Question

What factors would a company consider when choosing to use Straight-line or an accelerated (Double-declining balance for example) method of depreciation?

Answer 1

The purpose of depreciation is to give a rough estimate of an asset's current value and to spread its cost over the useful lifespan of the asset. There are three general categories of depreciation:-

• Straight line depreciation spreads the cost evenly over a number of years.
• Accelerated depreciation writes off a greater portion of the cost in early years and a smaller portion in later years.
• Units of production depreciation writes off an asset as it is actually used.

The characteristics of the straight line method is that the depreciation expense is constant so the valuation of the company is easier as you know how to adjust it if necessary.

The common method of accelerated depreciation is called the double declining balance (DDB) method. This is where the depreciation expense doubles the straight line depreciation expense of the first year. The same percentage is then applied to the non depreciated amount in the subsequent years.

The following factors influence the selection of a depreciation method:-

1. Legal Provisions: The statute governing an enterprise may the basis for computation of depreciation. In India, in the case of company, the Companies Act, 1956, provides that the provision of depreciation, unless permission to the contrary is obtained from the central government, should either be based on reducing balance method at the rate specified in the Income-Tax Act/Rules or on the corresponding straight-line depreciation rates which would write off 95 per cent of the original cost over the specified period. For tax purposes, the asset should be written off as quickly as possible.

2. Financial Reporting: The goal in financial reporting for long-life assets is to seek a statement of income that realistically measures the expiration of those assets. The only difficulty is that no one knows, in any satisfactory sense, just what portion of the service potential of a long- life asset expires in any one period. All that can be said is that financial statements should report depreciation charges based on reasonable estimates of assets’ expiration so that the goal of fair presentation can more nearly be achieved.

3. Effect on Managerial Decision: The suitability of a depreciation method should not be argued only on the basis of correct portrayal of the objective facts but should also be decided in terms of their various managerial effects. Depreciation and its financing effect take the less basic but still realistic approach that, regardless of any effect which depreciation may have upon the total revenue stream, the recognition of depreciation either through the cost of product or as an element in administration and marketing expenses, does cut down the showing of net income available for dividends, and thus, restricts the outflow of cash. A depreciation method which matches the asset costs distributed period by period against the revenues produced by the asset, thus helping management to make correct judgment regarding operating efficiency, would be a good method.

4. Inflation: Depreciation is a process to account for decline in the value of assets and for this many methods such as straight line, different accelerated methods are available. In recent years, inflation has been a major consideration in selecting a method of depreciation. The problem created by inflation in depreciation accounting has contributed in the emergence of the concept of inflation accounting. In inflation accounting, an attempt is made to increase the depreciation amount in line with inflation so that enough money to replace the asset at its current inflated cost can be accumulated.

5. Technology: Depreciation is vital because it decides the regenerating capacity of industry and enables enterprises to set aside an amount before submitting profits to taxation, for replacing machines. Realistically, the depreciation that enterprises are eligible for and capable of accumulating should cover the purchase price of assets, when the time comes for replacement. Commercial life of machine is decided by technological progress. The arrival of new machines is not governed by the depreciation policies of government. Therefore, the shorter the period over which the enterprise is able to recover depreciation, the better its chances to adapt to the new technology and survive.

6. Capital Maintenance: During inflation, depreciation, if based on historic cost of assets, helps a business firm to gather an amount equivalent to the historical cost of the asset less its salvage value. This treatment of depreciation facilities in maintaining only the ‘money capital’ or financial capital of business enterprises. However, this results into matching between historic amount of depreciation and sales in current Rupees. However, if depreciation is provided on replacement or current value of assets, it gives matching between current cost (depreciation) and current revenues. Depreciation on current value of assets provides real operating income in the profit and loss account. This means that capital of business enterprise would be maintained in real terms.