Depreciation on a Dairy Farm

As assets are "used-up" in order to generate income, their reduction in value must be accounted for.  Dairy production can be described as an asset heavy business but many astute producers are realizing the impact that depreciating assets have on the net income of the operations they are responsible for managing. Accumulated depreciation results in a credit to the assets account on the balance sheet and a debit to the depreciation expense account. This increase in expenses reduces net income on a dairy's income statement and this can have dramatic impacts on the financial health of the operation. The types of depreciation most commonly used for financial accounting within the dairy industry include straight-line methods and accelerated methods such as declining balance and sum of years'.

In order to determine depreciation using any of the above methods, one must first know a few pieces of information. The cost of the asset is the most obvious and easy piece of data to determine. For example, the dairy purchases a new tractor for $100,000. This represents the cost of the asset which is used to begin the depreciation calculations. One must also be able to come up with a salvage value and useful life for the asset that will be depreciated. Both of these parts of the equation are estimates. Most firms are very good at providing accurate information with regard to useful life and salvage value based on the history of similar assets, particularly if similar equipment has already been employed within the business. In this example, the owner's know that the useful life of the equipment they purchase is impacted by many factors that are in the control of the farm in question. These variables include the number of acres the harvester will cover each year, the ability of the farm to properly maintain their equipment, and how careful the particular operator running the equipment tends to harvest forage, among other factors. Let's say for this particular example that the farm depreciates the asset over a period of 7 years. The salvage value is also a bit of a "shot in the dark" and the dairy producer estimates it to be $20,000 at the end of 7 years of useful life.

The straight line method reduces the assets net book value by the same amount each year. In the above example, accumulated depreciation is a debit of $11,428 and depreciation expense is credited $11,428. When compared to accelerated depreciation methods, such as double declining balance, the straight line method will yield lower depreciation expense. Anytime a firm can reduce an expense, it has increased its net income. From a tax implication standpoint, this may mean the farm has to pay more taxes in this simple example.

The double declining method reduces the net book value of the tractor more quickly early in the life of the asset. Thus, the depreciation expense is higher so net income is lower in the early years of useful life for the asset. In this method the constant rate of 200% of the straight line depreciation is applied to the net book value each year. The double-declining balance method reduces the net book value by 28.5% per year. So, after one year of useful life, the net book value of the tractor would be $71,500 (Depreciation Expense= $100,000 x 28.5% =  $28,500. $100,000 - $28,500 = $71,500 or the new net book value). Year 2 of useful life results in a net book value of $51,123 with a depreciation expense of $20,377 and accumulated depreciation of $48,877 ($51,123 + $28,500). These calculations continue until the 7 years of useful life fully depreciate the tractor to its salvage value of $20,000. The depreciation expense in the double-declining method yields a greater depreciation expense early in the useful life of the asset resulting in a lower net income. Toward the end of the useful life of the tractor, the depreciation expense is lower, thus the depreciation expense will be lower and yield higher net income.

Modified Accelerated Cost Recovery System (MACRS) are the IRS guidelines for depreciation methods. This method of depreciation establishes acceptable rules for properly depreciating assets. According to the IRS publication, "Farmer's Tax Guide 2009," the useful life a farm accountant may use for equipment and farm machinery with respect to tax reporting is 5 years. This would generate a larger depreciation expense if applied to the previous straight line and double declining depreciation examples discussed above.  Based on this information, a farm owner may be better served to simply use the MACRS guidelines to avoid increasing the cost of the farm's accounting systems by employing multiple depreciation methods.

Multiple depreciation methods exist for properly spreading the cost of a tractor or any other asset used in generating income over its useful life. As is the case with most management decisions with regard to the accounting methods a dairy business chooses to use, the different options that exist will influence the year end statements. Investors and managers alike will benefit from a fundamental understanding of the different accounting methods used in depreciating assets. Decisions have to be made every day by those supplying the funds to support the dairy operation as well as those ensuring a respectable return on those funds. Understanding depreciation will allow those involved to better guide the business and the dollars flowing into and out of the business.