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Business strategy using financial statements Depreciation at Delta Air Lines and Singapore Airlines(A) Case Analysis

Learning Objectives:

Learning Objectives How to understand the component of a depreciation policy--cost, life, residual value, and pattern for reporting depreciation How to do the “compare and contrast” when the two airlines adopt significantly different accounting policy for depreciation of aircraft. How to do analysis in the economic context where each airline operates. Doing analysis should link accounting choices to financial reporting and business strategy.

Comparison of Depreciation Expense for Delta and Singapore Airlines:

Comparison of Depreciation Expense for Delta and Singapore Airlines Assumptions Depreciable Life Annual Depreciation for Aircraft Salvage Value for Expense Per \$100 Gross (years) Aircraft(% of cost) Value of Air Craft Singapore Prior to 4/1/89 8 10% \$11.25(a) 4/1/89 to date of case 10 20% \$8.00(b) Delta Prior to 7/1/86 10 10% \$9.00(c) 7/1/86 to 3/31/93 15 10% \$6.00(d) 4/1/93 to date of case 20 5% \$4.75(e) 100*(1-10%)/8 (b) 100*(1-20%)/10 © 100*(1-10%)/10 (d) 100*(1-10%)/15 (e) 100*(1-5%)/20

Comparison of Depreciation Expense for Delta and Singapore Airlines(cont.):

Comparison of Depreciation Expense for Delta and Singapore Airlines(cont.) We can establish a analytic model by calculating the annual depreciation expense for each airline for each \$100 in gross value of aircraft. The annual depreciation expense for Delta and Singapore per \$100 of gross aircraft value ranges from \$4.75 to \$11.25—an enormous range. Applying that to aircraft values of many billions of dollars is obviously going to have a very material impact on companies’ depreciation expense and therefore on their reported earnings.

Useful life analysis:

Useful life analysis Singapore Airline is using very conservative depreciation assumptions compared with Delta liberal assumptions. The average age of aircraft for Singapore is only 5.1 years compared with Delta’s 8.8 years. The useful, depreciable aircraft life for Singapore is only 10 years compared with Delta’s 15-20 years. Singapore’s useful life is less than the average life of a several major American airlines(United airline, Continental and TWA)

Useful life analysis(cont.):

Useful life analysis(cont.) What factors would probably affect the useful, depreciable life of aircraft? The nature of the technology employed. Technologically newer aircraft probably last longer than earlier, technologically less advanced aircraft. According to the exhibit3 and exhibit7, we can see that Singapore has more of the Boeing 747-400,but Delta does n’t have any 747-400s. The specific use that aircraft is given The case indicates that Singapore is a much longer-haul carrier than Delta. The average passenger trip length for Delta is about 900 miles, whereas the average passenger trip length for Singapore is about 2700 miles. Maintenance The better maintained aircraft are, the longer they are likely to last. Due to the existing maintenance standards for aircrafts we can assume that major airlines like Delta and Singapore both have good maintenance programs.

Financial Considerations:

Financial Considerations The recent financial performances of these two airlines are dramatically different. Delta lost \$1.2 billion from 1991 to 1993. Meanwhile Singapore remains profitable in the same period and made \$1.6 billion. We can imagine that Delta want to reduce its reported expenses,if at all possible, while Singapore can afford to take a larger hit from depreciation expense,if just as insurance against a possible downturn in the future.

Financial Considerations(cont.):

Financial Considerations(cont.) How much of a different amount in depreciation expense. The average gross value of Delta’s flight equipment in 1993 (9043+173+8354+173)/2=8872 million Compared to Singapore’s depreciation assumptions, Delta can save about \$288 million a year in depreciation expense. 8827*(0.08-0.0475)=\$288 million Compared to Delta’s own depreciation assumptions prior to April 1, 1993, Delta can save about \$111 million on an annual base. 8872*(0.06-0.0475)=\$111 million We can do a couple of reality checks on this Delta disclosed in its annual report that it reduced depreciation expense by \$34.3 million from April 1,1993. When Delta changed its depreciation assumptions in 1986, it reduced annual depreciation expense by \$130 million.

Singapore’s Strategy:

Singapore’s Strategy Why would Singapore employ depreciation assumptions that are so much more conservative than Delta’s? The answer is that Singapore will get all of the difference in depreciation expense back One way Singapore could get it back is by having much less depreciation expense in the future ; In the book gains on the sale of flight equipment. Exhibit 1 and 5 of the case indicate that Delta’s annual book gain on the sale of flight equipment during 1989-1993 was about \$30 million, whereas Singapore’s average annual book gain on the sale of flight equipment was \$134 million in Singapore dollars, \$74 million in U.S. dollar

Singapore’s Strategy(cont.):

Singapore’s Strategy(cont.) How Singapore’s accounting practice relates to its overall business strategy. Singapore airline is renowned for its customer service and it gets the aircraft’s market price above book value Singapore intends to sell its aircrafts from the very start when they are not so much “used”. Singapore can afford to take a large hit in its depreciation expense because it knows that it can record large gains on their sale Singapore can maintain its differentiation in the marketplace with a regular supply of new aircraft. We can see a likely consequence of this strategy from Singapore airline’s capacity utilization—over 70%.