The Aircraft Depreciation Dilemma

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Market depreciation typically accounts around 30% of total costs, and can reach upto 60% of total operational costs. With depreciation defined as an implicit cost measure of decline in value of a particular asset over periods of its lifespan, it is ever so relevant to the aviation industry; namely aircraft assets (diverse catalysts), currency, and capital stock having coexisting impacts on the bottom line of aviation supply chain businesses. Despite being a science in its very own right, this article piece will tap into how different businesses across the chain handle depreciation of assets (especially aircraft), contextualized to a macroeconomic industry-wide understanding. This will allow a new spectrum and understanding of conversation, coexistence and joint-operations between one supply entity and another.

Depreciation is charged to the profit and loss account in order to reflect consumption of investment in assets over the period. Tax Depreciation is the government’s procedure for expensing, or “writing off” the change in an asset’s value over time. Tax depreciation is an artificial depreciation based on law, not the market’s treatment of the asset. Book Depreciation is the term commonly used to refer to the depreciation expense shown on a company’s financial statement (or the “books”). Book Depreciation is tied into legal and accounting principles. Residual value is the amount an entity could receive for the asset of age and condition it will be in when disposed of (without inflation). Two significant accounting estimates management uptakes to estimate depreciation rates are useful lives and residual values of assets (namely aircraft). Useful life is the period over which an asset is expected to be available for use by an entity. Businesses periodically review whether useful lives are appropriately set, and subsequent alterations are displayed also as an implicit cost.

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Market Depreciation is a widely changing variable based on the value of the asset in the marketplace. Until the asset is sold, no one really knows the exact market value of the asset. Once an asset is sold, the difference between what the assets was purchased for and the eventual selling price is referred to as Market Depreciation. Aircraft, unlike automobiles and other equipment, tend to retain more of their value for a longer period of time. Timing is a big factor. The economic markets are in constant flux. Four trends as follows:

  • Aircraft values hold their own or even increase with strong economic conditions.
  • In an economic downturn, aircraft prices call fall as quickly as the stock market.
  • As a general rule, aircraft prices tend to follow the larger business cycles. When businesses are growing and profitable, demand for aircraft increases.
  • As demand increases, the available supply will decrease, and then used prices will rise. When the business cycle declines, the reverse is true.
  • Inflation helps market depreciation due to the inflated value of money helping retain aircraft value.
  • The rule of thumb for depreciation is 4-6% per annum.

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Factors associated to depreciation include:

  • economic repair lives (dictated by manufacturer and valuers in demand for parts, maintenance requirements)
  • fleet deployment plans (rigorous use dictates higher cycles, wear and tear, higher MRO requirements, lower useful life and hence needs higher depreciation)
  • technological change (new technology and presence in the market quickens replacement requirements)
  • overall development of aircraft asset portfolio
  • aircraft related fixed-asset depreciation
  • Legal constraints.

Depreciation methods by the book include straight line (seldom the case but most often used) and diminishing (reducing-balance) method. While straight line is simply original amount minus residual value all over asset life. The reducing balance takes into account accelerated (or decelerated) rates of depreciation over time contingent on the differences between net book values over the period.

For airlines, the best way to go about facilitating greater profit margins is to depreciate the aircraft, and accumulate tax credits and breaks. The current methodology for aircraft in the US, in fact for all manufactured capital assets used in business today, go back to the days of the Reagan Administration and the Economic Recovery Act of 1984. The law effectively eliminated the old 10% Investment Tax Credit (some of you may still remember those days) as well as the old longer term depreciation, with a new, more attractive shorter recovery period, referred to as the Modified Asset Cost Recovery System (MACRS). Generally speaking, the interpretation was and still is that aircraft owned and operated pursuant to FAR Part 91 choose the five year schedule while those aircraft operated under FAR Part 135 and commercially operated aircraft utilized the not quite as attractive, seven year methodology. And by the way, the schedules are not linear. The five year schedule, as an example, does not recover at 20% per year. Instead, the code is set for the following methodology:

  • Year One – 20%
  • Year Two – 32%
  • Year Three – 20%
  • Year Four – 52%
  • Year Five – 52 %
  • Year Six – 5.76%

As we all know, depreciation under the current tax code is a tax “deduction” for the benefit of the entity who has placed the asset into service, assuming they are a current tax payer. This is beginning to roll out across the globe to sustainably manage domestic industries and facilitate tax cost minimization. The US also sports The American Taxpayer Relief Act of 2012 extended the 50% bonus depreciation allowance through the end of 2013 for qualifying property, which may allow 50% of the cost of the aircraft to be deductible in the first year of purchase ( a credit rather than an actual sped devaluation in assets). Singapore on the other hand, has liberal rules and tax breaks on aircraft, of which is classified under machinery and plants depreciation rates rules governing leniency for both credits and quickened depreciation of aircraft facilitating shorter useful life. New Zealand regulatory bodies also allow for as little as 5 years till an aircraft can be fully depreciated with respective tax credits. Many airlines to date, utilize depreciation capability to sustain lower tax costs from taxable income demonstrated.

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In Australia, the Australian and International Pilots Association has called once again for depreciation rates on new aircraft to be accelerated to bring Australia into line with jurisdictions in which foreign competitor airlines operate. AIPA President Captain Barry Jackson states the concern of stringent depreciation regulations to protect government revenue streams over the competition competency of Australian airlines, as follows:

“Qantas pilots have been pushing for accelerated depreciation rates as part of a package of measures to redress the imbalance in the international airline investment environment for two years. We have conducted this push without the support of Qantas management, however I was glad to see Corporate Affairs Spokeswoman Olivia Wirth making a similar call in today’s press. It currently takes 10 years for Australian airlines to write-off a new aircraft. While a reduction to a five-year write-off would at least match the rate available to Air New Zealand, it would fall short of matching the investment environment of the major international airlines flooding our market. For example, Singapore Airlines can depreciate its aircraft over three years. Accelerating our local depreciation rate would help Qantas – and indeed all other Australian international airlines – to compete against advantaged foreign competitors. After opening our skies to foreign airlines Australia should not make it even more difficult for our international airlines to compete through uncompetitive taxation arrangements. We need to think of the impact on Australia’s national interest if we allow this nation to become a mere stop-over in an air transport system provided entirely from overseas. When Qantas CEO Alan Joyce grounded the fleet last year the effect was devastating. One shudders to think about a situation down the track when such a decision might be made by a CEO offshore without any redress in Australian courts”.

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While book depreciation is crucial, airlines are required to preserve their aircraft efficiently through means of operational rationalization, balancing in-house and outsourced works, and whether to lease or purchase (with portfolio facilitations for buy-leaseback for high equity low-prospective carriers). Environmental inputs of the replacement market (both through lease/purchase market), finance capability, regulatory structures, profitability, cost-management involvement, maintenance needs and fleet requirements drive the write-downs of aircraft too.

Other airlines looking into the secondary and used market (typically cash and ownership oriented airlines, or periods of high interest rates), look to maximize book and agglomerated depreciation of previous owners to leverage lower acquisition costs (even for ownership of new mature late-delivery aircraft). This achieves the greater objective of taking advantage of lower capital costs for used planes and reaping a longer commercial lifespan for those aircraft with its in-house maintenance crews.

An example is where Richard Anderson (CEO of Delta Airlines) mentioned an “aircraft bubble” and oversupply, excess competition, and cannibalization of aircraft within seating/payload brackets.“The aircraft market is going to be ripe for Delta over the course of the next 12 to 36 months. Prices are going to get lower. A 9- or 10-year-old 777 on the market is for as little as $10 million. Dozens of such wide-bodies coming off lease or retiring soon”. Delta later signed a Letter of Intent for a 10 year old 777-200 priced at $7.7M USD (or 2.95% of list price, amounting to 28% depreciation per year with discounts). This particularly relates to the 777-200 and 777-200ER aircraft argued to have a current market value of $10M USD, thanks to used 777s coming onto the market (Malaysia Airlines, Transaero, Kenya Airways and Singapore Airlines 777s), abundance/scale of A330-300s, and new replacement aircraft programs such as the A350-900, 787-9 and A330-900.

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Meanwhile, both FedEx and UPS top up new 767 orders (old air-frame optimized for cargo) from Boeing to replace their even older DC-10, MD-11, A300 and A310 fleets (with approximately 10% lover unit operating costs than the DC-10). This is thanks to cash-orientation, maximization of current supply chain maturity in the market, and full control of operations without strings pulled by lessors/financiers.

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The leasing market has been especially active recently, with an influx of capital and investors becoming increasing drawn to this lucrative sector. Lessors have a similar demand by the book, and ensure that the aircraft are not physically depreciated as from the book. Preservation to reduce overhaul maintenance requirements, and extend life-span of the aircraft are predominantly done through supply-agreements (maintenance, services, discounting, delivery-flexibility, options-flexibility, cancellation-capability and guarantees independently negotiated) and demand-agreements (operations outline, operational parameters, oversight-capability, de-risk implementations, offsetting costs, rigorous price-negotiations and guarantees with customers).Given the ludicrous competition in the leasing market, lessors are often forced to (similar but to greater extent for lessors) disproportionately depreciate and fluctuate rates in which stock is written down. Typical leasing prices is 1/100th of aircraft value per month, and strive to ensure balance is made between the market value and base value for any type of aircraft (transferable niche facilitation and development-investment/trajectory)

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For manufacturers, depreciation of their produced aircraft reflects on a frame’s ability to remain financially efficient in the marketplace. The rate of depletion in current market value dictates the requirement of an airframes producer to refresh and re-strategize the aircraft. Correlations between the current market value and base value market correlations distinguish the trajectory of aircraft values. Adjustments to the market value given inputs must be recognized by an airframe manufacturer, with competitive/environmental inputs and current business state defining capability to refresh an aircraft model. Value retention factors manufacturers target for is:

  • A sizable order backlog to adjust manufacturing operations gradually, and dictate aircraft productions and adjustments/phase-outs.
  • Improve market penetration through various means. This includes manufacturers outsourcing works and services to tap better in the respective markets (Tianjin, USA etc.), tender for emerging economies and growth centres, liberalization of manufacturing works operations, improve diplomatic ties and trade facilitations, and general marketing.
  • Increasing the product life-cycle of an air frame. This can be done by utilizing the versatility of an aircraft to tap into versatile aircraft requirements for operators. An airframe examples include the A330 Regional (using parts availability, depreciation rates and operator-trends to allow an aircraft for high-density short/medium-haul services, and high wear/tear). Meanwhile for engines, power-plant manufacturers facilitate for paper de-rates, performance improvement packages, discounting of stock, and maintenance guarantees (complementary service provisions).
  • Flexibility from surplus and shortage inputs of an aircraft type. This is done through managing troughs and crests in aircraft demand, recognizing macroeconomic inputs, and rationalizing outputs from the business.
  • Affiliations and relationships between manufacturers and customers are crucial for retainment even after the sale, as a way for a manufacturer to manage the second-hand and lease markets. Recognizing behaviors customers undertake can allow appropriation of responses to aircraft requirements. This is seen in alignment of understandings, parameters the aircrafts operate within, demand and supply rationalization, and even as far as joint operations.
  • Closely linked to above, accommodating for financing requirements, competitive environments and operator-needs is crucial to retain the value and flexibly allow aircraft valuations. This includes re-engines, re-winging, and pax-freighter conversions.
  • Understand when a program ends, and facilitate replacement and retirements.
  • And of course, improving the aircraft specs, economics and technology incrementally on the air-frame, while also accommodating diversification and minimizing cannibalization of a manufacturer’s product line.
  • Consolidation industry-wide of customers (lessors and airlines especially) improve negotiation and discounting power of demand, hence hinder the manufacturer’s capability to retain value of aircraft, hence resulting in pushed-higher list prices.

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