Annuity Method of Depreciation

12/08/2008 21:04

 

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 installments 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:

1. Asset account
       To Interest account
  (Being interest on capital sunk in asset)

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

2. Depreciation account
       To Asset account
  (Being the depreciation of asset)

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.

Years 3% 3.5% 4% 4.5% 5%
3 0.353530 0.359634 0.360349 0.363773 0.367209
4 0.269027 0.272251 0.275490 0.278744 0.282012
5 0.218355 0.221418 0.224627 0.227792 0.230975
6 0.184598 0.187668 0.190762 0.193878 0.197017
7 0.160506 0.163544 0.166610 0.169701 0.172820
8 0.142456 0.145477 0.148528 0.151610 0.154722

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

  Debit Side     Credit Side  
Date   $ Date   $
1st Year     1st Year    
Jan. 1 To Cash 40,000 Dec. 31 By Depreciation 9,239
Dec. 31 To Interest 2,000   By Balance c/d 32,761
   
   
    42,000     42,000
   
   
2nd Year     2nd Year    
Jan. 1 To Balance b/d 32,761 Dec. 31 By Depreciation 9,239
Dec. 31 To Interest 1,638   By Balance c/d 25,160
   
   
    34,399     34,399
   
   
3rd Year          
Jan. 1 To Balance b/d 25,160 Dec. 31 By Depreciation 9,239
Dec. 31 To Interest 1,258   By Balance c/d 17,179
   
   
    26,418     26,418
   
   
3rd Year          
Jan. 1 To Balance b/d 17,170      

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.