MBA-611 Accounting For Executive Action

MBA-611 Accounting For Executive Action

Depreciation at Delta Air Lines and Singapore Airlines UAA ACCT 650 Seminar in Executive Uses of Accounting Fred Barbee Dr. ia to n Financial Reporting c e r

p e D 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 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 Declin e in fu t servic ure

e ben efits. Time Book Value 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 Declin e in fu t servic ure e ben efits. Time

Book Value 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 Net

present value. 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 Placing it in its operational setting; and Preparing Less an operational asset; it for use; 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 Systematic of cause and effect and rational allocation

40 Cost Cost Flows Flows in in aa Manufacturing Manufacturing Firm Firm Produ ct Costs Manufacturing Costs DM DM DL DL MOH

MOH Balance Sheet Unused Use d Used ed i l p Ap WIP WIP

Income Statement = = Unfinished WIP WIPInv. Inv. Fini she d

Sales - DM DMInv. Inv. COGS COGS Sale Sold Gross Margin S&A S&A

Net Income Period Costs FG FGInv. Inv. 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 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-yearsdigits 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 These are set at acquisition

of Depreciation 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 Depreciation Expense Book Value is reported on the Balance Sheet. Depreciation

Expense is reported on the Income Statement. 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 67 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 Life in Years 5

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 Singapor e 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. 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 Long utilization 62.3% 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 Singapor e Lets 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 Singapore Aircraft

has newer aircraft Use 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 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? 96

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 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 Singapor e Air Delta Air Difference in Depreciation

Look at Previous Delta Policies Average Gross Value Deltas Previous Policy Deltas 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 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? 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

Singapores Rate Additional Depreciation Delta Vs. Singapore Savings in depreciation expense due to more liberal assumptions $288 Savings in depreciation due to older aircraft 92

Total savings Delta over Singapore $380 105 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 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

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