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<title>Depreciation and Capital Gains</title>
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<body>
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<h1> Depreciation and Capital Gains</h1>
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<p> This section provides a treatment of the handling of
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depreciation and appreciation of assets in GnuCash.</p>
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<p> It also provides a brief introduction to the related tax
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issues.</p>
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<p> <b> Warning:</b> <em>Be aware that different countries can
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have <b> substantially</b> different tax policies for handling
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these things; all that this document can really provide is some
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of the underlying ideas to help you apply your "favorite"
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tax/depreciation policies.</em></p>
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<p> Note that appreciation and depreciation of assets tend to
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be treated somewhat differently:</p>
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<ul>
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<li>
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<a href="#depr"> Depreciation</a> is <em> usually</em>
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recognized (the technical term is <b> accrued</b>) as an
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expense on an ongoing basis, gradually reducing the value
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of an asset towards zero.
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<p> Depreciation tends to only get calculated on assets
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that are used for professional or business purposes, because
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governments
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don't generally allow you to claim depreciation deductions
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on personal assets, and it's pointless to bother with the
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procedure if it's not deductible. </p>
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</li>
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<li>
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In contrast, <a href="#appr"> Capital Gains,</a> which
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could be called <em>asset value appreciation,</em> are
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typically <em> not</em> recognized until some time down the
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road when the asset is sold, and at that <em> instant,</em>
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the entire gain becomes income.
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<p> Unlike depreciation, governments tend to be <em> quite
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interested</em> in taxing capital gains in one manner or
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another.</p>
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<p> (As always, there are exceptions. If you hold a bond
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that pays all of its interest at maturity, tax authorities
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will often require that you recognize interest each year,
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and refuse this to be treated as a capital gain. The
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phrases <em>accrued interest,</em> or <em> imputed
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interest</em> are often there to scare those that are
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sensitive to such things...)</p>
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</li>
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</ul>
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<h1>Capital Gains - Asset Appreciation</h1>
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<a name="appr"></a>
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<p>Appreciation of assets is, in general, a fairly tricky matter
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to deal with. This is so because, for some sorts of assets, it
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is difficult to correctly estimate an increase in value <em>
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until you actually sell the asset.</em></p>
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<p> If you invest in <a href="xacc-ticker.html">securities</a>
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that are traded on a daily basis on open markets such as stock
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exchanges, prices may be quite exact, and selling the asset at
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market prices may be as simple as calling a broker and issuing
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a <b> Market Order.</b></p>
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<p> On the other hand, homes in your neighborhood are sold
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somewhat less often, such sales tend to involve expending
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considerable effort, and involve negotiations, which means that
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estimates are likely to be less precise. Similarly, selling a
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used automobile involves a negotiation process that makes
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pricing a bit less predictable.</p>
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<p> Harder to estimate are values of collectible objects such
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as jewelry, works of art, baseball cards, and "Beanie Babies."
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The markets for such objects are somewhat less open than the
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securities markets.</p>
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<p> Worse still are one-of-a-kind assets. Factories often
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contain presses and dies customized to build a very specific
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product that cost tens or hundreds of thousands of dollars;
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this equipment may be <em>worthless</em> outside of that very
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specific context. In such cases, there several conflicting
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values might be attached to the asset, <em>none</em> of them
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unambiguously correct.</p>
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<p> Let's suppose you buy an asset expected to increase in
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value, say a Degas painting, and want to track this. (The
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insurance company will care about this, even if nobody else
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does.)</p>
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<p> Properly tracking the continually-increasing value of the
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Degas will require at least three, quite possibly the following
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four accounts (plus a bank or cash account where the money for
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the purchase comes from):</p>
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<ul>
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<li>An <em>Asset Cost</em> asset account to track the
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original cost of the painting,</li>
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<li>An <em>Accrued Unrealized Gains on Asset</em> asset
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account to keep track of increases in value, and</li>
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<li>An <em>Accrued Gain On Asset Income</em> income account
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in which to record the income side of the annual gains in
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your riches, and</li>
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<li>A <em>Realized Gain On Asset Income</em> income account
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in which to record the realized income when you sell the
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asset.</li>
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</ul>
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<p> The <em>accrued gains</em> likely won't affect your taxable
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income for <em> income</em> tax purposes, although it could
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have some effect on <em> property</em> taxes.</p>
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<h2>The handling of capital gains in GnuCash</h2>
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<h3> The Acquisition</h3>
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<p>The first thing you have to do is to create the <em>asset
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cost account</em>, then transfer the sum you paid for this
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painting from your bank account to this asset account to record
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the purchase.</p>
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<p> A month later, you have reason to suspect that the value of
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your painting has increased by $1200. In order to record this
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you transfer $1200 from your <em>accrued gains on asset</em>
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income account to your asset account.</p>
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<p>Your main window will resemble this:</p>
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<img src="appr-main1.gif" alt=
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"Main window after purchase and appreciation">
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<p>and your asset account will resemble this:</p>
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<img src="appr-asset1.gif" alt=
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"Asset account after purchase and appreciation">
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<h3> While You Hold the Asset</h3>
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<p>Asset appreciation is a sort of income but it is <em>
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not</em> cash in hand.</p>
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<p> The people that got "rich" in 1999 from IPOs of
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Linux-related companies like Red Hat Software and VA Linux
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Systems could verify this. They hold options or stock that are
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<em> theoretically</em> valued at millions of dollars USD.</p>
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<p> That doesn't mean that they are actually millionaires; the
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principal participants have to hold their stock for at least
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six months before selling <em> any</em> of it. The fact that
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they <em>can't</em> sell it means that while it may in theory
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be worth millions of dollars on paper, there is, as of late
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1999, no way for them to legally <em> get</em> those
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millions.</p>
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<h3> Selling the Asset</h3>
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<p>Let´s say another month later prices for Degas
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paintings have gone up some more, in your case about $2500, you
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estimate. You duly record these $2500 as an income like above,
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then decide to sell the painting.</p>
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<p>Now there arise three possibilities:</p>
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<ol>
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<li>
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Your optimistic estimate of the painting´s value was
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correct.
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<p> The income account is left alone (or perhaps gets
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transferred from an <em> Accrued Gain</em> income to a <em>
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Realized Gain</em> income account), and the recording is
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rather like:</p>
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<table summary="BIGGAIN">
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<tr>
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<th>Account</th>
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<th>Amount</th>
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</tr>
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<tr>
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<td>Cash</td>
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<td>$16055</td>
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</tr>
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<tr>
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<td>Painting</td>
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<td>-$11000</td>
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</tr>
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<tr>
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<td>Realized Gain Income</td>
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<td>-$5055</td>
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</tr>
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</table>
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<p> And if any amounts had been accrued as <em> Accrued
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Gains,</em> the asset amount should be closed out, offset
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by a <em> negative</em> value for <em> Accrued Gain</em>
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income. If the total that had been accrued was $5000, then
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the transaction might look like the following:</p>
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<table summary="BIGGAINACCRUEDTOO">
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<tr>
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<th>Account</th>
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<th>Amount</th>
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</tr>
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<tr>
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<td>Cash</td>
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<td>$16055</td>
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</tr>
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<tr>
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<td>Painting</td>
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<td>-$11000</td>
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</tr>
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<tr>
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<td>Accrued Gain Asset</td>
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<td>-$5000</td>
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</tr>
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<tr>
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<td>Realized Gain Income</td>
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<td>-$5055</td>
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</tr>
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<tr>
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<td>Accrued Gain Income</td>
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<td>$5000</td>
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</tr>
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</table>
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<p> Note that the two income accounts offset one another so
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that the <em> current</em> income resulting from the
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transaction is only $55. The remaining $5000 had previously
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been recognized as <em> Accrued Gain Income.</em></p>
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</li>
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<li>
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You were over-optimistic about the value of the painting.
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<p> Instead of the $16055 you thought the painting was
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worth are only offered $15000. But you still decide to
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sell, because you value $15000 more than you value the
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painting.</p>
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<p> The numbers change a little bit, but not too
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dramatically.</p>
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<table summary="SMALLGAINACCRUEDTOO">
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<tr>
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<th>Account</th>
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<th>Amount</th>
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</tr>
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<tr>
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<td>Cash</td>
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<td>$15000</td>
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</tr>
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<tr>
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<td>Painting</td>
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<td>-$11000</td>
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</tr>
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<tr>
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<td>Accrued Gain Asset</td>
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<td>-$5000</td>
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</tr>
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<tr>
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<td>Realized Gain Income</td>
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<td>-$4000</td>
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</tr>
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<tr>
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<td>Accrued Gain Income</td>
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<td>$5000</td>
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</tr>
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</table>
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<p> Note that the two income accounts offset one another so
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that the <em> current</em> income resulting from the
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transaction turns out to be a <em> loss</em> of $1000.
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That's fine, as you had previously recognized $5000 in
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income.</p>
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</li>
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<li>
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You manage to sell your painting for more than you thought
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in your wildest dreams.
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<p> The extra value is, again, recorded as a gain, <em>
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i.e.</em> an income.</p>
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<table summary="HUGEGAIN">
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<tr>
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<th>Account</th>
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<th>Amount</th>
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</tr>
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<tr>
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<td>Cash</td>
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<td>$50000</td>
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</tr>
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<tr>
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<td>Painting</td>
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<td>-$11000</td>
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</tr>
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<tr>
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<td>Accrued Gain Asset</td>
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<td>-$5000</td>
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</tr>
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<tr>
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<td>Realized Gain Income</td>
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<td>-$39000</td>
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</tr>
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<tr>
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<td>Accrued Gain Income</td>
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<td>$5000</td>
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</tr>
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</table>
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</li>
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</ol>
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<p> In practice, it truly is important to keep the <em> Accrued
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Gain Income</em> separate from the <em> Realized Gain
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Income,</em> as the former is likely to be ignored by your tax
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authorities, who will only care to charge you on the <em>
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Realized Gain.</em></p>
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<p>Below, we show the second case discussed.</p>
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<img src="appr-main2.gif" alt="Main window after sale"><br
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clear="ALL">
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<img src="appr-asset2.gif" alt="Asset account after sale">
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<h2>Caution about Valuation</h2>
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<p>As we see in this example, for non-financial assets, it may
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be difficult to correctly estimate the ``true'' value of an
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asset.</p>
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<p> It is quite easy to count yourself rich based on
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questionable estimates that do not reflect "money in the
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bank."</p>
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<p> Thus, when dealing with appreciation of assets,</p>
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<ol>
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<li>
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Be careful with your estimation of values.
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<p> Do not indulge in wishful thinking.</p>
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</li>
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<li>
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Never, ever, count on money you do not have in your bank or
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as cash.
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<p> Until you have actually sold your asset and got the
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money, any numbers on paper (or magnetic patterns on your
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hard disk) are merely that.</p>
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<p> If you could realistically convince a banker to lend
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you money, using the assets as collateral, that is a pretty
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reasonable evidence that the assets have value, as lenders
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are professionally suspicious of dubious overestimations of
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value.</p>
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<p> Be aware: all too many companies that appear
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"profitable" on paper go out of business as a result of
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running out of <em> cash,</em> precisely because "valuable
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assets" were not the same thing as cash.</p>
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</li>
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</ol>
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<h2>Taxation of Capital Gains</h2>
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<p> Taxation policies vary considerably between countries, so
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it is virtually impossible to say anything that will be
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universally useful.</p>
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<p> However, it is <em> common</em> for income generated by
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capital gains to not be subject to taxation until the date that
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the asset is actually sold, and sometimes not even then.</p>
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<p> North American home owners <em> usually</em> find that when
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they sell personal residences, capital gains that occur are
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exempt from taxation. It appears that other countries treat
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sale of homes differently, taxing people on such gains. German
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authorities, for example, tax those gains only if you owned the
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property for less than ten years.</p>
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<p> <a href="mailto:cbbrowne@hex.net"> I have</a> one story
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from my professional tax preparation days where a family sold a
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farm, and expected a <em>considerable</em> tax bill that turned
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out to be virtually nil due to having owned the property before
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1971 (wherein lies a critical "Valuation Day" date in Canada)
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and due to it being a <em> dairy</em> farm, with some <em>
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really peculiar</em> resulting deductions.</p>
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<p> In short, this presentation is fairly simple, but taxation
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often gets terribly complicated...</p>
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<h1>Depreciation of assets</h1>
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<a name="depr"></a>
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<p>Compared to the often uncertain estimates one has to do
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where appreciation of assets is concerned, we are on somewhat
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firmer ground here.</p>
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<ul>
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<li>Governments tend to set up precise rules as to how you
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are required to calculate depreciation for tax purposes.</li>
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<li>It is easy to look up in references such as "Blue Books"
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estimates of what an automobile should be worth after 3 years
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of use.</li>
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</ul>
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<p> Since depreciation of assets is very often driven by tax
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policies, the discussion of depreciation will focus in that
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direction, on some of the more common depreciation calculation
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schemes.</p>
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<p> While there has been some discussion about how to
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accomplish automated calculation and creation of transactions
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to handle things like depreciation, there is not yet any
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working code, so for now, you will have to do calculations by
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hand.</p>
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<h2>Depreciation schemes</h2>
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<h3>Linear depreciation</h3>
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<p> Linear depreciation diminishes the value of an asset by a
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fixed amount each period until the net value is zero. This is
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the <em>simplest</em> calculation, as you estimate a useful
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lifetime, and simply divide the cost equally across that
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lifetime.</p>
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<p><b>Example:</b> You have bought a computer for $1500 and
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wish to depreciate it over a period of 5 years. Each year the
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amount of depreciation is $300, leading to the following
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calculations:<br clear="ALL">
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</p>
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<table summary="Example 1">
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<tr>
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<th>Year</th>
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<th>Depreciation</th>
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<th>Remaining Value</th>
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</tr>
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<tr>
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<td>1</td>
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<td>300</td>
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<td>1200</td>
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</tr>
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<tr>
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<td>2</td>
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<td>300</td>
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<td>900</td>
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</tr>
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<tr>
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<td>3</td>
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<td>300</td>
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<td>600</td>
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</tr>
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<tr>
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<td>4</td>
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<td>300</td>
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<td>300</td>
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</tr>
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<tr>
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<td>5</td>
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<td>300</td>
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<td>0</td>
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</tr>
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</table>
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<h3>Geometric Depreciation</h3>
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<p>Each period the asset is depreciated by a fixed percentage
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of its value in the previous period. In this scheme the rest
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value of an asset decreases exponentially leaving a value at
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the end that is larger than zero (<em> i.e.</em> - a resale
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value).</p>
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<p> <em> Beware: Tax authorities may require (or allow) a
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larger percentage in the first period.</em> On the other hand,
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in Canada, this is reversed, as they permit only a <em>
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|
half</em> share of "Capital Cost Allowance" in the first
|
|
year.</p>
|
|
|
|
<p> The result of this approach is that asset value decreases
|
|
more rapidly at the beginning than at the end which is <em>
|
|
probably</em> more realistic for most assets than a linear
|
|
scheme. This is certainly true for automobiles.</p>
|
|
|
|
<p><strong>Example:</strong> We take the same example as above,
|
|
with an annual depreciation of 30%.</p>
|
|
|
|
<table summary="Example 2">
|
|
<tr>
|
|
<th>Year</th>
|
|
|
|
<th>Depreciation</th>
|
|
|
|
<th>Remaining Value</th>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>1</td>
|
|
|
|
<td>450</td>
|
|
|
|
<td>1050</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>2</td>
|
|
|
|
<td>315</td>
|
|
|
|
<td>735</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>3</td>
|
|
|
|
<td>220.50</td>
|
|
|
|
<td>514.50</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>4</td>
|
|
|
|
<td>154.35</td>
|
|
|
|
<td>360.15</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>5</td>
|
|
|
|
<td>108.05</td>
|
|
|
|
<td>252.10</td>
|
|
</tr>
|
|
</table>
|
|
|
|
<h3>Sum of digits</h3>
|
|
|
|
<p>A third method most often employed in Anglo/Saxon countries
|
|
is the "sum of digits" method. Here is an illustration:</p>
|
|
|
|
<p><strong>Example:</strong> First you divide the asset value
|
|
by the sum of the years of use, <em> e.g.</em> 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:</p>
|
|
|
|
<table summary="Example 3">
|
|
<tr>
|
|
<th>Year</th>
|
|
|
|
<th>Depreciation</th>
|
|
|
|
<th>Remaining Value</th>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>1</td>
|
|
|
|
<td>100*5=500</td>
|
|
|
|
<td>1000</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>2</td>
|
|
|
|
<td>100*4=400</td>
|
|
|
|
<td>600</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>3</td>
|
|
|
|
<td>100*3=300</td>
|
|
|
|
<td>300</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>4</td>
|
|
|
|
<td>100*2=200</td>
|
|
|
|
<td>100</td>
|
|
</tr>
|
|
|
|
<tr>
|
|
<td>5</td>
|
|
|
|
<td>100*1=100</td>
|
|
|
|
<td>0</td>
|
|
</tr>
|
|
</table>
|
|
|
|
<h2>The handling of depreciation in gnucash</h2>
|
|
|
|
<p>In order to keep track of the depreciation of an asset, you
|
|
need :</p>
|
|
|
|
<ul>
|
|
<li>An <em>Asset Cost</em> asset account to keep track of the
|
|
original value;</li>
|
|
|
|
<li>An <em> Accumulated Depreciation</em> asset account in
|
|
which to collect the sum of all of the years' depreciation
|
|
amounts;</li>
|
|
|
|
<li>A <em>Depreciation Expense</em> expense account in which
|
|
to record periodic depreciation expenses.</li>
|
|
</ul>
|
|
|
|
<p>The first step, again, is to record the purchase of your
|
|
asset by transferring the money from bank bank account to the
|
|
<em>asset cost</em> account. Afterwards, in each accounting
|
|
period you record the depreciation as an expense in the
|
|
appropriate account.</p>
|
|
|
|
<p>The two windows below show your asset account and the main
|
|
window after the third year of depreciation using a "sum of
|
|
digits" scheme for the example above.</p>
|
|
<img src="depr-asset.gif" alt=
|
|
"Asset account after depreciation"><br clear="ALL">
|
|
<img src="depr-main.gif" alt="Main window after depreciation">
|
|
|
|
|
|
<h2>A word of caution</h2>
|
|
|
|
<p>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 <em> or required</em> to use.</p>
|
|
|
|
<p> Return to <a href="xacc-main.html"> Main Documentation
|
|
Page.</a></p>
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</body>
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</html>
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