Case study - fixed assets

Property, plant and equipment (P, P&E) is a significant asset category for most airlines. P, P&E often constitutes over half of the total assets of an airline, and depreciation of these assets is a substantial operating expense. The depreciation methods and estimates used to determine the amount of this expense can vary widely from company to company. Moreover, the methods and estimates adopted can have a significant impact on a company’s reported earnings. Hence, the reader of financial statements needs to sift through the ‘notes to the accounts’ in order to properly analyse the company’s financial performance and position and to draw meaningful inter-firm comparisons. This case will look at the depreciation practices of two major airlines — British Airways (BA) and Singapore Airlines (SIA) — in 1997/98.

British Airways (BA)

BA’s fixed assets totalled £8,667 million net book value in 1998. The largest part of this (£7,227million) consisted of aircraft (‘fleet’ using the company’s terminology). The average age of BA’s aircraft was more than 10 years, significantly more than that of SIA (see below). There was, however, no necessary connection between the average age of an airline’s fleet and the assumption it made regarding the fleet’s depreciable life.

See Appendix A for extracts from the company’s Report and Accounts 1997–98.

Singapore Airlines (SIA)

SIA’s fixed assets totalled S$11,398million net book value in 1998. The largest part of this (S$10,124.6million) consisted of aircraft. The company continues to invest heavily in new aircraft and this is reflected in the fact that the average age of SIA’s aircraft was just 5 years and 2 months, considerably less than BA’s and the industry average. See Appendix B for extracts from the company’s Annual Report 1997/98.

Requirements
Read the case, including the appendices, and any necessary readings and then answer the following in not more than 1,000 words:

1 If both airlines were to acquire £100 million worth of new passenger aircraft, how much would the annual depreciation expense be for these aircraft? (Calculate the figure for SIA in S$ as well as £s) (4 marks)

2 Identify the major differences in the way the two airlines account for depreciation expense for their aircraft (methods, asset lives, residual values, etc.). Are these differences significant? (you may refer to answer to question 1 for supporting evidence) Give reasons why the two companies depreciate their aircraft using different depreciable lives and salvage (residual) values. Do these differences present any problems when reading the accounts of the different companies? (10 marks)

3 How much more or less will SIA’s annual depreciation expense for aircraft be compared to what it would be if it were using BA’s depreciation assumptions? (4 marks)

4 SIA maintains depreciation assumptions for its aircraft that are very different from BA’s. What is the impact on profit before tax and NBVs of fixed assets by doing so? (6 marks)

5 Does the difference in the average age of BA’s and SIA’s aircraft fleets have any impact on the amount of depreciation expense that they record? (4 marks)

6 Both BA and SIA capitalise borrowing costs incurred on loans taken out to finance the purchase/construction of aircraft and freehold properties. What are the arguments for and against this practice? Is this practice allowed under existing accounting rules in Singapore? How does this affect the annual depreciation expense, profit before tax, and asset values of current and future periods? How much more or less will BA’s annual depreciation expense, profit before tax and NBVs of fixed assets be compared to what it would be if they did not capitalise borrowing costs (ignore the issue of interest capitalised in previous periods)? (10 marks)

7 BA revalues some of its fleet and all of its freehold properties while SIA does not. What are the arguments for and against this practice? How does this affect the annual depreciation expense, profit before tax, and NBVs of fixed assets for current and future periods? How much more or less will BA’s annual depreciation expense, profit before tax, and asset values be compared to what they would be if it were using SIA’s policy of not revaluing its fleet and properties? (8 marks)

8 Both companies do not depreciate freehold land. Can you suggest valid reasons for this policy of non-depreciation of land? What effect does this have on annual depreciation expense, profit before tax, and assets values? (4 marks)
(Total – 50 marks)

Please note that all calculations will inevitably involve making estimates since there is incomplete information; exact figures are not possible to calculate. State any assumptions (especially simplifying assumptions) that you make when making your estimations.

Approximate exchange rate: £1 = S$2.75 (where £ = pound sterling and S$ = Singapore dollar.

Accounting policy note (excerpt)
Tangible fixed assets
Tangible fixed assets are stated at cost or valuation as stated below. Depreciation is calculated to write off the cost or valuation, less estimated residual value, on the straight line basis.

(a) Capitalisation of interest on progress payments
Interest attributed to progress payments made on account of aircraft and other assets under construction is capitalised and added to the cost of the asset concerned ... (In 1998 BA capitalised, and included as part of the cost of its aircraft and properties, interest amounting to £44 million and £17million respectively.)

(b) Fleet
(i) Cost or valuation
All aircraft are stated at cost, net of manufacturer’s credits, with the exception of a small number that are stated at March 31, 1988 valuations, with subsequent expenditure stated at cost. The Concorde fleet remains at nil book value. Aircraft not in current use are included at estimated net realisable value...

(ii) Depreciation
Fleet assets owned, or held on finance leases or hire purchase arrangements, are depreciated at rates calculated to write down the cost or valuation to the estimated residual value at the end of the planned operational lives (residual values average 25% of original cost). Cabin interiors, including those required for brand changes and re-launches, are depreciated over the lower of five years and the remaining life of the aircraft at the date of such modification. Residual values and operational lives are reviewed annually.

(c) Property and equipment
Freehold properties and certain leasehold properties professionally valued at March 31, 1995 are included in these accounts on the basis of that valuation. Subsequent additions are included at cost. Provision is made for the depreciation of all property and equipment, apart from freehold land, based upon expected useful lives and, in the case of leasehold properties, over the duration of the leases if shorter.

(d) Leased and hire purchased assets
Where assets are financed through finance leases or hire purchase arrangements, under which substantially all the risks and rewards of ownership are transferred to the Group, the assets are treated as if they had been purchased outright…

Aircraft and engine overhaul expenditure
Aircraft and engine spares acquired on the introduction or expansion of a fleet are carried as tangible fixed assets and generally depreciated in line with the fleet to which they relate. Replacement spares and all other costs relating to the maintenance and overhaul of aircraft and engines are charged to the profit and loss account on consumption and as incurred respectively.

Fixed asset note (excerpt)

Fleets are generally depreciated over periods ranging from 16 to 27 years after making allowance for estimated residual values. (The effective average period of depreciation is 20 years.)

Property, apart from freehold land, is depreciated over its expected useful life subject to a maximum of 50 years. Equipment is depreciated over periods ranging from three to 20 years, according to the type of equipment.

Extracts from SIA’s Annual Report 1997/98

Accounting policy note (excerpt)

(e) Depreciation of fixed assets
Fixed assets are depreciated on a straight line basis at rates which are calculated to write down their estimated residual values at the end of their operational lives. Operational lives and residual values are reviewed annually in the light of experience and changing circumstances.

Aircraft fleet
The Group depreciates its new passenger aircraft, spares and spare engines over 10 years to 20% residual values. For leased aircraft where ownership is not transferred to the Group at the end of the lease period, nil residual values are used.

For used passenger aircraft less than 5 years old, the Group depreciates them over the remaining life (10 years less age of aircraft) to 20% residual values. In the case of used aircraft more than 5 years old, they are depreciated over 5 years to 20% residual values.

The Company depreciates its new freighter aircraft over 15 years to 20% residual values. For used freighter aircraft, they are depreciated over 6 years to 20% residual values. (Taking all aircraft together, the average period over which aircraft are depreciated is 10 years.)

Land and buildings
Buildings on freehold land and leasehold land and buildings are amortised to nil residual values as follows – Company owned according to lease period or 30 office premises – years whichever is the shorter.

Company owned according to lease period or 10 household premises – years whichever is the shorter.

Leased premises – according to lease period or 10 years whichever is the shorter.

Flight training equipment
Flight simulators and training aircraft are depreciated over 10 years to nil residual values, and 5 years to 20% residual values respectively.

Other fixed assets
These are depreciated over 1 to 7 years to nil residual values.

Fully depreciated assets are retained in the accounts until they are no longer in use. No depreciation is charged after assets are depreciated to their residual values.

(f) Leased assets
Where assets are financed by lease agreements that give rights approximating to ownership (finance leases), the assets are treated as if they had been purchased outright…

(g) Loan interest
Interest attributed to progress payments made on account of aircraft and other assets under construction is capitalised and added to the cost of the asset concerned. No interest was capitalised during the year.

Sources/references

SIA’s Annual Report 1997/98 at www.singaporeair.com (please note that the financial information contained on this site is highly complex — the excerpts included in the appendices are simplified extracts of material contained on this site).

ICPAS, (Institute of Certified Public Accountants of Singapore), Statements of Accounting Standard (Singapore), Nos 1, 14 and 19.

Ng Eng Juan, Statements of Accounting Standard (Singapore), Longman, 2nd Edition.

Answer

1 Annual depreciation expense for BA assuming same depreciation policy as existing aircraft depreciable life of 20 years (as per average for existing fleet) and residual value of 25% (as per average for existing fleet):

Residual value = £100 million x 25% = £25 million
Depreciable amount = £75 million
Annual depreciation expense = £75 million/20 years = £3.75 million

Annual depreciation expense for BA assuming same depreciation policy as existing aircraft, depreciable life of 10 years (as per ‘new’ passenger aircraft) and residual value of 20% (as per ‘new’ passenger aircraft):

Residual value = £100 million x 20% = S$20 million
Depreciable amount = £80 million
Annual depreciation expense = £80 million/10 years = £ 8 million
This equals, £8 million x 2.75 = S$22 million

2 A comparison of the ways that the two companies account for depreciation for their new passenger aircraft can be made using a table as follows:

As one can see the major differences are in the estimated useful lives of the aircraft and the residual values. In question 1 it can be seen that these differences can result in considerably different annual depreciation expense figures for the same aircraft. The purchase of £100 million of new assets resulted in £3.75 million depreciation expense for BA, compared to £8 million for SIA. This would have a significant impact on reported profits and asset values in the balance sheet.

There are several possible reasons for the difference in the policies, the three main ones being:

1 Different management intentions — the two airlines may differ in how much they intend using the aircraft (how many miles per year, no. of days per year in use, etc.) and how long they intend using them for (operational lives). SIA have a policy of renewing its fleet more often than others resulting in shorter operational lives. This explains, and justifies, the shorter depreciable asset life. On the other hand BA appears to hold onto and use its aircraft over a longer period — Concorde has been in service for some 30 years and is now fully depreciated.

2 Use of estimates — residual values and asset lives are estimates based on prevailing circumstances, present management intentions, past experience, and foresight. For this reason no two companies will make identical estimates though they do revise them in the light of new information and changing circumstances.

3 Application of accounting concepts — SIA may be more prudent in its estimation of residual values and asset lives than BA. It may base its estimates on a ‘worst case’ scenario, whereas BA takes a ‘middle of the road’ approach. One will note that BA assumes that it will hold onto its aircraft for longer and yet realise a larger residual value. Clearly BA are less prudent than SIA in this respect.

These differences do create problems for readers, especially those seeking to appraise the relative financial performance and position of the companies concerned. The accounting concept violated is that of consistency, a quality that is vital for making meaningful inter-firm comparisons. One can see from question 1 that different depreciation assumptions can lead to different depreciation expense figures for identical assets. In turn, profit and asset values will be affected making inter-firm comparisons difficult without some form of standardisation (for example, applying BA’s policies to SIA’s accounts and making the necessary adjustments to depreciation expense, profit and asset values).

3 SIA’s annual depreciation expense for aircraft would almost certainly be less were it to use BA’s depreciation assumptions, owing to BA’s longer asset lives and higher residual values (see question 1 and 2). The question as to how much less is difficult to answer with any degree of accuracy and requires us to make some simplifying assumptions in the drawing of estimates.

From question 1 we can see that for the same aircraft SIA’s annual depreciation expense is more than twice (£8 million divided by £3.75 million) that of BA. Put another way SIA’s expense would have been about 47% of amount actually reported had it adopted BA’s depreciation assumptions. So applying this factor to the total depreciation expense for aircraft (which includes freighters and old aircraft, but for this case assumed immaterial) reported in 1998 would give:

47% x S$922.8 million = S$433.7million
This is some S$489.1 million less than it actually charged in its 1998 accounts.

4 Following on from question 3 one can see that SIA would have reported a much lower annual depreciation expense (S$433.7 million verses S$922.8 million) had it used BA’s depreciation assumptions. Hence its profit before tax would have been S$1660.9 million (S$1,171.8 million as reported plus S$489.1million reduced depreciation), some 42% more than actually reported. This calculation ignores the effect that different depreciation assumptions and expenses would have on profits/losses on disposal of aircraft.

NBVs would also be significantly affected, though the actual effect is even more difficult to quantify since the effect of different depreciation assumptions would be cumulative. To simplify matters it is assumed that accumulated depreciation would be 47% of amount actually reported had it adopted BA’s depreciation assumptions. This gives a revised accumulated depreciation figure of S$2,728.6million (47% of S$5805.5m) and hence NBV of S$13,201.5million (original cost of S$15,930.1million less revised accumulated depreciation of S$2,728.6 million). This is 30.4% more than actually reported.

It is also worth noting that SIA will perhaps report larger profits on asset disposal than BA, owing to its assets being carried at lower NBVs (profit on disposal = proceeds – NBV). BA’s lower depreciation charges may be offset by larger maintenance costs owing to its fleet being older than SIA’s.

Though the impact of using BA’s depreciation assumptions is difficult to quantify, one can unambiguously conclude that SIA’s 1998 profits and NBVs would have been much higher than what was actually recorded.

5 BA’s fleet is significantly older than SIA’s owing to the latter’s policy of renewing its fleet at more regular intervals than BA. Furthermore, BA continues to use its Concorde fleet which were brought into service nearly 30 years ago, and which have been fully depreciated.

The age does have an effect on the depreciation expense since older aircraft, assuming carried at cost as opposed to valuation, will be recorded in the accounts based on prices ruling many years ago. That is the cost of old aircraft will be much less than that of new aircraft. Therefore the depreciation expense, being a percentage of cost, will be lower for old aircraft. Moreover, very old aircraft (like Concorde) may be fully depreciated and so their continued use does not bring with it depreciation charges.

6 Whether the interest cost incurred during the construction period (sometimes known as borrowing costs) should be capitalised as part of the cost of the fixed asset (in this case aircraft and property) is highly controversial and is described in Ng’s book as follows;

“The proponents of the view that interest cost . . . should be capitalised argue that capitalisation results in greater degree of comparability between the costs of purchased fixed assets (the price of which would have included interest cost incurred by the seller) and the costs of self-constructed assets. The opposing view is that capitalising the interest costs is necessarily arbitrary and therefore reduces comparability of financial statements”.

Another justification is that of enabling a better matching of revenues and expenses since the depreciation charge will include an element of interest cost.

SAS19 (Revised) allows both immediate write off as expense method (the ‘benchmark’ treatment) and capitalisation method (the ‘allowed alternative treatment’). SAS19 only permits capitalisation of those borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset (defined as an asset that necessarily takes a substantial amount of time to be readied for its intended use or sale). SIA’s policy appears to be in compliance with this provision since the assets in question are aircraft and property which by definition take some time to construct and get ready for use.

However, SIA must also adhere to the requirement that only those interest costs incurred on borrowed funds during the period of construction (ceasing when substantially all work has been completed). This appears to be the case. It should be noted that in 1998 no interest costs have been capitalised, presumably since no amounts qualify for capitalisation.

The impact of capitalisation of borrowing costs on the current period is to reduce interest charged in the profit and loss account which will in turn cause profits to increase. Capitalisation will also result in a higher carrying amount for the fixed assets concerned. In the future the higher carrying amount for fixed assets will result in higher depreciation charges and in turn lower profits.

In 1998 BA capitalised interest of £44 million as part of aircraft and £17 million as part of properties. It is clear that had they expensed this interest to the profit and loss account instead then profits would have been reduced by £61million to £519million. The NBV of fleet and properties will similarly be reduced by £44 million and £17 million respectively to £7,183 million and £1,164million. Depreciation for the current period will not be affected. However, the lower carrying amounts for fixed assets will translate into lower depreciation charges in future periods and may ultimately result in higher profits on disposal (since profit = proceeds less NBV).

7 SAS 14 permits the revaluation of all fixed assets, though in practice in Singapore one only finds land, building, and plant and equipment revalued. The main justification, or argument in favour of incorporating revaluations into the accounts is that the information produced is considered more relevant for decision-making purposes. Assets carried at cost, especially assets held for many years, will be recorded at amounts that bear no relation to the value to the business of these assets today. This is largely due to the effect of inflation.

Unfortunately the use of revaluations can impair the comparability and reliability of the accounts. Comparability (inter-period and inter-firm) can be adversely affected owing to the inconsistent application of revaluation accounting. For example, many companies only revalue selected categories, some companies do not revalue at all, others revalue at different time intervals or using different bases. Reliability is impaired since revaluations are generally based on the estimates of experts and not on the basis of an actual transaction.

Assuming that most revaluations result in higher carrying amounts for the fixed assets concerned (as with BA) one can see that the annual depreciation expense will be higher, thereby resulting in lower reported profits. On the plus side the company will report higher NBVs for its fixed assets, so increasing net assets and shareholders’ funds.

If BA were to adopt SIA’s policy of not revaluing its fleet and properties then the effect would be to reduce NBVs of fixed assets which would cause depreciation charges to reduce and profits to rise. The question as to how much is difficult to establish but some crude estimates can be made using the fixed asset note in Appendix A. One can see that the NBV of those assets that have been revalued amounts to £659million, compared to £363 million had they been carried at cost. So if BA switched to a non-revaluation policy the NBV of its fixed assets would fall by £296million.

Lower NBVs will feed through to lower depreciation charges (since depreciation is based on NBVs which will be lower than before). Quantification of the effect is difficult owing to lack of disclosure (property lives?), but assuming both asset categories have a 20 year life the effect will be to reduce depreciation, and so increase profits, by £14.8million (£296million divided by 20).

8 The primary justification for the non-depreciation of land is that land does not wear out in the same way as all other assets do and for this reason it does not have a finite life span and its usefulness does not erode with age. Furthermore, over time its value increases (largely due to inflation) and land requires little or no cost of maintenance. SAS14 and the Companies Act permits the non-depreciation of land held as fixed assets.

The effect of non-depreciation is to unequivocally lower the depreciation expense which will filter through to higher reported profits. At the same time NBVs of land and buildings will be higher than if land was to be depreciated on account of accumulated depreciation being less.

Please award marks for other valid points made and other appropriate ways of deriving the estimates.