Depreciation at Delta Air Lines and Singapore Airlines

UAA ACCT 650 Seminar in Executive Uses of Accounting Fred Barbee

Dr.

Financial Reporting

c re p e D

ia to n
i

Yeah!

MB A

MB A

Why study this case?

To

compare and contrast depreciation assumptions from two airlines that . . .

Are In

in some ways alike, and

other ways vastly different

Why Look at an Airline?

PP&E

for airlines usually comprise greater than 50% of total assets. of one airline are substantially similar to aircraft of another airline (at least to the lay person).

Aircraft

Depreciation The Concept

Time Consumed as Depreciation Expense

 Depreciation

is not

an attempt to establish the value of an asset.

Depreciation

is not a measure of the decline in value of an asset.

Depreciation Defined

The process of allocating the cost of property, plant, and equipment as an expense in a systematic and rational manner to those periods expected to benefit from the use of the asset.

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B E G I N N I N G

Depreciation
96 97 98 99 00 01 02 03 04 05

Life of the Asset

Depreciation is a process of allocation, not valuation.

E N D I N G

Depreciation
Balance Sheet Acquisition Cost Cost Allocation Income Statement Expense

Unused An application of the matching principle.

Used

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Depreciation
Depreciation Expense Income Depreciation for the current year Statement

Accumulated Depreciation Total depreciation to date of balance sheet

Balance Sheet

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Long-Term Assets

Long-Term Assets
Have Are Are Are

a useful life of more than one year.

acquired for use in the business. not intended for resale to customers. reported at carrying (book) value.

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Management Issues related to Accounting for Long Term Assets

Management Issues
The The

cost of the asset must be measured.

depreciable life of the asset must be estimated.

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Management Issues
The

salvage value of the asset at the end of its life must be estimated pattern for recognizing depreciation over the depreciable life of the asset must be selected.

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Issues Related to Long-Lived Assets

Asset Service Potential
Use in business operations Acquisition
Declin e in fu t servic ure e ben efits.

Disposal

Book Value

Time

Accounting Issues
Measuring Cost Allocation of cost Accounting For post acquisition expenses. Recording Disposals

Issues Related to Long-Lived Assets

Asset Service Potential
Use in business operations Acquisition
Declin e in fu t servic ure e ben efits.

Disposal

Book Value

Time

Accounting Issues
Measuring Cost Allocation of cost Accounting For post acquisition expenses. Recording Disposals

Acquisition cost of Property, Plant, and Equipment

Fundamental Issue #1: What is the value of the asset?

Measuring the Carrying Amount of Long-Lived Assets

Expected Benefit Approach

Recognizes

that assets are valuable because of the future cash inflows they are expected to generate.

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Economic Sacrifices Approach

Focuses

on the amount of resource expenditures required to acquire an asset.

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Measuring the Carrying Value of Long-Lived Assets

Expected

Benefit Approaches
present value.

Discounted Net

realizable value.

Economic
Historical

Sacrifice Approaches

cost less accumulated depreciation. cost.

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Replacement

Hypothetical Case A Truck

Original Two No

cost $100,000

years old, has remaining useful life of 8 years salvage value using straight-line

Depreciated

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Discounted Present Value

Expected

net operating cash inflows = $18,000 per year (assumed) for eight remaining years, discounted at a 10% (assumed) rate. x $18,000 = $96,029

5.33493

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Net Realizable Value

Current

resale price from an over-theroad equipment listing (Purple Book) for the specific vehicle model. (Assumed)

$85,000

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Historical Cost
Historical

Cost less Accumulated Depreciation [(100,000/10 years) x 2 years] = $80,000

$100,000

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Replacement Cost
Replacement $90,000

cost of a two-year-old vehicle in equivalent condition (assumed)

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Possibilities
Discounted PV Approach Net Realizable Value Historical Cost (Less A/D) Replacement Cost $96,029 85,000 80,000 90,000

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Possibilities
Discounted PV Approach Net Realizable Value Historical Cost (Less A/D) Replacement Cost $96,029 85,000 80,000 90,000

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Value of Asset
Cost

includes all reasonable and necessary expenditures incurred in:

Acquiring Placing

an operational asset;

it in its operational setting; and it for use;

Preparing Less

any cash discounts allowed.

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Acquisition cost of Property, Plant, and Equipment

Fundamental Issue #2: Allocating the Cost of an Asset?

Theoretical Justification
The

matching principle requires the cost of an asset be charged to expense in the periods benefited. allocation process is called depreciation.

The

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Revenue-Expense Association The Matching Principle

Three

principles govern the inclusion of an expense in the matching process:

Association Systematic

of cause and effect and rational allocation

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Cost Flows in a Manufacturing Firm Cost Flows in a Manufacturing Firm

Manufacturing Costs Balance Sheet Unused

Produ ct Costs

DM DM DL DL MOH MOH

Use d Used d plie Ap

DM Inv. DM Inv.
Unfinished
Fini sh e d
Sale Sold

WIP WIP

WIP Inv. WIP Inv. FG Inv. FG Inv.

Sales

COGS COGS Gross Margin S&A S&A Net Income

Income Statement

= =

Period Costs

Revenue-Expense Association The Matching Principle

Three

principles govern the inclusion of an expense in the matching process:

Association Systematic Immediate

of cause and effect and rational allocation

recognition

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The

depreciable life of the asset must be established.

The

salvage value of the asset at the end of its life must be estimated.

Factors in Computing Depreciation

Factors in Computing Depreciation

The

calculation of depreciation requires three amounts for each asset:

Cost Useful

life value

Salvage

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Depreciation Methods Based on Time

Straight-Line Accelerated

Sum-of-the-yearsdigits Declining Balance

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Depreciation Methods Based on Activity Level

Productive output Service quantity

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Depreciation

If an asset is expected to benefit all periods equally,

a straight-line method of depreciation would be appropriate.

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Depreciation

If more benefits are expected early in the life of an asset . . .

an accelerated method of depreciation would be appropriate.

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Depreciation

If benefits are related to the output of an asset . . .

the units-of-production method of depreciation would be appropriate.

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Types of Accounting Changes

Types of Accounting Changes

Change Change Change Errors

in Accounting Principle in Accounting Estimate in Reporting Entity

in Financial Statements

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What Can Change?

Estimated Estimated Pattern

Life Salvage Value

These are set at acquisition

of Depreciation

A change can be made if another method is preferable.

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Methods of Depreciation
Straight-Line Method

Straight-Line Depreciation The Rationale

Decline in service potential relates primarily to the passage of time. Level of activity is important but use of asset is relatively constant.

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Straight-Line Method Known

Depreciation Expense per Year

Estimated
Cost - Salvage Value Useful life in years

Appropriate if an asset is expected to benefit all periods equally.

Estimated

Straight-Line Method

On December 31, 2001, equipment was purchased for $50,000 cash. The equipment has an estimated useful life of 5 years and an estimated salvage value of $5,000.
$50,000 - $5,000 5 Years $9,000

Depreciation = Expense Per Year =

Depreciation Schedule
Depreciation Expense (debit) $ 9,000 9,000 9,000 9,000 9,000 45,000 Accumulated Depreciation (credit) $ 9,000 9,000 9,000 9,000 9,000 45,000 Accumulated Depreciation Balance $ 9,000 18,000 27,000 36,000 45,000 Undepreciated Balance (book value) $ 50,000 41,000 32,000 23,000 14,000 5,000

Year 2001 2002 2003 2004 2005 2006

Salvage Value

Straight-Line Method

Depreciation Expense is reported on the Income Statement.

Depreciation Expense

Book Value is reported on the Balance Sheet.

Methods of Depreciation
Declining-Balance

Accelerated Depreciation The Rationale

Superior Performance Repair and Maintenance Obsolescence

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Accelerated Depreciation

Repair Costs

Depreciation

Double-Declining-Balance Method
Step 1:
Straight-line = depreciation rate 100 % Useful life in periods

Step 2:
Double-decliningbalance rate = 2 Straight-line depreciation rate

Double-Declining-Balance Method
A Constant Rate Step 3:
Depreciation Double-decliningBeginning period = expense balance rate book value

Ignores salvage value.

A Declining Balance

Double-Declining-Balance Method

On December 31, 2001, equipment was purchased for $50,000 cash. The equipment has an estimated useful life of 5 years and an estimated residual value of $5,000. Calculate the depreciation expense for 2002 and 2003
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Double-Declining-Balance Method
Step 1:
Straight-line = depreciation rate 100 % 5 years = 20%

Step 2:
Double-declining= 2 20% = 40% balance rate

Step 3:
Depreciation = 40% $50,000 = $20,000 (2002) expense

Double-Declining-Balance Method
2002 Depreciation: 40% $50,000 = $20,000

2003 Depreciation: 40% ($50,000 - $20,000) = $12,000

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Double-Declining-Balance Method
Depreciation Accumulated Undepreciated Expense Depreciation Balance (debit) Balance (book value) $ 50,000 $ 20,000 $ 20,000 30,000 12,000 32,000 18,000 7,200 39,200 10,800 4,320 43,520 6,480 2,592 46,112 3,888 Below salvage value $ 46,112

Year 2001 2002 2003 2004 2005 2006

($50,000 $43,520) 40% = $2,592

Double-Declining-Balance Method
Depreciation Expense (debit) $ 20,000 12,000 7,200 4,320 1,480 45,000 Accumulated Depreciation Balance $ 20,000 32,000 39,200 43,520 45,000 Undepreciated Balance (book value) $ 50,000 30,000 18,000 10,800 6,480 5,000

Year 2001 2002 2003 2004 2005 2006

We usually have to force depreciation expense in the latter years to an amount that brings BV to salvage value.

Comparing Depreciation Methods

$10,000 $8,000

Straight-Line

Annual Depreciation

$6,000 $4,000 $2,000 $0 1 2 3 4 5

Life in Years
$20,000 $15,000

Double-Declining-Balance

Annual Depreciation

$10,000 $5,000 $0

Life in Years

Reporting Depreciation
Property, plant, and equipment: Land and buildings Machinery and equipment Office furniture and equipment Land improvements Total Less Accumulated depreciation Net property, plant, and equipment $ 150,000 200,000 175,000 50,000 $ 575,000 (122,000) $ 453,000

Net property, plant, and equipment is the undepreciated cost (book value) of the plant assets.

Book value

Market value

Selecting an Appropriate Depreciation Method

What are the factors that should be considered in selecting a depreciation method?

Depreciation at Delta Air Lines and Singapore Airlines

Now . . . On to the case!!!

Delta

Singapore

Lets Compare

Delta Air Lines

Delta Air Lines

Third $12

largest U.S. airline in 1993

billion in annual revenues (almost $15 billion in 1999) 161 cities in 44 states flights to 33 foreign countries.

Served

Operated

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Delta Air Lines

Losing

money age of aircraft 8.8 years (9.6 in depreciation assumptions in

Average

2000)
Changed

1993

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Delta Air Lines

Average

passenger trip length was 969 miles in 1993. utilization 62.3%

Capacity Long

term debt was $3,717

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Singapore Airlines

Singapore Airlines
Largest

private-sector employer in Singapore network covered 70 cities in 40 countries operating revenues in 1993 $5.1 billion (Singapore $)

Route

Total

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Singapore Airlines
Average

age of aircraft was 5.1 years

Profitable Capacity Average No

utilization 71.3% trip length 2,720 miles

long-term debt

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Delta

Singapore

Lets Compare Depreciation

Comparison . . .
Calculate

the annual depreciation expense that Delta and Singapore would record for each $100 gross value of aircraft.

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Delta Air Lines . . .

20-year Salvage

depreciable life value equal to 5% of cost

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Singapore Airlines . . .
10-year Salvage

depreciable life value equal to 20% of cost

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Life (in Years) < 4/01/89 > 4/01/89 8 10

Salvage Value 10% 20%

Depr. Exp Per $100 $11.25 8.00

Singapore Airlines

Delta Air Lines

< 7/01/8610 7/86 to 3/93 > 4/01/93 10 15 20 10% 10% 5% $9.00 6.00 4.75

Life (in Years) < 4/01/89 > 4/01/89 8 10

Salvage Value 10% 20%

Depr. Exp Per $100 $11.25 8.00

Singapore Airlines

Delta Air Lines

< 7/01/8610 7/86 to 3/93 > 4/01/93 10 15 20 10% 10% 5% $9.00 6.00 4.75

Comparison . . .
Are

the differences in the ways the two airlines account for depreciation expense significant? would companies depreciate aircraft using different depreciable lives and salvage?

Why

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Useful Life

Comparison . . .
Why

would companies depreciate aircraft using different depreciable lives and salvage values? reasons could be given to support these differences? different treatment proper?

What

Is

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Useful Life
Singapore Air

Delta Air

Useful Life - Factors

Technology
Singapore

has newer aircraft

Aircraft

Use
takeoffs and landings

Frequent

Maintenance
Remember

Valuejet?
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Financial Considerations
Singapore Air
For three year period 1990 - 1993

Delta Air

Delta Air Lines

Can we quantify Deltas more liberal depreciation policies?

Delta Air Lines

Assuming

the average value of flight equipment that Delta had in 1993, how much of a difference do the depreciation assumptions it adopted on April 1, 1993 make?

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Delta Air Lines

How

much more or less will its annual depreciation expense be compared to what it would be were it using Singapores depreciation assumptions?

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Look at Exhibit 2
1993 Owned Aircraft Leased Aircraft Gross Value of Aircraft Average Gross Value 1992

$9,043 $8,354 173 173

$9,216 $8,527 $8,872

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Life (in Years) < 4/01/89 > 4/01/89 8 10

Salvage Value 10% 20%

Depr. Exp Per $100 $11.25 8.00

Singapore Airlines

Delta Air Lines

< 7/01/8610 7/86 to 3/93 > 4/01/93 10 15 20 10% 19% 5% $9.00 6.00 4.75

Look

at Current Policies
Delta Air

Average Gross Value

Singapore Air

Difference in Depreciation

Look

at Previous Delta Policies

Deltas Current Policy

Average Gross Value

Deltas Previous Policy

Difference in Depreciation

Delta Vs. Singapore

There

is yet another difference in the two airlines leading to a savings of Delta over Singapore on depreciation expense.
Historical Age

cost basis; and

of the aircraft

101

Delta Vs. Singapore

Does

the difference in the average age of Deltas and Singapores aircraft fleets have any impact on the amount of depreciation expense they record? so, how much?

If

102

Look at the age of the aircraft

Age Delta Singapore Difference in age 8.8 5.1 3.7

Assume a 3% - 4% annual inflation in the mid to late 80s.

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Average Gross Value 3.5% Inflation x 3.7 Years Increased Value Adjusted Gross Value Increased Value Singapores Rate

$8,872 12.95% $1,150 $10,022

Additional Depreciation

Delta Vs. Singapore

Savings in depreciation expense due to more liberal assumptions Savings in depreciation due to older aircraft Total savings Delta over Singapore $288

92 $380

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Delta Vs. Singapore

Singapore

Airlines maintains depreciation assumptions that are very different from Deltas does it gain or lose by doing so?

What How

does this relate to the companys overall strategy? Strategies

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Compare

Singapore Airlines
1. Renowned for customer service

State-of-the-art aircraft Capacity utilization = 71.3% 1993 Annual Report: A superior product will probably enable us to sustain relatively high load factors.

107

Singapore Airlines
2. Long-haul Airline

Average passenger trip length in 1993 was 2,720 miles (Delta = 969) Less wear and tear on aircraft long trips are less stressful than frequent landings and takeoffs

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Singapore Airlines
3. Gain on sale of aircraft

Average gain $134 million Direct result of depreciation policies? Result of corporate strategy

Depreciate fast resulting in low book values on disposal

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Singapore Airlines
4. Owned Vs. Leased Aircraft

Singapore operates none of their aircraft under operating leases Delta operates close to 50% of their aircraft under non-cancelable operating leases.

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Delta Air Lines

4. Owned Vs. Leased Aircraft

Singapore operates none of their aircraft under operating leases Delta operates close to 50% of their aircraft under non-cancelable operating leases.

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