Farm Management Chapter 4 Depreciation and Asset Valuation

Farm Management Chapter 4 Depreciation and Asset Valuation farm management chapter 4

Chapter Outline • • Depreciation Methods Income Tax Depreciation Valuation of Assets farm management chapter 4 2

Chapter Objectives 1. To define depreciation and related terms 2. To illustrate the different methods of computing depreciation 3. To compare economic and income tax depreciation 4. To outline the different methods that can be used to value farm and ranch assets farm management chapter 4 3

Depreciation • Defined as the annual loss in value of durable assets due to use, wear, tear, age, and obsolescence • A business expense that reduces annual profit • A reduction in the value of an asset farm management chapter 4 4

Assets that May Be Depreciated • a useful life of more than one year • a determinable useful life but not an unlimited life • a use in business Examples: vehicles, machinery, equipment, building, fences, purchased breeding livestock, wells. Land is not depreciable, but some improvements to land (e. g. drains) are depreciable. farm management chapter 4 5

Depreciation Terms • Cost: the price paid for the asset • Useful life: number of years the asset is expected to be used in business • Salvage value: expected market value of the asset at the end of its useful life • Book value: the asset’s original cost less accumulated depreciation farm management chapter 4 6

Depreciation Methods • Straight Line • Sum-of-the-Year’s Digits (SOYD) • Declining Balance farm management chapter 4 7

Straight Line Annual Depreciation = Cost – Salvage Value Useful Life Or Annual Depreciation = (Cost – Salvage Value) x R where R is found by dividing 100% by useful life farm management chapter 4 8

Sum-of-the-Year’s Digits Annual Depreciation = (Cost – Salvage Value) x RL SOYD RL = remaining years of useful life SOYD = sum of all the numbers from 1 through the estimated useful life For 5 year life, SOYD = 1+2+3+4+5 = 15 farm management chapter 4 9

Declining Balance Annual Depreciation = Beginning Year Book Value x R R is a constant percentage rate. Its value depends on useful life and the type of declining balance chosen. It is a multiple of the straight line rate. farm management chapter 4 10

Examples Calculate depreciation for a machine with a cost of $10, 000, a salvage value of $2, 000, and a useful life of 10 years. farm management chapter 4 11

Using Straight Line Annual Depreciation = ($10, 000 – $2, 000) 10 = $800 Annual depreciation will be the same every year under this method. farm management chapter 4 12

Using SOYD 1+2+3+4+5+6+7+8+9+10 = 55 Year 1: ($10, 000 – $2, 000) x Year 2: ($10, 000 – $2, 000) x farm management chapter 4 10 55 9 55 = $1, 454. 55 = $1, 309. 09 13

Using Double Declining Balance Year 1: $10, 000 x 20% = $2, 000 Year 2: $ 8, 000 x 20% = $1, 600 Year 3: $ 6, 400 x 20% = $1, 280 20% = 2 x 100% 10 useful life farm management chapter 4 14

Using 150% Declining Balance Year 1: $10, 000 x 15% = $1, 500 Year 2: $ 8, 000 x 15% = $1, 275 Year 3: $ 6, 400 x 15% = $1, 084 100% 15% = 1. 5 x 10 useful life farm management chapter 4 15

When Using Declining Balance • If there is a salvage value greater than zero, declining balance methods can result in the salvage value being reached before the end of the useful life. Depreciation must stop when book value = salvage value. • If salvage value is zero, it is necessary to switch from declining balance to straight line (on the remaining value and remaining life) at some point to get all the depreciation allowed. farm management chapter 4 16

Partial Year Depreciation If an asset is purchased during the year, rather than at the beginning of the year, depreciation must be prorated. A tractor purchased April 1 would be eligible for 9/12 of a full year’s depreciation the first year. farm management chapter 4 17

Figure 4 -1 Three depreciation methods farm management chapter 4 18

Income Tax Depreciation • Must be done following rules of IRS • Modified Accelerated Cost Recovery System (MACRS) • An implied salvage value of 0 • Half year depreciation in year of purchase, regardless of when purchased • Property classes determine useful life of property farm management chapter 4 19

Asset classes • 3 -year: breeding hogs • 5 -year: cars, pickups, breeding cattle and sheep, dairy cattle, computers, trucks • 7 -year: most farm machinery and equipment, fences, grain bins, silos, office furniture • 10 -year: single purpose ag/hort structures • 15 -year: wells, paved lots, drainage tiles • 20 -year: general purpose buildings farm management chapter 4 20

Table 4 -1 MACRS Recovery Rates farm management chapter 4 21

Economic vs. Tax Depreciation • Economic depreciation is linked to asset’s reduced ability to produce revenue as it ages and wears out. • Tax depreciation is the allowable business expense for IRS purposes. It may or may not be close to the economic depreciation. • It may be advisable for managers to devise two depreciation schedules, one for tax purposes and one for business analysis. farm management chapter 4 22

Table 4 -2 Depreciation Schedule farm management chapter 4 23

Valuation of Assets • Market Value: fair market price less any transactions cost (for items normally sold) • Cost: for purchased items that do not normally lose value • Lower of cost or market: conservative method • Farm production cost: accumulated cost of producing the item (immature crops growing in field, livestock) • Cost less accumulated depreciation: book value. For items that depreciate farm management chapter 4 24

Summary A depreciation schedule is a necessary part of any accounting system. Depreciation is an expense used to calculate profit, and depreciation reduces the value of assets. Depreciation used for tax purposes may differ from economic depreciation and managers may need to calculate both. Valuation methods for business assets were also discussed. farm management chapter 4 25