Farm Management

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Farm Management

• Chapter 4
• Depreciation and Asset Valuation
• (Plus some material on fixed costs)

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Fixed Costs in Agriculture
Fixed costs in agriculture are normally very
high. This is why farmers frequently produce at
a loss.
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Ownership Costs
Many fixed costs are associated with owning
items. Ownership costs are sometimes called the
DIRTI-5
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DIRTI-5
Depreciation Interest Repairs Taxes Insurance
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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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Depreciation Definition
Depreciation is the loss of an assets value
caused by use, age, or obsolescence.
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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.

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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 assets original cost less
  accumulated depreciation

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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 youll repair it, the climate, normal
technical progress, your experience with similar
property.
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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.

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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.
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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.
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Depreciation Methods

• Straight Line
• Declining Balance

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Table 4-2 Depreciation Schedule
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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
(10,000 2,000)
Annual Depreciation
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
100

20 2 x
10
useful life
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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
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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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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.
• dont 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.

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(No Transcript)
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You cant depreciate below salvage value!
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Corrected depreciation
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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.
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Let the Salvage Value 0
Using DDB, we do not get to 0
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switch to straight line in year 6
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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.
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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
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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 years
depreciation the first year.
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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
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Economic vs. Tax Depreciation

• Economic depreciation is linked to assets
  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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Interest
Interest can be a cash cost (if there is a loan
on the item) or a non-cash, opportunity cost. Int
erest cost is the cost associated with tying up
the value of the item over the period of its use.
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Repairs
Maintenance repairs are fixed costs.
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Taxes
Property taxes are fixed costs. They are money
paid to the government for owning an asset,
usually land.
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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.
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Calculate interest
Annual interest cost is (Original Cost
Salvage Value) 2
__________________________
I
Where I is the opportunity cost interest rate
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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 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.