Depreciation: Airplanes and Garbage Trucks
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Your answers to the questions below should be clear, well-written, free of grammar and spelling errors, double-spaced with margins of at least one inch on all sides, and word-processed. In preparing this assignment, you may discuss the issues with each other or with anyone else, but your written answers must be your own work. If you need to quote someone else in your answer, you must give credit to your source. This assignment is due at the beginning of class on February 13, and should be printed and submitted in hard copy in class. No late papers will be accepted. If you cannot be in class on February 13, you may email your paper to [email protected] before the start of class on February 13. The assignment must be included as an attachment to the email in a single file in either Word or .pdf format. Please include your name on the first page of the assignment, and name the file with your name and the name of the assignment (example: John Smith Airplanes assignment.docx). We will discuss the assignment in class on the 12th. It would be a good idea to bring a second copy of your paper to have with you during the class discussion.
Part I: Airplanes Attached are excerpts taken from the 2004 annual reports of Northwest Airlines, Delta Airlines and United Airlines. Assume that on January 1, 2005, each of the three airlines purchases a new Boeing 757 for $75 million. Each airline estimates that the residual value will be 5% of cost. Each airline uses the average depreciation period that is consistent with its policies as stated in the Appendix, found on page 3. On January 1, 2009, each firm sells the plane. First, assume that Northwest sells its plane for $55 million, Delta sells its plane for $60 million, and United sells its plane for $65 million (Sale Price I). Second, assume each firm sells its plane for $60 million (Sale Price II). 1) Complete the following table. Report the dollar amounts in millions, rounded to thousands (i.e., $60 million as $60.000). Northwest Delta Book Value January 1, 2005 Residual Depreciable amount Useful life Annual Depreciation Accumulated Depreciation at December 31, 2008 Book Value at December 31, 2008 Sale Price I Gain (Loss) on Sale I Sale Price II Gain (Loss) on Sale II United
2) Why would these three companies depreciate the same equipment using different useful lives? Describe at least two possible explanations. 3) Which set of sale prices (I or II) do you think is more realistic? Why?
Part II: Garbage Trucks Read the Securities Exchange Commission (SEC) complaint against Waste Management, Inc. at http://www.sec.gov/litigation/complaints/complr17435.htm, especially paragraphs 1-19, 30-81, and 344-357, and the announcement of the settlement with Arthur Andersen LLP at http://www.sec.gov/news/headlines/andersenfraud.htm. These SEC materials will tell you about the terms of Andersen’s settlement with the SEC, but they do not tell you what happened next. To learn that, you should look at news articles from the spring of 2002. Two of them that might help are: “Waste Management Executives Are Named in S.E.C. Accusation”, New York Times, March 27, 2002: http://www.nytimes.com/2002/03/27/business/waste-management-executives-are-named-insec-accusation.html
1) Summarize the charges against Waste Management in your own words. 2) How did management use depreciation expense to manage earnings? 3) Why do you think the managers of Waste Management wanted to manage earnings? 4) What was Arthur Andersen’s role in the Waste Management case? What were the terms of its settlement with the SEC? Did Andersen abide by the terms of the settlement? 5) Suppose you were working in the accounting department at Waste Management in 1996. You receive instructions to extend the useful lives of certain assets. What ethical dilemma would you face? What information would you want to gather to help you evaluate the situation?
Part III: Overall Analysis Some accounting systems require all firms to use the same depreciation policies for similar assets. For example, every firm owning a Boeing 757 would depreciate it over the same period. Do you think GAAP should include such a requirement for financial statements? Why or why not? Regardless of your position, your answer should include a description of the advantages and disadvantages of the proposal.
Appendix: Depreciation policies
Below are excerpts taken from the 2004 annual reports of Delta Airlines, United Airlines and Northwest Airlines: Delta Airlines Long-Lived Assets We record our property and equipment at cost and depreciate or amortize these assets on a straight-line basis to their estimated residual values over their respective estimated useful lives. Residual values for flight equipment range from 5%-40% of cost. We also capitalize certain internal and external costs incurred to develop internal-use software; these assets are included in ground property and equipment, net on our Consolidated Balance Sheets. The estimated useful lives for major asset classifications are as follows: Estimated Useful Life 15-25 years Lease Term 3-10 years
Asset Classification Owned flight equipment Flight and ground equipment under capital lease Ground property and equipment
United Airlines f) Operating Property and Equipment Depreciation and amortization of owned depreciable assets is based on the straight-line method over the assets’ estimated service lives. Leasehold improvements are amortized over the remaining period of the lease or the estimated service life of the related asset, whichever is less. Aircraft are depreciated to estimated salvage values, generally over lives of 25 to 30 years; buildings are depreciated over lives of 25 to 45 years; and other property and equipment are depreciated over lives of 3 to 15 years. Northwest Airlines Property, Equipment and Depreciation: Owned property and equipment are stated at cost.