In annuity method of assets depreciation, it is supposed that the money invested in the purchase of the asset earns interest at a fixed rate which is debited to the asset account and according to the annuity table, a certain fixed amount of depreciation is charged everywhere for the estimated useful life of the asset.
The amount of depreciation calculated by the annuity table at a given rate of interest includes the element of interest. It remains thé same throughout the life of the asset while interest taken for will become less and less in the coming years method is followed where a large sum of money is required for the purchase of the asset and the life of the asset is definite, e.g., lease; but it is unsuitable for the assets where addition to the asset are made during the course of the life of the asset off and on.
The method is based on a comprehensive interpretation of the term ‘cost of the asset’ which is its purchase price as well as the interest on the capital investment in the asset that would have been earned on the amount invested therein.
Merits of annuity method of assets depreciation.
1. Use of Interest. Unlike the traditional methods of providing depreciation annuity method takes into account interest on capital invested in the asset.
2. Exact and Suitable Method. It is regarded as the most exact and precise from the point of view of calculations.
3. Scientific Method. The method is most scientific as it takes interest consideration.
Demerits of the Annuity Method
1. Too Many Calculation. It requires a number of calculations which are very complicated.
2. Not Suitable for Addition in Between. In case the asset requires frequent additions and extensions the calculations have to be revised quite after further complicating its application and operation.
3. Fixed Amount of Depreciation. Has the tendency to inequalise the charge to profit and loss account in respect of depreciation and repairs put together because the amount of depreciation remains fixed over the period of the life of the asset.
Application of the Annuity Method of Assets Depreciation
The method is very well applicable to assets which require considerable investment and do not call for frequent additions and do not need replacement, e.g., Long term leases. It is not suitable for plant and machinery which requires frequent addition and replacement.
A lease was acquired for $100,000 in 2018. Its working life is only for four years. Depreciation under the annuity system at 5% p.a. interest is charged. 282012 payable over four years @ 5% p.a. show lease A/C.
Depreciation = $100,000 x 282012 = $28,201