Most farmers enjoy a tax advantage that many other "manufacturers" do not have: the ability to use cash accounting when preparing income tax returns. However, there is a drawback to this method. A farmer who defers too much income just to save taxes usually ends up with higher interest costs and/or lower crop prices since the tax tail is wagging the farm operating dog, so to speak.
The cash method of accounting is the simplest method to use. Even though it uses the word "cash," it refers to the timing of income and deductions. Income is recognized when the farm receives the proceeds, not when the check is deposited. Expenses are deductible when the farmer writes the check and mails it.
The "income-tax" farm accrual method bridges the distance between cash accounting and true accrual accounting. Under this method, a farmer deducts expenses using the cash method but uses a three-step process to report sales. First, total your crop sales for the year. Second, determine the value of harvested crop inventory on hand at the beginning and end of the year. Third, add ending inventory plus total crop sales during the year less beginning inventory to provide the total reportable crop sales for the year.
For example, suppose a corn farmer has 25,000 bu. on hand, worth $100,000. Harvest brings in 100,000 bu., but 90,000 bu. are sold for $450,000. The ending inventory is 35,000 bu., worth $210,000. The revenues to be reported on the tax return are the total sales of $450,000 during the year plus the ending inventory value of $210,000, less the beginning inventory value of $100,000, for a net farm total revenue of $560,000.
Under the cash method of accounting, revenues would be $450,000. Most farmers would say this is not optimum tax planning since more farm income is reported than received. Let’s assume that beginning and ending farm inventory values are reversed. Total net farm revenues would be $450,000 plus $100,000 less $210,000, for a total of $340,000. Farm revenues will be the same using either method; the difference is the timing of the farm revenues.
What is wrong with both of these methods of accounting? Neither reflects what the farm is actually producing in profit for each crop. When a monthly cash income statement is prepared, every month that has no crop sales shows a large loss and every month with a crop sale produces a profit. Using the farm accrual method is not much better. You can reflect your beginning and ending crop inventories on a monthly basis; however, the month a large amount of fertilizer is purchased produces a loss.
A Reality Check. This brings us to the third level of farm accounting: the true accrual method. Under this method, a farmer accumulates all the costs necessary to grow the crop. These costs are not reflected on the income statement, but rather accumulate on the balance sheet as an asset. At the time of harvest, all of these accumulated costs are transferred over to crop inventory and deducted as the crop is sold.
For example, a wheat farmer plants his crop in September and all of the costs of prepping the soil, seeding, fertilizing, spraying, harvesting, etc., are accumulated. The farmer harvests 150,000 bu. with a net cost of $5 per bushel. The total cost of all wheat-related expenditures is therefore $750,000. This cost is transferred to crop inventory.
Now let’s assume the farmer sells the wheat for $8 per bushel. Total crop sales are $1.2 million and crop costs totaled $750,000, for a net profit of $450,000. This number is the actual wheat profit.
Even if a farmer uses this method of accounting for operating purposes, the cash method might still be used for income tax purposes; most available computer accounting programs handle this well.
What level is your farm operation at now, and what steps are you taking to get it to the third level?
Paul Neiffer is a tax accountant with LarsonAllen LLP and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at firstname.lastname@example.org.