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Farm Management Chapter 4 Depreciation and Asset Valuation (Plus some material on fixed costs)
Fixed Costs in Agriculture Fixed costs in agriculture are normally very high. This is why farmers frequently produce at a loss.
Ownership Costs Many fixed costs are associated with owning items. Ownership costs are sometimes called the “DIRTI-5”
DIRTI-5 Depreciation Interest Repairs Taxes Insurance
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
Depreciation Definition Depreciation is the loss of an asset’s value caused by use, age, or obsolescence.
Purpose of depreciation • Depreciation is an accounting procedure that spreads the original cost of a durable item over its useful life. • Depreciation is a tax-deductible business expense.
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 • 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
Useful Life When determining the useful life of an object (for your own records), consider how often you will use it, how old it is when acquired, how often you’ll repair it, the climate, normal technical progress, your experience with similar property.
How to Choose a Depreciation Method • For tax purposes: The IRS has explicit rules. • For your own records: Use a method that reflects the actual loss in value of the item over time.
BASIS The basis is an asset's value for tax purposes at a point in time. At the time of purchase, it is called a beginning tax basis. When this value changes, it is called an adjusted tax basis. Any asset purchased for cash, whether new or used, has a beginning tax basis equal to its purchase price.
Trades If an asset is acquired by trading in another one, beginning tax basis on the new asset is equal to the cash paid to complete the trade. The old asset (no longer owned) continues to be depreciated for tax purposes until all the depreciation is taken.
Depreciation Methods • Straight Line • Declining Balance
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 usefullife
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 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 ($10,000 – $2,000) Annual Depreciation = 10 = $800 Annual depreciation will be the same every year under this method.
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 Year 1: $10,000 x 15% = $1,500 Year 2: $ 8,500 x 15% = $1,275 Year 3: $ 7,225 x 15% = $1,084 100% 15% = 1.5 x 10 useful life
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.
Things to notice • do not subtract salvage value for DDB • the book value changes (gets smaller) every year so depreciation gets smaller every year as well. • don’t allow the book value to fall below the salvage value. • if the salvage value is zero, you must switch to straight line at some point.
Switching to straight line If an object has a salvage value of zero, you must switch to straight line at some point. Switch when straight line, on the remaining value over the remaining life, gives the same or higher depreciation than DDB would give.
Let the Salvage Value = 0 Using DDB, we do not get to 0
Easier way to figure out when to switch Divide the years of remaining life into the number “1.” When that fraction is greater than 2/L, switch.
Example If the years of useful life are 5, then 2/5 = 0.40. Calculated 1 /(remaining life) year 1 1/5 = 0.20 year 2 1/4 = 0.25 year 3 1/3 = 0.33 year 4 1/2 = 0.50 switch in year 4
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 • 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 • 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 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.
Interest Interest can be a cash cost (if there is a loan on the item) or a non-cash, opportunity cost. Interest cost is the cost associated with tying up the value of the item over the period of its use.
Repairs Maintenance repairs are fixed costs.
Taxes Property taxes are fixed costs. They are money paid to the government for owning an asset, usually land.
Insurance Property insurance is a fee paid to protect against loss of the value of the item through theft or disaster. Liability insurance is a fee paid to protect against losses caused by harm to others.
Calculate interest Annual interest cost is (Original Cost + Salvage Value) 2 __________________________ *I Where I is the opportunity cost interest rate
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 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.