1. © Mcgraw-Hill Companies, 2008 Farm Management Chapter 4 Depreciation and Asset Valuation

2. © Mcgraw-Hill Companies, 2008 Chapter Outline Depreciation Depreciation Methods Income Tax Depreciation Valuation of Assets

3. © Mcgraw-Hill Companies, 2008 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

4. © Mcgraw-Hill Companies, 2008 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

5. © Mcgraw-Hill Companies, 2008 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.

6. © Mcgraw-Hill Companies, 2008 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

7. © Mcgraw-Hill Companies, 2008 Depreciation Methods Straight Line Declining Balance

8. © Mcgraw-Hill Companies, 2008 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

9. © Mcgraw-Hill Companies, 2008 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.

10. © Mcgraw-Hill Companies, 2008 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.

11. © Mcgraw-Hill Companies, 2008 Using Straight Line Annual Depreciation = ($10,000 – $2,000) 10 = $800 Annual depreciation will be the same every year under this method.

12. © Mcgraw-Hill Companies, 2008 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

13. © Mcgraw-Hill Companies, 2008 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

14. © Mcgraw-Hill Companies, 2008 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.

15. © Mcgraw-Hill Companies, 2008 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.

16. © Mcgraw-Hill Companies, 2008 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%

17. © Mcgraw-Hill Companies, 2008 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

18. © Mcgraw-Hill Companies, 2008 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

19. © Mcgraw-Hill Companies, 2008 Table 4-1 MACRS Recovery Rates

20. © Mcgraw-Hill Companies, 2008 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.

21. © Mcgraw-Hill Companies, 2008 Table 4-2 Depreciation Schedule

22. © Mcgraw-Hill Companies, 2008 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

23. © Mcgraw-Hill Companies, 2008 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.