Economic depreciation for farm equipment and machinery

In 2013, strong U.S. commodity prices, relatively low interest rates and enhanced tax deductions led to robust sales of new farm machinery and equipment. According to the Association of Equipment Manufacturers’ February 2014 Flash Report, retail sales of tractors and combines in 2013 were substantially higher than the two previous years and much greater than the five-year average, said Kim Dillivan, SDSU Extension Crops Business Management field specialist.

“For example, tractor and combine sales for May 2013 totaled almost 25,000 units; this compares to 20,000 units sold in 2012 and 18,000 sold in 2011,” he said.

Dillivan said that the use of equipment and machinery in a farming operation represents a business expense because these assets wear out, age and become obsolete over time. “To account for this loss of value, economic depreciation should be calculated for these types of assets and utilized in accessing a farm’s profitability and solvency,” he said.

Economic Depreciation

Depreciation is the reduction in value of an asset over a period of time. Dillivan explained that assets depreciate as they age, are used or become obsolete. Depreciation can result from any combination of these factors. Economic depreciation appears as a non-cash business expense on the farm income statement and is used to calculate the asset’s book value for the balance sheet. Also, depreciating an asset for financial record analysis is a different process than depreciation for tax purposes.

Depreciable assets must have the following characteristics:

* must be owned, not rented,

* must have a life expectancy greater than one year,

* must have a useful life that can be projected, and

* must have a use in the business.

In agriculture, examples of assets that are depreciable include buildings, vehicles, machinery, equipment, fences, drainage tiles, other land improvements and breeding livestock. Land is not depreciable, nor is market livestock, crop inventories, materials or supplies. The calculation of depreciation utilizes the asset’s original cost and requires the projection of useful life and estimation of salvage value. Salvage value equals the asset’s worth after it has been fully depreciated. For some assets, salvage value is zero.

Depreciation for Income Statements

Depreciation is a non-cash business expense. “As a result, depreciation appears on an accrual income statement as an expense but it does not appear on a cash income statement. Income statements list revenue and costs and are used to estimate profit,” Dillivan said.

As an expense, depreciation represents the annual portion of the asset’s value that has been consumed by use in the business. When depreciation is accounted for on an accrual income statement, it represents a reduction in revenue, thereby contributing to the asset’s replacement cost.

Depreciation for Balance Sheets

Depreciation is also used to calculate an asset’s depreciated value or book value for the balance sheet. A balance sheet contains estimated values for assets and liabilities at a particular point in time, typically at year’s end.

For assets that are depreciable, book value or original cost less accumulated depreciation, value is the remaining cost-basis of the asset. Another option for determining an asset’s value is to use fair market value – an estimated worth of the asset if sold at auction. For a particular asset, cost-basis and market value are not necessarily identical.

“There are several methods for calculating depreciation. The method selected depends on the asset to be depreciated and how the asset is used in the business,” Dillivan said. “Managers should be aware that the purpose of depreciation is to accurately reflect an asset’s decline in value over time. As a result, the depreciation method chosen should be the one that most accurately reflects this reduction in value.”

Dillivan said there are several methods for calculating depreciation. “The method chosen depends on the asset and how the asset is being used,” he said. “Managers should be aware that calculating an asset’s depreciation for economic purposes is different than calculating depreciation for tax purposes.”

–SDSU Extension