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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
      simple 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 untill 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>

      <note>
        <para>Warning: 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>
      </note>
    </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
    (<application>&app;</application> 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 <application>&app;</application>, 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 <application>&app;</application>, 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>

    <literallayout>
-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)
  </literallayout>

    <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 <application>&app;</application> (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>

    <screenshot id="dep_example">
      <mediaobject>
        <imageobject>
          <imagedata fileref="figures/dep_example.png" format="PNG"
                     srccredit="Bengt Thuree" />
        </imageobject>

        <textobject>
          <phrase>Asset Depreciation Example1</phrase>
        </textobject>

        <caption><para>The asset depreciation example main window, before
        depreciation </para></caption>
      </mediaobject>
    </screenshot>

    <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>

    <screenshot id="dep_assetreg">
      <mediaobject>
        <imageobject>
          <imagedata fileref="figures/dep_assetreg.png" format="PNG"
                     srccredit="Bengt Thuree" />
        </imageobject>

        <textobject>
          <phrase>Asset Depreciation Register Window</phrase>
        </textobject>

        <caption><para>The asset depreciation register window
        </para></caption>
      </mediaobject>
    </screenshot>

    <screenshot id="dep_assetmain">
      <mediaobject>
        <imageobject>
          <imagedata fileref="figures/dep_assetmain.png" format="PNG"
                     srccredit="Bengt Thuree" />
        </imageobject>

        <textobject>
          <phrase>Asset Depreciation Main Window</phrase>
        </textobject>

        <caption><para>The asset depreciation main window </para></caption>
      </mediaobject>
    </screenshot>

    <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>
