Transcript MBA-611 Accounting For Executive Action

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
5
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).
6
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.
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.
11
B
E
G
I
N
N
I
N
G
Depreciation
96
97
98
99
00
01
02
03
04
Life of the Asset
Depreciation is a process
of allocation, not
valuation.
05
E
N
D
I
N
G
Depreciation
Balance Sheet
Acquisition
Cost
Unused
Income Statement
Cost
Allocation
Expense
Used
An application of the matching
principle.
13
Depreciation
Depreciation
Expense
Income
Depreciation for
the current year
Accumulated
Depreciation Total depreciation to
date of balance sheet
Statement
Balance
Sheet
14
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.
16
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.
18
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.
19
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
1
Expected Benefit Approach

Recognizes that assets are valuable
because of the future cash inflows they
are expected to generate.
24
Economic Sacrifices Approach

Focuses on the amount of resource
expenditures required to acquire an
asset.
25
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.
26
1
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
28
1
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
30
Net Realizable Value

Current resale price from an over-theroad equipment listing (Purple Book) for
the specific vehicle model.

$85,000 (Assumed)
31
1
Historical Cost

Historical Cost less Accumulated
Depreciation

$100,000 – [(100,000/10 years) x 2
years] = $80,000
33
Replacement Cost

Replacement cost of a two-year-old
vehicle in equivalent condition

$90,000 (assumed)
34
Possibilities
Discounted PV Approach
$96,029
Net Realizable Value
85,000
Historical Cost (Less A/D)
80,000
Replacement Cost
90,000
35
Possibilities
Discounted PV Approach
$96,029
Net Realizable Value
85,000
Historical Cost (Less A/D)
80,000
Replacement Cost
90,000
36
“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.
37
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.
39
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
40
Cost Flows in a Manufacturing Firm
Manufacturing Costs
Balance Sheet
Unused
DM
DL
Used
WIP
DM Inv.
Unfinished
MOH
FG Inv.
Sales
-
Income
Statement
WIP Inv.
COGS
=
Gross Margin
-
S&A
=
Net Income
Period
Costs
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
42
Factors in Computing
Depreciation
Factors in Computing
Depreciation

The calculation of depreciation requires
three amounts for each asset:

Cost

Useful life

Salvage value
45
Depreciation Methods
Based on Time

Straight-Line

Accelerated

Sum-of-the-years’digits

Declining Balance
46
Depreciation Methods
Based on Activity Level

Productive output

Service quantity
47
Depreciation

If an asset is expected to benefit all
periods equally,

a straight-line method of
depreciation would be
appropriate.
48
Depreciation

If more benefits are expected early in
the life of an asset . . .

an accelerated method of
depreciation would be
appropriate.
49
Depreciation

If benefits are related to the output of an
asset . . .

the units-of-production method
of depreciation would be
appropriate.
50
Types of Accounting
Changes
Types of Accounting Changes
 Change
in Accounting Principle
 Change
in Accounting Estimate
 Change
in Reporting Entity
 Errors
in Financial Statements
52
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.
53
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.
55
Straight-Line Method
Known
Depreciation
Expense per Year
=
Appropriate if an
asset is expected
to benefit all
periods equally.
Estimated
Cost - Salvage Value
Useful life in years
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
Year
2001
2002
2003
2004
2005
2006
Depreciation
Expense
(debit)
Accumulated
Depreciation
(credit)
Accumulated
Depreciation
Balance
$
$
$
$
9,000
9,000
9,000
9,000
9,000
45,000
$
9,000
9,000
9,000
9,000
9,000
45,000
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
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
Depreciation
Expense
Depreciation
Expense is
reported on the
Income
Statement.
2001 2002 2003 2004 2005 2006
For the year ended December 31
$60,000
Book Value is
reported on the
Balance Sheet.
Book Value
$50,000
$50,000
$41,000
$40,000
$32,000
$30,000
$23,000
$20,000
$14,000
$10,000
$5,000
$0
2001
2002
2003
2004
As of December 31
2005
2006
Methods of Depreciation
Declining-Balance
Accelerated Depreciation –
The Rationale

Superior Performance

Repair and Maintenance

Obsolescence
61
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
65
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
Year
2001
2002
2003
2004
2005
2006
Depreciation
Expense
(debit)
Accumulated
Depreciation
Balance
$
$
$
20,000
12,000
7,200
4,320
2,592
46,112
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
($50,000 – $43,520) × 40% = $2,592
Double-Declining-Balance Method
Year
2001
2002
2003
2004
2005
2006
Depreciation
Expense
(debit)
Accumulated
Depreciation
Balance
$
$
$
20,000
12,000
7,200
4,320
1,480
45,000
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
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
$8,000
$6,000
$4,000
$2,000
$0
1
2
3
4
5
Life in Years
Double-Declining-Balance
$20,000
Annual
Depreciation
Annual
Depreciation
$10,000
$15,000
$10,000
$5,000
$0
1
2
3
Life in Years
4
5
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
Let’s 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.
76
Delta Air Lines

Losing money

Average age of aircraft 8.8 years (9.6 in
2000)

Changed depreciation assumptions in
1993
77
Delta Air Lines

Average passenger trip length was 969
miles in 1993.

Capacity utilization 62.3%

Long term debt was $3,717
78
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 $)
80
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
81
Delta
Singapore
Let’s Compare Depreciation
Comparison . . .

Calculate the annual depreciation
expense that Delta and Singapore would
record for each $100 gross value of
aircraft.
83
Delta Air Lines . . .

20-year depreciable life

Salvage value equal to 5% of cost
84
Singapore Airlines . . .

10-year depreciable life

Salvage value equal to 20% of cost
85
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
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?
88
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?
90
Useful Life
Singapore Air
Delta Air
Useful Life - Factors

Technology


Aircraft Use


Singapore has newer aircraft
Frequent takeoffs and landings
Maintenance

Remember Valuejet?
92
Financial Considerations
Singapore Air
For three year period
1990 - 1993
Delta Air
Delta Air Lines
Can we quantify Delta’s 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 Singapore’s depreciation
assumptions?
96
Look at Exhibit 2
1993
1992
Owned Aircraft
$9,043
$8,354
Leased Aircraft
173
173
$9,216
$8,527
Gross Value of Aircraft
Average Gross Value
$8,872
97
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
Average
Gross Value
Singapore
Air
Delta
Air
Difference in
Depreciation
 Look at Previous Delta Policies
Average
Gross Value
Delta’s
Previous
Policy
Delta’s
Current 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 Delta’s and Singapore’s aircraft fleets
have any impact on the amount of
depreciation expense they record?

If so, how much?
102
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.
103
Average Gross Value
$8,872
3.5% Inflation x 3.7 Years
12.95%
Increased Value
$1,150
Adjusted Gross Value
Increased
Value
$10,022
Singapore’s
Rate
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
105
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
106
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
108
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
109
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.
110
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.
111