© mcgraw-hill companies, 2008 farm management chapter 4 depreciation and asset valuation
TRANSCRIPT
© Mcgraw-Hill Companies, 2008
Farm Management
Chapter 4Depreciation and Asset Valuation
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Chapter Outline
• 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
Annual Depreciation = Cost – Salvage Value
Useful Life
Annual Depreciation = (Cost – Salvage Value) x R
where R is found by dividing 100% by useful life
Or
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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 witha 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 yearunder this method.
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Using Double Declining Balance
Year 1: $10,000 x 20% = $2,000Year 2: $ 8,000 x 20% = $1,600Year 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% = $1,500Year 2: $ 8,000 x 15% = $1,275Year 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 tractorpurchased April 1 would be eligible for 9/12 of a full year’s depreciation thefirst 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 4-1MACRS Recovery Rates
Recovery 3-year 5-year 7-yearYear class class class
1 25.00 15.00 10.712 37.50 25.50 19.133 25.00 17.85 15.034 12.50 16.66 12.255 16.66 12.256 8.33 12.257 12.258 6.12
Recovery Precentages
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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 Depre-Date or Salvage ciation Depre- Book Depre- Book Depre- Book
Item Purchased Basis Value Life method ciation value ciation value ciation value
20______ 20_____ 20_____
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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 isan expense used to calculate profit, and depreciation reduces the value of assets.Depreciation used for tax purposes may differfrom economic depreciation and managers may need to calculate both. Valuation methods for business assets werealso discussed.