Annuity Method of Depreciation:
Learning Objectives:
-
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:
-
This method takes interest
on capital invested in the asset into account.
-
It is regarded as most
exact and precise from the point of view of calculations; and is
therefore most scientific.
Disadvantages:
-
The system is complicated.
-
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.
-
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.
|
