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 modified straight line, replacement value and capital cost recovery methods of calculating depreciation.
The modified straight line method has been used by the Saskatchewan Ministry of Agriculture in calculating machinery costs in their annual "Farm Machinery Custom and Rental Rate Guide". This method has been used for years.
Salvage value is usually calculated at 10 per cent of the purchase price but trade-in value could also be used. The life of the machine can be expressed in years or hours. Often life of the machine is expressed first in cost per year then divided by the annual hours of use to get the hourly rate of depreciation.
The advantages of modified straight line method is that it is simple to use, provides a constant annual charge and is relatively accurate in times of low inflation and low interest rates. Its primary disadvantage is that it underestimates depreciation in times of high inflation.
The replacement value method is an adjustment to the modified straight line where the cost of the replacement machine is used rather than the purchase price of the old machine and trade-in value for the old machine is used rather than salvage value.
This method works under high inflationary periods but has the disadvantage of trying to compare the replacement machine in terms of price with the old machine.
The capital recovery charge method of depreciation was developed by Dr. Richard Shoney at the University of Saskatchewan. This formula is as follows:
(Beginning value - ending value) amortized at "i" interest + (ending value * "i" interest)
For example a combine with a beginning value of $300,000 with an expected ending value of $180,000 after five years. The beginning value or purchase price was 70 per cent financed at five per cent and the investment value of the remainder is 1.5 per cent. The combined interest on the investment would be four per cent (.05*.7 + .015*.3). The amortized value at four per cent at five years is 0.224627. Thus, the difference of the beginning and ending values is $120,000 amortized would be $26,955.24. And the ending value at four per cent interest is $7,200. The annual depreciation according to this method would be $26,955.24 plus $7,200 or $34,155.24. If the annual use was 170 hours then the hourly depreciation would be the annual depreciation divided by annual hours or $200.91 per hour.
The advantage of this method is that it is accurate in any inflationary environment, provides a constant annual charge and includes opportunity costs on the machinery investment. The primary disadvantage is that some find it complex to understand.
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.
