Depreciation at Delta Air Lines and Singapore Airlines

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

Financial Reporting

Yeah!

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

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

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

Used

An application of the matching principle.

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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 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.

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Management Issues related to Accounting for Long Term Assets

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.

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Issues Related to Long-Lived Assets

Asset Service Potential
Use in business operations
Acquisition 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 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

Discounted present value.

Net realizable value.

Economic Sacrifice Approaches

Historical 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-theroad equipment listing (Purple Book) for the specific vehicle model. $85,000 (Assumed)

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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

Historical Cost (Less A/D) Replacement Cost

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 an operational asset;

Placing it in its operational setting; and

Preparing it for use; 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. The allocation process is called depreciation.

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Revenue-Expense Association The Matching Principle

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

Association of cause and effect Systematic and rational allocation

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Cost Flows in a Manufacturing Firm

Manufacturing Costs Balance Sheet Unused

DM DL MOH Sales Used

DM Inv.
Unfinished

WIP

WIP Inv. FG Inv.

COGS Gross Margin S&A Net Income Period Costs

Income Statement

=
=

Revenue-Expense Association The 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

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Factors in Computing Depreciation

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-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 Life

Estimated Salvage Value

Pattern of Depreciation

These are set at acquisition

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.
Depreciation Expense Per Year = = $50,000 - $5,000 5 Years $9,000

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

$10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 2001 2002 2003 2004 2005 2006 For the year ended December 31

Depreciation Expense is reported on the Income Statement.

Depreciation Expense

$60,000 $50,000 $50,000 $41,000 $32,000 $23,000 $14,000 $5,000 $0 2001 2002 2003 2004 2005 2006 As of December 31

Book Value is reported on the Balance Sheet.

Book Value

$40,000 $30,000 $20,000 $10,000

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

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

Straight-Line
$10,000

Annual Depreciation

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

Life in Years
$20,000

Double-Declining-Balance

Annual Depreciation

$15,000 $10,000 $5,000 $0 1 2 3 4 5

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 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

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Singapore Airlines

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

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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 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

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Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines
< 4/01/89
> 4/01/89

8
10

10%
20%

$11.25
8.00

Delta Air Lines

< 7/01/8610 7/86 to 3/93 10 15 10% 10% $9.00 6.00

> 4/01/93

20

5%

4.75

Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines
< 4/01/89
> 4/01/89

8
10

10%
20%

$11.25
8.00

Delta Air Lines

< 7/01/8610 7/86 to 3/93 10 15 10% 10% $9.00 6.00

> 4/01/93

20

5%

4.75

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?

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Useful Life

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?

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Useful Life
Singapore Air

Delta Air

Useful Life - Factors

Technology

Singapore has newer aircraft

Aircraft Use

Frequent takeoffs and landings

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?

95

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 $9,043 173 1992 $8,354 173

Gross Value of Aircraft

Average Gross Value

$9,216

$8,527

$8,872
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Life (in Years)

Salvage Value

Depr. Exp Per $100

Singapore Airlines
< 4/01/89
> 4/01/89

8
10

10%
20%

$11.25
8.00

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

Average Gross Value

Delta Air

Singapore Air

Difference in Depreciation

 Look at Previous Delta Policies

Average Gross Value

Deltas Current Policy

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 cost basis; and Age 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? If so, how much?

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Look at the age of the aircraft

Age Delta Singapore 8.8 5.1

Difference in age

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

$8,872 12.95%

Increased Value Adjusted Gross Value

Increased Value Singapores Rate

$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 What does it gain or lose by doing so? How does this relate to the companys 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.

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