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Two most popular methods of charging depreciation are:
1. Straight line method
2. Diminishing balance or written-down value method
For reporting to the shareholders, companies could charge depreciation either on the straight-line or the written-down value basis. However, no choice of depreciation method and rates for the tax purpose is available to companies.
Depreciation is allowed as deduction every year on the written-down value basis in respect of fixed assets as per the rates prescribed in the income tax rules. Depreciation is computed on the written down value of the block assets. Block assets means a group of assets falling within a class of assets, being building, machinery, plant or furniture, in respect of which some percentage of depreciation is prescribed. Ocean-going ships are also included in the block of assets. For example, plant and machines has been divided into three blocks with three rates of depreciation: 25%, 50% and 100%. Most of the plants and machines are covered in the 25% depreciation block. No depreciation is allowed on land.
Depreciation base
In the case of block assets, the written down value is calculated as follows:
• The aggregate of the written down value of all assets in the block at the beginning of then year
• Plus the actual cost of any asset in the block acquired during the year
• Minus the proceeds from the sale of any asset in the block during the year (provides such reduction does not exceed the written down value of the block arrived in the first two items above)
Thus, in a replacement decision, the depreciation base of a net asset (assuming that the new and the old assets belong to the same block assets) will be equal to:
Cost of new equipment + written down value of old equipment - salvage value of old equipment
• Depreciation and taxes
The computation of the after-tax cash flows requires a careful treatment of not-cash expense item such as depreciation. Depreciation is an allocation of cost of an asset. It involves an accounting entry and does not require any cash outflow; the cash outflow occurs when the assets are acquired. Depreciation, calculated as per the income tax rule, is a deductible expense for computing taxes. In itself, it has no direct impact on cash flows, but it indirectly influences cash flow since it reduces the firms tax liability. Cash outflow for taxes saved is in fact an inflow of cash. The saving resulting from depreciation is called depreciation tax shield.
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