There are several approaches to calculating depreciation for equipment and buildings including the straight line, declining balance, and market value methods. In this article we will outline the advantages and disadvantages of the market value approach.
The market value approach could be argued as the most accurate method of calculating depreciation. In this method the annual market ending value of the machine or building is subtracted from the annual beginning value. The previous years ending value becomes the current years beginning value. For example a half ton truck was valued at $20,000 at the beginning of the year and $15,000 at year end. So the market value depreciation would be $5,000.
The advantage of this approach is that it gives a clear financial picture of the change in value of each asset. However, there are several disadvantages in using this method of calculating depreciation. The most obvious is the difficulty in determining the market value of each asset. It can be difficult to find comparative sales of similar assets. Is it probable to find the auction price of a tractor of the same make, type, horse power, hours of use and accessories as the one being valued? Not likely. Therefore, it becomes difficult to make a complete comparison without making some assumptions. The things one person puts value on may not be the same as the next person. In addition we often feel our assets are worth more than the buyer. Further assets may vary significantly in value from sale to sale as market conditions change such as the number of bidders at each sale.
Inflation is another disadvantage of the market value approach. During high inflationary periods the ending value of the asset may be greater than the beginning value resulting in negative depreciation. It becomes difficult to determine what the actual depreciation is without making some assumptions on the impact inflation has on the beginning and ending value of the asset.
Finally, it is very difficult to predict price changes from year to year. This method becomes cumbersome when trying to do budgeting. An astute manager try's to set aside sufficient money each year to replace the asset so having a constant value for depreciation makes this process much easier.
The market value method of calculating depreciation is useful in determining the change in the net worth of the farm in a given year.
In future articles we will outline other methods of calculating depreciation - modified straight line, replacement value and capital cost recovery.
For more information on this, or other farm business related topics, contact Morley Ayars, Regional Farm Business Management Specialist at 306-446-7962 or the Agriculture Knowledge Centre at 1-866-457-2377.
