Depreciation at Delta Air Lines and Singapore Airlines

UAA – ACCT 650 - Seminar in Executive Uses of Accounting Dr. Fred Barbee

Financial Reporting

Dep

i

rec atio n

Yeah!

MBA

MB

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Why study this case?

To “compare and contrast” depreciation assumptions from two airlines that . . .Are in some ways alike, and

In other ways vastly different

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Why Look at an Airline?

PP&E for airlines usually comprise greater than 50% of total assets.

Aircraft of one airline are substantially similar to aircraft of another airline (at least to the lay person).

Depreciation – The Concept

1

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.

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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.

DepreciationBEGINNING

ENDING

Life of the Asset

96 97 98 99 00 01 02 03 04 05

Depreciation is a process of allocation,

not valuation.

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Cost

Allocation

AcquisitionCost

Balance Sheet Income Statement

Expense

Depreciation

Unused Used

An application of the matching principle.

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Income

StatementDepreciation

Expense Depreciation for

the current year

Balance

SheetAccumulatedDepreciation Total depreciation to

date of balance sheet

Depreciation

Long-Term Assets

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Long-Term Assets

Have a useful life of more than one year.

Are acquired for use in the business.

Are not intended for resale to customers.

Are reported at carrying (book) value.

Management Issues related to Accounting for Long Term Assets

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Management Issues

The cost of the asset must be measured.

The 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

A pattern for recognizing depreciation over the depreciable life of the asset must be selected.

Issues Related to Long-Lived Assets

Asset Service Potential

Acquisition DisposalUse in business operations

Time

Decline in future service benefits.

Book Value

Accounting Issues

Measuring Cost

Recording Disposals

Allocation of costAccounting For post

acquisition expenses.

Issues Related to Long-Lived Assets

Asset Service Potential

Acquisition DisposalUse in business operations

Time

Decline in future service benefits.

Book Value

Accounting Issues

Measuring Cost

Recording Disposals

Allocation of costAccounting For post

acquisition expenses.

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

1

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Expected Benefit Approach

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

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

Economic Sacrifices Approach

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Measuring the Carrying Value of Long-Lived Assets

Expected Benefit ApproachesDiscounted present value.

Net realizable value.

Economic Sacrifice ApproachesHistorical cost less accumulated

depreciation.

Replacement cost.

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Hypothetical Case – A Truck

Original cost $100,000

Two years old, has remaining useful life of 8 years

No salvage value

Depreciated using straight-line

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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.

5.33493 x $18,000 = $96,029

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Net Realizable Value

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

$85,000 (Assumed)

1

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Historical Cost

Historical Cost less Accumulated Depreciation

$100,000 – [(100,000/10 years) x 2 years] = $80,000

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Replacement Cost

Replacement cost of a two-year-old vehicle in equivalent condition

$90,000 (assumed)

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Possibilities

Discounted PV Approach $96,029

Net Realizable Value 85,000

Historical Cost (Less A/D) 80,000

Replacement Cost 90,000

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Possibilities

Discounted PV Approach $96,029

Net Realizable Value 85,000

Historical Cost (Less A/D) 80,000

Replacement Cost 90,000

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“Value” of Asset

“Cost” includes all reasonable and necessary expenditures incurred in:

Acquiring an operational asset;

Placing it in its operational setting; and

Preparing it for use;

Less any cash discounts allowed.

Acquisition cost of Property, Plant, and Equipment

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

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Theoretical Justification

The matching principle requires the cost of an asset be charged to expense in the periods benefited.

The allocation process is called depreciation.

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Revenue-Expense AssociationThe Matching Principle

Three principles govern the inclusion of an expense in the matching process:Association of cause and effect

Systematic and rational allocation

Cost Flows in a Manufacturing FirmCost Flows in a Manufacturing Firm

DMDM

DLDL

MOHMOH

DM Inv.DM Inv.

WIP Inv.WIP Inv.

FG Inv.FG Inv.

WIPWIP

Manufacturing Costs

COGSCOGS

S&AS&A

Sales

-= Gross Margin

-Net Income=

Balance Sheet

Period Costs

Income Statement

Pro

du

ct C

ost

s

Unfinished

Finished

Sold

UsedUsed

Applied

Unused

Sale

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Revenue-Expense AssociationThe Matching Principle

Three principles govern the inclusion of an expense in the matching process:Association of cause and effect

Systematic and rational allocation

Immediate recognition

Factors in Computing Depreciation

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Factors in Computing Depreciation

The calculation of depreciation requires three amounts for each asset:Cost

Useful life

Salvage value

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Depreciation Methods Based on Time

Straight-Line

Accelerated

Sum-of-the-years’-digits

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.

Types of Accounting Changes

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Types of Accounting Changes

Change in Accounting Principle

Change in Accounting Estimate

Change in Reporting Entity

Errors in Financial Statements

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What Can Change?

Estimated Life

Estimated Salvage Value

Pattern of Depreciation

These are set at

acquisition

A change can be made if another method is

preferable.

Methods of Depreciation

Straight-Line Method

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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.

Cost - Salvage Value

Useful life in years

Depreciation

Expense per Year=

Straight-Line Method

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

Known Estimated

Estimated

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.

Straight-Line Method

Depreciation Expense Per Year =

$50,000 - $5,000

5 Years

= $9,000

Depreciation Accumulated Accumulated UndepreciatedExpense Depreciation Depreciation Balance

Year (debit) (credit) Balance (book value)2001 50,000$ 2002 9,000$ 9,000$ 9,000$ 41,000 2003 9,000 9,000 18,000 32,000 2004 9,000 9,000 27,000 23,000 2005 9,000 9,000 36,000 14,000 2006 9,000 9,000 45,000 5,000

45,000$ 45,000$

Salvage Value

Depreciation Schedule

Straight-Line Method

$0$1,000$2,000$3,000$4,000$5,000$6,000$7,000$8,000$9,000

$10,000

2001 2002 2003 2004 2005 2006

For the year ended December 31

$50,000

$41,000

$32,000

$23,000

$14,000

$5,000$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

2001 2002 2003 2004 2005 2006

As of December 31

Boo

k V

alue

Dep

reci

atio

n

Exp

ense

Depreciation Expense is

reported on the Income

Statement.

Book Value is reported on the Balance

Sheet.

Methods of Depreciation

Declining-Balance

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Accelerated Depreciation –The Rationale

Superior Performance

Repair and Maintenance

Obsolescence

Repair Costs

Depreciation

Accelerated Depreciation

Step 2:Double-declining-

balance rate= 2 ×

Straight-linedepreciation rate

Double-Declining-Balance Method

Step 1:Straight-line

depreciation rate=

100 % Useful life in periods

Step 3:Depreciation

expense=

Double-declining-balance rate

×Beginning period

book value

Double-Declining-Balance Method

Ignores salvage value.

A Constant Rate

A Declining Balance

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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

Step 2:Double-declining-

balance rate= 2 × 20% = 40%

Step 3:Depreciation

expense= 40% × $50,000 = $20,000 (2002)

Step 1:Straight-line

depreciation rate=

100 % 5 years

= 20%

Double-Declining-Balance Method

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2002 Depreciation: 40% × $50,000 = $20,000

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

Double-Declining-Balance Method

Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)2001 50,000$ 2002 20,000$ 20,000$ 30,000 2003 12,000 32,000 18,000 2004 7,200 39,200 10,800 2005 4,320 43,520 6,480 2006 2,592 46,112 3,888

46,112$

($50,000 – $43,520) × 40% = $2,592

Below salvage value

Double-Declining-Balance Method

Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)2001 50,000$ 2002 20,000$ 20,000$ 30,000 2003 12,000 32,000 18,000 2004 7,200 39,200 10,800 2005 4,320 43,520 6,480 2006 1,480 45,000 5,000

45,000$

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

Double-Declining-Balance Method

Life in Years

An

nu

alD

epre

ciat

ion

$0

$5,000

$10,000

$15,000

$20,000

1 2 3 4 5

Double-Declining-Balance

Comparing Depreciation Methods

Life in Years

$0

$2,000

$4,000

$6,000

$8,000

$10,000

1 2 3 4 5

An

nu

alD

epre

ciat

ion

Straight-Line

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

Book value Market value

Reporting Depreciation

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

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!!!

Let’s Compare

Delta Singapore

Delta Air Lines

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Delta Air Lines

Third largest U.S. airline in 1993

$12 billion in annual revenues (almost $15 billion in 1999)

Served 161 cities in 44 states

Operated flights to 33 foreign countries.

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Delta Air Lines

Losing money

Average age of aircraft 8.8 years (9.6 in 2000)

Changed depreciation assumptions in 1993

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Delta Air Lines

Average passenger trip length was 969 miles in 1993.

Capacity utilization 62.3%

Long term debt was $3,717

Singapore Airlines

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Singapore Airlines

Largest private-sector employer in Singapore

Route network covered 70 cities in 40 countries

Total operating revenues in 1993 $5.1 billion (Singapore $)

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Singapore Airlines

Average age of aircraft was 5.1 years

Profitable

Capacity utilization 71.3%

Average trip length 2,720 miles

No long-term debt

Let’s Compare Depreciation

Delta Singapore

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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 depreciable life

Salvage value equal to 5% of cost

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Singapore Airlines . . .

10-year depreciable life

Salvage value equal to 20% of cost

Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines

< 4/01/89 8 10% $11.25

> 4/01/89 10 20% 8.00

Delta Air Lines

< 7/01/8610 10 10% $9.00

7/86 to 3/93 15 10% 6.00

> 4/01/93 20 5% 4.75

Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines

< 4/01/89 8 10% $11.25

> 4/01/89 10 20% 8.00

Delta Air Lines

< 7/01/8610 10 10% $9.00

7/86 to 3/93 15 10% 6.00

> 4/01/93 20 5% 4.75

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Comparison . . .

Are the differences in the ways the two airlines account for depreciation expense significant?

Why would companies depreciate aircraft using different depreciable lives and salvage?

Useful Life

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Comparison . . .

Why would companies depreciate aircraft using different depreciable lives and salvage values?

What reasons could be given to support these differences?

Is different treatment proper?

Useful Life

Singapore Air

Delta Air

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Useful Life - Factors

TechnologySingapore has newer aircraft

Aircraft UseFrequent takeoffs and landings

MaintenanceRemember Valuejet?

Financial Considerations

Singapore Air

Delta Air

For three year period 1990 - 1993

Delta Air Lines

Can we quantify Delta’s more liberal depreciation

policies?

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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 Singapore’s depreciation assumptions?

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Look at Exhibit 2

1993 1992

Owned Aircraft $9,043 $8,354

Leased Aircraft 173 173

Gross Value of Aircraft $9,216 $8,527

Average Gross Value $8,872

Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines

< 4/01/89 8 10% $11.25

> 4/01/89 10 20% 8.00

Delta Air Lines

< 7/01/8610 10 10% $9.00

7/86 to 3/93 15 19% 6.00

> 4/01/93 20 5% 4.75

Look at Current Policies

Singapore Air

Delta Air

Average Gross Value

Difference in Depreciation

Look at Previous Delta Policies

Delta’s Previous

Policy

Delta’s Current Policy

Average Gross Value

Difference in Depreciation

101

Delta Vs. Singapore

There is yet another difference in the two airlines leading to a savings of Delta over Singapore on depreciation expense.Historical cost basis; and

Age of the aircraft

102

Delta Vs. Singapore

Does the difference in the average age of Delta’s and Singapore’s aircraft fleets have any impact on the amount of depreciation expense they record?

If so, how much?

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Look at the age of the aircraft

Age

Delta 8.8

Singapore 5.1

Difference in age 3.7

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

Average Gross Value $8,872

3.5% Inflation x 3.7 Years 12.95%

Increased Value $1,150

Adjusted Gross Value $10,022

Increased Value

Singapore’s Rate

Additional Depreciation

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Savings in depreciation expense due to more liberal assumptions

$288

Savings in depreciation due to older aircraft 92

Total savings Delta over Singapore $380

Delta Vs. Singapore

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Delta Vs. Singapore

Singapore Airlines maintains depreciation assumptions that are very different from Delta’s

What does it gain or lose by doing so?

How does this relate to the company’s overall strategy?

Compare Strategies

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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.

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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.