Depreciation — What It Is and How To Use It

 

Depreciation is the decrease in value of an asset over time. The purpose is to recognize that a purchased asset such as a tractor will last more than one year, but does have a limited useful life.

 

Two accounting principles drive the calculation and reporting of depreciation. The first is the cost principle. The cost principle requires us to record an asset at its historical original cost. If I buy a tractor on auction for $20,000 that has a fair market value of $29,000, the cost principle states that our records should record the $20,000 purchase price since that is the original cost to us.

 

The second principle is the matching principle. The matching principle requires us to match income to expenses. Going back to the $20,000 tractor, how many years can I expect to use it?  Maybe the tractor has five years of useful life. During those five years the tractor will be used for the production of income. Under matching, we attempt to allocate the original cost of $20,000 over the five years of useful life, matching the expense of the tractor to the income it helps produce. In record keeping the tracking of depreciation happens on depreciation schedules. It is not uncommon for an operation to have two separate depreciation schedules: book and tax.

 

 

Operations may choose to use two depreciation schedules: one depreciation schedule for book financial purposes and one for tax purposes. The book depreciation schedule follows accounting principles and is used in business financial statements. Then, there are tax depreciation schedules that follow Internal Revenue Service codes and regulations. Having a depreciation figure on your financial statement that is different from your tax return is completely legitimate. To demonstrate why operations have two schedules, take a look at the illustration. For tax purposes, we want to minimize our tax liability. In this example we have $275,000 of income from operations. To minimize our tax liability we might use Section 179 to fully depreciate the $250,000 combine in year one. This puts the tax liability at just $25,000 of net taxable income in this simplified example.

 

Now let’s look at book depreciation. On the book financial statements, our concern is showing profitability and sustainability. The ending net income is a component of credit applications from financial institutions to determine your borrowing capacity. The capacity for someone to repay a loan that has $225,000 of net income versus $25,000 of net income is significant.

 

There is another managerial component to consider: your grain marketing plan. The more expense that is recognized in a given year, the higher your target grain price is going to need to be for that year’s crop.

 

 

 

This is a brief description of what depreciation is and why having both a book and a tax depreciation schedule could be beneficial. Watch for an upcoming article where I will cover the basic depreciation methods used on the book depreciation schedule.