It may affect you more than you think
Before going any further, please accept my apology for dragging you into a subject that, for the most part, probably does not affect your day-to-day routine. But it does affect you in some manner.
What is this subject to which I am referring? Due to the title, you know that it's depreciation. This article will explain depreciation in general and demonstrate its relevance to you.
What is depreciation?
I will answer this by first posing two questions. Let's assume that you purchase a piece of machinery and plan to own it for 20 years. Is it likely that the machine's physical condition will deteriorate due to use or due to the elements in which it operates? Or will technology advance enough to render the machine obsolete at the end of or during the 20-year period? If the answer to either is yes, then the machine will have experienced depreciation.
While the "using up of the asset" is an expense to the business, understand two other characteristics of depreciation. It is an expense that does not directly affect cash nor does it imply that an organization is reserving cash.
Now that we know more about depreciation and what it represents, how can organizations quantify it or place a value on it?
How do we measure depreciation?
I would like to answer this question in two parts. The first part will examine measuring depreciation in a more general sense, while the second part will examine some of the specific rules that exist in two of the more common applications, tax and financial accounting.
Measuring or calculating depreciation in a general sense involves three ingredients - purchase price of the asset, length of ownership, and estimated asset value at the end of ownership.
Purchase price is what you actually pay for the asset plus any costs incurred to ready the asset for its intended use. For example, an aircraft's purchase price would include not only the price paid for the aircraft, but also the many associated costs such as sales tax, delivery costs, completion work, painting, and installation of optional equipment.
Length of ownership is really straightforward. This ingredient requires you to estimate the length of time that you plan to own and/or operate the asset. Estimating the length of ownership may be difficult on the day of purchase because it represents a guess about the future. What seemed like a sure seven-year ownership on the purchase date may change due to varying conditions. The current economic situation would be an example.
Estimating asset value at the end of ownership may be the ingredient with the least amount of certainty. Look at our current situation in aviation. Who would have predicted five years ago that aircraft market values would be what they are today? You should base an asset's residual value on the best available information at the time and recognize the value for what it really is, an estimate.
The three ingredients mix together to calculate the depreciable cost of the asset as follows.
(Purchase Price - Residual Value) / Length of Ownership = Depreciable Cost
Seems easy enough, if only our discussion could end here. Unfortunately, it can't. What we've calculated up to this point is the total amount of depreciation that we will take over the period of ownership. What we haven't determined is what portion of the total will be assigned to each year of ownership. Your organization has several choices.
Straight-line (See chart #1) and declining balance (accelerated) depreciation (See chart #2) are two of the most common. An example will illustrate each method. Let's assume that we purchased a $5,000,000 aircraft, plan to own it for five years, and estimate the resale value at $2,000,000.
Each method will generate the same amount of depreciation over the five-year period. However, the declining balance method recognizes or accelerates the amount of depreciation taken in the earlier years when compared to the straight-line method. Interestingly, due to the significant resale value, we have taken all of our depreciable cost when using the declining balance method by the end of the second year.
This difference in the timing of depreciation leads us to the second part about calculating depreciation, the part that begins to have more relevance for you in the maintenance department. Unfortunately, this second part also adds confusion to how organizations recognize depreciation. But remember, regardless of when depreciation is recognized the fundamental ingredients remain consistent.
Depreciation for tax purposes. Without realizing it, if you have been involved in discussions about depreciation, chances are pretty good that it involved depreciation for tax purposes. In the United States our legislative process, through the Internal Revenue Code and its related regulations, uses depreciation as a tool to affect the economy. Since the early 1980s, the government has used depreciation to stimulate the economy by allowing businesses to recognize depreciation in an accelerated manner. (Have you ever heard the term Modified Accelerated Cost Recover System (MACRS)?) More specifically, but without boring you with the actual regulations, businesses
- Start with the full purchase price.
- Must depreciate the aircraft in five or seven years depending upon how the aircraft is classified and use accelerated percentages in the earlier years.
- Can fully depreciate the aircraft by not having to recognize a resale value at the end of the depreciation period.
Using our earlier example, (See chart #3) the table shows the depreciation schedule for the aircraft, which we will assume is classified as a five-year asset. Notice that total depreciation equals the $5,000,000 and that by the end of two years 52 percent of the total asset value has been depreciated. Remember, depreciation for tax purposes is aggressive.
Actually, we have had a recent example (within the last year) of how the government has used depreciation as a tool to affect the economy. Initially, in an effort to stimulate our current sagging economy, Congress passed a bonus depreciation that would allow businesses to accelerate the recognition of depreciation in the first year by an additional 30 percent above the MACRS' rate. Additionally, legislation passed in May apparently allows businesses to recognize an additional bonus percentage in the first year of use.
How do MACRS and the recently passed bonus programs stimulate the economy? Remember, depreciation is an expense. Expenses reduce revenues. Less revenue means less tax. And if a business realizes all of its depreciation in five or seven years, what is the business likely to do? Sell the original aircraft and buy another one, so the business will have continued depreciation. This activity of purchasing aircraft, in turn, stimulates the economy. At least that's the theory.
Depreciation for financial accounting purposes. If the primary objective of depreciation for taxes is to have an effect on the economy, then the objective for financial accounting has a totally different objective. Less known or discussed than tax depreciation, financial accounting relies upon several principles as mandated by its governing body. One of those principles is matching. As it relates to revenues and expenses, the objective is to associate expenses with the revenues that they help create. With depreciation, then, the objective is to match the depreciable cost of the asset with the corresponding revenue. If the organization estimates that it will own an asset for 15 years and produce revenue with the asset during that time then the organization needs to spread the corresponding depreciation expense, using the three ingredients, over 15 years.
The organization has some flexibility as to how it will spread the depreciation expense over the useful life. As we saw earlier, the organization can use the straight-line method or the accelerated method. There are several acceptable methods. The governing body asks that the organization remain consistent (another principle) with the method chosen.
Recognizing depreciation cost for financial accounting reasons makes more sense than for tax reasons if you are trying to accurately capture the financial events of your organization. However, it is important to remember that each has different underlying objectives that will influence the timing of the expense.
How could depreciation affect the manager in the maintenance organization?
Up to this point you're probably wondering how does all of this relate to you in your position in the aviation or maintenance department. In your day-to-day tasks, it probably doesn't that much. But the application of depreciation expense could affect the perception by others about how much it costs to operate your aircraft. Let's use an example.
Let's assume that as the manager of your organization you have a pretty good idea of what it will cost to operate the new $5,000,000 aircraft that your company purchased and plans to own for 15 years. You have done your homework and know what your fuel costs, maintenance costs, reserve amounts for future major maintenance items, and other related costs will be. You estimate that the cost of operation will be about $400 per hour. You estimate that the average flying hours per year will be about 400.
After six months, you're beginning to wonder why more folks aren't using the aircraft. Flight hours are not where they should be. Then you talk with someone that had indicated they would be using your services but you noticed had not done so. You find out that the charge back rate to their department is $3,300 per hour. After picking yourself up off the floor you decide to do a little checking.
You certainly knew that the rate would not remain at $400 per hour due to the addition of certain overhead rates but you estimated that to be around another $400 per hour. Even with that allowance, you are still far short of the $3,300 charge back rate. To get an answer to explain the large discrepancy, you turn to the accounting department.
The accounting department is assigning depreciation based upon the equivalent of the tax method, an accelerated method. Referring to our earlier table, the first year of tax depreciation would equal to $1,000,000 or $2,500 per flight hour assuming 400 hours per year. If the department had used depreciation based upon the financial accounting straight-line method, the depreciation expense would have been more reasonable, $500 per flight hour.
(Purchase Price $5 mil. - Est. resale value $2 mil) / Est. years of ownership 15 = $200,000 annual depreciation / Est. annual flight hours 400 = $500 per flight hour.
The accounting department was making a decision based upon an accounting perspective. Your operation has a totally different perspective. The reason your organization purchased the aircraft was to use it, not to have it sit on the ramp.
The intent of this article is not to make you an expert about a subject that does not affect you on a daily basis. My intent was to make you aware of how something as obscure and seemingly unrelated to your aviation or maintenance organization can affect you. As a manager, it is your responsibility to make yourself as aware of costs like depreciation as possible. Depreciation is a silent expense. It does not affect cash flow but it can affect the perception of your organization.
Brandon Battles is a partner with Conklin & de Decker. He has spent more than 15 years in aviation working with maintenance organizations in the areas of cost collection and analysis, systems review, inventory analysis, and management training.