What is the 'Annuity Method of Depreciation'

The annuity method of depreciation is a process used to calculate depreciation on an asset by calculating its rate of return as if it was an investment. This method requires the determination of the internal rate of return (IRR) on the cash inflows and outflows of the asset. The IRR is then multiplied by the initial book value of the asset, and the result is subtracted from the cash flow for the period in order to find the actual amount of depreciation that can be taken. It is commonly used with assets that have a large purchase price and long life.

BREAKING DOWN 'Annuity Method of Depreciation'

The annuity method of depreciation is also referred to as the compound interest method of depreciation. If the cash flow of the asset being depreciated is constant over the life of the asset, then this method is called the annuity method. However, the annuity method of depreciation is not endorsed under generally accepted accounting principles.

Many methods of measuring depreciation fail to take into account the interest lost on capital invested in an asset; the annuity method of depreciation makes up for this deficiency. The annuity method assumes that the sum spent on buying an asset is an investment that should be expected to yield interest. As such, the interest is charged on the diminishing balance of the asset. It is then debited to an asset account and also credited to an interest account, which is then transferred 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 using an annuity table. How much is actually depreciated depends on the interest rate and the lifetime of the asset.

Annuity Method of Depreciation: Steps

The annuity method of depreciation focuses on figuring for a constant rate of return on any asset. To do so, these steps should be followed:

  1. Make an estimate of the future cash flows that are associated with an asset.
  2. Determine what the internal rate of return will be on those cash flows.
  3. Multiply that IRR by the asset's initial book value.
  4. Subtract the above result from the cash flow for the current period.
  5. The result of step 4 will be the depreciation to charge to expense in the current period.

Annuity Method of Depreciation: Uses

The annuity method of depreciation is useful for assets that have a high initial cost and a long life span, such as property and buildings secured under leases. Some disadvantages of using this method are that it can be difficult to understand and that it may require frequent recalculations depending on the asset. Also, it can be burdensome to profit and loss accounting over time, as the level of depreciation diminishes with every year.

RELATED TERMS
  1. Accelerated Depreciation

    Accelerated depreciation is any method of depreciation used for ...
  2. Retirement Method of Depreciation ...

    Retirement method of depreciation describes the accounting practice ...
  3. Depreciation

    Depreciation is an accounting method of allocating the cost of ...
  4. Sinking Fund Method

    The sinking fund method is a method for depreciating an asset ...
  5. Fully Depreciated Asset

    A fully depreciated asset is a property, plant or piece of equipment ...
  6. Group Depreciation

    Group depreciation combines similar fixed assets into a pool ...
Related Articles
  1. Investing

    An Overview of Annuities

    As part of your overall investment strategy, annuities may add value to your retirement in more ways than you think. Here's how they work.
  2. Financial Advisor

    Annuities: A Good Option in Turbulent Times?

    Annuities can be an enticing option as Americans near retirement, but there are several reasons to be wary of them.
  3. Retirement

    Annuities: How To Find The Right One For You

    Fixed, variable and indexed annuities offer different features. Find out which one fits your needs.
  4. Retirement

    How a Fixed Annuity Works After Retirement

    These popular investments can provide a steady stream of income during your retirement years. Here are the details.
  5. Investing

    What Do You Need to Know About Annuities?

    There are varying views on annuities. Use this basic information to draw your own conclusions.
  6. Retirement

    Who Benefits From Retirement Annuities

    Annuities guarantee some degree of fixed income in retirement. But is the security worth the fees and less favorable tax treatment? How to decide.
  7. Investing

    The Many Benefits of Deferred Annuities

    Having a deferred annuity can ensure income in retirement above and beyond Social Security.
  8. Retirement

    Guaranteed Retirement Income in Any Market

    By laddering annuities, you can be sure you'll have income no matter what the market does.
  9. Taxes

    Recoverable Depreciation: How it Works

    Recoverable depreciation is a concept used in many insurance policies and claims.
RELATED FAQS
  1. How is salvage value used in depreciation calculations?

    Learn how an asset's salvage value is subtracted from its initial cost to determine the amount by which an asset is depreciated ... Read Answer >>
  2. What is the relationship between accumulated depreciation and depreciation expense?

    Understand the relationship between accumulated depreciation and depreciation expense. Learn how each one is accounted for ... Read Answer >>
  3. Does accumulated depreciation affect net income?

    Accumulated depreciation is a running total of the depreciation expense that has been recorded over the years. However, it ... Read Answer >>
  4. How does depreciation affect cash flow?

    Depreciation is a non-cash accounting charge doesn't directly affect cash flow, but there are certain tax situations whereby ... Read Answer >>
Trading Center