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Annuity Method of Depreciation Definition

What Is the Annuity Methodology of Depreciation?

The annuity methodology of depreciation is a course of used to calculate depreciation on an asset by calculating its rate of return—simply as if it have been an funding. It’s generally used with belongings which have a big buy worth, lengthy life, and a set (or at the very least fixed) fee of return.

This annuity methodology of depreciation requires the dedication of the internal rate of return (IRR) on the money inflows and outflows of the asset. The IRR is then multiplied by the preliminary ebook worth of the asset, and the result’s subtracted from the money stream for the interval to search out the precise quantity of depreciation that may be taken.

Key Takeaways

  • The annuity methodology of depreciation, additionally referred to as the compound curiosity methodology of depreciation, seems at how an asset depreciates by figuring out its fee of return.
  • To calculate utilizing the annuity methodology of depreciation, you identify the interior fee of return (IRR) on the asset’s money inflows and outflows, then multiply by the preliminary ebook worth of the asset, then subtracted from the money stream for the time frame that’s being assessed. 
  • This methodology of depreciation works particularly effectively for belongings which might be expensive upfront and are anticipated to final for a few years, resembling property or buildings that an organization may lease.
  • On the upside, this methodology takes under consideration the curiosity misplaced on the cash spent to purchase the asset, which many depreciation strategies do not do.
  • On the draw back, the annuity methodology of depreciation may be exhausting to grasp and will necessitate frequent recalculations.

How the Annuity Methodology of Depreciation Works

The annuity methodology of depreciation can also be known as the compound interest methodology of depreciation. If the money stream of the asset being depreciated is fixed over the lifetime of the asset, then this methodology is named the annuity methodology.

Many strategies of measuring depreciation fail to take into consideration the curiosity misplaced on capital invested in an asset. The annuity methodology of depreciation makes up for this deficiency. The annuity methodology assumes that the sum spent on shopping for an asset is an funding that must be anticipated to have a yield. The reasoning is that, had one invested an quantity equal to the price of the asset elswhere, they might have earned some form of return or curiosity on it.

As such, the curiosity is charged on the diminishing steadiness of the asset. It’s then debited to an asset account and likewise credited to an curiosity account, which is then transferred to a revenue and loss account. The asset is then credited with a set quantity of depreciation for every successive 12 months. How a lot depreciation is assigned is calculated by utilizing an annuity table. The quantity that’s depreciated is determined by the rate of interest and the lifetime of the asset in query.

Calculating the Annuity Methodology of Depreciation

The annuity methodology of depreciation focuses on figuring for a continuing fee of return on any asset. It may be calculated utilizing these steps:

  1. Make an estimate of the long run money flows which might be related to an asset.
  2. Decide what the interior fee of return shall be on these money flows.
  3. Multiply that IRR by the asset’s preliminary ebook worth.
  4. Subtract the above outcome from the money stream for the present interval.
  5. The results of Step 4 would be the depreciation to cost to expense within the present interval.

This course of yields the quantity of depreciation that may be accounted for over a set time frame.

The annuity methodology calculation can be expressed in a system:

Annuity

=

i

×

TDA

×

(

1

+

i

)

n

(

1

+

i

)

1

n

Depreciation

=

annuity

(

i

×

BVSY

)

the place:

i

=

Curiosity fee share

/

100

TDA

=

Whole depreciation on quantity

n

=

Annuity quantity of years

BVSY

=

E-book worth begin of 12 months

beginaligned&textAnnuity=fracitimestextTDAtimes(1+i)^n(1+i)-1^n&textDepreciation=textannuity-(itimestextBVSY)&textbfwhere:&i=textInterest fee share/100&textTDA=textTotal depreciation on quantity &n=textAnnuity variety of years&textBVSY=textBook worth begin of yearendaligned

Annuity=(1+i)1ni×TDA×(1+i)nDepreciation=annuity(i×BVSY)the place:i=Curiosity fee share/100TDA=Whole depreciation on quantityn=Annuity quantity of yearsBVSY=E-book worth begin of 12 months

Benefits and Disadvantages of the Annuity Methodology of Depreciation

The annuity methodology of depreciation is beneficial for belongings which have a excessive preliminary value and an extended life span, resembling property and buildings secured underneath leases. It takes under consideration the curiosity misplaced on the cash spent to purchase the asset, which many depreciation strategies do not do.

Some disadvantages of utilizing this methodology are that it may be obscure and that it might require frequent recalculations relying on the asset. Additionally, it may be burdensome to revenue and loss accounting over time, as the extent of depreciation diminishes with yearly.

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