Quoted from Pharro Cattle Company…
I’m not a depreciation expert either. However, I AM a recovering ag banker and have dealt with depreciation in one form or another for 20 years.
Steve, you are correct when it comes to “tax” depreciation, which is what most farmers think of when they hear the word depreciation. You need to have purchased a depreciable asset in order to claim the depreciation. A raised heifer that peaked in value as a second-calf cow at, say, $3,000 and is now worth only $1200 as a butcher cow has generated no depreciation for income tax purposes.
That’s not to say she didn’t cost you that money. As Charlie correctly points out, selling animals at or near their peak value is a great way to avoid “real world” depreciation, which is the loss of value as an asset ages or is used up. And as he says, that number is not given a great deal of thought by many producers today.
Accrual accounting is a wonderful tool for cutting through the mess that is often caused by accountants and producers looking to limit tax liability. It can be complicated and requires that a producer be honest with himself, which is not always the easiest thing to do. But it can also create some good surprises.
I used accrual accounting exclusively when I was a banker. While I learned this method at Farm Credit training school, I was surprised that very few bankers did this in the real world, because it takes digging pretty deep in a balance sheet as well as a tax return. I soon discovered that even bank examiners didn’t have a firm grasp on the concept, which pretty much allowed me to BS my way through many exams!
If you do a good job filling out a financial statement on the same day each year (January 1st works great for those of use who are on the typical year tax cycle) and you are honest with yourself about the value of all your assets, including hay on hand, prepaid expenses, stockpiled forages, and capital assets, you can identify good and bad trends in your business long before your neighbors, no matter what the Schedule F says.
Consider this example:
Rancher A has a five year average Schedule F profit of $100,000, with tax depreciation of $50,000 a year. He has a herd of 200 cows that he bought five years ago and annually bought enough bred heifers to replace his open cows. He has a full line of newer machinery that he spends $50,000 a year on between payments and updates.
His “real world” depreciation is probably somewhere around $70,000 to $90,000 a year. $50,000 of that is due to equipment depreciation, and his cow herd is dropping at a rate of $100-$200/cow/year due to aging. To handle that depreciation, he has $150,000 in profits (Schedule F plus the depreciation), so he’s left with something in the neighborhood of $60,000 to $80,000 to feed his family and grow his business.
Rancher B has a five year average Schedule F profit of $150,000, with tax depreciation of $0 a year. His herd of 200 cows was raised, and he has a full pipeline of heifers each year. Rather than selling steers and heifers, he sells steers, a handful of open cows, and a large number of 4 and 5 year old bred cows. His equipment line is smaller, older, and depreciated out. He doesn’t even use most of it.
On an accrual basis, we can see that rancher B has no real depreciation, and actually has APPRECIATION. His cow herd maintains its value year after year because it is not aging, and as cattle prices have increased over the last five years his average animal is worth $500/head more than it was 5 years ago. This averages out to an gain of $100/head/year, or $20,000 for him. This, added to his income, gives him $170,000 to feed his family and grow his business.
Driving by these two operations, one would be fairly certain Rancher A is better off. He has nice equipment, after all. Digging deeper, you can see that he is barely feeding his family, while Rancher B is poised to grow his business. Granted, this is a pretty simplistic example, but I can assure you that accrual adjustments make a world of difference for many operations.