What the heck is depreciation, and why do I need it in my financial statements?

close up old tractorLast week I took my pile of papers to my accountant so he could prepare my annual taxes. (Yes, even though I’ve been a financial manager for years, I feel it’s worthwhile to pay a knowledgeable accountant to do my taxes!) Every year at this time I have to get over my mixed feelings about depreciation. When we fill in my tax forms, depreciation appears kind of good, as it reduces my taxable income. But, when I run financial statements to look at my farm profitability, depreciation can make things look bad, as it is a non-cash adjustment that reduces my net profit.

So, what the heck is depreciation, and why do we need to account for it? As simply put as possible, depreciation is an accounting of the value that you have “used up” in equipment or property. Depreciation also helps spread out the cost of a large purchase that will be useful for several years beyond the initial purchase year.

Say, for instance, you buy a new tractor in 2009. You pay $25,000 for it and feel pretty good. The day you bring it home, and it switches from “new” to “used,” it drops in value. Each year that you use it, it gets a little more worn out. Even if you are vigilant with maintenance, every year a little of that tractor gets “used up.” To account for this drop in value, the IRS (or accountants) came up with the concept of “depreciation.”

Because it is hard to go out and figure out how much of a tractor is “used up,” the IRS came up with a way of “scheduling” depreciation. The average piece of farm equipment, for instance, is scheduled to last for seven years. This means that your accountant will take the total value of your tractor, divide by 7 and reduce its value by that amount each year. This means that, in effect, your $25,000 tractor will have no “book” value at the end of 7 years.

Depreciation reduces tax liability, and so many farmers really like its impact on their annual tax bill.

The real-world impact of depreciation is that some assets, like computers, really do lose value over time. If you buy a computer, 7 years later it probably will be worth nothing. By depreciating your computer, you are forced to account for the fact that, in order to maintain the same level of service, you will have to replace that $2,000 computer in 7 years (or sooner), and so the overall “value” of what your company owns is that much less as time goes on.

Depreciation is, in effect, a “savings account” designed to allow for equipment replacement. If you include depreciation in your budgeting, and budget for a positive bottom line, that assures you will have a reserve large enough to cover replacement of your equipment as it wears out.

The funny thing is that most farm equipment, land and buildings don’t always lose that much value over time. In fact, a John Deere 4320 you bought new in 1972 for $12,000, if well maintained, may still be worth $10,000 today. That trusty machine was depreciated down to no value in 1979, 7 years after you bought it. But, in reality, you can get 80% of its original value if you sold it today! I’m hoping the land and farm buildings I bought in 2001 will be worth the same, or maybe even a little more, when I get around to selling them in the future.

However, it doesn’t matter what you’ll actually get paid for your depreciated piece of equipment or land when you get around to selling it. Bankers and the IRS will want you to use a depreciation schedule to reduce their value at standardized rates.

To make depreciation even more complicated, a while ago the IRS created an “accelerated depreciation” commonly called “Section 179” of the IRS tax code. Under Section 179 a farmer can increase the tax implications of a purchase by deducting the full purchase of equipment or property in the first tax year (up to $500,000 in 2013). While this provides immediate tax relief, it will reduce future tax year depreciation deductions. This can be useful for the management of tax payments, but will make your profitability look terrible.

If you do this, you’ll want to make different calculations for “tax depreciation” from “book depreciation.” On financial statements prepared for your and your banker’s understanding of your operation, I recommend that you use depreciation that goes out the full schedule rather than condensed under the Section 179 rules.

Depreciation will show up as a separate (negative) line on your balance sheet. Your assets will retain their original value on a cost-basis balance sheet until you sell something and remove it from your asset list.

The tax gains you get from depreciation aren’t really “free money.” When you sell an asset the amount of depreciation that you claimed will be brought back into the picture as “recaptured income.” You will have to pay taxes on either the total gain or on the total amount depreciated, whichever is less. You will want a tax accountant help you with this.

I won’t claim to understand the realities behind farm asset depreciation, but I do appreciate the logic and the tax implications. And, since it is governed by the IRS, it isn’t something I can change anyway.

For more discussion about depreciation, see Fearless Farm Finances, page 97.

Jody Padgham is the Financial Director for MOSES, and Editor of Fearless Farm Finances.

March 7, 2014

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