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Depreciation at Delta Air

Lines and Singapore Airlines

UAA – ACCT 650 -


Seminar in Executive Uses of Accounting
Dr. Fred Barbee
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).

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Depreciation – The
Concept

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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 Depreciation
E
E
G
N
I 96 97 98 99 00 01 02 03 04 05 D
N
I
N Life of the Asset N
I
G
N
G
Depreciation is a
process of allocation,
not valuation.
Depreciation

Balance Sheet Income Statement


Acquisition Cost
Expense
Cost Allocation

Unused Used

An application of the matching


principle.
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Depreciation

Income
Depreciation
Expense Depreciation for Statement
the current year

Balance
Accumulated
Depreciation Total depreciation to Sheet
date of 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
Allocation of cost
Measuring Recording
Cost Accounting For post Disposals
acquisition expenses.
Issues Related to Long-Lived Assets
Asset Service Potential
Use in business operations
Acquisition Disposal

Book Value
Time
Accounting Issues
Allocation of cost
Measuring Recording
Cost Accounting For post Disposals
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

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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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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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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

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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

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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)

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1
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.

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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 DM Inv.

Used Unfinished
DL WIP WIP Inv.

MOH FG Inv.

Sales
- COGS
Income = Gross Margin
Statement
- S&A Period
Costs
= Net Income
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-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.

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Types of Accounting
Changes
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 These are set


 Estimated Salvage Value
at acquisition

 Pattern of Depreciation

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 Estimated

Depreciation Cost - Salvage Value


=
Expense per Year Useful life in years

Appropriate if an
asset is expected Estimated
to benefit all
periods equally.
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 $50,000 - $5,000
=
Expense Per Year 5 Years

= $9,000
Depreciation Schedule

Depreciation Accumulated Accumulated Undepreciated


Expense 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

Straight-Line Method
$10,000
$9,000
Depreciation
Depreciation
Expense $8,000

Expense is
$7,000
$6,000
$5,000
$4,000
$3,000 reported on the
Income
$2,000
$1,000

Statement.
$0
2001 2002 2003 2004 2005 2006
For the year ended December 31

$60,000

$50,000 $50,000

Book Value is
Book Value

$40,000 $41,000

$32,000

reported on the
$30,000
$23,000
$20,000

Balance Sheet.
$14,000
$10,000
$5,000
$0
2001 2002 2003 2004 2005 2006
As of December 31
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 100 %
=
depreciation rate Useful life in periods

Step 2:
Double-declining- Straight-line
= 2 ×
balance rate depreciation rate
Double-Declining-Balance Method
A Constant Rate

Step 3:
Depreciation Double-declining- Beginning period
= ×
expense balance rate book value

A Declining Balance
Ignores salvage
value.
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 100 %
= = 20%
depreciation rate 5 years

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 Accumulated Undepreciated
Expense 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 Below salvage value

($50,000 – $43,520) × 40% = $2,592


Double-Declining-Balance Method
Depreciation Accumulated Undepreciated
Expense 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 the


latter years to an amount that brings BV to salvage value.
Comparing Depreciation Methods
Straight-Line
$10,000
Depreciation

$8,000
Annual

$6,000

$4,000

$2,000

$0
1 2 3 4 5
Life in Years
Double-Declining-Balance
Depreciation $20,000

$15,000
Annual

$10,000

$5,000

$0
1 2 3 4 5
Life in Years
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

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.

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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

Let’s 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 Salvage Depr. Exp
(in Years) Value 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 Salvage Depr. Exp
(in Years) Value 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?

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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 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?

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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

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Life Salvage Depr. Exp
(in Years) Value 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 Delta
Gross Value Air

Singapore Difference in
Air Depreciation
 Look at Previous Delta Policies

Delta’s
Average
Current Policy
Gross Value

Delta’s Difference in
Previous Depreciation
Policy
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

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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.
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Average Gross Value $8,872
3.5% Inflation x 3.7 Years 12.95%
Increased Value $1,150
Adjusted Gross Value $10,022

Increased Singapore’s
Value Rate

Additional
Depreciation
Delta Vs. Singapore

Savings in depreciation
expense due to more liberal $288
assumptions
Savings in depreciation due to
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older aircraft
Total savings Delta over
$380
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.

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