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<chapter id="chapter_dep">
  <title>Depreciation</title>

  <para>This chapter will introduce the concept of depreciation in accounting and give some real life
    examples for using it.
  </para>

  <sect1 id="dep_concepts1">
    <title>Basic Concepts</title>

    <para>Depreciation is the accounting method for expensing capital purchases over time. There are two
      reasons that you may want to record depreciation; you are doing bookkeeping for your own
      personal finances and would like to keep track of your net worth, or you are doing bookkeeping
      for a small busines and need to produce a financial statement from which you will prepare your
      tax return.
    </para>

    <para>The method of recording depreciation is the same in either case. but the end goal is different. This
      section will discuss the differences between the two. But first, some terminology.
    </para>

    <itemizedlist>
      <listitem>
        <para><emphasis>Accumulated depreciation</emphasis> - the accumulated total of book depreciation taken
          over the life of the asset. This is accumulated in the depreciation account in the asset
          section.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Book depreciation</emphasis> - this is the amount of depreciation that you record in your
          financial statements per accounting period.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Fair market value</emphasis> - the amount for which an asset could be sold at a given
          time.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Net book value</emphasis> - this is the difference between the original cost and the
          depreciation taken to date.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Original cost</emphasis> - this is the amount that the asset cost you to purchase. It
          includes any cost to get the asset into a condition in which you can use it. For example -
          shipping, installation costs, special training.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Salvage value</emphasis> - this is the value that you estimate the asset can be sold for
          at the end of it&rsquo;s useful life (to you).
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Tax depreciation</emphasis> - this is the amount of depreciation that you take for income
          tax purposes.
        </para>
      </listitem>
    </itemizedlist>

    <sect2 id="dep_concepts_personal2">
      <title>Personal Finances</title>

      <para>Depreciation is used in personal finances to periodically lower an asset&rsquo;s value to give you
        an accurate estimation of your current net worth. For example, if you owned a car you could
        keep track of its current value by recording depreciation every year. To accomplish this,
        you record the original purchase as an asset, and then record a depreciation expense each
        year (See <xref linkend="dep_example1" /> for an example). This would result in the net book
        value being approximately equal to the fair market value of the asset at the end of the
        year.
      </para>

      <para>Depreciation for personal finance has no tax implications, it is simply used to help you estimate
        your net worth. Because of this, there are no rules for how you estimate depreciation, use
        your best judgement.
      </para>

      <para>For which assets should you estimate depreciation? Since the idea of depreciation for personal
        finances is to give you an estimate of your personal net worth, you need only track
        depreciation on assets of notable worth that you could potentially sell, such as a car or
        boat.
      </para>
    </sect2>

    <sect2 id="dep_concepts_business2">
      <title>Business</title>

      <para>As opposed to personal finance where the goal is tracking personal worth, business is concerned with
        matching the expense of purchasing capital assets with the revenue generated by them. This
        is done through book depreciation. Businesses must also be concerned with local tax laws
        covering depreciation of assets. This is known as tax depreciation. The business is free to
        choose whatever scheme it wants to record book depreciation, but the scheme used for tax
        depreciation is fixed. More often than not this results in differences between book and tax
        depreciation, but steps can be taken to reduce these differences.
      </para>

      <para>Now, what purchases should be capitalized? If you expect something that you purchase to help you
        earn income for more than just the current year, then it should be capitalized. This
        includes things like land, buildings, equipment, automobiles, and computers - as long as
        they are used for business purposes. It does not include items that would be considered
        inventory. So if you made a purchase with the intent to resell the item, it should not be
        capitalized.
      </para>

      <para>In addition to the purchase of the asset itself, any costs associated with getting the asset into a
        condition so that you can use it should be capitalized. For example, if you buy a piece of
        equipment and it needs to be shipped from out of town, and then some electrical work needs
        to be done so you can plug the machine in, and some specialized training is needed so you
        know how to use the machine, all these costs would be included in the cost of the equipment.
      </para>

      <para>You also need to know the estimated salvage value of the asset. Generally, this is assumed to be
        zero. The idea behind knowing the salvage value is that the asset will be depreciated until
        the net book value (cost less depreciation) equals the salvage value. Then, when the asset
        is written off, you will not have a gain or loss resulting from the disposal of the asset.
      </para>

      <para>The last step is to determine the method of depreciation that you want to use. This will be
        discussed on the next few pages.
      </para>

      <warning>
        <para>Be aware that different countries can have substantially different tax policies for depreciation;
          all that this document can really provide is some of the underlying ideas to help you
          apply your <quote>favorite</quote> tax/depreciation policies.
        </para>
      </warning>
    </sect2>
  </sect1>

  <sect1 id="dep_value1">
    <title>Estimating Valuation</title>

    <para>A central issue with depreciation is to determine how you will estimate the future value of the
      asset. Compared to the often uncertain estimates one has to do where appreciation of assets is
      concerned, we are on somewhat firmer ground here. Using sources listed below should make it
      fairly straight forward to estimate the future value of your depreciating assets.
    </para>

    <itemizedlist>
      <listitem>
        <para><emphasis>Tax Codes:</emphasis> For businesses that want to use depreciation for tax purposes,
          governments tend to set up precise rules as to how you are required to calculate
          depreciation. Consult your local tax codes, which should explicitly state how to estimate
          depreciation.
        </para>
      </listitem>

      <listitem>
        <para><emphasis>Car Blue Book:</emphasis> For automobiles, it is easy to look up in references such as
          <quote>Blue Books</quote> estimates of what an automobile should be worth after some
          period of time in the future. From this you will be able to develop a model of the
          depreciation.
        </para>
      </listitem>
    </itemizedlist>

    <sect2 id="dep_valueschemes2">
      <title>Depreciation Schemes</title>

      <para>A <emphasis>depreciation scheme</emphasis> is a mathematical model of how an asset will be expensed
        over time. For every asset which undergoes depreciation, you will need to decide on a
        depreciation scheme. An important point to keep in mind is that, for tax purposes, you will
        need to depreciate your assets at a certain rate. This is called tax depreciation. For
        financial statement purposes you are free to choose whatever method you want. This is book
        depreciation. Most small businesses use the same rate for tax and book depreciation. This
        way there is less of a difference between your net income on the financial statements and
        your taxable income.
      </para>

      <para>This section will present 3 of the more popular depreciation schemes: <emphasis>linear</emphasis>,
        <emphasis>geometric</emphasis>, and <emphasis>sum of digits</emphasis>. To simplify the
        examples, we will assume the salvage value of the asset being depreciated is zero. If you
        choose to use a salvage value, you would stop depreciating the asset once the net book value
        equals the salvage value.
      </para>

      <orderedlist>
        <listitem>
          <para><emphasis>Linear depreciation</emphasis> diminishes the value of an asset by a fixed amount each
            period until the net value is zero. This is the simplest calculation, as you estimate a
            useful lifetime, and simply divide the cost equally across that lifetime.
          </para>

          <para>Example: You have bought a computer for $1500 and wish to depreciate it over a period of 5 years.
            Each year the amount of depreciation is $300, leading to the following calculations:
          </para>

          <para><table>
              <title>Linear Depreciation Scheme Example</title>

              <tgroup cols="3">
                <tbody>
                  <row>
                    <entry>
                      <emphasis>Year</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Depreciation</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Remaining Value</emphasis>
                    </entry>
                  </row>

                  <row>
                    <entry>
                      0
                    </entry>

                    <entry>
                      -
                    </entry>

                    <entry>
                      1500
                    </entry>
                  </row>

                  <row>
                    <entry>
                      1
                    </entry>

                    <entry>
                      300
                    </entry>

                    <entry>
                      1200
                    </entry>
                  </row>

                  <row>
                    <entry>
                      2
                    </entry>

                    <entry>
                      300
                    </entry>

                    <entry>
                      900
                    </entry>
                  </row>

                  <row>
                    <entry>
                      3
                    </entry>

                    <entry>
                      300
                    </entry>

                    <entry>
                      600
                    </entry>
                  </row>

                  <row>
                    <entry>
                      4
                    </entry>

                    <entry>
                      300
                    </entry>

                    <entry>
                      300
                    </entry>
                  </row>

                  <row>
                    <entry>
                      5
                    </entry>

                    <entry>
                      300
                    </entry>

                    <entry>
                      0
                    </entry>
                  </row>
                </tbody>
              </tgroup>
            </table>
          </para>
        </listitem>

        <listitem>
          <para><emphasis>Geometric depreciation</emphasis> is depreciated by a fixed percentage of the asset value
            in the previous period. This is a front-weighted depreciation scheme, more depreciation
            being applied early in the period. In this scheme the value of an asset decreases
            exponentially leaving a value at the end that is larger than zero (i.e.: a resale
            value).
          </para>

          <para>Example: We take the same example as above, with an annual depreciation of 30%.
          </para>

          <para><table>
              <title>Geometric Depreciation Scheme Example</title>

              <tgroup cols="3">
                <tbody>
                  <row>
                    <entry>
                      <emphasis>Year</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Depreciation</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Remaining Value</emphasis>
                    </entry>
                  </row>

                  <row>
                    <entry>
                      0
                    </entry>

                    <entry>
                      -
                    </entry>

                    <entry>
                      1500
                    </entry>
                  </row>

                  <row>
                    <entry>
                      1
                    </entry>

                    <entry>
                      450
                    </entry>

                    <entry>
                      1050
                    </entry>
                  </row>

                  <row>
                    <entry>
                      2
                    </entry>

                    <entry>
                      315
                    </entry>

                    <entry>
                      735
                    </entry>
                  </row>

                  <row>
                    <entry>
                      3
                    </entry>

                    <entry>
                      220.50
                    </entry>

                    <entry>
                      514.50
                    </entry>
                  </row>

                  <row>
                    <entry>
                      4
                    </entry>

                    <entry>
                      154.35
                    </entry>

                    <entry>
                      360.15
                    </entry>
                  </row>

                  <row>
                    <entry>
                      5
                    </entry>

                    <entry>
                      108.05
                    </entry>

                    <entry>
                      252.10
                    </entry>
                  </row>
                </tbody>
              </tgroup>
            </table>
          </para>

          <note>
            <para>Beware: Tax authorities may require (or allow) a larger percentage in the first period. On the other
              hand, in Canada, this is reversed, as they permit only a half share of <quote>Capital
              Cost Allowance</quote> in the first year. The result of this approach is that asset
              value decreases more rapidly at the beginning than at the end which is probably more
              realistic for most assets than a linear scheme. This is certainly true for
              automobiles.
            </para>
          </note>
        </listitem>

        <listitem>
          <para><emphasis>Sum of digits</emphasis> is a front-weighted depreciation scheme similar to the geometric
            depreciation, except that the value of the asset reaches zero at the end of the period.
            This is a front-weighted depreciation scheme, more depreciation being applied early in
            the period. This method is most often employed in Anglo/Saxon countries. Here is an
            illustration:
          </para>

          <para>Example: First you divide the asset value by the sum of the years of use, e.g. for our example from
            above with an asset worth $1500 that is used over a period of five years you get
            1500/(1+2+3+4+5)=100. Depreciation and asset value are then calculated as follows:
          </para>

          <para><table>
              <title>Sum of Digits Depreciation Scheme Example</title>

              <tgroup cols="3">
                <tbody>
                  <row>
                    <entry>
                      <emphasis>Year</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Depreciation</emphasis>
                    </entry>

                    <entry>
                      <emphasis>Remaining Value</emphasis>
                    </entry>
                  </row>

                  <row>
                    <entry>
                      0
                    </entry>

                    <entry>
                      -
                    </entry>

                    <entry>
                      1500
                    </entry>
                  </row>

                  <row>
                    <entry>
                      1
                    </entry>

                    <entry>
                      100*5=500
                    </entry>

                    <entry>
                      1000
                    </entry>
                  </row>

                  <row>
                    <entry>
                      2
                    </entry>

                    <entry>
                      100*4=400
                    </entry>

                    <entry>
                      600
                    </entry>
                  </row>

                  <row>
                    <entry>
                      3
                    </entry>

                    <entry>
                      100*3=300
                    </entry>

                    <entry>
                      300
                    </entry>
                  </row>

                  <row>
                    <entry>
                      4
                    </entry>

                    <entry>
                      100*2=200
                    </entry>

                    <entry>
                      100
                    </entry>
                  </row>

                  <row>
                    <entry>
                      5
                    </entry>

                    <entry>
                      100*1=100
                    </entry>

                    <entry>
                      0
                    </entry>
                  </row>
                </tbody>
              </tgroup>
            </table>
          </para>
        </listitem>
      </orderedlist>
    </sect2>
  </sect1>

  <sect1 id="dep_accounts1">
    <title>Account Setup</title>

    <para>As with most accounting practices, there are a number of different ways to setup depreciation
      accounts. We will present here a general method which should be flexible enough to handle most
      situations. The first account you will need is an <emphasis>Asset Cost</emphasis> account
      (&app; account type <guilabel>Asset</guilabel>), which is simply a place where you record the
      original purchase of the asset. Usually this purchase is accomplished by a transaction from
      your bank account.
    </para>

    <para>In order to keep track of the depreciation of the asset, you will need two depreciation accounts.
      The first is an <emphasis>Accumulated Depreciation</emphasis> account in which to collect the
      sum of all of the depreciation amounts, and will contain negative values. In &app;, this is an
      account type <emphasis>asset</emphasis>. The <emphasis>Accumulated Depreciation</emphasis>
      account is balanced by a <emphasis>Depreciation Expense</emphasis> account, in which all
      periodic depreciation expenses are recorded. In &app;, this is an account type
      <emphasis>expense</emphasis>.
    </para>

    <para>Below is a generic account hierarchy for tracking the depreciation of 2 assets,
      <emphasis>ITEM1</emphasis> and <emphasis>ITEM2</emphasis>. The <emphasis>Asset Cost</emphasis>
      accounts are balanced by the <emphasis>Bank</emphasis> account, the <emphasis>Accumulated
      Depreciation</emphasis> account is balanced by the <emphasis>Expenses:Depreciation</emphasis>
      account.
    </para>
<screen>
-Assets
   -Fixed Assets
      -ITEM1
         -Cost                (Asset Cost account)
         -Depreciation     (Accumulated Depreciation account)
      -ITEM2
         -Cost                (Asset Cost account)
         -Depreciation     (Accumulated Depreciation account)
   -Current Assets
      -Bank
-Expense
   -Depreciation        (Depreciation Expense account)</screen>
    <para>One of the features of the account hierarchy shown above is that you can readily see some important
      summary values about your depreciating asset. The <emphasis>Assets:Fixed
      Assets:ITEM1</emphasis> account total shows you the current estimated value for item1, the
      <emphasis>Assets:Fixed Assets:ITEM1:Cost</emphasis> shows you what you originally paid for
      item1, <emphasis>Assets:Fixed Assets:ITEM1:Depreciation</emphasis> shows you your accrued
      depreciation for item1, and finally, <emphasis>Expenses:Depreciation</emphasis> demonstrates
      the total accrued depreciation of all your assets.
    </para>

    <para>It is certainly possible to use a different account hierarchy. One popular account setup is to
      combine the <emphasis>Asset Cost</emphasis> and <emphasis>Accrued Depreciation</emphasis>
      asset accounts. This has the advantage of having fewer accounts cluttering your account
      hierarchy, but with the disadvantage that to determine some of the summary details mentioned
      in the paragraph above you will have to open the account register windows. As with most
      things, there are many ways to do it, find a way that works best for you.
    </para>

    <para>The actual input of the depreciation amounts is done by hand every accounting period. There is no
      way in &app; (as of yet) to perform the depreciation scheme calculations automatically, or to
      input the values automatically into the appropriate accounts. However, since an accounting
      period is typically one year, this really is not much work to do by hand.
    </para>
  </sect1>

  <sect1 id="dep_example1">
    <title>Example</title>

    <para>Let&rsquo;s go ahead and step through an example. Imagine you are a photographer and you use a car
      and an expensive camera for your personal business. You will want to track the depreciation on
      these items, because you can probably deduct the depreciation from your business taxes.
    </para>

    <para>The first step is to build the account hierarchy (as shown in the previous section, replace
      <emphasis>ITEM1</emphasis> and <emphasis>ITEM2</emphasis> with <quote>car</quote> and
      <quote>camera</quote>). Now, record the purchase of your assets by transferring the money from
      your bank account to the appropriate <emphasis>Asset Cost</emphasis> accounts for each item
      (eg: the <emphasis>Assets:Fixed Assets:Car:Cost</emphasis> account for the car). In this
      example, you start with $30k in the bank, the car cost $20k and the camera cost $10k and were
      both purchased on January 1, 2000.
    </para>

    <figure pgwide="1">
      <title>Asset Accounts Before Depreciation</title>
      <screenshot id="dep_example">
        <mediaobject>
          <imageobject>
            <imagedata fileref="figures/dep_example.png"
                       srccredit="Bengt Thuree" />
          </imageobject>
          <caption>
            <para>The asset accounts still only have the investments stored.
            </para>
          </caption>
        </mediaobject>
      </screenshot>
    </figure>

    <para>Looking at the tax codes, we realize that we must report depreciation on these items using the
      <quote>sum of digits</quote> scheme, over a 5 year period. So, the yearly depreciation amounts
      for the car come to $6667, $5333, $4000, $2667, $1333 for years 1 to 5 respectively, rounded
      to the nearest dollar. The yearly depreciation amounts for the camera are $3333, $2667, $2000,
      $1333, $667. Consult the previous section on Depreciation Schemes for the formula for
      calculating these values.
    </para>

    <para>For each accounting period (IE: fiscal year) you record the depreciation as an expense in the
      appropriate <emphasis>Accrued Depreciation</emphasis> account (eg: the <emphasis>Assets:Fixed
      Assets:Car:Depreciation</emphasis> account for the car). The two windows below show your
      car&rsquo;s accrued depreciation account and the main window after the third year (IE: three
      periods) of depreciation using this <guilabel>sum of digits</guilabel> scheme.
    </para>

    <figure pgwide="1">
      <title>Asset Depreciation In The Register</title>
      <screenshot id="dep_assetreg">
        <mediaobject>
          <imageobject>
            <imagedata fileref="figures/dep_assetreg.png"
                       srccredit="Bengt Thuree" />
          </imageobject>
          <caption>
            <para>This account shows a list of depreciation transactions.
            </para>
          </caption>
        </mediaobject>
      </screenshot>
    </figure>

    <figure pgwide="1">
      <title>Accounts Tab After Asset Depreciation</title>
    <screenshot id="dep_assetmain">
      <mediaobject>
        <imageobject>
          <imagedata fileref="figures/dep_assetmain.png"
                     srccredit="Bengt Thuree" />
        </imageobject>
          <caption>
            <para>The asset accounts got decreased by the depreciation.
            </para>
          </caption>
      </mediaobject>
    </screenshot>
    </figure>

    <note>
      <para>A Word of Caution: Since depreciation and tax issues are closely related, you may not always be free
        in choosing your preferred method. Fixing wrong calculations will cost a whole lot more time
        and trouble than getting the calculations right the first time, so if you plan to depreciate
        assets, it is wise to make sure of the schemes you will be permitted or required to use.
      </para>
    </note>
  </sect1>
</chapter>
