This article throws light upon the top six factors influencing choice of a depreciation method. The factors are: 1. Nature of Assets 2. Tax Considerations 3. Price Fluctuations 4. Accounting Conventions 5. Obsolescence 6. Management Policy.
Factor # 1. Nature of Assets:
The nature of the asset is of primary consideration in selecting the depreciation method. It will be seen whether the asset depreciates by use or by passage of time, how much amount is required for repairs, whether the asset is costly or cheap?
All these questions are related to the nature of the asset. The life of the asset is also estimated while choosing a depreciation method. Different methods of depreciation are used for different assets.
Factor # 2. Tax Considerations:
The depreciation provides a tax shield. The amount of depreciation is allowed as expenditure by tax authorities, so it will reduce profit and tax burden will similarly be reduced. If a method shows more amount of depreciation, it will reduce taxable profits. Depreciation provides tax-free amount to the business, so the method should be properly selected.
Factor # 3. Price Fluctuations:
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During inflationary situation, the prices of assets will considerably fluctuate. Under such situations depreciation should be based on replacement cost basis rather than on historical cost basis.
Factor # 4. Accounting Conventions:
Some accounting conventions are followed while preparing business accounts. The convention of consistency is followed to make the accounts more comparable in nature. Whatever method is selected, it should be used in future also otherwise profit and loss account will not give a consistent view of business activities.
Factor # 5. Obsolescence:
If the asset is likely to go out of use because of technological changes or a change in fashion or tastes, then the depreciation method should be such that the asset should be written off quickly, otherwise profit and loss account will be burdened with more amounts in the year in which it obsoletes.
Factor # 6. Management Policy:
The thinking of management is very important in selecting a depreciation policy. For the reason of simplicity, management may select straight line method. If the burden of depreciation and repairs are to be divided evenly in all the years then diminishing balance method of depreciation will be preferred. So, management takes a policy decision while selecting a particular method of depreciation.