Friday, October 4, 2013

Precision Fitting your Farm Bottom Line: Accrual Adjustments for the Production Based Income Statement

By Miguel Saviroff, Extension Educator, Somerset County

The Income Statement is a tool performance evaluation form a management point of view. The Accrual Income Statement offers a more accurate picture of farm business profits and financial position. It shows the farm’s net income for the production year. Usually, the production or fiscal year is made to coincide with your calendar year. The net income is defined as your farm returns from sales, minus total production expenses as they happen along the year. Any gain or loss on the sale of capital assets should be added to this amount. The following is the format for the Cash Based Income Statement:

+Total Revenue
- Total Expenses
Net farm income from operations
+ Gain (or – Loss) on sale of capital assets
Net Farm Income.

Here’s a simple example of a Cash Based Income Statement:

Table 1. Income Statement

Description
Quantity
Price
$
Crop Sales
20,000 bu
$5/bu
 100,000
Livestock Sales
2500 cwt
$120/cwt
 300,000
Gross Income


 400,000
Cash Expenses


 260,000
Net Cash Income


 140,000
Depreciation*


   35,000
Net farm Income


 105,000
* Note1: depreciation, a non-cash expense, is required by IRS to be recorded in cash-Basis and accrual basis Income Statement.

Net income can be cash-basis or accrual adjusted. Cash-based includes only cash receipts, cash expenses, and depreciation.

In farming, due to inventories of crops and livestock, accounts receivable, accounts payable and prepaid expenses, produced or incurred in one year and sold, used or received the following year, we are more interested in the accrual adjusted income statement. In this format, farm sales are accounted only in the year when a crop was harvested or livestock was finished and ready to sell, no matter if the product started growing or was being raised in the previous production cycle. Likewise, the only expenses considered are those associated with the products harvested or finished in the current production year. Year-end accrual adjustments to cash basis income statement will create your accrual income statement; all you need is a beginning and an ending balance sheet for the year.

Table 2 outlines the process for adjusting cash basis income to approximate accrual income.

Table 2. Adjusting cash basis records to approximate accrual basis records
Cash basis
Adjustments to cash basis
Equals accrual basis
Cash Receipts
- Beginning inventories
+ Ending inventories
- Beginning accounts 
   receivable
+ Ending accounts receivable
Gross Revenue
Cash disbursements
- Beginning accounts payable
+ Ending accounts payable
- Beginning accrued expenses
+ Ending accrued expenses
+ Beginning prepaid expenses
-  Ending prepaid expenses
+ Beginning supplies
   (fuel, chemical, seeds, etc.)
-  Ending supplies
+ Beginning investment in          growing crops
-  Ending investments in 
   growing crops

Operating expenses
Depreciation expense
No adjustment made  (see note 1)
Depreciation expense
Cash net income
(pre-tax)

Accrual adjustment net income (pre-tax)
Cash income and Social Security taxes
- Beginning income taxes and
   S.S. taxes payable 
+ Ending income taxes and
    S.S. taxes payable 
-  Beginning current portion
    of deferred tax liability  
+ Ending current portion of
   deferred tax liability  

Cash Net income (after tax)

Accrual adjusted net income (after- tax)
Source: Adapted from Financial Guidelines from Agricultural Producers, Recommendations of the Farm Financial Standard Council, 1997. 

When you make adjustments, an increase (beginning to ending) in assets, such as inventories and account receivable will have a positive impact of change on the year’s Net farm Income. In the same way, an increase in an accrual-type liability item will cause a negative impact (decrease) in Net Farm Income.

Cash to accrual income adjustment of $ 5,000 is illustrated below for crop sales:

Table 3
Cash receipts from Crop sales this year
       $ 100,000
less:   Beginning crop inventory           (produced in prior year)
         -$20,000
plus:   Ending crop inventory (current year production)
        +$25,000
equals: Accrual crop revenue
(approximate value of current year production)
          $105,000

The beginning inventory value is subtracted from cash receipts, because it is already sold or consumed by the farm livestock during the year, and the sales are included as cash receipts. The ending inventory value is added to cash receipts, because this is the current year’s production that has not yet been sold or consumed.

The process for accounts receivable is the same. Beginning accounts receivable are subtracted from cash receipts because this amount was collected during the year and recorded as cash receipts. Ending accounts receivable are added, because they represent production during the year that is ending although payment has not been received yet.
  
Table 4 shows an $8,000 year-end adjustment for accounts receivable.

Table 4
Cash receipts from crop sales
$100,000
Less: Beginning accounts receivable
-$25,000
Plus: Ending accounts receivables
+$ 33,000
Equal: Accrual crop revenue
$108,000

There are several adjustments to cash disbursements or expenses, including account payable and accrued expenses. They are often the largest expense adjustments, and accrued interest will be the largest accrued expense.

Table 5 shows a -$2,000 adjustment of accrued interest expenses. They are expenses that helped produce income during the accounting year but for which no cash has yet been spent.

Table 5
Cash disbursements for interest paid this year
$40,000
less:   Beginning accrued interest (interest owed but not paid in prior year)
-$10,000
plus:   Ending accrued  interest (interest owed but not paid in current year)
+$8,000
Equals: Accrual interest expense (approximate cost of borrowed funds)
$38,000

Once you have calculated changes in inventory ($5,000+$8,000-$2,000), you can compare Income Statements: cash basis (left) and accrual- adjusted basis (right). The farm appears to be profitable on a cash basis. However, after adjusting the cash basis income statement, it increased from $105,000 to $116,000 for the same period.

Table 1. Cash vs. Accrual Income Statement
Description
Quantity
Price
$ Cash
$ Accrual
Crop Sales
20,000 bu
$5/bu
 100,000
 100,000
Livestock Sales
2500 cwt
$120/cwt
 300,000
 300,000
Gross Income


 400,000
 400,000
Cash Expenses


 260,000
 260,000
Net Cash Income


 140,000
 140,000
Depreciation*


   35,000
   35,000
Accrual Adjustment



 +11,000
Net farm Income


 105,000
 116,000


Many farmers leave out these adjustments from the calculation of net profit without realizing they are understating the “Bottom Line.” Using some financial tools such as FINPACK relieves you from many calculations that are done internally by the program. For any assistance in figuring out a close figure for your real profitability, contact Miguel Saviroff at Penn State Extension at 814-445-8998 Extension 144.  

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