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Annuity Method

The main drawback of the different methods of calculating depreciation is that they take no account of the interest on the capital invested in the field assets. Annuity method deals with the effect of cost of capital in depreciation calculation. It makes the treatment of interest more explicitly by showing the interest payments in the profit and loss account. Under this system the capital sunk is assumed to earn a certain rate of interest. The asset is, therefore, charged with interest along with the actual payments; interest is calculated on the debit balance of the asset on the commencement of the year. The relevant journal entry is:

Asset Account                Dr.
    To Interest Account

At the same time of fixed account (i.e., on a straight line basis) is charged as a depreciation expenses so that it eliminates the asset or brings it down to its salvage or scrap value, as the case may be. The important point to be noted is that the amount of depreciation to be charged every year must be so calculated as to reduce that asset together with interest accumulated thereon to its salvage value at the end of the useful life of the asset. Such a calculation, if done manually, would be very difficult. Hence the figures of depreciation are obtained form Annuity tables. As the yearly interest diminishes while the depreciation charge is the same, the net charge to revenue increases annually.

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