In Part 1 of The Missing Management Component we covered the difference an accounting system makes on the Net Income Calculation. The Jones and Smith farms were equal in Net Cash Income, but there was a large discrepancy when the Accrual Method was used to include inventory changes and calculate the Net Income.
Depreciation: Accelerated vs. Straight-Line
Another component of determining Net Income is Depreciation. This is one component of the Schedule F that many understand the least. Typically, the most use it gets is to minimize income tax through accelerated tax depreciation under section 179. However, several methods can be used to determine a more accurate year-to-year depreciation value for purchased assets. Purchased assets that can be depreciated include buildings, vehicles, machinery, equipment, fences and other land improvements and breeding livestock. A discussion on the different methods to determine depreciation can be found in the article: The Importance of Depreciation When Keeping Records for 2017 Taxes.
Depreciation Effects Example:
Once again, we will use the Jones farm example. The Jones’ Schedule F Income and Expenses resulted in $50,000 of Net Cash Income. Due to the good crop yields, their inventory increased by $100,000. Now, consider the No-Till Drill Mr. Jones purchased 3 years ago.
w/ Tax Depreciation
w/ Economic Depreciation
|Net Cash Income||$50,000||$50,000|
How to put this information to use? Unfortunately to become better at bookkeeping and understanding where the ag operations finances really are, it will require an increased amount of paperwork. Maximizing tax depreciation by utilizing the tools available will help keep cash expenses for the farm as low as possible. However, another depreciation schedule will need to be kept to determine the economic depreciation for each year. This increase in management will once again provide the producer with better numbers thus increasing the chances of good management decisions being made.
The Cash vs. Accrual Conversion
Can we average the numbers and be close? Iowa State University utilized the farm data from the numbers in their Farm Management Association to evaluate the need for keeping an additional depreciation schedule. Their research found that one cannot approximate the Net Income Accrual numbers by averaging many years of Schedule F income.
Calculating depreciation is important to determine Net Income. This will require a dedicated effort to keep an additional depreciation schedule, however, this step will provide a more accurate Income calculation for the operation, compared to the tax depreciation number.