The Annuity Depreciation Method is an activity-based method of calculating depreciation. Under this method, depreciation is not calculated simply on the basis of the passage of time. Instead, depreciation is determined according to the level of activity or use of the asset.
The level of activity may differ according to the nature of the asset. For a vehicle, the activity level may be measured in terms of miles driven. For a machine, it may be measured according to the number of operating cycles completed by the machine.
Thus, the depreciation expense under this method is directly linked with the actual level of use of the asset.
Estimation of Asset Life in Terms of Activity
When an asset is acquired, its expected life is estimated in terms of a particular level of activity.
Instead of estimating the useful life only in years, the business estimates the total amount of activity that the asset is expected to perform during its lifetime.
For example, the useful life of a vehicle may be estimated as the total number of miles it is expected to travel. Similarly, the useful life of a machine may be estimated according to the total number of operating cycles it is expected to complete.
This estimated total activity forms the basis for calculating the depreciation rate per unit of activity.
Calculation of Depreciation Rate
The depreciation rate is calculated by deducting the salvage value from the original cost of the asset and dividing the resulting depreciable amount by the estimated total level of activity.
The formula is:
Depreciation Rate per Unit of Activity = (Cost of Asset − Salvage Value) ÷ Estimated Total Activity
The result represents the amount of depreciation to be charged for each unit of activity performed by the asset.
For a vehicle, the result may be expressed as depreciation per mile. For a machine, it may be expressed as depreciation per operating cycle.
Example of Annuity Depreciation
Suppose a vehicle is purchased at a cost of $17,000. The estimated salvage value of the vehicle is $2,000, and the vehicle is expected to travel 50,000 miles during its lifetime.
The depreciable amount of the vehicle is:
$17,000 − $2,000 = $15,000
The depreciation rate per mile is calculated as:
$15,000 ÷ 50,000 miles = $0.30 per mile
Therefore, the vehicle will be depreciated at the rate of $0.30 for every mile driven.
Calculation of Annual Depreciation Expense
After determining the depreciation rate per unit of activity, the depreciation expense for each accounting year is calculated according to the actual activity of the asset during that year.
The formula is:
Annual Depreciation Expense = Actual Level of Activity × Depreciation Rate per Unit of Activity
For example, if the vehicle travels 10,000 miles during a year, the depreciation expense will be:
10,000 miles × $0.30 = $3,000
If the vehicle travels 15,000 miles during another year, depreciation expense will be:
15,000 miles × $0.30 = $4,500
Therefore, the amount of depreciation changes according to the actual use of the asset.
Relationship between Asset Use and Depreciation
Under the Annuity Depreciation Method, there is a direct relationship between the level of asset use and the amount of depreciation expense.
If the asset is used more during an accounting period, a higher amount of depreciation is charged. If the asset is used less, the depreciation expense is lower.
For example, a vehicle travelling more miles during a year will have a higher depreciation expense than a year in which the vehicle travels fewer miles.
Similarly, a machine completing a larger number of operating cycles will have a higher depreciation expense.
Thus, the method allocates the depreciable cost of the asset according to its actual activity.
Difference from Time-Based Depreciation
The Annuity Depreciation Method is not based mainly on the passage of time.
Under a time-based depreciation method, the cost of an asset is allocated according to its estimated useful life in years. For example, the Straight Line Method charges an equal depreciation amount every year.
Under the Annuity Depreciation Method, depreciation is based on the actual level of activity, such as miles driven or machine cycles.
Therefore, annual depreciation may vary from one accounting period to another depending on the actual use of the asset.
Exam Focus
The Annuity Depreciation Method is based on the level of activity or use of an asset rather than the passage of time.
The activity may be measured in terms of miles driven by a vehicle or operating cycles completed by a machine.
The depreciation rate per unit of activity is calculated as:
(Cost of Asset − Salvage Value) ÷ Estimated Total Activity
Annual depreciation is calculated as:
Actual Level of Activity × Depreciation Rate per Unit of Activity
For a vehicle costing $17,000, having a salvage value of $2,000, and an estimated life of 50,000 miles, the depreciation rate is $0.30 per mile.
Under this method, greater use of the asset results in higher depreciation expense, while lower use results in lower depreciation expense.