Machinery depreciation is a big cost for most farm businesses. Gary Markham from Grant Thornton proovides tips on how to get to grips with it
What is depreciation?
Assets such as machinery, equipment and buildings reduce in value as they are used over their working lives. This reduction is known as depreciation.
"It is a simple management accounting term measuring the drop in value every 12 months, which is a cost to the business," says Gary Markham, director of agriculture at Grant Thornton. "You're trying to monitor what's happening within the business and this is a drop in value so you have to record it."
Depreciation is shown in the profit and loss account. It is not an actual cash expense paid out each year but is realised when the machine or other asset comes to the end of its life and is scrapped or sold.
Depreciation will be high where machines and equipment are replaced often and it can be very variable. Getting the right rate for each type of asset is important and Mr Markham is keen to see more effort being put into this by farmers and their accountants.
How is depreciation calculated?
To avoid assessing the value of each machine or piece of equipment every year within a business to calculate its drop in value or depreciation, a standard percentage is used to reduce the value.
There are two common methods of calculating depreciation - straight-line and reducing balance. Both start with the initial cost of the asset and reduce its value by a fixed percentage each year, however each method produces different results.
Straight line depreciation
Here, the difference between the initial cost and a nil value at the end is divided by the number of years the machine is expected to be used in the business. This gives an equal amount of depreciation for each year of use, the logic being that the business recognises the full cost of the machine over the time it is used in the business.
For example, you buy a combine for £100,000. You plant to use it for five years, so it will reduce in value (ie depreciate) by the full £100,000 over those five years. Under a straight line calculation of depreciation, it would be depreciated by £20,000 for each of those five years.
Reducing balance method
Under this method, the annual depreciation charge is higher in the first few years of the life of the asset and reduces gradually as the machine ages, thereby attempting to recognise the actual drop in value.
Instead of a fixed sum being taken as the annual reduction in value, a fixed percentage reduction is applied to the value of the asset, reducing the balance each year. So, for the £100,000 combine it would be as follows:
£100,000 less 15% = £85,000 | | Year 2 | £85,000 less 15% = £72,250 |
| Year 3 | £72,250 less 15% = £61,412 |
| Year 4 | £61,412 less 15% = £52,200 |
| Year 5 | £52,200 less 15% = £44,370 |
This is more suitable for some assets as it will more fairly reflect the way the value reduces over the years and also recognises that there is a residual value.
Whatever the method, the depreciation charge is shown as an expense in the profit and loss account. In the balance sheet the machine is shown at cost, less its total depreciation accumulated to date, to give a net book value.
Can I use different methods of depreciation for different assets?
Yes, there are no hard and fast rules about how you depreciate assets but it should be realistic and a fair reflection of what is happening in the business. You can change your method of depreciating assets, but ideally only if the change is to a measure which is a truer reflection of the position.
Which method is best for farms?
For long-term assets which you are not going to sell, such as buildings, Mr Markham suggests that straight-line depreciation is best. This would also be sensible for an asset such as parlour equipment which usually has little second-hand value. For vehicles and farm machinery a reducing balance is more suitable, he says.
However, more care should be taken to show a realistic percentage rate of depreciation for different classes of asset, as they all lose their value at different rates. Reflecting the true rate helps farm businesses understand this cost and plan replacement more accurately.
"I would split machinery and vehicles into several classes. First, tractors which depreciate at around 15% a year. Next, trailed machinery, which has a typical depreciation rate of 20%, and then combines at around 15%. Other farm vehicles such as pickups should have a rate of around 25%. The weighted average of these rates within a farming business is 18%."
| GRANT THORNTON Harvest survey results Depreciation on arable farms typically represents between 30% and 35% of machinery costs. In Grant Thornton's recently released Farm Business Survey for the 2008 harvest, depreciation has risen substantially to £54/acre for the top-performing 25% arable farms. Improved profits from the higher grain prices of 2007 have allowed reinvestment but in some cases that reinvestment is more than businesses can strictly afford and this level of depreciation is higher than it should be, he says. |
Why is it necessary to account for depreciation?
It must be accounted for because those managing the business need to know the effect of the reduction in value of equipment so they can plan replacements. Otherwise farm income may be overestimated and there will be problems when it comes to raising the cash to replace depreciating assets.
Knowing your true rate of depreciation allows you to assess the position of the business in terms of both planning capital investment and net asset value. It also allows you to measure your performance against other similar businesses. However, it is important to understand how depreciation is being calculated in any figures you are comparing with, warns Mr Markham.
"Some of the benchmarking series use current-cost accounting which adds a small extra percentage to build a fund to allow for the cost of a replacement machine, leading to a higher rate of depreciation."
If I have high depreciation charges, my profits will be lower so I will pay less tax, right?
No, this is a common misunderstanding, says Mr Markham. Depreciation has nothing to do with tax.
Although depreciation appears in the profit and loss account, effectively lowering profit because it is an expense, it is not an allowable expense against tax. When it comes to calculating the tax bill, depreciation is taken back out of the profit figure.
This gives profit before depreciation which, in general terms in a viable business, should at least be enough to cover drawings, tax, capital repayment and re investment.
The system of capital allowances deals with investment costs for tax purposes. Machinery and other depreciating assets are put into a tax pool and capital allowances are claimed against that pool, reducing the tax bill.
However, it's important to apply realistic depreciation rates so that you don't get caught out by profits on the disposal of assets when you sell them.
If a simple 25% reducing balance figure is used for all machinery, for example, depreciation can be too high. The result of this can be that assets are worth more than their book value when you come to sell them, showing as a "profit on disposal of fixed assets" in the profit-and-loss account, thus distorting the profit figure.
| Harvest year | 2006 | 2007 | 2008 |
| Depreciation (£/acre) | | | |
| Top-performing 25% arable units | 40 | 50 | 54 |
| Average-performing arable units | 36 | 37 | 42 |
| Bottom-performing 25% arable units | 36 | 37 | 34 |
| Machinery syndicates | 20 | 20 | 21 |
| * Source: Grant Thornton, Farm Business Survey, 2008/09, Harvest 2008 |
Capital budgets
Depreciation is a big cost for most businesses and catches up with them unless they plan replacements carefully, warns Mr Markham. He suggests using a capital budget to plan replacement policy and assess the cash requirements to fund those replacements.
"Too often, machinery is replaced on an unplanned basis because the business is hit by a big repair bill or there is an unbeatable offer." Sudden expansion and extra land can also prompt a quick and potentially unwise purchase.
"A capital budget forces you to realistically calculate and judge the long-term demands on the business, alerting you to large expenses and allowing you to plan cash flow and borrowing. Understanding the impact of depreciation on the business helps in this planning.
"Most arable businesses have capital invested in machinery of £200-240/acre which leads to depreciation of £36-43/acre. When we set up machinery syndicates we usually have a target capital value of £180-190/acre, which takes depreciation down to £32-34/acre. This should be seen as the target level of depreciation for arable businesses.
"A business should reinvest on average the annual drop in value of the machinery but it should be the target depreciation amount that is reinvested and not the actual depreciation amount. This gradually restructures the cost base of the arable operation to a more sensible level
"Drawing up a capital budget also allows time to look at all the alternative ways of using and acquiring machinery and how to fund these alternatives."
A capital budget covering eight years caters for the life of most machinery in arable businesses and should:
Include a list of equipment and age Show target replacement date and purchase value for each machine Show trade-in values of existing kit at replacement dates Show the difference between the two, ie net changeover cost Allow you to identify years where changeover is higher than average and to plan for this. You can average the net changeover across the eight years, divide by the cropped acres and compare that with target depreciation.
| DEPRECIATION FACTS Depreciation is the difference between the initial cost of an asset and the eventual value when it is sold or scrapped by the business There are various ways to account for depreciation, the most common being straight line and reducing balance methods A reducing balance is usually most suitable for machinery and other assets which will have a second-hand value once your business has finished with them An amount is written off each year, reducing the net book value of the asset in the balance sheet Depreciation is not allowable as an expense for tax purposes - capital allowances make up for this It is important to use a realistic rate of depreciation - for arable machinery this is a weighted average of around 18% on a reducing balance basis, which reflects the rate at which the machines are actually falling in value, says Mr Markham As well as tractors and other agricultural machinery, depreciation must be allowed for on farm vehicles including cars and pickups, equipment such as generators, boilers, grain drying and irrigation kit, buildings, loaders and tools with a purchase value higher than, say, £500 Machinery on contract hire or rental does not carry depreciation in the farm accounts. The rental cost is recorded in the profit and loss account. |