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Farm Management. Chapter 4 Depreciation and Asset Valuation. Chapter Outline. Depreciation Depreciation Methods Income Tax Depreciation Valuation of Assets. Chapter Objectives. To define depreciation and related terms To illustrate the different methods of computing depreciation

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farm management

Farm Management

Chapter 4

Depreciation and Asset Valuation

chapter outline
Chapter Outline
  • Depreciation
  • Depreciation Methods
  • Income Tax Depreciation
  • Valuation of Assets
chapter objectives
Chapter Objectives
  • To define depreciation and related terms
  • To illustrate the different methods of computing depreciation
  • To compare economic and income tax depreciation
  • To outline the different methods that can be used to value farm and ranch assets
depreciation
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
assets that may be depreciated
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.

depreciation terms
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
depreciation methods
Depreciation Methods
  • Straight Line
  • Sum-of-the-Year’s Digits (SOYD)
  • Declining Balance
straight line

Cost – Salvage Value

Annual Depreciation =

Useful Life

Straight Line

Or

Annual Depreciation = (Cost – Salvage Value) x R

where R is found by dividing 100% by usefullife

sum of the year s digits

RL

Annual Depreciation = (Cost – Salvage Value)x

SOYD

Sum-of-the-Year’s Digits

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

declining balance
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.

examples
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.

using straight line
Using Straight Line

($10,000 – $2,000)

Annual Depreciation =

10

= $800

Annual depreciation will be the same every year

under this method.

using soyd
Using SOYD

1+2+3+4+5+6+7+8+9+10 = 55

10

Year 1: ($10,000 – $2,000) x = $1,454.55

55

9

Year 2: ($10,000 – $2,000) x = $1,309.09

55

using double declining balance
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

100%

20% = 2 x

10

useful life

using 150 declining balance
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

when using declining balance
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.
partial year depreciation
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.

income tax depreciation
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
asset classes
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
economic vs tax depreciation
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.
valuation of assets
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
summary
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.