Annuity method of depreciation definition
/What is the Annuity Method of Depreciation?
The annuity method of depreciation is a depreciation technique that focuses on achieving a constant rate of return on an asset. It is more likely to be used for more expensive fixed assets that are expected to have a long useful life. To employ the annuity method, follow the steps noted below. The annuity method is not endorsed by generally accepted accounting principles.
Step 1. Estimate Cash Flows
Estimate the future cash flows that will be associated with an asset. This should involve setting up your best estimates of cash inflows and cash outflows that are likely to occur in each successive year for the remainder of the asset’s useful life.
Step 2. Calculate the IRR
Calculate the internal rate of return on those cash flows. It is the rate of return at which the present value of a series of future cash flows equals the present value of all associated costs.
Step 3. Derive Depreciation
Multiply the internal rate of return by the initial book value of the asset. Then subtract the result from the cash flow for the current period. The residual value is the depreciation to charge to expense in the current period.
Terms Similar to Annuity Method of Depreciation
This approach is also called the compound interest method of depreciation.
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Example of the Annuity Method of Depreciation
As an example of the annuity method of depreciation, a company purchases machinery for $100,000, expecting it to last 5 years, with an assumed interest rate of 8%. Instead of spreading the depreciation evenly, as would be the case with the straight-line method, the annuity method factors in the opportunity cost of the capital (the interest the company could have earned elsewhere). Using annuity tables, the company determines that the annual annuity factor for 5 years at 8% is 0.25046, resulting in an annual charge of $25,046 ($100,000 × 0.25046).
In the first year, the company calculates the interest as 8% of the $100,000, which is $8,000. The depreciation expense for the first year is the annual charge ($25,046) minus the interest ($8,000), equaling $17,046. In the second year, interest is calculated on the reduced book value of the machinery, resulting in lower interest and higher depreciation. This process continues until the asset is fully depreciated at the end of 5 years. The annuity method ensures that the combined depreciation and interest expense remains consistent each year, making it useful when assets are expected to provide a steady return over their useful life.