15.

516 Financial Accounting

Session 6 - Depreciation

John Core
MIT Sloan School of Management
Summer 2020
Agenda for today
1. Understand transactions underlying property, plant, and equipment (PPE)
▪ Acquisition
▪ Depreciation
▪ Change in estimate
▪ Sale

2. Delta-Singapore case

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How Do We Record An Acquisition?
▪ If a company purchases a car for $25,000 in cash, what transaction does it record?
Assets Liab S/E
Cash A/R Equip = CC R/E

▪ At the time of the acquisition, the cost of a fixed asset does not enter the income statement.
Why?

▪ When does the cost enter the income statement?

▪ What happens when we sell the asset?

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Accounting for Property, Plant, and Equipment (PPE)
Matching Principle
Capitalization puts costs
Capitalize as an onto the B/S so the firm
Purchase a building asset can match the benefits
of the asset with its
costs.
Calculate
Depreciation

Inventory In a manufacturing firm, costs Period Expense

associated with the manufacturing
process go into inventory.
We will not go over the cost
Cost of Goods Sold accounting process here.

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Accounting for Property, Plant, and Equipment (PPE)
Matching Principle

Purchase a building Capitalize as an

asset

Calculate
Depreciation

Inventory Period Expense

Thus in this class we will illustrate

Cost of Goods Sold depreciation as a period expense

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To account for PPE one must answer the following four
questions
1. What is the acquisition cost?
Amount to be
depreciated
2. How much is the estimated salvage value?

3. What is the expected useful service life?

How the amount is
depreciated
4. What is the depreciation pattern?

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Useful life and salvage value
1. Useful life:
▪ Time period over which asset will be used
▪ Not the same as the physical life of the asset Note that both these
estimates require
2. Salvage value: managerial judgment
▪ Estimate of value at disposal, net of selling costs
▪ Longer useful life typical implies lower salvage value

Example of relation between useful life and salvage value: Two types of car owners:
Sunday driver Drive till it dies
Miles per year 2,000 20,000
Trade-in? Every 2 years no
Useful life 2 years 10-15 years
Salvage value High $0

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GAAP Depreciation Methods
Straight-line Depreciation
▪ Used by overwhelming majority of US firms
▪ Straightforward to calculate
▪ Constant allocation of the cost of an asset from the balance sheet to the income
statement
▪ This is our focus for this part of course

Accelerated Depreciation
▪ Mostly confined to tax reporting – we will talk about this in class on taxes

Aside: How is accounting depreciation related to economic depreciation?

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Calculating Depreciation Expense
▪ The “Straight Line Method” Depreciation expense per year =

(Acquisition Cost – Salvage Value)

Estimated Useful Life

▪ Depreciation is a cost allocation process intended to match the asset costs with the
benefits in each period

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Effects on the Financial Statements
▪ What financial statements are affected by depreciation?
▪ Income Statement? Yes, Depreciation Expense
▪ Balance Sheet? Yes, Accumulated Depreciation
▪ Statement of Cash Flows?
▪ It does not affect cash, but...
▪ there will be an adjustment to income on the Indirect Statement of Cash Flows (as we will
discuss next time in class 4b)

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Overview: Delta / Singapore
You are an analyst following the airline industry and obtained the case information on Delta and
Singapore Air

What are your thoughts on their fixed asset accounting policies? Are there differences?
▪ Delta: longer useful lives, lower salvage values
▪ Singapore: shorter useful lives, higher salvage values
▪ Both airlines change estimates over time

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Key Differences

Delta Singapore Air

Age of Airplane
8.8 5.1
(from text)
Average trip length
969 2,720
(Ex 1 and 5)
a) Which airline subjects their planes to more wear-and-tear per year?

b) For planes of the same age, which airline’s planes should have higher salvage value?

c) How do the two firms’ depreciation expenses differ? Why?

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Depreciation Differences Across Delta and Singapore Air
Delta
1987 1993
Useful life = 10 years Useful life = 15 years Useful life = 20 years
Salvage value = 10% Salvage value = 10% Salvage value = 5%

Singapore Air
1989
Useful life = 8 years Useful life = 10 years
Salvage value = 10% Salvage value = 20%

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Assume Delta has the following transactions
A. On January 1, 1988, the company acquires a new Boeing 747 aircraft in exchange for cash.
The cost is $50 million

B. On January 1, 1994, the salvage value is changed from 10% to 5% (of the acquisition value)
and the useful life is extended by 5 years, from 15 to 20

C. On Jan 1, 2000, the company sells the aircraft for $15 million

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Delta Depreciation 1/1/1988
1. What is the acquisition price?

2. What is the salvage value?

3. How much will be depreciated?

4. What is the useful life of the airplane?

5. What is annual depreciation expense?

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Delta – Depreciation Expense ($ ’000)
Contra-Asset to record reduction in PPE Values

Assets = Liab S/E

Cash PPE – AccDep = R/E
1/1/88
12/31/88
12/31/89 . .
.
. . .
. . .
12/31/93

Note that depreciation does not affect cash. Depreciation allocates expenses to periods
to match the firm’s use of PPE but does not require cash outflows!

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Delta Depreciation Schedule ($ ’000)
Net Book Depreciation
Gross PP&E -Accum Dep
Value Expense
12/31/1988
12/31/1989
12/31/1990
12/31/1991
12/31/1992
12/31/1993

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Delta – Change in Depreciation Policy on 1/1/94
What happens when they change the useful life and/or salvage value?
Changes in useful lives or salvage value are accounted for prospectively. That means we re-
calculate the depreciation rate using the new estimates
Salvage value is changed to:

Useful life is stretched by:

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Delta – Change in Depreciation Policy on 1/1/94
When Delta increased the useful life by 5 years, we need to calculate how much needs to be
depreciated, and divide this by the new useful life
The amount remaining to be depreciated is…

Recall, the remaining useful life is…

Therefore the depreciation expense going forward will be?

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Delta – Depreciation Expense ($ ’000)

Assets = Liab S/E

Cash PPE – AccDep = R/E
1/1/88
12/31/88
. . .
. . .
. . .
12/31/99

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Delta depreciation schedule
Net Book Depreciation
Gross PP&E -Accum Dep
Value Expense
12/31/1988
12/31/1989
12/31/1990
12/31/1991
12/31/1992
12/31/1993
12/31/1994
12/31/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999

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Acc Dep, Net Book Value, Etc…
▪ Accumulated Depreciation at the end of 1999:

▪ Net Book Value of Asset or Net PPE at the end of 1999 =

▪ What happens when they sell the airplane for $15,000?

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Gain or Loss on Disposal of PPE
Procedure for disposal of PPE
1. Record cash or the market value of the asset received for the PPE
2. Record disposal of the asset by removing the cost of the asset from PPE
3. Remove the accumulated depreciation associated with the asset
4. Calculate gain or loss as follows:
Cash – (Cost – AccDep) = Gain/Loss

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Delta – Disposal of the asset
Assets = Liab S/E
Cash PPE – AccDep = R/E
Ending Balance
12/31/1999 50,000 30,643
Sale Entry
1/1/2000

This is the cash effect of transaction Solve for the I/S effect of transaction

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PPE Impairment
▪ Suppose instead that Delta determines that the fair value of the plane is $14,000 (vs. the net
book value of $19,357). What does Delta do?

▪ The fair value is $5,357 less than net book value.

▪ In this case, we must impair or write down the asset.

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PPE Impairment

Assets = Liab S/E

Cash PPE – AccDep= N/P CC R/E
Ending Balance
12/31/1999 50,000 30,643
Impairment entry
1/1/2000
Ending Balance
12/31/2000

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Depreciation and Book Value Differences
Original Delta Singapore Air
Purchase Price: Net Book Depreciation Net Book Depreciation
50,000 Value Expense Value Expense
12/31/1988
12/31/1989
12/31/1990
12/31/1991
12/31/1992
12/31/1993
12/31/1994
12/31/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999

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Singapore Air’s Strategy I
▪ It depreciates its airlines faster!
▪ What does this imply for Dep Exp as a % of all expenses?
Will be higher (check Ex 5)
▪ What about Singapore’s operating margins? (Ex 5 and 1)
Still higher than Delta’s! Why?
▪ Newer, more well-maintained planes
▪ Product differentiation
▪ Better service

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Singapore Air’s Strategy II
▪ What does this imply about
▪ how often does Singapore sell its existing planes?

▪ what are the sale prices are going to be (relative to Delta’s)?

▪ what are the net book values going to be (relative to Delta’s)?

▪ what are the gains on airplane sales going to be (relative to Delta’s)?

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Effects on the Financial Statements
▪ What financial statements are affected by depreciation?
▪ Income Statement? Yes, Depreciation Expense
▪ Balance Sheet? Yes, Accumulated Depreciation
▪ Statement of Cash Flows?
▪ It does not affect cash, but...
▪ there will be an adjustment to income on the Indirect Statement of Cash Flows (as we
will discuss in the class on the cash flow statement)

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Take-Away Slide
Depreciation is a cost allocation process intended to match the asset costs with
the benefits

Depreciation does not necessarily follow economic truth

Depreciation is not a transaction that affects cash!

However, depreciation policy still affects:

▪ Income statement (via depreciation and/or gains/losses)
▪ Balance Sheet (via net book values of assets)

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Next Class
▪ Intangible assets
▪ For prep/review: See Microsoft case in Course Pack
▪ (under “Study.Net Materials”)

▪ For practice on PPE see the mid-chapter review question

(p. 387 text; do straight-line only)

▪ On-line homework:
▪ You can now do problems 9-12

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General Terminology
▪ Cost of Asset: expenditure necessary to ready the asset for intended use, e.g. purchase price,
installation, delivery, training, etc.

▪ Estimated Salvage (Residual) Value: predicted selling price of long-lived asset less any
removal costs at the end of useful life

▪ Depreciable base: Asset Cost - Salvage value

▪ Accumulated depreciation: The cumulative amount of depreciation expense taken over the
asset’s useful life
▪ A contra asset
▪ Typically deducted from historical cost of the asset
▪ Sum of past depreciation

▪ Book value: Asset’s remaining unallocated cost → historical cost less accumulated depreciation

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