Understanding Economic Depreciation for Farms and Ranches
by K.D. Dillivan* (12/12)
- Economic depreciation should reflect an asset’s reduction in value over time from use, age, and other factors.
- Economic depreciation appears as an expense on the accrual income statement and is used to estimate asset value on the cost-basis balance sheet.
- Three common methods for computing depreciation are straight-line, declining balance, and sum-of-year’s digits.
- Depreciating an asset for tax purposes is different than calculating depreciation for an income statement or balance sheet.
Depreciation is defined as the annual reduction in value of a durable asset due to use, wear, age, or obsolescence. Depending on the asset, depreciation may result from a combination of any of these factors. For an asset to be depreciable it must: 1) be owned, 2) have a useful life greater than one year, 3) have a finite and determinable life, and 4) have productive use in the business. In agriculture, examples of assets that are depreciable include buildings, vehicles, machinery, equipment, fences and other land improvements, and breeding livestock. Real estate, market livestock, crop inventories, and supplies are not depreciable.
Depreciation appears on an accrual income statement (the list of revenues and expenses that provides an estimate of annual profit) as a non-cash expense. Depreciation represents the annual portion of the asset’s value used up by the business. As a reduction in revenue, depreciation also contributes financially to the asset’s replacement cost. Depreciation is not accounted for on cash income statements or cash flow budgets because it is a non-cash item (meaning depreciation does not result in actual cash leaving the business).
Depreciation is also used to calculate an asset’s depreciated value or book value for the cost-basis balance sheet. A balance sheet contains estimated values for assets and liabilities at a particular point in time (typically at year’s end). For those assets that are depreciable, book value—original cost less accumulated depreciation—is the remaining cost-basis of the asset.
Depreciation calculations utilize the asset’s original cost (i.e., basis), and require business managers to estimate salvage value and useful life. The cost of an asset is generally the purchase price plus shipping, installation, and any other associated expense required prior to use. Occasionally, an asset will have an adjusted basis to account for increases or decreases in value that have occurred between the time the asset was purchased and when it was placed into service. For assets without a purchase price (e.g. raised breeding livestock), fair market value is used as the asset’s beginning basis.
There exist several common methods for calculating economic depreciation. The selection of a particular method depends on the asset to be depreciated. Managers should also be aware that depreciating an asset for tax purposes is different than calculating depreciation for an income statement or balance sheet.
Although calculating depreciation is a relatively simple procedure, the process is complicated by the fact that assets depreciate at different rates depending on use, conditions, and other factors. Managers should be mindful that the purpose of depreciation is to accurately reflect an asset’s decline in value over time. As a result, managers should choose the depreciation method that most accurately reflects this decline for each asset in productive use. Three common methods for computing depreciation are straight-line, declining balance, and sum-of-year’s digits.
The straight-line method produces a constant depreciation value for each year. The formula for straight-line is:
|Annual Depreciation =|
|(Original Cost – Salvage Value)|
To illustrate, assume a farm implement has a purchase price of $60,000, an economic life of 10 years, and a salvage value of $10,000. In this example, the annual depreciation for this asset is:
|($60,000 - $10,000)/10 = $5,000|
Using the straight-line method, the asset depreciates $5,000 annually resulting in a salvage value of $10,000 when fully depreciated at the end of year 10. (Note that with depreciable assets, original cost minus accumulated depreciation equals book value in any given year.)
Declining balance is an accelerated method of depreciation used for assets that depreciate more rapidly in early years and less rapidly as they age. The formula for declining balance is:
|Annual Depreciation =|
|Book Value of Asset|
|at Beginning of Year x R|
|(where R is a constant percentage rate)|
Declining balance uses the percent reduction in value from the straight-line method as R. Using the farm implement example provided earlier, a projected useful life of 10 years corresponds to a 10% reduction in annual value (i.e., R = 10%). Therefore, annual depreciation for the implement using declining balance is:
|Year 1 = $6,000 ($60,000 x 10%)|
Year 2 = $5,400 ($54,000 x 10%)
Year 3 = $4,860 ($48,600 x 10%)
Year 4 = $4,374 ($43,740 x 10%)
Year 5 = $3,937 ($39,366 x 10%)
Year 6 = $3,543 ($35,433 x 10%)
Year 7 = $3,189 ($31,889 x 10%)
Year 8 = $2,870 ($28,700 x 10%)
Year 9 = $2,583 ($25,830 x 10%)
Year 10 = $2,325 ($23,247 x 10%)
If economic life should end before salvage value is reached, managers should add any unused depreciation to the accumulated depreciation in the final year. An alternative would be to lengthen the asset’s useful life.
Double declining balance (a common modification of declining balance) necessitates an R double that of the percent reduction from the straight-line method. With the double declining balance method, R is now 20% (assuming an asset with a useful life of 10 years). The farm implement’s annual depreciation using double declining balance is:
|Year 1 = $12,000 ($60,000 x 20%)|
Year 2 = $9,600 ($48,000 x 20%)
Year 3 = $7,680 ($38,400 x 20%)
Year 4 = $6,144 ($30,720 x 20%)
Year 5 = $4,915 ($24,576 x 20%)
Year 6 = $3,932 ($19,661 x 20%)
Year 7 = $3,146 ($15,729 x 20%)
Year 8 = $2,517 ($12,583 x 20%)
Frequently, using the double declining balance method results in the asset fully depreciating before its useful life ends (in this example, the depreciated value is $10,066 at the end of Year 8). With declining balance the manager must select an R of 100%, 150%, or 200% of the straight-line annual reduction value.
Like declining balance, sum-of-year’s digits is an accelerated depreciation method. The formula for sum-of-year’s digits is:
|Annual Depreciation =|
|(Original Cost – Salvage Value)|
|(where RL is remaining years of life|
|and SOYD is sum of the year’s digits)|
An asset with a useful life of 10 years has SOYD = 55 (10+9+8+ . . . +1). To illustrate this approach, assume an asset has a 10-year useful life, a purchase price of $10,000 and a salvage value of $2,000. The sum-of-year’s digits method yields depreciation amounts for years 1-3 of:
|Year 1 = $1,454.54 ($10,000 - $2,000)|
|Year 2 = $1,309.09 ($10,000 - $2,000|
|Year 3 = $1,163.63 ($10,000 - $2,000)|
This process will continue through Year 10 at which point the asset will be fully depreciated and book value will equal salvage value.
Comparison of Three Methods
Because the straight-line method produces a constant depreciation value for each year, this method is appropriate for assets that are used an equal amount (approximately) in each year of useful life. The declining balance method depreciates the asset at an accelerated rate rather than spreading the cost evenly over its useful life. As a result, declining balance is the appropriate method for assets used more in the early years of life and less as they age, or for assets that wear out relatively quickly. Like the declining balance method, sum-of-year’s digits results in relatively large depreciation charges in early years and smaller charges as the asset ages.
Figure 1 shows depreciation amounts per year for each of the three methods. These depreciation amounts were calculated assuming an asset with a purchase price of $60,000, a salvage value equal to $10,000, and a useful life of 10 years. Note that double declining balance and sum-of-year’s digits result in greater depreciation in early years and less in later years (see Figure 1).
Figure 1. Comparison of Annual Depreciation Amounts
Income Tax Depreciation
Income tax depreciation and economic depreciation have different purposes and can result in very different annual depreciation values for the same asset. The purpose of income tax depreciation is to reduce taxable income by writing-off the asset’s cost over a proscribed recovery period. Income tax depreciation is calculated in ways that are similar, but not identical to those used for economic depreciation. From a financial standpoint, income tax depreciation is used to maximize after-tax income.
While taxpayers do have some choice regarding the depreciation method they may use for income tax purposes, the IRS stipulates methods available and potential recovery periods depending on asset class. Farms and ranches with depreciable assets use the Modified Accelerated Cost Recovery System (MACRS) for assets placed in service after 1986. MACRS groups assets into nine property classes: 3-year property, 5-year property, 7-year property, 10-year property, 15-year property, 20-year property, 25-year property, residential rental property, and nonresidential real property. These property classes determine recovery periods. For example, most agricultural machinery and equipment will be in the 7-year class and have a 7-year recovery period. Purchased dairy and beef cattle are in the 5-year class; while swine and horses are in the 3-year and 7-year classes respectively.
Economic depreciation should reflect an asset’s reduction in value over time from use, age, and other factors. Economic depreciation appears as an expense on the accrual income statement and is used to estimate asset value on the cost-basis balance sheet. As shown in this document, different depreciation methods are available. The method selected should be based on the characteristics of the asset and how the asset is used. It is recommended that the farm business manager consult with a tax professional before selecting a depreciation method for income tax purposes, and carefully study the projected income statement and balance sheet impacts of any economic depreciation method prior to adopting it.
*K.D. Dillivan, Colorado State University Extension agent and county director, Dolores County. 12/12
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Updated Tuesday, July 22, 2014