The Significance of Depreciation - Example

Abstract The report which analyzes the manner in which depreciation is treated in Aviator and Eagle aircraft carriers shows similarity as well as differences. Both the organization uses straight line method of depreciation but there exist differences with regard to the residual value and estimated life of an assets. This thereby increases the risk for the business as comparison of the financials becomes difficult because of the different treatment which has been provided to depreciation. To ensure better comparability it is important that the differences between the methods of depreciation are removed and same method is used. Further, the depreciation method used by Qantas Airways is the same where they have followed a straight line method and requires that changes need to be done so that better international comparison becomes possible. The report also shows the significance of depreciation and requires the use of financial ratios so that better comparison can be achieved and will thereby help to ensure that maximum productivity is ensured. This will ensure better comparison and will help to bring the required transformation in preparing financial statements. Table of Contents Introduction 3 Depreciation policy of Aviator & Eagle 3 Financial Calculation of depreciation for Aviator & Eagle 5 Review of another national aircraft company 6 Significance of depreciation policies on the financial statement 7 Conclusion 9 References 10 Introduction Depreciation is an important aspect for organization as it helps the organization to make arrangement for the required funds which can be used when the asset becomes obsolete. Since, depreciation involves the transfer of money it is imperative that it is prepared according to the accounting standards so that correct information can be provided in the financial statement. This report compares the depreciation policy being used by Aviator and Eagle which performs in the airline sector. This is followed by calculating the depreciation for both the organization and comparing the same with another aircraft company of another nation. The report then dwells on the significance of depreciation on the financial statement and financial ratios and helps to understand the importance and value which it attaches. This thereby helps to understand the different aspect of depreciation and helps to develop policies through which better use of accounting standards becomes possible. Depreciation policy of Aviator & Eagle Comparing the depreciation method for both Aviator and Eagle shows that both of them uses a straight line method of depreciation where depreciation is charged on the cost of the assets less any residual value divided by the estimated life of the assets. Using a straight line method is a preferable method of depreciating as the Australian Accounting Standard prefers a straight line method of depreciation to be used in case of plant, machinery and equipment (AASB, 2013). Both the organization have further ensured that the residual value is determined each year because of the fact that airlines undergo heavy wear and tear which can result in a sudden decrease in the residual life of the assets. This thereby requires that the residual value and the life of the asset are accounted each year and retrospective effect for the change in depreciation is made for all the past years. No information regarding the retrospective effect has been provided for both the organization. Using a method of calculating the residual value and estimated life each year ensures better estimation of the depreciation that has to be incurred and helps to make necessary arrangements for the funds in case the asset becomes obsolete (Asset Management, 2013). A contrasting difference is seen while looking at the different head under which the aircrafts, spares and engines are accounted by both the organization. Aviator looks to account it under the head “Property, plant and equipment” which according to the Australian Accounting Standard falls under the purview of the straight line method of depreciation. Eagle on the other hand accounts it under the head fixed category named “Aircraft, spares and spare engines”. This increases the complexity for the users as accounting the same under different head makes it difficult to compare the financial ratios and will require more integrated and deeper look to be able to bring the required transformation in the comparison of the financial statement (Asset Management, 2013). A further look at the estimated life for both Eagle and Aviator shows discrepancies in the estimated life being chosen by both the organization. Aviator which accounts for domestic destinations having smaller hauls; compared to Eagle which accounts for longer destination flights having fewer hauls have ascertained the same estimated life for their aircrafts. This is incorrect as smaller duration flights undergo more wear and tear compared to long flights as small duration flights have to land and fly continuously, the number of passengers carried it high which will thereby result in higher depreciation and wear and tear. This requires that the estimated life for Eagle should be more compared to Aviator. Using the same estimated life of 15 to 20 years results in over estimating the depreciation for Eagle. This has thereby made the financials to be incorrect as the organization has reduced their profits then it should actually be as depreciation is treated as a charge against income. The policy has thereby resulted in the aircraft being considered obsolete even before it becomes resulting in a conservative policy being adopted and highlighting differences in the estimation of the useful life of the assets. Thus, there exist some differences in the manner in which depreciation is being accounted by both Aviator and Eagle aircraft carriers. Different treatment with regard to residual value and estimated life gas created differences in depreciation making it difficult for the users to compare the same on the same platform. Financial Calculation of depreciation for Aviator & Eagle Calculation of Depreciation for Aviator Cost = 13389.9 million Residual Value = 20% = 20% of 13389.9 = 2677.98 Remaining Value of Total Aircraft & Engine = 13389.9 – 2677.98 = 10711.92 Estimated Life = 18 years Depreciation Value = 10711.92/ 18 = 595.107 million Calculation of Depreciation for Aircraft Spare Parts Cost = 750.7 million Residual Value = 20% = 20% of 750.7 = 150.14 Remaining Value of Total Aircraft spare parts = 750.7 – 150.14 = 600.56 Estimated Life = 18 years Depreciation Value = 600.56/ 18 = 33.364 million Calculation of Depreciation for Eagle Calculation of Depreciation for Eagle for Total Aircraft & Engine Cost = 17718.1 million Residual Value = 12% = 12% of 17718.1 = 2126.172 Remaining Value of Total Aircraft & Engine = 17718.1 – 2126.172 = 15591.928 Estimated Life = 15 years Depreciation Value = 15591.928/ 15 = 1039.462 million Calculation of Depreciation for Aircraft Spare Parts Cost = 1306.1 million Residual Value = 12% = 12% of 1306.1 = 156.732 Remaining Value of Total Aircraft spare parts = 1306.1 – 156.732 = 1149.368 Estimated Life = 15 years Depreciation Value = 1149.368/ 15 = 76.625 million To ensure comparability between the financial statements of both the company it is important that both the organization follow the same method of depreciation. These will that both the organization have the same residual percentage and estimated life of assets. This will ensure that the financials can be compared as it will look towards evaluating the performance of both the organization similarly. This will help to remove the differences which exist due to difference in depreciation method and will provide a common platform and background based on which the performance can be compared. Review of another national aircraft company Reviewing the depreciation policy which is being used by Qantas Airlines which operates in Australia has also looked towards the same method of depreciation which is straight line method for depreciating its assets. Qantas works on the same model as the provided airlines like Eagle and Aviator aircraft carrier which looks towards providing services to its customers. Qantas has also looked towards depreciating its assets i.e. aircrafts, spares and others over a period of 10 years and is done on a straight line basis. The organization financial statement shows that instead of engaging in retrospective effect a conservative approach is developed which aims towards depreciating the asset over a period of 10 years. Despite, having an approach where the asset is depreciated in 10 years Qantas Airlines is facing difficulties with regard to other international players. It is seen that Singapore Airlines aims at depreciating its aircraft over a period of 3 years. This has been matched by the increasing complexities faced in different regions like India, China, Singapore to name a few where old airlines are not allowed to fly (Tarry, 2010). This has increased and multiplied the difficulties for Qantas and requires ramification in the depreciation policy which will allow the airline to be depreciated over a period of 5 years. Presently, Qantas is operating under the Australian Accounting Standard which allows aircraft operators to depreciate their aircrafts and others asset over a period of 10 years. Qantas has worked on the same line but the multiplying difficulties and complexities which is being faced in the other parts of the world has multiplied the level of difficulties and requires a change in the accounting standard which will allow the asset to be depreciated over 5 years or less. The case which deals with Eagle and Aviator on the other hand uses a mechanism of 10 to 15 years to depreciate their aircraft which is as per the Australian Accounting Standards as well (Qantas, 2012). Using the process of straight line method which is preferred in the Australian Accounting Standard has provided the opportunity through which Qantas has been able to depreciate its assets correctly and have ensured a correct mechanism for determining the estimated life and residual value of the asset. Significance of depreciation policies on the financial statement Depreciation holds important significance with regard to the preparation of financial ratios and financial statement. Since, depreciation is treated as a charge against income and is shown in the profit and loss statement an incorrect estimation could lead towards either an increase or decrease in the final profits. This will thereby make the financial statement incomplete as it will reflect the errors which should not be accounted for. It is increasingly being witnessed that organizations to reduce their profits over estimate their depreciation so that the overall profits for the business can be reduced. This is done with the purpose of saving on taxes and undermining the profits also ensures that the organization has an opportunity to manipulate the finances. The problem compounds in case different organization uses different depreciation policy. For example in the case Eagle and Aviator has adopted a straight line method of depreciation which provides the flexibility to compare the financials of both company directly. In case one of the organizations within the same industry uses another method of depreciation then the problem increases as the financial statement cannot be directly compared as different depreciation policies would mean different accounting treatment with regard to the financial figures and will thereby multiply the difficulties to compare the financial statement directly. To deal with the issues especially within the same organization it is important that financial ratios are calculated. This helps to reduce the gap which is present and financial ratios tend to convert the entire financials into percentage terms. This will thereby ensure that the same platform is provided to both the organization which will ensure easy comparison. Instead organizations using the same depreciation method also look to compare the financial performance based on ratios because it helps to understand the financial statement better. It helps to remove the differences which financial figures might otherwise highlight. Using reducing value method of depreciation would ensure that the depreciation is high at the initial years but slowly it reduces whereas straight line method of depreciation ensures the same depreciation every year. This multiplies the difficulties in comparing as it could lead towards over statement of a financial figure for one company and understatement of the financial figures for another company. The differences can be reduced to a certain extent by ensuring that financial ratios are used so that it helps to reflect the actual financial position. Thus, deprecation has an important implication for the financials of the organization and requires development of a process which will ensure flexibility by looking to find out a mechanism through which the differences can be reduced. This will require the use of ratios and developing a mechanism through which comparison between firms will be facilitated and a process will be developed which will be aimed towards ensuring comparability between the financials of the organization. Conclusion The report thereby shows the manner in which depreciation policies have been implemented by Eagle and Aviator airlines carrier. Both the organization has used the straight line method of depreciation and has ensured that the policies get reflected in their financial statement. Further a look at the depreciation policy for Qantas Airlines shows that the financials get reflected using a process of straight line method. Further, the policy of depreciation shows that a process of different method of depreciation thereby results in difference in financials which thereby results in creating differences between the financial figures and requires the use of financial ratios so that the difference can be reduced and will facilitate comparison and ensure that the financial figures ensures better comparison. References AASB. 2013. Depreciation in accordance with Australian Accounting Standard. Retrieved on August 5, 2013 from http://www.dhs.vic.gov.au/facs/bdb/fmu/service-agreement/3.-terms-and-conditions/3.7-assets/3.7.6-depreciation-in-accordance-with-australian-accounting-standards Asset Management. 2013. AASB Standard for Asset Management. . Retrieved on August 5, 2013 from http://www.anao.gov.au/bpg_assets2010/HTML/4_9_AASB_Standards_for_asset_management.html Depreciation. 2013. Depreciation of Assets. Retrieved on August 5, 2013 from http://www.ofs.mq.edu.au/asset_management/depreciation.htm Tarry, C. 2010. Market Outlook: Feeling Under Depreciated. Retrieved on August 5, 2013 from http://www.flightglobal.com/news/articles/market-outlook-feeling-under-depreciated-339816/ Qantas. 2012. Better Depreciation Rates will help Qantas Compete. Retrieved on August 5, 2013 from http://www.aipa.org.au/mediaroom/2012/689-accelerated-depreciation-rates-needed-to-help-level-playing-field-for-australian-aviation Read More