Recalling what has so far been said and demonstrated, the choice of depreciation policy depends on the following considerations; however, once a decision on a method is taken, it has to be consistently followed and frequent changes are not in favour, except for switch point, if permitted by law.
Tax Implications
Providing larger amounts of depreciation in earlier years saves more on taxes in those earlier years; and as any income sooner is better than an equal income later (due to discounting), accelerated depreciation has advantage over straight-line depreciation.
Effect on Dividend Distribution
Dividends can be paid only out of profits. With straight line depreciation, the distributable surplus in the earlier years would be larger. Thus, with straight line method of depreciation, management is enabled to declare dividend more easily. The image of the company in the minds of the investing public is based on the return the company offers to them; and early impressions often carry the day.
Cash Flow Implications
As obvious from the above two paragraphs, if the depreciation figure is less, the quantum of profit will be more and vice-versa. With a given cash flow, if a greater amount is paid out as dividend, the part of the cash flow left for replacing the asset will be less. Since replacement costs also increase with time, it is essential to maximize the funds available therefor, i.e. to earn the maximum return on the depreciation funds. Thus, higher quantum of funds in earlier years earns more interest as well over the longer years before replacement - and this policy has this advantage.
Implication of Changing Price Levels
Depreciation is based on historical costs. Since replacements are likely to be costlier, extra appropriation out of the distributed profits should have to be made to meet the rising cost of replacement, though there is no tax advantage by this extra provision.
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