Is sale of breeding cattle considered operating financing or investing
How much did your farm business earn last year? Was it profitable? There are many ways to answer these questions.
A farm income statement (sometimes called a profit and loss statement or P&L) is a summary of income and expenses that occurred during a specified accounting period, usually the calendar year. It is a measure of input and output in dollar values. It offers a view of the value of what your farm produced for the time period covered and what it cost to produce it.
Most farm families do a good job of keeping records of income and expenses for the purpose of filing income tax returns. Values from the tax return, however, may not accurately measure the economic performance of the farm. Consequently, you need to have a clear understanding of the purpose of an income statement, the information needed to prepare the statement, and the way in which it is summarized.
Net farm income, as calculated by the accrual or inventory method, represents the economic return to your contributions to the farm business: labor, management, and net worth in land and other farm assets. Cash net farm income also can be calculated. It shows how much cash was available for purchasing capital assets, debt reduction, family living, and income taxes.
Preparing the Statement
The income statement is divided into two parts: income and expenses. Each of these is further divided into a section for cash entries and a section for noncash (accrual) adjustments.
An example income statement is shown at the end of this publication, along with a blank form. Blank forms for developing your own income statement are also available in ISU Extension and Outreach publication FM 1824/AgDM C3-56, Farm Financial Statements.
Most of the information needed to prepare an income statement can be found in common farm business records. These include a farm account book or program, Internal Revenue Service (IRS) forms 1040 Schedule F Profit or Loss From Farming and 4797 Sales of Business Property, and your beginning and ending balance sheets for the year. If you use the IRS forms, you will need to organize the information a bit differently to make allowances for capital gains treatment of breeding stock sales, and the income from feeder livestock or other items purchased for resale. Consult with a tax professional specializing in farm business entities for operation specific questions.
Cash Income
Cash income is derived from sales of livestock, livestock products, crops, government payments, tax credits and refunds, crop insurance proceeds, and other miscellaneous income sources.
- Include total receipts from sales of both raised livestock and market livestock purchased for resale. Remember not to subtract the original cost of feeder livestock purchased in the previous year, even though you do this for income tax purposes. Also include total cash receipts from sales of breeding livestock before adjustments for capital gains treatment of income are made. These are termed “gross sales price” on IRS Form 4797.
- Do not include proceeds from outstanding USDA marketing loans in cash income even if you report these as income for tax purposes.
- Do not include noncash income such as profits or losses on futures contracts and options. However, do include cash withdrawn from hedging accounts.
- Do not include sales of land, machinery, or other depreciable assets; loans received; or income from nonfarm sources in income.
Adjustments to Income
Not all farm income is accounted for by cash sales. Changes in inventory values can either increase or decrease the net farm income for the year. Changes in the values of inventories of feed and grain, market livestock, and breeding livestock can result from increases or decreases in the quantity of these items on hand or changes in their unit values (see Example 1). Adjusting for inventory changes ensures that the value of farm products is counted in the year they are produced rather than the year they are sold. Subtract beginning of the year values from end of the year values to find the net adjustment.
Changes in the market values of land, buildings, machinery, and equipment (except for depreciation) are not included in the income statement unless they are actually sold. Accounts receivable and unpaid patronage dividends from a cooperative are included, however, because they reflect income that has been earned but not yet received.
Cash Expenses
All cash expenses involved in the operation of the farm business during the business year should be entered into the expense section of the income statement. These can come from Part II of IRS Schedule F. Under livestock purchases include the value of breeding livestock as well as market animals.
- Do not include death loss of livestock as an expense. This will be reflected automatically by a lower ending livestock inventory value.
- Income tax and Social Security tax payments are considered personal expenses and should not be included in the farm income statement, unless the statement is for a farm corporation.
- Interest paid on all farm loans or contracts is a cash expense, but principal payments are not.
- Do not include the purchase of capital assets such as machinery and equipment. Their cost is accounted for through depreciation. Land purchases also are excluded.
- You may wish to exclude wages paid to family members, because these also are income to the family.
- Include cash deposits made to hedging accounts.
Adjustments to Expenses
Some cash expenses paid in one year may be for items not actually used until the following year. These include feed and supply inventories, prepaid expenses, and investments in growing crops. Subtract the ending value of these from the beginning value to find the net adjustment (see Example 2).
Other expenses may be incurred in one year but not paid until the following year or later, such as farm taxes due, and other accounts payable. Record accounts payable so that products or services that have been purchased but not paid for are counted. However, do not include any items that already appear under cash expenses. Subtract the beginning total of these items from the ending totals to find the net adjustment. Note that interest expense due is not included until later, after net farm income from operations is calculated.
Depreciation is the amount machinery, equipment, buildings, and other capital assets decline in value due to use and obsolescence. The depreciation deduction allowed on your income tax return can be used, but you may want to calculate your own estimate based on more realistic depreciation rates. One simple procedure is to multiply the value of these assets at the end of the year by a fixed rate, such as 10%. This way you can group similar items, such as machinery, rather than maintain separate records for each item.
If you include breeding livestock under beginning and ending inventories, do not include any depreciation expense for them.
The beginning and ending balance sheets for the farm are a good source of information about inventory values and accounts payable and receivable. ISU Extension and Outreach publication FM 1791/AgDM C3-20, Your Balance Sheet, provides more detail on how to complete a balance sheet. ISU Extension and Outreach publication FM 1824/AgDM C3-56, Farm Financial Statements contains schedules for listing adjustment items for both income and expenses. Use the same values that are shown on your beginning and ending balance sheets for completing adjustments to your net income statement for the year.
Summarizing the Statement
You have now accounted for cash farm income and cash expenses (excluding interest). You also have accounted for depreciation and changes in inventory values of farm products, accounts payable, and prepaid expenses. You are now ready to summarize two measures of farm income.
Net Farm Income from Operations
Subtract total farm expenses from gross farm revenue. The difference is the net income generated from the ordinary production and marketing activities of the farm, or net farm income from operations.
Interest Expense
Interest is considered to be the cost of financing the farm business rather than operating it. Net interest expense is equal to cash interest expense adjusted for beginning and ending accrued interest.
Capital Gains and Losses
Some years income is received from the sale of capital assets such as land, machinery, and equipment. The sale price may be either more or less than the cost value (or basis) of the asset.
For depreciable items the cost value is the original value minus the depreciation taken. For land it is the original value plus the cost of any nondepreciable improvements made. The difference between the sale value and the cost value is a capital gain or loss. For purposes of the farm income statement, capital gain would also include the value of “recaptured depreciation” from the farm tax return. Information for calculating capital gains and losses can come from the depreciation schedule and/or IRS Form 4797.
Sales of breeding livestock can be handled two ways: (1) record sales and purchases as cash income and expenses, and adjust for changes in inventory, or (2) record capital gains or losses when animals are sold and include depreciation as an expense. Either method can be used, but do not mix them.
Net Farm Income
Subtract interest expense, then add capital gains or subtract capital losses from net farm income from operations to calculate net farm income. This represents the income earned by the farm operator’s own capital, labor, and management ability. It also represents the value of everything the farm produced during the year, minus the cost of producing it.
Further Analysis
Net farm income is an important measure of the profitability of your farm business. Even more can be learned by comparing your results with those for other similar farms. ISU Extension and Outreach publication FM 1845/AgDM C3-55, Financial Performance Measures for Iowa Farms, contains information about typical income levels generated by Iowa farms. It also illustrates other important measures and ratios that can help you evaluate the profitability, liquidity, and solvency of your own business over time.
Other Financial Statements
Two other financial statements are often used to summarize the results of a farm business. While they are not as common as the net income statement and the balance sheet, they do provide useful financial information.
Statement of Cash Flows
A statement of cash flows summarizes all the cash receipts and cash expenditures that were received or paid out during the accounting year. It is sometimes called a flow of funds statement. Unlike the net income statement, it does not measure the profitability of the business. It merely shows the sources and uses of cash. The statement of cash flows is divided into five sections:
- cash income and cash expenses
- purchases and sales of capital assets
- new loans received and principal repaid
- nonfarm income and expenses (sole proprietor)
- beginning and ending cash on hand
If all cash flows are accurately recorded, the total sources of cash will be equal to the total uses of cash. If a significant difference exists, the records should be carefully reviewed for errors and omissions.
An example of a statement of cash flows is found at the end of this publication, along with a blank form.
Statement of Owner Equity
The statement of owner equity ties together net farm income and the change in net worth. Net worth will increase or decrease during the accounting year based on three factors:
- net farm income (accrual)
- net nonfarm withdrawals (nonfarm income minus nonfarm expenditures)
- adjustments to the market value of capital assets (affects market value net worth, only)
If these factors are recorded accurately and added to the beginning net worth of the farm, the result will equal the ending net worth.
An example of a statement of owner equity is presented in the accompanying “pdf” file that you can access by clicking here or on the icon above.
Further resources on financial information can be found on the Ag Decision Maker website.
- Decision Tool C3-26, Cash to Accrual Net Farm Income Worksheet
- Decision Tool C3-56, Comprehensive Farm Financial Statements
Paul Martin, farm management field specialist, pmartin1@iastate.edu
William Edwards, retired economist. Questions?
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