Now You See It

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1. How does a company decide on the method of depreciation and why? How does the method chosen impact net income? Cash flow?

According to AS 6 in the Indian Accounting Standards, “The management of a business selects the most appropriate method(s) based on various important factors e.g., (i) type of asset, (ii) the nature of the use of such asset and (iii) circumstances prevailing in the business. A combination of more than one method is sometimes used” (p. 104).

In relation to changes in depreciation methods, AS 6 also states “A change from one method of providing depreciation to another is made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When such a change in the method of depreciation is made, depreciation is recalculated in accordance with the new method from the date of the asset coming into use” (p 104-105). Jet Airways didn’t meet the first criteria, and the second criteria is very subjective.

Using double declining depreciation will result in a higher initial depreciation expense which will lead to lower tax expense. The inverse is true for straight line, where the initial depreciation expense is lower, but consistent across all periods. This will result in a higher tax expense in early years, but that expense will remain constant through the life of the asset. The choice of method has no impact to actual cash flow. Depreciation is simply an allocation of an asset’s initial costs across its useful life.

2. Evaluate the alternative depreciation policy adopted by the company, as for 35,000 invested, useful life of 3 years, residual value of 5,000.

Using straight line depreciation, the annual depreciation expense will be $10,000 per year for each of the three years of the asset’s useful life. Using...