With all the talk about financial crisis, you had better have a firm grasp on your bottom line. Traditionally, the Schedule F tax form has been a determining factor in deciding whether a farm operation is profitable. Yet there are some significant handicaps to that approach.
In general, basic cash accounting doesn't give you a true picture of profitability, says Greg Wolf, an agriculture consultant for Kennedy and Coe, an accounting and consulting firm. That's because cash accounting is essentially just a register that tracks cash income and expenses flowing in and out of the farm business for a particular time period.
"The biggest handicap with cash accounting is timing,” Wolf says. For example, cash accounting does not handle such things as fertilizer used in 2009 but paid for in 2008, or profit from grain produced in 2008 but held for a better price and sold in 2009. If grain sales aren't properly matched with expenses for producing that crop, it is difficult to know whether the crop was profitable, Wolf explains (see sidebar below).
Why accrual. Accrual accounting, on the other hand, says that income and expense exist when they are earned or incurred, regardless of when the cash transaction occurs. It allows you to generate a balance sheet not only at the end of the year, but anytime you need one.
"With rising input costs and cash rents, the person using accrual accounting is going to be able to detect changes in his operation quicker than someone who just does cash accounting,” says Ron Swanson, a Galt, Iowa, farmer and former president of the Farm Financial Standards Council (FFSC).
Accrual accounting, although fair-ly new to agriculture, is used in nearly all the business world and can be applied at the whole-farm level. Swanson began shifting from cash to full accrual accounting after the 1980s farm crisis.
"Back then, I could only make decisions based on what I could see with cash flowing through my operation,” he says. "By the time I figured out the problems, I was a year beyond where I should have made changes.”
In the mid-1980s, for example, Swanson cash-rented a farm that had drainage problems that led to crop losses from drowned-out areas. After adopting accrual-based accounting principles, which helped him analyze income and expenses as they were occurring, he singled out this problem farm as a loss to his entire operation.
After a few years, and with the records to show losses, Swanson negotiated a change from cash rent to a crop-share lease, so the production risk was shared with the landlord.
"If I kept using cash accounting, I may not have seen the hit I was taking in profitability from that one farm,” Swanson says.
Today, with an accrual-based system, Swanson knows where his operation stands in terms of profitability at all times. He knows earned gain for a particular year and can report profitability based on inventory at cost values, which tells him his return on investment and return on equity.
Real-time and enterprise. In a study by the FFSC, profitability problems were often masked for two years or more with cash accounting practices.
In a University of Illinois study analyzing farm income from 2002 to 2006, researchers found an an-nual average difference of more than 50% between net income measured on an accrual versus cash basis. In 2007, that difference was more than $120,000.
One of the key tenets of full accrual accounting is maintaining a clear picture of the costs accruing against a particular product, whether it represents all of an operation's grain production, one of several commodities or even production from one field.
While market values are vital and very much a part of a manager's decision-making process, they do not affect the accrual accounting system until a sale is actually made and the market value is realized, Wolf says.
"Timing of cash sales or cash expenses will not directly affect an accrual income statement,” explains Paul Ellinger, a University of Illinois ag economist. "That's why an accrual statement will provide a more accurate measure of your historic and projected profitability.”
How to step up. It's not easy to jump from basic cash accounting to accrual accounting, Swanson says. He suggests that farmers move through the process in steps: cash accounting to accrual-adjusted accounting to full accrual accounting.
"First, start putting together a balance sheet at the end of the year based on market value,” Swanson says. This will give you the ability to generate an accrual-adjusted income statement.
After that, you can adopt a true accrual system. "Don't be afraid to hire accounting help,” he urges.
Many agriculture-specific accounting software packages generate both accrual reports and cash reports for tax purposes. Watch our Profit Puzzle series for software choices.
The University of Illinois also offers a spreadsheet on its Web site (www.farmdoc.uiuc.edu/fasttools/) that allows farmers to estimate accrual income from a Schedule F.
Four Benefits of Accrual Accounting
1. More accurately determine profitability for each farming enterprise
2. Know profitability for each enterprise with the click of a mouse
3. More quickly evaluate the success of management changes
4. Accurately determine your return on investment
Read Solve the Profit Puzzle, from the October 2008 Top Producer.
To contact Jeanne Bernick, e-mail JBernick@farmjournal.com.
Top Producer, November 2008