Question

Assume that Delta made extensive repairs on an airplane engine, increasing the fuel efficiency and extending the useful life of the airplane. The existing airplane originally cost $45,000,000, and by the end of last year, it was half depreciated based on use of the straight-line method, a 20-year estimated useful life, and no residual value. During the current year, the following transactions related to the airplane were made:

a. Ordinary repairs and maintenance expenditures for the year, $7,000,000 cash.
b. Extensive and major repairs to the airplane's engine, $2,700,000 cash. These repairs were completed at the end of the current year.
c. Recorded depreciation for the current year.
Required: 1. Applying the policies of Delta, complete the following, indicating the effects for the preceding expenditures for the current year. If there is no effect on an account, write NE on the line.
2. What was the net book value of the aircraft on December 31 of the current year?
3. Explain the effect of depreciation on cash flows.

Answer 1

The expenditures on repair and maintenance would be expensed, while extensive repairs that improve asset efficiency or extend its useful life would be capitalized. The net book value of the airplane must account for the original cost, accumulated depreciation, and added value from capital improvements. Depreciation affects net income but does not entail a direct cash outflow and could lower tax payments.

Step-by-step explanation:

Assuming Delta made extensive repairs on an airplane engine, here are the ledger effects for the current year for each transaction:

1. Ordinary repairs and maintenance expenditures ($7,000,000 cash) would be expensed in the current period with no effect on the airplane's book value. Therefore, cash would decrease, and repair and maintenance expense would increase, but there would be no effect (NE) on the airplane's capital account.
2. Extensive and major repairs to the airplane's engine amounting to $2,700,000 in cash can be capitalized since they increase the asset's efficiency and useful life. Thus, the airplane's asset value on the balance sheet would increase, and cash would decrease by the same amount.
3. Recorded depreciation for the current year will depend on the new useful life, remaining book value, and whether any new residual value is considered post repairs.

The net book value of the airplane on December 31 of the current year depends on the new depreciable base (original cost minus accumulated depreciation plus capital improvements) and any depreciation expense recognized during the year.

Regarding the effect of depreciation on cash flows, it's important to note that depreciation is a non-cash expense. Therefore, while it reduces net income for the period, it does not directly result in an outflow of cash. However, the lower net income resulting from depreciation could lead to lower taxable income, which may reduce cash payments for taxes.