Question

Airline X depreciates its airplanes over a 15-year period and estimates a salvage value of 10% of the cost of the plane. At the same time, Airline Y depreciates identical airplanes over a 25-year period and estimates a salvage value of 15% of the cost of the plane. As expected, these different assumptions resulted in different operating results. For example, if an airplane costs $10 million, Airline X will depreciate $260,000 more per year for 15 years than Airline Y.

Which company’s estimate of useful life more closely reflects reality?

Will you feel comfortable as a passenger in a 25-year old airplane?

Does the fact that Airline Y subsequently went out of business provide any information as to why its estimates were so substantially different from those of financially sound Airline X?

Answer 1

The airline industry is capital intensive and the accounting for aircraft assets has a significant impact on the financial results of airlines. Aircraft are high-cost,long-life assets and contain many individual components.

For the above reasons the accounting for aircraft acquisition and subsequent depreciation is complex. IAS 16 Property, Plant and Equipment provides clear accounting principles, but the application of these principles to aircraft and aircraft related assets often requires judgement by airlines. Judgements relating to useful economic life and residual value must be revisited each reporting period.

Accounting standards require an asset to be depreciated on a systematic basis over its useful life to its residual value and that the estimates of useful life and residual value are reviewed at least at the end of each annual reporting period. For aircraft these estimates may have a significant impact on the amount of depreciation recognised in the income statement. Each aircraft component should be categorised and depreciated separately using its specific useful life and residual value. This results in a range of useful lives and residual values for different aircraft components.

As per airlines industry , aircraft are depreciated using the straight -line method over their average estimated useful life of 20 years, assuming no residual value for most of the aircraft of the fleet. This useful life can, however, be extended to 25 years for some aircraft.

Therefore , in given case, Airline Y 's estimate is close reflecting reality.

As a passenger , I feel comfortable in a 25 year old airplane unless airplane is running in useful condition and inspection reports about airlines are known for goodwill and good services.

The fact that Airline Y subsequently went out of business does provide information as to why its estimates were so substantially different from those of financially sound Airline X. Airline Y might have considered 25 years as useful life so that yearly amortisation expense reduces and profit can be shown on higher side.