Annuity Method of Depreciation:

Learning Objectives:

1. What is annuity method of depreciation? Where is it adopted?

According to this method, the purchase of the asset concerned is considered an investment of capital, earning interest at certain rate. The cost of the asset and also interest thereon are written down annually by equal instalments until the book value of the asset is reduced to nil or its bread up value at the end of its effective life. The annual charge to be made by way of depreciation is found out from annuity tables. The annual charge for depreciation will be credited to asset account and debited to depreciation account, while the interest will be debited to asset account and credited to interest account.

Journal Entries:

Under annuity method, journal entries have to be made in respect of interest and depreciation. As regards interest, it has to be calculated on the debit balance of the asset account at the commencement of the period, at the given rate. The entry that is passed:

With regard to depreciation the amount found out from the depreciation annuity table, the following entry is passed:

It should be remembered that the interest is charged on the diminishing balance of the asset account, the amount of interest goes on declining year after year. But the amount of depreciation remains the same during the life time of the asset.

Example:

A firm purchased a 5 years’ lease for $40,000 on first January. It decides to write off depreciation on the annuity method. Presuming the rate of interest to be 5% per annum.

Show the lease account for the first 3 years. Calculations are to be made to the nearest dollar.

Annuity Table

Amount required to write off $1 by the annuity method.

Solution:

According to the annuity table given above, the annual charge for depreciation reckoning interest at 5 percent p.a. would be:

230975 × 40,000 = $9,239

Lease Account

Advantages:

1. This method takes interest on capital invested in the asset into account.

2. It is regarded as most exact and precise from the point of view of calculations; and is therefore most scientific.

Disadvantages:

1. The system is complicated.

2. The burden on profit and loss account goes on increasing with the passage of time whereas the amount of depreciation charged each year remains constant. The amount of interest credited goes on diminishing as years pass by, the ultimate consequence being that the net burden on profit and loss account grows heavier each year.

3. When the asset requires frequent additions and extensions, the calculation have to be changed frequently, which is very inconvenient.

Scope of Application:

This method is best suited to those assets which require considerable investment and which do not call for frequent additions e.g., long lease.

You may also be interested in other articles from “accounting for depreciation” chapter:

1. Definition and Explanation of Depreciation
2. Causes of Depreciation
3. Need for Depreciation
4. Depreciation, Depletion and Amortization
5. Difference Between Depreciation and Fluctuation
6. Basic Factors of Determination of Depreciation
7. Depreciation Methods / Methods for Providing Depreciation
8. Fixed Installment Method / Straight Line Method / Original Cost Method
9. Diminishing balance/written Down Value/Reducing Installment Method of Depreciation
10. Annuity Method of Depreciation
11. Depreciation Fund Method or Sinking Fund Method
12. Insurance Policy Method of Depreciation
13. Revaluation Method of Depreciation
14. Sum of the Years’ Digits Method of Depreciation
15. Double Declining Balance Method of Depreciation
16. Depletion Method of Depreciation
17. Basis of Use System of Depreciation
18. Depreciation Of Various Assets
19. Depreciation Accounting – General Questions and Answers