(continued from last month) Calculation: Theoretically, care should be applied to determine the economic life of an asset, and its residual value on disposal.
Annual depreciation expense equates to: asset cost, less residual value, divided by economic life.
There may also be one process for determining accounting depreciation, and another for determining tax depreciation.
In reality, accountants may usually rely on the tax version of depreciation, as determined by the Australian Taxation Office.
In each case, there will ultimately be a profit or loss on disposal of the asset depending on the residual value received compared to the depreciated value.
Two main methodologies are applied
Straight-line depreciation charges the Profit & Loss Account with the same value each year for a given asset.
Reducing balance depreciation (also known as accelerated depreciation) charges more to the Profit & Loss Account in the early years of use and lower values in later years.
This method fits in with the fact that the cost of asset repairs and maintenance usually increases over time; therefore the total annual cost of the asset may be quite stable during its use.
Accelerated depreciation also brings tax benefit forward.
Choice of depreciation type
A University of South Carolina study considered the affect that choice of depreciation type could have on decision-making.
It found that managers of firms that used straight-line depreciation were less likely to invest in a replacement asset than were managers of firms that used accelerated depreciation—because the lower depreciated values under straight-line depreciation can result in higher accounting losses at time of disposal, and this inhibits decision-making.
My own view is that, for most farming businesses, many other issues will influence an asset replacement decision ahead of depreciated value.
Implications
So what are the implications associated with an expense that is generated by the accountant, and which does not appear in your cashflow forecasts, because it is a non-cash expense?
This issue is important because, for a sizeable horticultural business, the annual depreciation charge can be hundreds of thousands of dollars. The following implications may be considered:
- The direct operational cashflow of the business can be determined by adding depreciation back to the net profit. (Please note that total business cashflow also takes other factors, such as working capital movements into account). As I have alluded to elsewhere, and as bank managers will pursue, the direct operational cashflow should be sufficient to cover: owners’ drawings/dividends, existing funding commitments, new funding commitments and, possibly, something for off-farm investment.
- In the short-term the depreciation expense value may not be important because short-term cashflow is of greater consideration. In the short-term, depreciation may typically be ignored for decisions made by many businesses.
-Continued next month-
For more information, see Tree Fruit Sept 2014
