Annuity Method of Depreciation

What Is the Annuity Method of Depreciation?

The annuity method of depreciation is an interaction used to compute depreciation on an asset by working out its rate of return — similarly as though it were an investment. It is generally utilized with assets that have a large purchase price, long life, and a fixed (or possibly consistent) rate of return.

This annuity method of depreciation requires the determination of the internal rate of return (IRR) on the cash inflows and outflows of the asset. The IRR is then increased by the initial book value of the asset, and the outcome is deducted from the cash flow for the period to find the real amount of depreciation that can be taken.

How the Annuity Method of Depreciation Works

The annuity method of depreciation is likewise alluded to as the compound interest method of depreciation. Assuming the cash flow of the asset being depreciated is steady over the life of the asset, then, at that point, this method is called the annuity method.

Numerous methods of measuring depreciation fail to consider the interest lost on capital invested in an asset. The annuity method of depreciation compensates for this deficiency. The annuity method assumes that the sum spent on buying an asset is an investment that ought to be expected to have a yield. That's what the thinking is, had one invested an amount equivalent to the cost of the asset elswhere, they would have earned a return or interest on it of some kind or another.

Accordingly, the interest is charged on the diminishing balance of the asset. It is then charged to an asset account and furthermore credited to an interest account, which is then moved to a profit and loss account. The asset is then credited with a fixed amount of depreciation for each successive year. How much depreciation is assigned is calculated by utilizing a annuity table. The amount that is depreciated relies upon the interest rate and the lifetime of the asset being referred to.

Ascertaining the Annuity Method of Depreciation

The annuity method of depreciation centers around figuring for a steady rate of return on any asset. It tends to be calculated utilizing these steps:

1. Make an estimate representing things to come cash flows that are associated with an asset.
2. Figure out what the internal rate of return will be on those cash flows.
3. Duplicate that IRR by the asset's initial book value.
4. Deduct the above outcome from the cash flow for the current period.
5. The consequence of Step 4 will be the depreciation to charge to expense in the current period.

This interaction yields the amount of depreciation that can be accounted for over a set period of time.

The annuity method calculation can likewise be communicated in a formula:
$\begin&\text=\frac{i\times\text\times(1+i)n}{(1+i)-1n}\&\text=\text-(i\times\text)\&\textbf\&i=\text/100\&\text=\text \&n=\text\&\text=\text\end$

Benefits and Disadvantages of the Annuity Method of Depreciation

The annuity method of depreciation is valuable for assets that have a high initial cost and a long life span, for example, property and structures secured under leases. It considers the interest lost on the money spent to buy the asset, which numerous depreciation methods don't do.

The annuity method of depreciation isn't embraced under generally accepted accounting principles (GAAP).

A few drawbacks of utilizing this method are that it tends to be hard to comprehend and that it might require successive recalculations relying upon the asset. Likewise, it very well may be troublesome to profit and loss accounting over the long run, as the level of depreciation lessens with each year.

Highlights

• This method of depreciation functions admirably for assets that are pricey upfront and are expected to last for a long time, like property or structures that a company could lease.
• On the upside, this method considers the interest lost on the money spent to buy the asset, which numerous depreciation methods don't do.
• The annuity method of depreciation, likewise called the compound interest method of depreciation, takes a gander at how an asset devalues by deciding its rate of return.
• To work out utilizing the annuity method of depreciation, you decide the internal rate of return (IRR) on the asset's cash inflows and outflows, then, at that point, increase by the initial book value of the asset, then deducted from the cash flow for the period of time that is being assessed.
• On the downside, the annuity method of depreciation can be difficult to comprehend and may require incessant recalculations.