Farm Management
Chapter 4
Depreciation and Asset Valuation
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Chapter Outline
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•
•
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Depreciation
Depreciation Methods
Income Tax Depreciation
Valuation of Assets
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Chapter Objectives
1. Define depreciation and related terms
2. Illustrate the different methods of
computing depreciation
3. Compare economic and income tax
depreciation
4. Outline the different methods that can be
used to value farm and ranch assets
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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
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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.
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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
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Depreciation Methods
• Straight Line
• Declining Balance
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Straight Line
Cost – Salvage Value
Annual Depreciation =
Useful Life
Or
Annual Depreciation = (Cost – Salvage Value) x R
where R is found by dividing 100% by useful life
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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.
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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.
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Using Straight Line
Annual Depreciation =
($10,000 – $2,000)
10
= $800
Annual depreciation will be the same every year
under this method.
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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
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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
15% = 1.5 x
100%
10
useful life
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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.
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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.
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Quick Estimate of Economic Depreciation
• Economic depreciation can be
approximated for the entire farm business.
• For machinery and equipment:
Economic Depreciation =
(Beginning Value + Purchases or Trades – Sales) × 10%
• For buildings:
(Beginning Value + Purchases or Trades – Sales) × 5%
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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
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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
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Table 4-1
MACRS Recovery Rates
Recovery
Year
1
2
3
4
5
6
7
8
Recovery Precentages
3-year 5-year 7-year
class
class
class
25.00
37.50
25.00
12.50
15.00
25.50
17.85
16.66
16.66
8.33
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10.71
19.13
15.03
12.25
12.25
12.25
12.25
6.12
Economic Versus 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.
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Table 4-2
Depreciation Schedule
Cost
Date
or
Item Purchased Basis
Salvage
Value
Life
Depreciation
method
20______
Depreciation
Book
value
20_____
Depreciation
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Book
value
20_____
Depreciation
Book
value
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
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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.
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