## 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.

Next Up

## 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. ### Bonus Depreciation

A bonus depreciation is a tax relief that allows a business to ...
2. ### Recovery Property

Recovery Property was a term used when the Accelerated Cost Recovery ...
3. ### Asset Depreciation Range - ADR

Asset depreciation range was an accounting method established ...
4. ### Section 1250

Section 1250 of the U.S. Internal Revenue Service Code states ...
5. ### General Depreciation System - GDS

The general depreciation system (GDS) is the most commonly used ...
6. ### Useful Life

An estimate of how long one can expect to use an income-producing ...
Related Articles
1. Insights

### Are Equity-Indexed Annuities Right For You?

Equity-indexed annuities can be confusing to understand, but for conservative investors, they can be valuable savings plans.
2. Retirement

### 5 Mistakes to Avoid When Shopping for Annuities

Annuities give retirees guaranteed income but they aren't all created equal.
3. Retirement

### Taking The Bite Out Of Annuity Losses

If this investment product has caused you sleepless nights, it's time to consider alternatives.
4. Retirement

### Annuities Vs. Bonds: Which One Is Better For You?

Compare the important features of annuities and bonds, and understand which investment vehicle is the better choice based on retirement goals.

### Advising FAs: Explaining Annuities to a Client

Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
6. Retirement

### Break Out Of Annuity Prison

Annuities offer security but also lock up your cash. The secondary market could be your key.
7. Retirement

### Watch Your Back In The Annuity Game

Find out how to get the upper hand when dealing with this payout challenge.
8. Taxes

### Recoverable Depreciation: How it Works

Recoverable depreciation is a concept used in many insurance policies and claims.
RELATED FAQS
1. ### What is the tax impact of calculating depreciation?

Understand the tax implications of a company's depreciation. Learn how differences in accounting methods change the amount ... Read Answer >>
2. ### 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 >>
3. ### What's the difference between amortization and depreciation?

Learn the difference between amortization, depreciation, and depletion and how companies use these accounting methods to ... Read Answer >>
Hot Definitions
1. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
2. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
3. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
4. ### Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
5. ### Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
6. ### Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...