Let us make in-depth study of the three alternatives for selecting method of depreciation.
Selection of method of depreciation is an important point because choice of method plays a vital role on the net income reported by any business enterprise. Selection of method of depreciation depends upon the type and shape of the enterprise, nature of the asset and objective of the management.
1. Type and Shape of the Enterprise:
Written down value method allows more depreciation in the initial years and straight line method allows a uniform amount of depreciation throughout the entire life of the asset. It is well known that expenses in respect of repairs and maintenance are less required in the initial years and more amounts is required in the later years.
Under written down value method, total burden on profit and loss account is almost the same throughout the life of the asset because in the initial years when repair and maintenance cost is less, the enterprise charges more depreciation on the asset. On the other hand, when repair and maintenance cost is high in later years, the enterprise charges less amount of depreciation.
Actually, the enterprise that is using written down method for computing its net profit is doing the business more conservatively, because under this method, a higher amount of depreciation is charged in the initial periods.
So by charging a larger amount of depreciation in the initial year, business enterprise can gather a larger amount of depreciation and eventually the amount gets utilised at the time of replacement of asset. The enterprise in which cost of maintenance and repairs of assets are high in the later years, as compared to the initial years, written down value method can be adopted.
2. Nature of Asset:
Where the estimated useful life of an asset can be easily determined and the assets which give almost equal utility in terms of productivity during their useful life, straight line method can be adopted like Trademark, Copyright etc. Similarly, where the maintenance and repair cost of the assets is almost the same during the useful life of the asset like Furniture etc., straight line method can be used.
3. Objective of the Management:
Management is directly responsible for formulation of policies and decision making, so goal of the enterprise must be kept in mind while selecting methods of depreciation. It is well known that public limited companies raise funds through public by issuing shares or debentures. At the time of raising funds, it is necessary to show good picture of the operational efficiency of the business enterprise. Straight line method reports higher profits than the profits reported by using written down value method. To attract the public, higher profits are to be shown so straight line method can be used.
It is worth mentioning that as per requirement of the enterprise, management can use any of the methods for recording depreciation, however, for income tax purpose only written down value method is allowable.
It is also not necessary that the same method is to be followed in the enterprise during the entire life of the asset. An enterprise can switch over to a different method at any point of time. AS-6 (Revised) also facilitates the change in the method, but retrospectively, i.e., from the back date.