Depreciation expense is the way that the use of an asset is matched with the revenue that is generated from the asset on the income statement during the time period being reported. Each asset used in a business has a useful life as disclosed by the company’s depreciation policies for each category of asset. The other piece of calculating depreciation is the assumed salvage or “residual” value. There are several different methods of depreciating an asset:
Delta and Singapore both use “straight-line” but they assume different salvage values for their fleet as well as different useful life assumptions. This case study will evaluate the differences in their rates of depreciation and the impact on their operating income and profitability before and after they changed their methodology and depreciation assumptions in their policy.
Calculate the annual depreciation expenses that Delta and Singapore would record for each $100 gross value of aircraft.
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? Both Delta and Singapore airlines use the same straight-line depreciation method to account for their depreciation expense. However, the assumptions they use for the depreciation lives and salvage values are different. Oftentimes companies prefer to use different salvage values and depreciation lives when recording their depreciation expense because of the policies of their airlines or due to managerial decision-making.
Singapore prefers to pay less in taxes so they can decrease their profit by recording their depreciation expense within a short period. They benefit from following this policy, especially since their net profit is sufficient. Since there are no explicit or mandatory rules governing the treatment of depreciation, each company can decide which method they prefer for their company. Therefore, different treatment is proper as long as they follow the policy in place by their company.
Assuming the average value of flight equipment that Delta had in 1993, how much of a difference do the depreciation assumptions it dopted on April 1, 1993 make? How much more or less will its annual depreciation expense be compared to what it would be were it using Singapore’s depreciation assumption? By changing their rules for depreciation on April 1, 1993, Delta began to record $4. 75 per year instead of the $6 per year depreciation expense they used to record per $100 of gross aircraft value. That results in a 21% decrease in their depreciation expense. Had Delta been using Singapore’s depreciation assumptions, the depreciation expense would have increased from the $6 per year to $8 per year of depreciation expense per $100 gross aircraft value.
That would result in a 33% increase in their depreciation expense from $679 million to $905 million or $226 million more in expenses for 1993.
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? Singapore maintains one of the youngest average fleet ages in the industry at 5. 1 years old. They were depreciating their aircraft over 8 years with a salvage value of 10% up until 1989 and then increased it to 10 years and 20% salvage value.
The average depreciation rate per $100 for Singapore Airlines was $11. 25 prior to this change and $8. 00 after, compared with Delta’s $6. 00. The company is majority-owned by the Singapore government, but did not receive any subsidy from the government. Its stock is, however, followed by over 20 investment analysts worldwide. In 1993, their net profit dropped from $922 to $741 million in Singapore dollars as depreciation expense as a percent of total operating expenses had grown from 14. 8% to 15. 8% in one year. Staff bonuses were cut from 3. 4 months of pay to . 5 months of pay in one year.
The other issue that that was hurting their profitability was that their strategy was not in line with their utilization rate of only 71. 3%, down from 78. 9% in 1989. They should have been focusing on the amount of depreciation they were paying expensing as a percent of operating expense much sooner. With profits and utilization rates declining constantly over the last five years, a focus on the depreciation methods could have helped them reduce the decline in net profits. With an aggressive capital expansion program of $2 billion per year, they needed to figure out a way to increase net income and cash flow to fund these strategic plans.
In order to reduce expenses and increase net income they needed to make a change in the way they were depreciating their fleet. If they continue to purchase new aircraft, they needed to come up with a new depreciation method or incur higher depreciation expenses as they bring on newer planes that will add more to the depreciation base of the current fleet.
Does the difference in the average age of Delta’s and Singapore’s aircraft fleets have an impact on the amount of depreciation expense that they record? If so, how much?
The average age of Delta’s aircraft in 1993 was 8. 8 years, which was fairly young by industry standards, but Singapore’s average age was even younger at only 5. 1 years. Using the formula for the depreciation cost per $100 formulaof gross value, the age does not come into play in the calculation of total depreciation since the formula includes the useful life and salvage value to calculate the rate of depreciation. The amount of depreciation left for each fleet would be impacted depending on how many of the older planes haves been fully depreciated, but not the average amount per year.
Changing the assumptions in their corporate depreciation policy can have a significant impact on the net income of the company. For any company, whether it is in the airline industry or manufacturing industry, managing earnings is very important to the shareholders and also to the management team and other employees who are on bonus plans. A significant increase in assets can raise the depreciation expense in any one year enough to reduce the net income from the previous year to a net loss the next year.