit is worth the risks — much like most any other decisions most fleet managers must make.

The depreciation reserve decision doesn’t change in a strong market; the criteria used are no different, and the ultimate goal is the same. Fleet managers, when making such decisions, are well advised to carefully analyze the alternatives. Keep in mind that choosing a reserve rate is first and foremost a financial decision.