What is An Annuity in Accounting? (Definition, Explanation, Example, and More)

Definition

An annuity is an arrangement where parties agree to pay/receive the fixed amount after a fixed time. In other words, it’s a system where series of equal payments is made at equal intervals for a specific period under consideration.

The payment frequency of an annuity may vary depending on the contract between parties, and the frequency may range from days to weeks, quarters, months, and years.

Detailed concept

The concept of an annuity can be applied to different heads of the financial statement. For instance, the following circumstance elaborates the use of annuity with perspective to accounting.

  1. Monthly payments on the lease agreement for vehicles and equipment.
  2. Annual payments agreed in the contract to purchase.
  3. An equal amount of interest is paid on the bank loan every quarter.
  4. The business agrees to receive a fixed compensation for the next ten years under some dispute resolution.

It’s important to note that all the payments have an equal amount and are made after an equal interval. If there is variation in the amount/frequency of the payments, the concept no more remains annuity.  

The concept of an annuity is specifically important with the financing/investment perspective of the business. This financing/investment may fall in the area of the giving/obtaining lease, capital assets, banks loans, purchase/sale, etc.

Irrespective of the operational side of the transaction, the financing terms need to fulfill criteria of equal payment and equal time to be recorded as an annuity.

These equal payments after equal time are discounted to produce the net present value, which is recorded in the company’s balance sheet. The calculation of the net present value requires using the cash flows in the future, discounting rate to incorporate the time value of money, and the time frame of the arrangement.

Change in any of these variables leads to changes in the annuity amount calculated to be recorded in the balance sheet.

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As per the accounting perspective of the annuity, if the business has acquired the obligation to pay a fixed amount after a fixed interval, it needs to be recorded as a liability by discounting (annuity).

Similarly, if the business has acquired the right to collect the fixed economic benefits, it will be recorded as an asset. It’s important to note that annuity is just the name of a cash flow arrangement and does not impact accounting treatment in any form.

Example of the annuity as business liability

Suppose the business has entered an annuity contract for the lease rentals amounting to $2,000 each year for the next seven years with an effective interest rate of 10%. Let’s understand the present value of the arrangement to be recorded in the company’s balance sheet.

Here is the calculation,

YearCash flow in an annuityDiscounting factor @ 10%Present value
12,0000.9091818
22,0000.8261652
32,0000.7511502
42,0000.6831366
52,0000.6211242
62,0000.5641128
72,0000.5131026
 Annuity amount 9,743

$9,743 needs to be recorded as a liability in the books of accounts. The logic is that the business has agreed to pay off certain cash in the next seven years against the acquisition of the asset. Hence, there is an obligation that needs to be discounted and recorded in the books of accounts.

The given cash flow arrangement can also be used to calculate annuity with formula,

Present Value = PMT x ((1 – (1 + r) ^ -n) / r)

Present Value = 2,000 x ((1 – (1 + 0.1)7 -7) / 0.01)

Present Value = 9,743

It’s important to note that the present value of the annuity changes and needs to be updated in the books at the end of each accounting period.

Further, an unwinding of the present value will be recorded as an expense in each accounting period by increasing the liability and vice versa in the case of assets.

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Example of the annuity as a business asset

Suppose the business reached an agreement to receive the $5,000 per annum for the next ten years. If the business records $50,000 (5,000×10), it will overstate assets in the books of accounts due to the time value of money.

So, there is a need to discount an asset to reflect present value with an effective interest rate of 10%. The following table can be drafted for the annuity.

YearCash flow in an annuityDiscounting factor @ 10%Present value
15,0000.9094,545
25,0000.8264,130
35,0000.7513,755
45,0000.6833,415
55,0000.6213,105
65,0000.5642,820
75,0000.5132,565
85,0000.4672,335
95,0000.4242,120
105,0000.3861,930
 Annuity 30,720

The right to receive the cash will be recorded in present value terms. So, it’s logical to understand that the business has agreed to receive $30,720 in today’s terms. The given cash flow can also be calculated with the following formula of an annuity.

Present Value = PMT x ((1 – (1 + r) ^ -n) / r)

 Present Value = 5,000 x ((1+0.1) ^-10)/0.1)

Present Value = 30,720

So, the business needs to record future receipt of the cash flow in today’s terms, and the unwinding of the discount in the future will be recorded as income in the income statement.

Types of annuity

There are two main types of annuity depending on when the business starts to receive the payments. These types include immediate annuity and deferred annuity.

Immediate annuity– It involves immediate payout of the funds when annuity begins.

Deferred annuity – It involves delayed payout of the funds once annuity begins.

It’s important to note that the calculation method remains the same for annuity irrespective of the type of annuity.

Difference between annuity and perpetuity

An annuity arrangement includes a fixed period for the payment. In other words, the terms of the payment are known. On the other hand, in perpetuity, the payments are received forever.

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Similarly, the annuity involves compounding, and perpetuity valuation only includes the actual interest rate.

Conclusion

The concept of annuity includes a fixed amount of the payout with equal frequency. The annuity can be used in finalizing different financing arrangements. For instance, the payments for the rentals, lease, and other arrangements include fixed terms of the payment after fixed frequency.

Calculation of annuity makes use of the compounding concept and the discount rate. On the flip side, the perpetuity arrangement of the cash flow is forever.

Similarly, the future cash flow is discounted when the business enters into the arrangement for an annuity. Upon unwinding of discount, the interest expense/interest income is recorded in the financial statement in proportion to the extension of liability or asset, respectively.

Further, there can be different types of annuity depending on the timing of payout. If the payout is to occur in the initial time of the annuity, it’s called an immediate annuity. On the other hand, if the payout is to be made after the passage of time, it’s referred to as a deferred annuity.

Frequently asked questions

What’s an accounting of annuity?

Accounting for the annuity is the same as accounting for the present value/time value of money. The cash flow is discounted to reflect value in today’s terms; the balance is subsequently unwound.

What’s the advantage of annuity for the business?

It allows the business to save money without paying taxes. Further, the business can easily predict income streams that can help develop reliable cash flow.

What’s the disadvantage of annuity for the business?

An annuity is a very illiquid asset, and it may take longer for an annuity to be realized in cash. Further, there is an opportunity cost for investing in the annuity for the business.

What are the four types of annuity?

Four types of annuity include immediate variable, fixed variable, deferred variable, and the fixed variable. The type of annuity is dependent on the timing of payout and the mechanism of annuity growth.

Why is an annuity purchased?

An annuity is purchased to secure the future’s series of cash flows. It’s mostly the case with retirement, as it’s the age when one thinks to set some passive and guaranteed source to meet expenses.

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