DEPRECIATION IS THE SYSTEMATIC ALLOCATION OF AN ASSET'S COST OVER ITS USEFUL LIFE. THE FIRST THING TO BE CLEAR ABOUT — and it is examined: DEPRECIATION IS NOT A CASH FLOW. NO MONEY MOVES WHEN AN ASSET IS DEPRECIATED. The cash left when the machine was bought. Depreciation merely records, year by year, how much of that spending is treated as an expense of each year's operations. WHY IT IS DONE AT ALL — three distinct purposes, often confused: 1. MATCHING (accounting). An asset earns revenue over several years, so charging its whole cost to the year of purchase would understate that year's profit and overstate every later year's. 2. TAX (the reason that matters financially). Depreciation is a DEDUCTIBLE EXPENSE, so it reduces taxable income and therefore reduces tax paid. THAT TAX REDUCTION IS A REAL CASH SAVING — the DEPRECIATION TAX SHIELD. 3. REPLACEMENT PLANNING — tracking book value indicates when an asset is nearing the end of its economic life. THE CAUSES OF DEPRECIATION: PHYSICAL — wear, corrosion, fatigue, accidental damage FUNCTIONAL — obsolescence, inadequacy for grown demand, a change in requirements NOTE THAT OBSOLESCENCE OFTEN DOMINATES: a five-year-old server may be in perfect physical condition and still worthless, which is why computing equipment is depreciated far faster than a building. THE TERMS: P or C first cost (purchase + installation + commissioning) S salvage (residual) value at the end of life n useful life in years Dₜ depreciation charge in year t BVₜ BOOK VALUE at end of year t = C − (accumulated depreciation) DEPRECIABLE BASE = C − S, the amount to be written off. NOTE THAT BOOK VALUE IS NOT MARKET VALUE. Book value is an accounting construct following a formula; market value is what someone will pay. They coincide only by accident. ── STRAIGHT LINE METHOD (SLM) ────────────────────────────── The simplest and most widely used: D = (C − S) / n the same every year BVₜ = C − t·D WORKED: C = 500,000, S = 50,000, n = 5. D = (500,000 − 50,000)/5 = Rs 90,000 per year YEAR DEPRECIATION BOOK VALUE ───────────────────────────────── 0 — 500,000 1 90,000 410,000 2 90,000 320,000 3 90,000 230,000 4 90,000 140,000 5 90,000 50,000 ← equals salvage ✓ ───────────────────────────────── ADVANTAGES: simple, predictable, easy to audit. DISADVANTAGE: IT DOES NOT MATCH REALITY. Most assets lose value fastest in their early years — a vehicle loses a large fraction of its value the moment it is driven away — and straight line depreciation charges the same amount in year 5 as in year 1.

ACCELERATED METHODS CHARGE MORE DEPRECIATION EARLY AND LESS LATER. They match the real pattern of value loss better, and — the practical reason they are chosen — THEY DEFER TAX, which is valuable because a rupee of tax paid later is worth less than one paid now. ── SUM OF YEARS DIGITS (SYD) ─────────────────────────────── SYD = n(n + 1)/2 Dₜ = (C − S) × (n − t + 1) / SYD For n = 5: SYD = 5(6)/2 = 15, and the fractions run 5/15, 4/15, 3/15, 2/15, 1/15. YEAR FRACTION DEPRECIATION BOOK VALUE ──────────────────────────────────────────── 1 5/15 150,000 350,000 2 4/15 120,000 230,000 3 3/15 90,000 140,000 4 2/15 60,000 80,000 5 1/15 30,000 50,000 ← salvage ✓ ──────────────────────────────────────────── YEAR 1 CHARGES 150,000 AGAINST STRAIGHT LINE'S 90,000 — 67% more — while year 5 charges only a third as much. The total written off is identical at 450,000; ONLY THE TIMING DIFFERS, AND TIMING IS WORTH MONEY. ── DECLINING BALANCE (DB) ────────────────────────────────── Dₜ = BVₜ₋₁ × d, where d is a fixed rate DOUBLE DECLINING BALANCE (DDB) uses d = 2/n THE ESSENTIAL DIFFERENCE FROM THE OTHER TWO: THE RATE IS APPLIED TO THE BOOK VALUE, NOT TO (C − S). SALVAGE VALUE DOES NOT ENTER THE FORMULA AT ALL — it enters only as a FLOOR below which book value may not fall. WORKED, same asset, d = 2/5 = 0.40: YEAR CALCULATION DEPRECIATION BOOK VALUE ──────────────────────────────────────────────────────── 1 500,000 × 0.40 200,000 300,000 2 300,000 × 0.40 120,000 180,000 3 180,000 × 0.40 72,000 108,000 4 108,000 × 0.40 43,200 64,800 5 64,800 × 0.40 = 25,920 BUT that would give BV = 38,880 < salvage 50,000, SO THE CHARGE IS LIMITED TO 14,800 50,000 ──────────────────────────────────────────────────────── total written off: 450,000 = C − S ✓ YEAR 5 SHOWS THE RULE THAT EXAMS TEST: DEPRECIATION STOPS AT THE SALVAGE VALUE. Applying 0.40 mechanically would have written the asset below its residual worth, so the final charge is truncated to exactly what remains. NOTE ALSO THAT PURE DECLINING BALANCE NEVER REACHES ZERO — a fixed percentage of a shrinking number is always positive — which is why a switch to straight line, or truncation as here, is always needed. ── COMPARISON OF THE THREE ───────────────────────────────── YEAR SLM SYD DDB ───────────────────────────────────── 1 90,000 150,000 200,000 2 90,000 120,000 120,000 3 90,000 90,000 72,000 4 90,000 60,000 43,200 5 90,000 30,000 14,800 ───────────────────────────────────── total 450,000 450,000 450,000 EVERY METHOD WRITES OFF THE SAME TOTAL. The choice affects only WHEN the deduction is taken — and because of the time value of money, EARLIER IS WORTH MORE. DDB's year-1 charge is more than double straight line's. ── THE TAX EFFECT, which is the point ────────────────────── AFTER-TAX CASH FLOW = (revenue − cash expenses − depreciation) × (1 − tax rate) + depreciation Equivalently, and more revealingly: after-tax cash flow = (revenue − cash expenses)(1 − t) + (depreciation × t) THE SECOND TERM IS THE DEPRECIATION TAX SHIELD: depreciation multiplied by the tax rate. At a 25% tax rate, a 200,000 depreciation charge saves 50,000 in tax — REAL CASH, in that year. THIS IS WHY ACCELERATED DEPRECIATION IS VALUABLE and why governments offer it as an investment incentive: it moves the tax shield earlier, raising its present value without changing the total tax eventually paid. ── DEPRECIATION IN NEPAL ─────────────────────────────────── The Income Tax Act 2058 (2002) uses a POOLED DECLINING BALANCE SYSTEM rather than depreciating each asset individually. Assets are grouped into classes, each with its own rate, broadly: CLASS A — buildings, structures: LOW rate CLASS B — office equipment, furniture CLASS C — vehicles and heavy plant CLASS D — general plant and machinery CLASS E — intangibles, amortised over their legal life Additions during the year enter the pool and disposals leave it, with depreciation applied to the pool's closing balance. SPECIAL INDUSTRIES — manufacturing, hydropower — receive ADDITIONAL ALLOWANCES (commonly a further third of the normal rate), which is industrial policy expressed through the tax code. ALWAYS CHECK CURRENT RATES against the Finance Act of the year, since they are revised in the annual budget. NOTE THE DIFFERENCE FROM THE TEXTBOOK METHODS: WITH POOLING, NO INDIVIDUAL ASSET HAS A BOOK VALUE — only the pool does. That is administratively far simpler and is why most modern tax systems have moved to it.