14.1.12 Annuity Method of Depreciation

The Issue:

Whether Annuity Method of Depreciation is an appropriate method of depreciation under IFRS.

Opinion:

The annuity method is a compounded interest method whereby the depreciation is calculated based on the assumption that depreciation plus the normal cost of capital to finance the assets are constant over the life of the assets. This results in lower depreciation charges in the earlier years of the assets life and higher charges in the later years.

Although IAS 16 ‘Property, Plant and Equipment’ does neither expressly prohibit the annuity method nor mentions it as a permissible method, it states that the depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity (paragraph 60 of IAS 16). Therefore, depreciation should reflect the actual diminution of the value of the asset or the direct revenue streams arising from such assets duly ignoring indirect and inconsistent revenues and other associated costs which can, however, not be considered to be a part of the pattern of flow of economic benefits from such assets. This implies the straight-line method or the reducing balance method to be more appropriate for most of the leasing assets.

Further it needs to be noted that in case of applicability of annuity method of depreciation, the depreciation charged in the initial years is on the lower side and accordingly, there arises an inevitable risk that the carrying value of such assets would exceed their fair values, which might create accounting issues in future with regard to impairment testing in line with IAS -36.

In view of the aforesaid, the Committee is of the considered opinion that annuity method of depreciation under IFRS is not an appropriate method of depreciation particularly for assets given on operating lease for a determined period.