Is your farm business profitable? How do you know?
Being able to answer this question is vital for long-term success, and entails more than cash or taxable income.
There are two primary methods of accounting for your business: cash or accrual. Cash accounting is simply recording sales when cash is received and expenses when cash is paid – very similar to using your checkbook register.
While this is a simple way to maintain records, it does not provide management with the information necessary to measure profitability, which is an accrual measure of income.
The measurement of cash income depends on the timing of inflows and outflows of cash, and can be manipulated easily. For example, when producers decide whether to sell grain in December or wait until January they are affecting when to receive cash and subsequently when sales are reported for tax purposes. However, the receipt of cash has nothing to do with profitability.
Profitability is an accrual concept and is the process of recognizing revenue when it is earned, regardless of when the cash from the sale occurs (more on expenses below). Whether a farmer defers a grain sale or not does not impact the measurement of accrual income. And, accountants use accrual earnings when measuring true financial performance for businesses.
The concept of accrual income may seem a bit academic, but is crucial to understanding true profitability. Accrual income is measured by subtracting expenses from revenues for a defined period of time. Revenues measure the benefits an entity receives from its operating activities, and result from the production activities of the farm. These benefits include not only cash, but also assets received as a result of the farm's operations, such as accounts receivable for goods or services sold or inventories of crops and livestock produced. Sale of the commodity or receipt of cash is not necessarily required for revenues to have occurred. An event that increases revenues will increase equity, and vice versa.
Selecting the correct period to recognize revenue is a crucial issue. Revenue should be recognized only when economic activities necessary to create and dispose of goods have been performed.
Expenses measure the costs incurred to generate revenue for a defined period. An expense may occur with or without an actual cash payment. An activity that increases expenses will decrease equity, and vice versa.
Match expenses with revenues
To measure profitability, it is necessary to match expenses with the revenues generated. The matching principle means that expenses are recognized in the same period as the revenues generated.
In agriculture, it may be easier to think of this a bit backwards: production expenses are deducted when paid (for cash basis taxpayers, which are the majority of producers), even if the expense is not incurred (e.g., purchasing seed in the fall for next year's crop). So, in order to match revenues and expenses, a producer includes the value of the entire crop in revenue, regardless of how much is sold. This is accomplished with an accrual adjustment for the value of ending inventory.
While this is an oversimplification of the concept, it illustrates the difference between cash and accrual income.
A typical farm record keeping system will capture receipts and expenditures, not revenues and expenses. Because of the desire to file a cash basis tax return, farmers have tended to use farm record keeping systems that focus primarily on cash transactions. Therefore, procedures are necessary to estimate accrual net income from typically available data, and the guidelines of the Farm Financial Standards Council provide these procedures. To order a copy of the Guidelines, please visit the FFSC website.
Brought to you by Farm Financial Standards Council. The opinions of Todd Doehring are not necessarily those of Farm Futures or the Penton Farm Progress Group.