It seems obvious that firms' choices of accounting policies will affect managers' decision-making. But somehow when...

  

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It seems obvious that firms' choices of accounting policies will affect managers' decision-making. But somehow when accounting choices are being considered, the financial reporting implications of the choices seem to dominate. This case was written to force students to consider the decision-making implications of one seemingly important accounting policy choice decision. The example is of aircraft depreciation accounting for airlines. This example was chosen because property, plant and equipment (PP&E) comprises more than 50% of the total assets of an airline, and aircraft are a large proportion of the PP&E. Further, airlines depreciation policies vary significantly. What are the effects of this accounting policy choice on managerial decisions? More rapid depreciation causes higher expense on the income statement but reduces aircraft book values on the balance sheet more quickly. But, interestingly, the reality does not change at all! In the United States, there are no tax effects and no cash flow effects, and the economic value of the company does not change. Academic studies have shown that the stock market is very good at seeing through fully disclosed differences such as these. Some people get confused about this issue because they do not realize that in the books US firms keep for tax purposes firms will depreciate their aircraft as quickly as possible, assuming that the company is profitable. The case tries to make this clear, in item #5 in the list of "other facts". In some other countries the allowed disparities between the financial reporting and tax books of record are not as significant. While there are no direct effects of this accounting policy choice on real firm value, value can be affected because managers' decisions can be affected. Managers do make decisions based on accounting numbers. One of the clearest behavioral implications of depreciation accounting policies is in the replacement-of-aircraft decision. Managers in firms that depreciate aircraft slowly tend to be slow to replace their aircraft because they have to absorb the write-off of the remaining book value. This is a known empirical regularity. For example, Singapore Airlines and Lufthansa have quite young fleets (e.g., Lufthansa average age is 3.9 years), while companies such as AMR and Delta have fleets over twice as old. Similarly, more rapid depreciation will yield higher full costs in cost analyses and can affect pricing decisions and route/line of business analyses. Management evaluations, on the other hand, should not be affected because whatever depreciation policies are chosen are built into the budgets that are the primary performance standard. In theory, management decision-making should be improved if the accounting records reflect the economic reality. We know, for example, that the early US railroad companies did not depreciate their fixed assets. As a consequence, the railroads overstated their income and assets, and the railroad managers were misled by their own financial statements. Ultimately about 50% of the track put in place before 1900 was placed in receivership. But what is the "real" economic depreciation of aircraft? The reality will vary somewhat with the type of plane and the aircraft's usage. In general, airframes depreciate based on the number of cycles-takeoffs and landings-to which they are subjected. The engines depreciate based on the number of hours of usage. In theory, maintenance could affect aircraft's real economic depreciation, but there is not much variation in airlines' maintenance procedures. The procedures are largely determined by law. Because used aircraft prices decline very slowly, the economic depreciation is likely to be much slower than any policy any airline currently uses. So all airlines' aircraft depreciation policies are conservative, at least, in relatively good economic times. Some are more conservative than others. What is the management decision-making implication of this conservatism? It seems obvious that firms' choices of accounting policies will affect managers' decision-making. But somehow when accounting choices are being considered, the financial reporting implications of the choices seem to dominate. This case was written to force students to consider the decision-making implications of one seemingly important accounting policy choice decision. The example is of aircraft depreciation accounting for airlines. This example was chosen because property, plant and equipment (PP&E) comprises more than 50% of the total assets of an airline, and aircraft are a large proportion of the PP&E. Further, airlines depreciation policies vary significantly. What are the effects of this accounting policy choice on managerial decisions? More rapid depreciation causes higher expense on the income statement but reduces aircraft book values on the balance sheet more quickly. But, interestingly, the reality does not change at all! In the United States, there are no tax effects and no cash flow effects, and the economic value of the company does not change. Academic studies have shown that the stock market is very good at seeing through fully disclosed differences such as these. Some people get confused about this issue because they do not realize that in the books US firms keep for tax purposes firms will depreciate their aircraft as quickly as possible, assuming that the company is profitable. The case tries to make this clear, in item #5 in the list of "other facts". In some other countries the allowed disparities between the financial reporting and tax books of record are not as significant. While there are no direct effects of this accounting policy choice on real firm value, value can be affected because managers' decisions can be affected. Managers do make decisions based on accounting numbers. One of the clearest behavioral implications of depreciation accounting policies is in the replacement-of-aircraft decision. Managers in firms that depreciate aircraft slowly tend to be slow to replace their aircraft because they have to absorb the write-off of the remaining book value. This is a known empirical regularity. For example, Singapore Airlines and Lufthansa have quite young fleets (e.g., Lufthansa average age is 3.9 years), while companies such as AMR and Delta have fleets over twice as old. Similarly, more rapid depreciation will yield higher full costs in cost analyses and can affect pricing decisions and route/line of business analyses. Management evaluations, on the other hand, should not be affected because whatever depreciation policies are chosen are built into the budgets that are the primary performance standard. In theory, management decision-making should be improved if the accounting records reflect the economic reality. We know, for example, that the early US railroad companies did not depreciate their fixed assets. As a consequence, the railroads overstated their income and assets, and the railroad managers were misled by their own financial statements. Ultimately about 50% of the track put in place before 1900 was placed in receivership. But what is the "real" economic depreciation of aircraft? The reality will vary somewhat with the type of plane and the aircraft's usage. In general, airframes depreciate based on the number of cycles-takeoffs and landings-to which they are subjected. The engines depreciate based on the number of hours of usage. In theory, maintenance could affect aircraft's real economic depreciation, but there is not much variation in airlines' maintenance procedures. The procedures are largely determined by law. Because used aircraft prices decline very slowly, the economic depreciation is likely to be much slower than any policy any airline currently uses. So all airlines' aircraft depreciation policies are conservative, at least, in relatively good economic times. Some are more conservative than others. What is the management decision-making implication of this conservatism?

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ANSWER Decisionmaking is an integral part of modern management Essentially rational or sound decisio... View the full answer