# Depreciation

This chapter will present some of the techniques used to keep track of the changing values of assets, IE: depreciation, unrealized gains, capital gains.

## Basic Concepts

This chapter will present some of the techniques used to keep track of the changing values of assets, IE: depreciation, unrealized gains, capital gains.

Certain resellable assets can change value over time, such as stocks, bonds, houses, or cars. Some assets (eg: a stock) could increase in value, some (eg: a car) could decrease in value. It is important to be able to track some of these time-dependent asset valuations, this chapter will show you how.

Probably everything you own will increase or decrease in value over time. So, the question is for which of these assets should you track this changing value? The simple answer is that you only need to track this for items which could be sold for cash in the future or which relate to taxation.

Consumable and disposable items (eg: food, gas for your car, or printer paper) are obviously not involved. Thus, even though the new clothes you recently bought will certainly depreciate, you would not want to track this depreciation since you have no intention of reselling the clothes and there is no tax implications to the depreciation on clothing. So, for this example, the purchase of new clothes should be recorded as a pure expense... you spent the money, and it is gone.

Depreciation is the effect in which the value of an asset decreases with time. The often used example of an asset to which this is often applied is an automobile. An automobile holds retained value after the purchase date, but this value decreases with time. If you hold assets for business purposes, their depreciation can be treated as a deduction for tax purposes.

Depreciation is usually recognized as an ongoing (accrued) expense, gradually reducing the value of an asset toward zero.

Normally, depreciation is only calculated on assets used for professional or business purposes, because governments don't generally allow you to claim depreciation deductions on personal assets, and it's usually pointless to bother with the procedure if it's not deductible. The only case where you may want to track depreciation for personal assets would be if you will sell the asset in the future and you want to track your potential personal worth.

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 "favorite" tax/depreciation policies.

## Estimating Valuation

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.

- Tax Codes: 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.

- Car Blue Book: For automobiles, it is easy to look up in references such as "Blue Books" 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.

### Depreciation Schemes

A depreciation scheme is a mathematical model of how an asset will lose value over time. For every asset which undergoes depreciation, you will need to decide on a depreciation scheme. Since depreciation of assets is very often driven by tax policies, the discussion of depreciation will focus in that direction, on some of the more common depreciation calculation schemes.

Once you have an idea of the future value of your asset, you must decide on a depreciation scheme (remember, this may be dictated by your local tax codes). This section will present 3 of the more popular depreciation schemes: linear, geometric, and sum of digits.

1. Linear depreciation 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.

   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:

   #### Linear Depreciation Scheme Example

   Year | Depreciation | Remaining Value
   0 | - | 1500
   1 | 300 | 1200
   2 | 300 | 900
   3 | 300 | 600
   4 | 300 | 300
   5 | 300 | 0

2. Geometric depreciation 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).

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

   #### Geometric Depreciation Scheme Example

   Year | Depreciation | Remaining Value
   0 | - | 1500
   1 | 450 | 1050
   2 | 315 | 735
   3 | 220.50 | 514.50
   4 | 154.35 | 360.15
   5 | 108.05 | 252.10

   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 "Capital Cost Allowance" 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.

3. Sum of digits 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:

   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:

   #### Sum of Digits Depreciation Scheme Example

   Year | Depreciation | Remaining Value
   0 | - | 1500
   1 | 100*5=500 | 1000
   2 | 100*4=400 | 600
   3 | 100*3=300 | 300
   4 | 100*2=200 | 100
   5 | 100*1=100 | 0

## Account Setup

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 Asset Cost account (GnuCash account type "asset"), 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.

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

Below is a generic account hierarchy for tracking the depreciation of 2 assets, ITEM1 and ITEM2. The "Asset Cost" accounts are balanced by the "Bank" account, the Accumulated Depreciation account is balanced by the Depreciation Expense account.

    -Assets
       -ITEM1
          -Cost                (Asset Cost account)
          -Depreciation     (Accumulate Depreciation account)
       -ITEM2
          -Cost                (Asset Cost account)
          -Depreciation     (Accumulate Depreciation account)
       -Bank
    -Expenses
       -Depreciation        (Depreciation Expense account)

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 "Assets:ITEM1" account total shows you the current estimated value for item1, the "Assets:ITEM1:Cost" shows you what you originally paid for item1, "Assets:ITEM1:Depreciation" shows you your accrued depreciation for item1, and finally, "Expenses:Depreciation" demonstrates the total accrued depreciation of all your assets.

It is certainly possible to use a different account hierarchy. One popular account setup is to combine the Asset Cost and Accrued Depreciation 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.

The actual input of the depreciation amounts is done by hand every accounting period. There is no way in GnuCash (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.

## Example

Let'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.

The first step is to build the account hierarchy (as shown in the previous section, replace ITEM1 and ITEM2 with "car" and "camera"). Now, record the purchase of your assets by transferring the money from your bank account to the appropriate Asset Cost accounts for each item (eg: the "Assets:Car:Cost" 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.

Asset Depreciation Example1

The asset depreciation example main window, before depreciation

Looking at the tax codes, we realize that we must report depreciation on these items using the "sum of digits" 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.

For each accounting period (IE: fiscal year) you record the depreciation as an expense in the appropriate Accrued Depreciation account (eg: the "Asset:Car:Depreciation" account for the car). The two windows below show your car's accrued depreciation account and the main window after the third year (IE: three periods) of depreciation using this "sum of digits" scheme.

Asset Depreciation Register Window

The asset depreciation register window

Asset Depreciation Main Window

The asset depreciation main window

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.