What is the Annuity Method of Depreciation?

The annuity method of depreciation is a depreciation technique that focuses on achieving a constant rate of return on an asset. It is more likely to be used for more expensive fixed assets that are expected to have a long useful life. To employ the annuity method, follow the steps noted below. The annuity method is not endorsed by generally accepted accounting principles.

Step 1. Estimate Cash Flows

Estimate the future cash flows that will be associated with an asset. This should involve setting up your best estimates of cash inflows and cash outflows that are likely to occur in each successive year for the remainder of the asset’s useful life.

Step 2. Calculate the IRR

Calculate the internal rate of return on those cash flows. It is the rate of return at which the present value of a series of future cash flows equals the present value of all associated costs.

Step 3. Derive Depreciation

Multiply the internal rate of return by the initial book value of the asset. Then subtract the result from the cash flow for the current period. The residual value is the depreciation to charge to expense in the current period.