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Six Steps To Move To Accrual Accounting

Cash accounting of farm inflows and outflows records financial transactions like sales and expenditures when money actually changes hands. It’s reasonably simple to do things this way; it meets the legal requirements of the Canadian tax system. It also gives farm managers the flexibility to level out the highs and lows in income that are the inevitable result of variability in weather and international prices.

It does have its drawbacks, however, especially if it’s used as the basis of major management decisions. This is where accrual adjustments come into play. The term accrual is not to be confused with “cruel” — although farm managers may well be forgiven for thinking that this is the best way to describe what’s involved with making adjustments to their cash income. No, accrual accounting, according to the textbooks, “recognizes income when it is earned.”

Accrual adjustments are meant to “correct” the shortcomings of cash accounting so that the resulting financial statements measure the actual production that took place on the farm within a given time period, usually a year, either calendar or fiscal. But it doesn’t have to be as daunting a task as it may first seem.

Here is a list of the top six accrual adjustments that a manager should make to a cash income statement. The first five relate to the farm’s inventories at start and end of year, the last to the farm’s capital assets. As we move through these adjustments, we will look at how they affect a farm that, in terms of cash income, has had a pretty good year with cash sales of $600,000 and cash expenses of only $375,000.

1. CROPS AND FEED INVENTORY

Many farms — especially sole proprietorships and partnerships — have accounting periods which correspond to the calendar year. This usually means a large carryover of crops and feed that can vary quite a bit in value from the start to the end of the year. Crops and feed on hand at the start of the year were produced at some point in time in the past. As they are sold, they increase revenue but, in a sense, they skew cash sales because they result from a previous year’s activities.

Inventories at the end of the year, on the other hand, include production from the current year that will only be sold at some future date. Carrying these amounts forward again skews the ability of cash sales to truly represent what happened on the farm during the year. In other words, cash sales only reflect what was sold, not what was produced. To get a true read on production, the value of carry-in has to be subtracted from cash sales and the value of carry-out or year-end inventories has to be added.

Example:

Total cash sales for 2010: $600,000

Value of crops and feed inventory on 01/01/10: $200,000

Value of crops and feed inventory on 31/12/10: $125,000

Adjusted value of gross production = $600,000 –$200,000 + $125,000 = $525,000

The change in crops and feed inventory (a decrease of $75,000) is subtracted from the farm’s cash sales. If this was the only accrual adjustment, the net farm income (NFI) for this farm would be $525,000 -$375,000 or $150,000.

2. LIVESTOCK INVENTORY

Much like crops and feed on-hand, livestock inventories also belong on a farm’s net worth statement. Market livestock, like calves, piglets and broilers, belong in the current asset section. Breeding livestock like sows, cows, replacement gilts and bred heifers going back into the herd are an intermediate asset for the farm because there is no intention of selling them within the next year. A farm that retains a lot of heifers or gilts in an effort to grow the herd will have less cash sales than if all the replacement animals were sold. And yet, the increase in the overall value of the breeding herd is a direct result of production on the farm.

In light of this, livestock inventories are handled the same way as crops and feed: if the market or breeding livestock have a higher overall value at the end of the year than at the start, that increase is attributable to production. The increase should be added to cash sales of livestock, just like a decrease should be subtracted. Perhead or per-pound values should be held consistent from start to end of year for breeding livestock. Market livestock should be handled like crops and feed inventories with prices reflecting what can be realistically expected from the marketplace when the animals or birds are to be sold.

Example:

Sales for 2010 after adjustment for changes in crops and feed inventory -$525,000

Value of market livestock on 01/01/10: $50,000

Value of breeding livestock on 01/01/10: $120,000

Value of market livestock on 31/12/10: $75,000

Value of breeding livestock on 31/12/10: $135,000

Adjusted value of gross production = $525,000 -$50,000 – $120,000 + $75,000 + $135,000 = $565,000

The value of both market and breeding livestock on hand went up during the year. The total change is an increase of $40,000. This amount is added to the farm’s sales.

3. ACCOUNTS RECEIVABLE

What kinds of things show up as accounts receivable on a typical Prairie farm? Deferred cheques, Canadian Wheat Board (CWB) pay- ments (adjustment, interim and final) and crop insurance claims are a few of the more common examples. They should appear as current assets on a farm’s net worth statement. Just like crops, feed and livestock inventories, any start of year receivables are the result of last year’s production. CWB receivables, for instance, are the result of past wheat and barley sales for which only the initial payment was paid. On the other hand, the outstanding accounts receivable at year end are tied to production that occurred during the year for which the farm has not been fully paid. As a result, any increase in receivables should be added to cash revenue and any deceases should be taken away.

Example:

Sales for 2010 after adjustment for changes in crops, feed and livestock inventory: $565,000

Accounts receivable on 01/01/10: $100,000

Accounts receivable on 31/12/10: $40,000

Adjusted value of gross production = $565,000 -$100,000 + $40,000 = $505,000

So far, the accrual adjustments have all been to the income side of the farm’s operations and they have all followed the same pattern: subtract the start of year, add the end of year amount. The various adjustments in the example that we have been following have lowered the farm’s net cash revenue from $600,000 to $505,000.

The final three adjustments modify the cash expenses that the farm has incurred.

4. ACCOUNTS PAYABLE

Accounts payable are things like unpaid bills that the farm may have at the local input dealer or outstanding bills for custom work that a neighbour may have done over the course of the past year. They are different from term and operating credit that have scheduled principal and interest payments and that have been arranged through a financial institution. Start-of-year accounts payable relate to costs incurred in past years. When the total amount of payables is greater at end of year than at the start, that increase is attributable to expenses incurred for production that have gone unpaid. They have to be added to cash expenses. Reductions in the amount of payables, on the other hand, are subtracted.

Example:

Total cash expenses for 2010: $375,000

Accounts payable on 01/01/10: $25,000

Accounts payable on 31/12/10: $75,000

Adjusted value of farm expenses = $375,000 -$25,000 + $75,000 = $425,000

A $50,000 increase in accounts payable from start to end-of-year means an increase in farm expenses.

5. FARM SUPPLIES

What classifies as farm supplies? Farm supplies are things like fuel, repairs, fertilizer, chemical and vet and medical supplies that a farm actually has on hand at the start or at the end of the accounting period. Some operations purchase large amounts of supplies for income tax reasons; others are trying to take advantage of lower prices in the fall to pre-purchase some of the inputs (especially fertilizer) that they’ll require the following year. This is what makes farm supplies unique among the accrual adjustments that we’ve looked at so far. Instead of subtracting start of year amounts, they are added in. Why? Because they represent expenses that were incurred in a previous period for production that will happen this year. End of year supplies, on the other hand, were bought this year for use in the next. So it makes sense to take them out of this year’s cash expenses.

Example:

Expenses for 2010 after adjustment for changes in accounts payable: $425,000.

Farm supplies on hand on 01/01/10: $150,000

Farm supplies on hand on 31/12/10: $100,000

Adjusted value of farm expenses = $425,000 + $150,000 – $100,000 = $475,000

6. DEPRECIATION

Depreciation, by definition, is a non-cash cost. It is supposed to represent the loss in value that capital assets undergo as they are used to produce crops and livestock on a farm. Capital asset purchases are not considered to be expenses, as they contribute to production over a number of years, rather than just one.

Depreciation is similar, in some respects, to Capital Cost Allowance (CCA) which allows farmers to claim a portion of the value of capital assets against their farm income for tax purposes. CCA rates, though, are set quite arbitrarily at 30 per cent for self-propelled equipment, 20 per cent for pull-type implements and 10 per cent for buildings. Farms will normally use as much CCA as they can regardless of the actual loss in value of the equipment in order to reduce their tax liability. Depreciation, like CCA, uses a flat rate to estimate how quickly assets are losing value. In the case of machinery, seven to 10 per cent is a pretty typical rate — buildings run at about three to five. Some assets may not need to be depreciated. If they are already at salvage value — basically a price at which they are expected to remain regardless of what happens to them — then a zero per cent depreciation rate is most appropriate. One way or another, depreciation rates can be very different from one farm to the next, depending on how well equipment is maintained, how it is operated and the number of hours that are put on the equipment annually.

Depreciation, needless to say, is added to cash expenses.

Example:

Expenses for 2010 after adjustment for changes in accounts payable and supplies inventory: $425,000

Value of machinery as of 01/01/10: $350,000

Depreciation rate on machinery: Eight per cent

Value of buildings as of 01/01/10: $120,000

Depreciation rate on buildings: Five per cent

Adjusted value of farm expenses = $475,000 + ($350,000 x 8 %) + ($120,000 x 5%) = $509,000

So in the example that we’ve been following through these various accrual adjustments, we started with cash revenue of $600,000 and cash expenses of $375,000. This would have yielded a cash income of $225,000. But by the time changes in crops and feed inventory, livestock inventory, accounts receivable, accounts payable and farm supplies are accounted for and by the time depreciation is added in, the actual value of farm production is down to $505,000 and total cost of production is up to $509,000 for a net farm loss of -$4,000.

In summary, cash accounting is useful in that it allows a farm to meet its legal requirements in terms of reporting income for tax purposes. It also provides useful information in terms of a farm’s liquidity. But when it comes to measuring profitability and actual production, the numbers provided by cash accounting should be supplemented by accrual adjustments, most of which involve bringing in figures from the start and end of year inventories.

As well, depreciation must be added to cash expenses. The result is a far more complete picture of

how the farm performed during

the year. And it might even make

those Agri-Stability worksheets

seem a little bit clearer!

RhealCeneriniwritesfromLaSalle,Man.

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