AAE 320 Farming Systems Management Problem Set #3

AAE 320 Farming Systems Management Problem Set #3 ANSWER KEY 1) You had a machine shed built and bought a new combine. The machine shed costs $100,000 and the combine costs $200,000. For your internal accounting purposes, you will depreciate the machine shed over 12 years and the combine over 5 years. The machine shed will have zero salvage value, but the combine will have a salvage value of $100,000. For this problem, you will make 6 tables that report the annual amount of depreciation during each year and the value of the asset at the end of each year. There will be 3 tables for the machine shed and 3 for the combine. The 3 tables for each asset will each use a different depreciation method. The first table will use Straight Line depreciation, the second will use Sum of the Year s Digits, and the third will use 150% Declining Balance. You will do the full life cycle for each asset (i.e., 12 years for the shed and 5 years for the combine). For the 150% Declining Balance, do not let the asset value fall below the salvage value (set depreciation to zero if needed) and if the implied value does not reach the salvage value by the end of the useful life, take the remaining value in the last year as depreciation. Note: I found it easiest to use a spreadsheet program to do the calculations. Be sure to label each table so I can know what the asset is and the depreciation method. Answers to Problem 1 presented as a series of tables. Machine Shed Straight Line 1 100,000 8,333 91,667 2 91,667 8,333 83,333 3 83,333 8,333 75,000 4 75,000 8,333 66,667 5 66,667 8,333 58,333 6 58,333 8,333 50,000 7 50,000 8,333 41,667 8 41,667 8,333 33,333 9 33,333 8,333 25,000 10 25,000 8,333 16,667 11 16,667 8,333 8,333 12 8,333 8,333 0 Combine Straight Line 1 200,000 20,000 180,000 2 180,000 20,000 160,000 3 160,000 20,000 140,000 4 140,000 20,000 120,000 5 120,000 20,000 100,000 1

Machine Shed Sum of Years Digits 1 100,000 15,385 84,615 2 84,615 14,103 70,513 3 70,513 12,821 57,692 4 57,692 11,538 46,154 5 46,154 10,256 35,897 6 35,897 8,974 26,923 7 26,923 7,692 19,231 8 19,231 6,410 12,821 9 12,821 5,128 7,692 10 7,692 3,846 3,846 11 3,846 2,564 1,282 12 1,282 1,282 0 Combine Sum of Years Digits 1 200,000 33,333 166,667 2 166,667 26,667 140,000 3 140,000 20,000 120,000 4 120,000 13,333 106,667 5 106,667 6,667 100,000 Machine Shed 150% Declining Balance 1 100,000 12,500 87,500 2 87,500 10,938 76,563 3 76,563 9,570 66,992 4 66,992 8,374 58,618 5 58,618 7,327 51,291 6 51,291 6,411 44,880 7 44,880 5,610 39,270 8 39,270 4,909 34,361 9 34,361 4,295 30,066 10 30,066 3,758 26,308 11 26,308 3,288 23,019 12 23,019 2,877 20,142 12 23,019 23,019 0 Without adjustment, year 12 does not end at salvage value, so take all remaining basis in year 12. 2

Combine 150% Declining Balance (no adjustment) 1 200,000 60,000 140,000 2 140,000 42,000 98,000 3 98,000 29,400 68,600 4 68,600 20,580 48,020 5 48,020 14,406 33,614 Without adjustment, in year 2 the basis falls below the salvage value of $100,000, so only take $40,000 in year 2 and no depreciation after that. Combine 150% Declining Balance 1 200,000 60,000 140,000 2 140,000 40,000 100,000 3 100,000 0 100,000 4 100,000 0 100,000 5 100,000 0 100,000 Straight Line depreciation and Sum of the Year s Digits depreciation are generally clear. If you had problems with these methods, see the class notes/think breaks or come and see me. 150% Declining Balance (150% DB) depreciation has two common problems either the asset value never reaches the salvage value (machine shed) or it becomes less than the salvage value (combine). For the machine shed, 150% DB never actually reaches $0 (the salvage value) and so you have to take the remaining value in the last year (or switch to straight line depreciation some time along the way). For this key, I took the remaining $23,019 in the last year so the machine shed hit the salvage value in the last year. For the combine, the other common problem with 150% DB happens. Specifically, the depreciated value ends up lower than the salvage value before the last year. If you keep using the 150% DB unchanged, the combine becomes worth less than the salvage value (1 st 150% DB table for Combine). In this case, the common method is to stop deprecation once it hits the salvage value (the asset is fully depreciated), the 2 nd (correct) 150% DB table for Combine. See the class notes on these problems with declining balance depreciation, slides 37-41. 2) In this problem, you will figure the depreciation you could claim for tax purposes for the combine. You will need to use IRS Publication 946: How to Depreciation Property on the course home page at http://www.aae.wisc.edu/aae320/farm Finance/IRS 2007 Depreciation pub 946.pdf (or search the web). For this problem, you will use MACRS, electing the GDS option and not claiming any Section 179 depreciation (Read Which Depreciation Systems (GDS or ADS) Applies? beginning on page 30 and What is the Basis for Depreciation? beginning on page 34). a) Read What Property Class Applies under GDS on pages 31-32. What property class (3- year, 5-year, etc) must be used for the combine, a type of agricultural machinery? Read Recovery Periods on GDS on pages 34-35. What recovery period (how many years) must be used for the combine? 3

On page 31, 2 nd column, item b under number 3. 7-year property, Agricultural machinery and equipment is listed, which is what a combine would be classified as. Thus, a combine is in the 7-year property class. On page 35, at the top of the 1 st column, the table lists the Property Class and Recovery Period. For the 7-year property class, the recovery period is also 7 years, so this is the number of years that must be used for the combine. b) Suppose you bought the combine and had it ready for use on August 25, 2008. Read Which Convention Applies? on pages 36-37. Unless the combine is a large portion of the total depreciable property you will claim for deductions (the more than 40% of the total depreciable bases of all MACRS property under the mid-quarter convention), I interpret this section to mean that you should use the half-year convention. Using Chart 1 on page 70, which depreciation percentage table must be used for the combine? For this question, I should have also asked you to read pages 36-39, including Table 4-1 on page 38. On these pages, it explains that farm equipment is depreciated under GDS (General Depreciation system) using 150% Declining Balance. In some special cases, farmers must or can elect to use ADS (Alternative Depreciation System). Using Chart 1 on page 70, for GDS with 150% declining balance under the half-year convention for 7 year property using a 7 year recovery period, the Chart lists Table A-14 (in the 3 rd row in Chart 1). Hopefully, you noted the Nonfarm for the Recovery Period column under the first two lines for 200% GDS and did not use Table A-1. Table A-14 on page 85 lists the depreciation percentages for a 7 year recovery period, which are reported here in the second column of the table below. c) Use the appropriate depreciation percentage table to calculate the depreciation you will be able to claim as a deduction each year. What is required is to multiply the annual percentage from the table by the initial cost of the asset (here $200,000). I have created an example table below, under the assumption that the combine cost $180,000 and is depreciated over 10 years using straight line depreciation (which is definitely not the actual case). The key to note is that under the half-year convention, you claim half a year in year 1 and another half year in year 11 and a normal year s deduction in the intervening 9 years for a total of deductions claimed for 11 years. Create a similar table for the actual answer for the combine, using the correct number of years, the percentages from the correct column in the correct table, and then determine depreciation in $ each year and the implied value of the combine at the end of each year. Note that the combine with a $200,000 purchase price will actually be depreciated for tax purposes under the half-year convention for 8 years, with half a year taken in years 1 and 8. The table below reports the depreciation % from Table A-14 required for use in tax depreciation for the combine, then reports the dollar value of depreciation claimed in each year and the asset s remaining basis for tax purposes. 4

Year Depreciation (%) Depreciation ($) Remaining Basis 1 10.71% 21,420 178,580 2 19.13% 38,260 140,320 3 15.03% 30,060 110,260 4 12.25% 24,500 85,760 5 12.25% 24,500 61,260 6 12.25% 24,500 36,760 7 12.25% 24,500 12,260 8 6.13% 12,260 0 d) For this problem, you want to see if you can take Section 179 depreciation for the combine (you will elect this option, if possible, only for the combine and no other assets). Skim over IRS Pub 946 Electing the Section 179 Deduction (beginning on p. 16). Focus on determining i) whether the combine qualifies for this deduction (see Eligible Property p. 16 and following) and ii) how much you can claim (see How Much Can you Deduct (p. 18 and following). Specific questions to answer for this problem: Does the combine qualify for Section 179 depreciation deduction? What is the maximum amount of a depreciation deduction you can take in the first year? First, page 16, 2 nd column indicates that Machinery and equipment qualifies as Tangible personal property and so the combine qualifies for the Section 179 depreciation deduction. How much you can take depends on the details (see page 18, 2 nd column: How Much Can You Deduct? Only the cash portion you pay for the combine, not any of the trade-in value you may have used to purchase the combine. You are allowed a maximum of $125,000 in any one year, so if you take some Section 179 depreciation of another asset, you cannot take $125,000 for the combine, but only $125,000 minus whatever you took for the other assets(s). It gets more complicated if you are married (see the example on page 20). My real goal was for you to see how there are lots of rules on section 179 depreciation, but you can usually take a maximum of $125,000 in any one year, though exceptions exits. This is why people hire tax prepares to help them on this sort of stuff and why Phil Harris spends lots of time teaching tax prepares how to do taxes for farmers. 3) Use the example Balance Sheet from the Farm Financial Standards Council s Publication Financial Guidelines for Agricultural Producers. The Text and Appendix are posted on the class home page, copies were handed out in class, and the Balance sheet pages are posted separately on the course home page http://www.aae.wisc.edu/aae320/farm Finance/Balance Sheet Example.pdf (or pages A2-A6 from the Appendix http://www.aae.wisc.edu/aae320/farm Finance/FFSC Appendix.pdf). Use these pages to answer the following questions: a) What is this farm s current ratio in 19X2? What was it in 19X1? Give a brief intuitive description of the current ratio, what it means, and what it is used for. Interpret this farm s current ratio are they doing okay or is there a problem? 5

Current Ratio = current assets/ current liabilities 19X2 Current Ratio = 322,014/246,712 = 1.31 19X1 Current Ratio = 300,203/225,917 = 1.33 The current ratio measures liquidity of the farm, i.e., how easily it can respond to short term cash needs, or how much of a margin it has to cover short term cash needs. In general, farms do not want to have such a low current ratio that they have to sell a non-current asset (e.g., land, tractor), to cover current liabilities (e.g., the feed bill for cattle or hired labor). See the class notes for examples of typical current ratios. Notice that the balance sheet does not explain what type of farm this is, so it s hard to exactly compare it to the IL data, but the schedules show it has corn, soybeans and feeder cattle. Comparing to the IL data, this may be a little low in terms of the cash grain part of the operation, since this balance sheet is for early in the year. b) What is this farm s debt to asset ratio in 19X2? What is this farm s equity to asset ratio in 19X2? What is this farm s debt to equity ratio in 19X2? Give a brief intuitive description of each of these ratios, what it means, and what it is used for. Interpret this farm s ratios are they doing okay or is there a problem? Debt to Asset Ratio = Total Liabilities/Total Assets 19X2 Debt to Asset Ratio = 596,335/1,087,914 = 0.548 The Debt to Asset Ratio measures solvency, how close the farm is to being able to cover all its outstanding liabilities. The closer it gets to 1, the closer to insolvency the farm becomes. Another way to think of it is the proportion of the farm assets that are owned by whomever providing equity to you (e.g., the bank). These ratios imply that the bank or whomever owns a little more than half of the farm assets, but that the farmer is making headway and decreasing the debt relative to the size of the farm. You can use the class notes to compare these to typical ratios in different states and across different farm types. Equity to Asset Ratio = Total Equity/Total Assets 19X2 Equity to Asset Ratio = 491,579/1,087,914 = 0.452 The Equity to Asset Ratio is another way to measure solvency. It is the proportion of the farm assets that the farmer owns (i.e., 45.2% of the value of all farm assets are the farmers). The farmer owns almost half of the farm assets and is making headway in owning a larger portion of the farm assets. You can use the class notes to compare these to typical ratios in different states and across different farm types. Debt to Equity Ratio = Total Liabilities/Equity 19X2 Debt to Equity Ratio = 596,335/491,579 = 1.213 The Debt to Equity Ratio is another measure of solvency. It indicates the importance of debt financing relative to equity financing. A Debt to Equity Ratio of 1 means that for each dollar the bank provides, the farm provides a dollar of equity financing. As the Debt to Equity 6

Ratio becomes very large, the farm is moving closer to insolvency. Again, use the class notes to compare these to ratios in different states and across different farm types. c) On 12/31/X2, how many heifers did the farm have, at what price were they valued, and how much total value were they? What is the total value of the heifers if the price of $80.00/cwt were used? How much does this change the current ratio for 19X2? On Schedule 1: Inventories, Mkt Cattle/Heifers/1000 lbs is listed as 45.00 (i.e., 45 heifers at 1,000 lbs = 10 cwt) and valued at a price of $68.00/cwt for a total value of 45 x 10 x 68 = $30,600. At a price of $80/cwt, the value would be 45 x 10 x 80 = $36,000, which increases current assets by the amount of $36,000 $30,600 = $5,400. Adding this amount to the original current assets for 19X2 gives $322,014 + $5,400 = $327,414, so the new current ratio becomes $327,414/$246,712 = 1.327. d) How many stock cows did they have on 12/31/X2? What was their total book value? How did this compare to their market value? Schedule 2: Breeding Livestock lists 25 Stock Cows on 12/31/X2. The total book value is listed as $12,500 (which equals their cost basis). The total market value is listed as $10,000, which is $2,500 lower than their book value (tax basis). e) How many acres did the farm have on 12/31/X2? When did they buy the land and how much total did they pay for all of it? What was the land worth on 12/31/X2? Schedule 4: Real Estate and Improvements lists two farms, Johnson Farm of 235 acres and Section 18 Farm of 160 acres, for a total of 395 acres. The Johnson Farm was bought in 1975 for $152,750 and the Section 18 Farm in 1963 for $32,000, so that the total paid for the farmland was $184,750. Schedule 4 lists the respective market values as $293,750 and $224,000, for a total market value of $517,750 for the land (without including the value of the feedlot improvement). 7