Depreciation at Delta (2)

8/6/2019 Depreciation at Delta (2)

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Depreciation at Delta AirLines and Singapore Airlines

UAA ACCT 650 -Seminar in Executive Uses of

Accounting Dr.Fred Barbee


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Financial Reporting

Dep

irec a

tio n


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Yeah!

MBA


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MBA


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5

Why study this case?

To compare and contrast depreciationassumptions from two airlines that . . .

Are in some ways alike, and In other ways vastly different


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6

Why Look at an Airline?

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

Aircraft of one airline are substantiallysimilar to aircraft of another airline (atleast to the lay person).


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Depreciation TheConcept

1


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Time

Consumed asDepreciationExpense


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Depreciation is not

an attempt toestablish the valueof an asset.

Depreciation is not ameasure of the decline

in value of an asset.


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11

Depreciation Defined

The process ofallocating the cost ofproperty, plant, and equipment as anexpense in a systematic and rational

manner to those periods expected tobenefit from the use of the asset.


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DepreciationB

EGIN

NIN

G

END

ING

Life of theAsset

96 97 98 99 00 01 02 03 04 05

Depreciation is aprocess of allocation,not valuation.


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13

Cost

Allocation

AcquisitionCost

Balance Sheet Income Statement

Expense

Depreciation

Unused Used

An application of the matchingprinciple.


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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.


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Management Issues related toAccounting 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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Issues Related to Long-Lived Assets

Asset Service Potential

Acquisition DisposalUse in business operations

Time

Declineinfutureservicebenefits.Book Value

Accounting Issues

MeasuringCost

RecordingDisposals

Allocation of costAccounting For post

acquisition expenses.


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Issues Related to Long-Lived Assets

Asset Service Potential

Acquisition DisposalUse in business operations

Time

Declineinfutureservicebenefits.Book Value

Accounting Issues

MeasuringCost

RecordingDisposals

Allocation of costAccounting For post

acquisition expenses.


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Acquisition cost of Property,Plant, and Equipment

Fundamental Issue #1:

What is the value of the asset?


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Measuring the CarryingAmount of Long-Lived Assets

1


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Measuring the Carrying Value ofLong-Lived Assets

Expected Benefit Approaches

Discounted present value.

Net realizable value.

Economic Sacrifice Approaches

Historical cost less accumulateddepreciation.

Replacement cost.


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1


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1


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Discounted Present Value

Expected net operating cash inflows =$18,000 per year (assumed) for eightremaining years, discounted at a 10%

(assumed) rate.

5.33493 x $18,000 = $96,029


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31

Net Realizable Value

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

$85,000 (Assumed)


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1


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Historical Cost

Historical Cost less AccumulatedDepreciation

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


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Replacement Cost

Replacement cost of a two-year-oldvehicle in equivalent condition

$90,000 (assumed)


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Possibilities

Discounted PV Approach $96,029

Net Realizable Value 85,000Historical Cost (Less A/D) 80,000

Replacement Cost 90,000


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36

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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37

Value of Asset

Cost includes all reasonable andnecessary 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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39

Theoretical Justification

The matching principle requires thecost of an asset be charged to expensein the periods benefited.

The allocation process is calleddepreciation.

R E A i ti


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40

Revenue-Expense AssociationThe Matching Principle

Three principles govern the inclusion ofan expense in the matching process:

Association of cause and effect

Systematic and rational allocation


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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

PeriodPeriod

CostsCosts

IncomeStatement

Prod

uctCosts

Prod

uctCosts

Unfinished

Finished

Sold

UsedUsed

Applied

Unused

Sale

Re en e E pense Association


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Revenue-Expense AssociationThe Matching Principle

Three principles govern the inclusion ofan expense in the matching process:

Association of cause and effect

Systematic and rational allocation

Immediate recognition


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The depreciable

life of the assetmust beestablished.

The salvage valueof the asset at the

end of its life mustbe estimated.


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Factors in ComputingDepreciation

Factors in Computing


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Factors in ComputingDepreciation

The calculation of depreciation requiresthree amounts for each asset:

Cost

Useful life

Salvage value

Depreciation Methods


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Depreciation MethodsBased on Time

Straight-Line

Accelerated

Sum-of-the-years-digits

Declining Balance

Depreciation Methods


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Depreciation MethodsBased on Activity Level

Productive output

Service quantity


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48

Depreciation

If an asset is expected to benefit allperiods equally,

a straight-line method ofdepreciation would beappropriate.


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50

Depreciation

If benefits are related to the output of anasset . . .

the units-of-production methodof depreciation would beappropriate.


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Types of AccountingChanges


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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 areset at

acquisition

A change can be made if

another method ispreferable.


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Methods of Depreciation

Straight-Line Method

Straight-Line Depreciation


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Straight-Line Depreciation The Rationale

Decline in service potential relatesprimarily to the passage of time.

Level of activity is important but use ofasset is relatively constant.


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Cost - Salvage ValueUseful life in years

DepreciationExpense per Year

=


Appropriate if anasset is expectedto benefit allperiods equally.

Known Estimated

Estimated

Straight Line Method


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On December 31, 2001, equipment was

purchased for $50,000 cash. Theequipment has an estimated useful life of 5years and an estimated salvage value of

$5,000.


DepreciationExpense Per Year

= $50,000 - $5,000

5 Years

= $9,000

Depreciation Schedule


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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



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Depreci a

tion

Expense

DepreciationExpense is

reported on theIncome

Statement.

Book Value is

reported on theBalance Sheet.


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Methods of Depreciation

Declining-Balance

Accelerated Depreciation


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Accelerated Depreciation The Rationale

Superior Performance

Repair and Maintenance

Obsolescence


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RepairCosts

Depreciation

Accelerated Depreciation

D bl D li i B l M th d


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Step 2:

Double-declining-balance rate = 2 Straight-line

depreciation rate

Double-Declining-Balance Method

Step 1:

Straight-linedepreciation rate

=100 %

Useful life in periods



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Step 3:

Depreciationexpense

= Double-declining-balance rate

Beginning periodbook value


Ignores salvagevalue.

A Constant Rate

A Declining Balance

Double-Declining-Balance


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Double Declining BalanceMethod

On December 31, 2001, equipment waspurchased for $50,000 cash.

The equipment has an estimated usefullife of 5 years and an estimated residualvalue of $5,000.

Calculate the depreciation expense for2002 and 2003


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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%




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

2003

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

Double Declining BalanceMethod



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Depreciation Accumulated UndepreciatedExpense Depreciation Balance

Year (debit) Balance (book value)

2001 50,000$

2002 20,000$ 20,000$ 30,0002003 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 3,88846,112$

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

Below salvage value


Double Declining Balance Method


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Depreciation Accumulated Undepreciated

Expense Depreciation BalanceYear (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.


Comparing Depreciation Methods


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Life in Years

Annua

l

Deprecia

tion

$0

$5,000

$10,000

$15,000

$20,000

1 2 3 4 5


Comparing Depreciation Methods

Life in Years

$0

$2,000

$4,000

$6,000

$8,000

$10,000

1 2 3 4 5Annual

Deprecia

tion

Straight-Line

Reporting Depreciation


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Net property, plant, and equipment is theundepreciated 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


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g pp pDepreciation Method

What are thefactors that should

be considered inselecting adepreciation

method?


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Depreciation at Delta AirLines and Singapore Airlines

Now . . . On to the case!!!


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Lets Compare

Delta Singapore


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Delta Air Lines


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Delta Air Lines


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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

Delta Air Lines


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Delta Air Lines

Average passenger trip length was 969miles in 1993.

Capacity utilization 62.3%Long term debt was $3,717


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Singapore Airlines

Singapore Airlines


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Singapore Airlines

Largest private-sector employer inSingapore

Route network covered 70 cities in 40countries

Total operating revenues in 1993 $5.1

billion (Singapore $)

Singapore Airlines


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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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Lets Compare Depreciation

Delta Singapore

Comparison


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Comparison . . .

Calculate the annual depreciationexpense that Delta and Singapore wouldrecord for each $100 gross value of

aircraft.


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Singapore Airlines


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Singapore Airlines . . .

10-year depreciable life

Salvage value equal to 20% of cost


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Life(in Years)

SalvageValue

Depr. ExpPer $100

Singapore Airlines< 4/01/89 8 10% $11.25

> 4/01/89 10 20% 8.00Delta 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


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Comparison . . .

Are the differences in the ways the twoairlines account for depreciationexpense significant?

Why would companies depreciateaircraft using different depreciable livesand salvage?


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Useful Life

Comparison


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Comparison . . .

Why would companies depreciateaircraft using different depreciable livesand salvage values?

What reasons could be given to supportthese differences?

Is different treatment proper?


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Useful Life

Singapore Air

Delta Air

Useful Life - Factors


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Useful Life - Factors

Technology

Singapore has newer aircraft

Aircraft UseFrequent takeoffs and landings

Maintenance

Remember Valuejet?


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Financial

ConsiderationsSingapore Air

Delta Air

For three year period1990 - 1993


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Delta Air Lines


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Delta Air Lines

Assuming the average value of flightequipment that Delta had in 1993,how much of a difference do thedepreciation assumptions it adoptedon April 1, 1993 make?

Delta Air Lines


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Delta Air Lines

How much more or less will itsannual depreciation expense becompared to what it would be wereit using Singapores depreciationassumptions?

Look at Exhibit 2


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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 Salvage Depr. Exp


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Life(in Years)

SalvageValue

Depr. ExpPer $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

L k t C t P li i


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Look at Current Policies

SingaporeAir

DeltaAir

AverageGross Value

Difference inDepreciation

Look at Previous Delta Policies


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Look at Previous Delta Policies

DeltasPreviousPolicy

DeltasCurrent Policy

AverageGross Value

Difference inDepreciation

Delta Vs. Singapore


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Delta Vs. Singapore

There is yet another difference in the twoairlines leading to a savings of Deltaover Singapore on depreciation

expense.Historical cost basis; and

Age of the aircraft

Delta Vs. Singapore


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Delta Vs. Singapore

Does the difference in the average ageof Deltas and Singapores aircraft fleetshave any impact on the amount of

depreciation expense they record?If so, how much?

Look at the age of the aircraft


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103

Look at the age of the aircraft

Age

Delta 8.8

Singapore 5.1Difference in age 3.7

Assume a 3% - 4% annualinflation in the mid to late80s.

Average Gross Value $8,872


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3.5% Inflation x 3.7 Years 12.95%

Increased Value $1,150

Adjusted Gross Value $10,022

Increased

Value

Singapores

Rate

Additional

Depreciation

Delta Vs. Singapore


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Savings in depreciationexpense due to more liberalassumptions

$288

Savings in depreciation dueto older aircraft

92

Total savings Delta over

Singapore

$380

Delta Vs. Singapore

Delta Vs. Singapore


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Delta Vs. Singapore

Singapore Airlines maintainsdepreciation assumptions that are verydifferent from Deltas

What does it gain or lose by doing so?

How does this relate to the companys

overall strategy?Compare Strategies

Singapore Airlines


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S gapo e es

1. Renowned for customer service

State-of-the-art aircraft

Capacity utilization = 71.3%

1993 Annual Report: A superior productwill probably enable us to sustain relatively

high load factors.

Singapore Airlines


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g p

2. Long-haul Airline

Average passenger trip length in 1993 was2,720 miles (Delta = 969)

Less wear and tear on aircraft long tripsare less stressful than frequent landingsand takeoffs

Singapore Airlines


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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 ondisposal

Singapore Airlines


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4. Owned Vs. Leased Aircraft

Singapore operates none of their aircraftunder operating leases

Delta operates close to 50% of theiraircraft under non-cancelable operatingleases.

Delta Air Lines


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4. Owned Vs. Leased Aircraft

Singapore operates none of their aircraftunder operating leases

Delta operates close to 50% of theiraircraft under non-cancelable operatingleases.

Depreciation at Delta (2)

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