Chapter 1: Farm financial statements.
Farming is a business. Ills of many industrial and commercial businesses in our large cities are corrected by the inauguration of better financial, accounting and marketing policies. Many of the ills of the farming business likewise can be cured by good management from within rather than legislation from without the farm boundaries. Accounting is one of the best tools of the successful manager anywhere. If the farmer can keep accounts even on a simple basis and learn to use them properly he will be in a better position to detect his weaknesses in producing and marketing the products of the farm.
So wrote Hiram T. Scovill in his review of Farm Accounting Principles and Problems, a book by Karl F. McMurry and Preston E. McNall. The book was published in 1926 and the review appeared shortly thereafter in The Accounting Review, an accounting academic journal that still publishes research papers in accounting. Professor Scovill’s words are no less relevant today than they were in the 1920s. Many technological, environmental, political, financial, social, and global changes have occurred since then, but the need for good management (including accounting) remains. Because changes occur rapidly, good management and good accounting in agriculture may be more important than ever before.
This book addresses one aspect of farm management–the tool that Professor Scovill refers to as one of the best that a successful manager must use–accounting. Financial management involves the acquisition and use of capital, the minimization of risk, financial planning and analysis, and relationships with financial institutions, to name a few. Accounting helps provide information for making decisions. Good decision making and good management are hampered by incomplete, inaccurate, or inconsistent information. The purpose of this book is to help you, the reader, to learn and apply accounting principles and procedures to help develop good farm management practices.
In this chapter, you will learn why financial information about a farm business is required. At the end, you will be able to define “financial statements” and describe the characteristics of these statements that make them useful to others. You will also be able to define “financial accounting” and to identify the rules for financial accounting and the parties that developed them. You will also be able to define terms including financial analysis, financial position, and financial performance. You will understand the meaning of the term “capital,” describe the three types of financial activities, and provide some examples of each activity. You will be able to name the four primary Farm Financial Statements, describe the general purpose or function of each of them, and name the elements contained in each statement. You will learn how to define and calculate “net income” or “net loss,” state the general format for the Income Statement, and define or describe each of the items or categories in it. You will also be able to explain the advantage of the expanded format of the Income Statement, and state the main differences between the general format and the expanded format. You will learn how to define the concept of “equity,” describe the general and expanded formats for the Statement of Owner Equity, and define or describe each of the items or categories in it. You will also be able to state the Accounting Equation and the general format for the Balance Sheet and to define or describe the items or categories in it. You will be able to identify the components of equity, name the three categories of activities reported on the Statement of Cash Flows, provide examples of each category, and outline the general format for the Statement of Cash Flows.
OVERVIEW OF AGRICULTURAL ACCOUNTING
Learning Objective 1 * To explain why financial information about a farm business is required. Learning Objective 2 * To define "financial statements" and describe the characteristics of these statements that make them useful to those who read them.
Accounting is an information system that provides financial information about an economic entity. Economic entities include farms and ranches, and other types of businesses. Financial information includes many types of reports and documents with financial data. Farm and ranch managers and owners use these reports to evaluate the success or failure of the farm business and to help decide future activities. Outside parties, such as agricultural lenders, who must also make decisions in conducting business with agricultural operations, request some of these reports.
This book is primarily about reports submitted to outside parties. These reports are called financial statements. Financial statements summarize the results of the financial activities of a farm operation. These statements present this information in terms of dollar value. (1)
Exercise 1-1 Many people might not be aware of the amount of accounting that occurs in everyday life. Not only do businesses and farms and ranches engage in accounting activities, but so do individuals, almost on an everyday basis. Can you think of any activities that you do that might be considered accounting activities? What kinds of financial information do you require to make your personal financial decisions? Answer: There are many correct answers. If you thought about writing a check to pay for groceries and entering the information in your checkbook check register, using your credit card to pay for gas for your car, or gathering your W-2 forms, filling out your 1040 tax form and paying any income tax you owe, you would be on the right track. These are examples of personal accounting activities. There are many others. Financial information that you might require in making decisions (such as "Can I afford to take a vacation at this time?") might be your bank statements, credit card statements, or checkbook, to determine how much cash or credit you have available. You might also have a budget, which is a financial plan, and use it to determine what you will use your next paycheck for.
You will learn that financial statements summarize activities for an entire year or for part of a year. (2) Farm managers and owners and outside parties need financial information on a periodic and timely basis, (3) so financial statements should be prepared at least once a year. They can gain useful information from financial statements in evaluating their farm activities from one year to the next. The primary reports used by farm managers, owners, and outside parties are the four types of financial statements discussed in this chapter. These four statements are the Income Statement, the Statement of Owner Equity, the Balance Sheet, and the Statement of Cash Flows.
For financial statements to be useful to farm managers, owners, and outside parties, the accounting system must provide understandable information. (4) One way to accomplish this is for each type of statement to follow a format that everyone recognizes. This chapter presents a general format and specific examples of detailed formats for each of the four financial statements. Whether you are preparing the financial statements or using them for some type of analysis, you cannot understand them without knowing the rules and guidelines used to produce the information. These rules and guidelines are developed so that the financial statements are not biased, a concept called neutrality. (5) To minimize bias, any estimates should be as conservative as possible. Furthermore, for financial information to be useful, the rules and guidelines must be used consistently, so that owners and managers can evaluate the performance of the farm business from one year to the next. (6) Lenders and other outside parties may want to compare one farm to another. That task is easier if these rules and guidelines are followed consistently by the farms they are comparing. (7)
Information summarized in the statements must be reliable for financial statements to be useful. (8) The system in this book helps to make financial statements reliable because it requires a balance in the financial numbers. For the information to be reliable, it should be verified by documents from which the information originated, (9) or source documents. They should be stored and organized for easy reference. This requirement to verify information results in reporting many financial statement items at the original (historical) cost of the item. (10) Historical information contributes to unbiased information. To enhance reliability, the information should also be as accurate and complete as possible. Furthermore, titles identify financial statement items. It is important to learn these titles, to understand what the titles describe.
For financial statements to be useful, they must be relevant. (11) You will learn about an approach that helps to make financial statements relevant because it helps to provide complete and up-to-date information. Relevant financial statements provide feedback on past activities of the farm operation and some ability to predict future financial activities on a timely basis. (12) Relevant financial statements provide information that is likely to make a difference in decisions. The farm accountant has to be aware of the benefits that the information provides. If the information is insignificant for making decisions (a concept called “materiality”), then it should not be reported. (13) The usefulness of the information has to exceed the cost of recording and reporting it. (14)
Steve and Chris Farmer started their farming operation in the year 20X1. At the end of their first farming year, they found themselves short of cash, so they arranged to meet with their agricultural lender to negotiate for an operating loan until they could generate some positive cash flow. Their lender agreed to meet with them if they brought financial statements to the meeting. Appendix A presents the financial statements that they took to the meeting. The statements are incomplete (they do not include all of the revenues and expenses for an entire year) but as you study this book, you will learn about how they prepared these statements, and what they did to help ensure that the financial statements are useful for themselves and the lender.
The rules and guidelines for accounting have been developed with several other concepts in mind. One of these is that the farm business is a separate entity from the owners. (15) You will learn that Farm Financial Statements should be prepared without any personal items reported. Some of the accounting procedures reflect the principle that the farm business will continue to operate indefinitely, a concept called “going concern.” (16) A concept called “revenue recognition” forms the basis for when financial activities should be reported. (17) This concept goes along with an idea called matching, which designates that financial transactions should be reported when they occur, even if the money has not been paid or received. (18) Finally, a concept called “full disclosure” requires that financial statements be accompanied by additional information that clarifies the numbers in the financial statements and the methods used to calculate them. (19)
The Financial Accounting Standards Board (FASB) and other groups have developed financial accounting rules or procedures (also called “standards”) for companies in the United States. These accounting standards, called Generally Accepted Accounting Principles (GAAP), provide a standardized system for financial accounting. Financial accounting refers to the accounting systems that produce financial statements for farm managers and owners and for outside parties. As indicated earlier, financial statements provide a summary of the financial activities of the farm operation. Farm managers and owners can also benefit from other accounting systems that produce more details about the farm activities, for example, the cost of production. These systems are usually designated as management (or managerial) accounting systems, which are not discussed in this book.
Learning Objective 3 * To define "financial accounting" and to identify the rules for financial accounting and the parties that developed them.
Standardized systems of accounting are useful for outside parties to compare more than one business. People who wish to invest in or lend money to a company need to know that similar procedures are used to summarize financial information. If that were not the case, it would be difficult to know which company is performing the best. Outside parties that are interested in doing business with an agricultural operation (such as lending money) sometimes also need to evaluate the performance of a farm operation and to compare one farm operation to others to make the best decisions about working with them.
Many agricultural operations are small, family-owned farms with simple and incomplete financial information. GAAP is often not relevant for these agricultural operations. A group called the Farm Financial Standards Council (FFSC) developed and published a set of recommendations in an attempt to standardize accounting procedures for agricultural operations. Their recommendations for farm and ranch accounting are called Financial Guidelines for Agricultural Producers (the Guidelines). The FFSC recommends the use of GAAP in preparing financial statements for agricultural operations, for the most part. However, the FFSC recognizes that many farm businesses cannot generate the necessary information to conform to GAAP completely. Therefore, the FFSC has identified alternatives to GAAP that the FFSC believes are adequate for providing useful information.
GAAP and the FFSC Guidelines provide the basis for the accounting principles and procedures that you are learning about in this book. Figure 1-1 portrays the relationship between the sources of accounting rules and their usefulness. When you have studied this book, you will have a basic understanding of accounting and how it is applied in an agricultural operation. Each farm business has unique characteristics and situations that may require complex accounting procedures. More information is available on the FFSC Website and from certified public accountants and farm consultants for these situations. The remainder of this chapter discusses the financial activities of agricultural operations and presents an overview of Farm Financial Statements.
FARM FINANCIAL ACTIVITIES AND FINANCIAL STATEMENTS
Learning Objective 4 * To define the following terms: "financial analysis," "financial position," and "financial performance."
Farm Financial Statements report financial accounting information about an agricultural operation in a specified format. Financial accounting refers to the accounting system that prepares these financial statements. Financial reporting entails providing the financial statements along with additional details (the full disclosure concept). This additional information is reported in Disclosure by Notes (or Notes to the Financial Statements) and often includes schedules and explanations of computations. Financial analysis is a set of procedures in which a farm’s financial position and financial performance is evaluated. Financial position refers to the farm’s financial state at a specified point in time. Financial performance measures how profitable the farm was over a specified period, usually a year. The items for the financial analysis are reported on the financial statements. Chapter 10 explains the procedures for financial analysis in more detail.
[FIGURE 1-1 OMITTED]
The first step in developing and using a farm financial accounting system is to understand which financial statements need to be prepared by the farm owner, manager, or accountant, what kind of information is to be included in each of the statements, and the format for each of the statements. With this understanding, the farm owner or manager knows what to provide for outside parties and for internal purposes. This chapter explains these concepts first by relating financial activities to the four Farm Financial Statements, and then describing the purpose and format of each of the statements.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should be able to complete Problem 1-1 at the end of the chapter. Learning Objective 5 * To define "capital," to describe the three types of financial activities, and to provide some examples of each activity.
An agricultural operation engages in three types of financial activities: financing, investing, and operating. In financing activities, capital is provided to the farm business. Capital may be money or personal items used in the business, or it might be borrowed money. There are two sources of financing: from the owner(s) and from outside parties. Some outside parties are lenders, such as a bank or agricultural credit institution. When the owner invests savings in the farm operation or contributes personal items, such as vehicles, these also are financing activities. Recall that for accounting purposes, the farm business is a separate entity from the owners, so any personal thing used in the farm business is considered a contribution by the owners to the business. Investing activities involve buying and selling items needed for production of farm products. Buying and selling items such as land, buildings, machinery, equipment, and breeding livestock are considered investing activities. Agricultural producers are primarily engaged in operating activities. These are the day-to-day activities of producing or selling crops and livestock, managing hired help, and so on. Table 1-1 outlines these types of activities.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should be able to complete Problem 1-2 at the end of the chapter. Learning Objective 6 * To name the four primary Farm Financial Statements, to describe the general purpose or function of each of the financial statements, and to name the elements contained in each.
The financial statements provide reports of each of these activities. The four main financial statements are the Income Statement, the Statement of Owner Equity, the Balance Sheet, and the Statement of Cash Flows. The Balance Sheet reports on most of the results of financing and investing activities. The equity section of the Balance Sheet primarily summarizes the financing activities involving the owner. Equity refers to the amount of money owed to the owners of the farm business. Another section on the Balance Sheet, called the liabilities section, summarizes the financing activities involving outside parties. Liabilities are the amounts of money owed to outside parties (for example, lenders). The Statement of Owner Equity reports the financing activities involving the owner in more detail than the Balance Sheet, and it shows the profit or loss of the farm business. The asset section on the Balance Sheet shows the results of the farm’s investing activities. The items purchased by the farm business and expected to earn money for the farm are called assets. Thus, the Balance Sheet provides a summary of the financing and investing activities by reporting on the assets, liabilities, and equity of the farm business. The financial position of the farm business can be evaluated from the Balance Sheet.
The Income Statement summarizes the results of operating activities: money earned by the farm business, called revenues, from the production or sale of farm products, and the costs of operating the farm, called expenses. Net Income or Net Profit is the “bottom line” on the Income Statement and the difference between revenues and expenses. The Income Statement also reports the gains and losses. Gains are financial benefits from various activities. For example, when a piece of farm equipment is traded in to purchase a new piece of equipment, depending on the terms of the purchase, a gain may result. (To learn how to tell if a gain does occur, see this example in further detail in Chapter 8.) Losses are the opposite of gains. The primary purpose of the Income Statement is to help evaluate the financial performance of the farm operation (whether or not a profit was made). Primarily, it reports on the results of operating activities; however, some of the gains and losses reported on the Income Statement also may arise from financing or investing activities.
The fourth financial statement is the Statement of Cash Flows. The Statement of Cash Flows reports on all of the activities (financing, investing, and operating) involving cash. The reader of the Statement of Cash Flows can learn where money came from and where it went during the year, for example, how much money was borrowed this year and what it was used for. The Statement of Cash Flows provides details about the farm’s money activities for a year.
Table 1-2 depicts the elements of the four primary Farm Financial Statements.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should be able to complete Problem 1-3 at the end of the chapter.
Learning Objective 7 * To define and calculate "Net Income" or "Net Loss."
The Income Statement summarizes the financial activities from the sale of farm products (revenues), the costs to produce and sell those products (expenses), and gains and losses. When revenues and gains exceed expenses and losses, the difference is reported as Net Income, profit, or earnings. When the reverse is true, the difference is reported as net loss. This relationship is depicted in the following general format for the Income Statement:
Revenue + Gains – Expenses – Losses – Net Income or (Net Loss)
(The parentheses around “Net Loss” indicate that it is a negative number.)
PRACTICE WHAT YOU HAVE LEARNED Can you calculate Net Income? See Problem 1-4.
The farm manager or owner and outside parties want to evaluate the financial performance of the farm business. The Income Statement is the primary financial statement for this evaluation. They need to know how successful the operating activities have been. However, some of the gains and losses on the Income Statement are the result of financing and investing activities. Therefore, Net Income will include the results of operating activities, and the effects of some financing or investing activities. In that case, the general format is inadequate for evaluation purposes.
Learning Objective 8 * To state the general format for the Income Statement and to define or describe each of the items or categories in it.
For that reason, the Income Statement is usually divided into subsections, to separate the operating activities from the financing and investing activities. The operating activities are presented first, followed by the other activities. The following format for the Income Statement is more useful in presenting the results of the operating activities:
+ Other Revenues and Gains
– Other Expenses and Losses
Each of these items on the Income Statement represents categories of financial items. Each category summarizes the various types of items within each category.
In this format, Farm Revenues include the money earned from the production or sale of farm products and gains from operating activities. Examples of Farm Revenues are the money received for the sale of a wheat crop and the cash received from an insurance claim for crop damage. An example of an operating gain is the value of the feeder pigs raised on the farm. Operating Expenses is the amount of money paid for supplies and other costs that are required to operate the farm business and any losses from operating activities. Examples of Operating Expenses are feed, fertilizer, herbicides and pesticides, wages for hired help, insurance, and feeder livestock, just to name a few. An example of an operating loss would be a loss from the sale of culled breeding livestock. Operating Income is calculated as the difference between the Revenues and the Operating Expenses (Revenues minus Operating Expenses). Other Revenues is money earned from other types of farm activities besides the production and sale of farm products and operating gains. An example of Other Revenues is interest earned on a checking account. The Gains listed with Other Revenues are the gains from financing and investing activities, such as the gain on a trade-in of a vehicle. Other Expenses are costs associated with financing and investing activities, for example, interest paid on a loan, and farm income taxes. Losses listed with Other Expenses are losses associated with farm financing and investing activities. For example, a trade-in of a vehicle could result in a loss instead of a gain.
Exercise 1-2 Can you name which of the items on the Farmers' Income Statement (Appendix A) are revenues, expenses, gains, and losses? Answer: (See Appendix A).
The format presented above is only one way to present the Income Statement. You might see an Income Statement with more detail. Sometimes the analysis of the Income Statement requires more detail than the format above. The amount of detail required will depend upon what the farm owner or manager, or the lender, want to evaluate. An alternative version for the Income Statement lists all farm revenues and certain adjustments first, followed by several subcategories and subtotals. Table 1-3 presents an expanded Income Statement using this format, which you can refer to while reading the following paragraphs.
Learning Objective 9 * To explain the advantage of the expanded format of the Income Statement and to state the main differences between the general format and the expanded format.
Farm Revenues include the following items. This list might not include all sources of revenue for all farm operations, but considers those most commonly found.
* Crop cash sales
* Changes in crop inventories
* Cash sales of market livestock and poultry
* Changes in market livestock and poultry inventories
* Livestock products sales (for example, milk, eggs, wool)
* Proceeds from government programs
* Gain or loss from the sale of culled breeding livestock
* The change in value due to changes in quantity of raised breeding livestock
* Crop insurance proceeds
* Changes in accounts receivable
The sum of these items is reported as Gross Revenue.
The next item on the Income Statement is Operating Expenses, the amount of money paid for supplies and other costs that are required to operate the farm business plus or minus certain adjustments (explained in Chapter 4). The next item is Depreciation Expense, an item related to annually allocating the cost of buying assets. The next item is Interest Expense, the amount of money paid for interest on loans from a lender. This item may also include certain adjustments (also explained in Chapter 4). These items are added and subtracted to calculate an item called Net Farm Income from Operations, which is another version of Operating Income. Net Farm Income from Operations differs from Operating Income above because it includes some adjustments for Operating Expenses and Interest Expense.
Then the Income Statement separates the Gains and Losses from the Other Revenues and Other Expenses. (These categories of Gains and Losses are defined in more detail in Chapter 2.) The Gains and Losses are added or subtracted, as the case may be, to calculate Accrual Adjusted Net Farm Income. Accrual Adjusted Net Farm Income is another way to present Operating Income with the addition of these specific Gains and Losses. The Other Revenue and Other Expenses are the same as those defined above, except that Interest Expense is part of Net Farm Income from Operations and is not included here as part of Other Expenses. When Other Revenue and Other Expenses are added to and subtracted, respectively, from Accrual Adjusted Net Farm Income, another subtotal is calculated, which is called Income before Taxes. The next item is the amount paid for income taxes, Income Tax Expense, plus certain adjustments (explained in Chapter 4). When these items are added or subtracted, Accrual Adjusted Net Income is calculated. Accrual Adjusted Net Income is similar to Net Income described above. The main difference between the expanded format and the general format indicated earlier in this chapter is the level of detail, which is more extensive in the expanded format. The adjustments in the expanded format (see Chapter 4) provide a more accurate assessment of financial performance.
STATEMENT OF OWNER EQUITY
Learning Objective 10 * To define the concept of "equity." Learning Objective 11 * To state the general and expanded formats for the Statement of Owner Equity and to define or describe each of the items or categories in it.
The Statement of Owner Equity reports the changes in the owner’s interest in the farm business during a period. The owner’s interest in the farm business refers to what the owner has put into the business (in the form of money or other capital) and the amount of profit that the farm business has earned for the owner. The owner’s interest in the farm business is also known as Equity. When the farm business earns a profit, the owner’s equity increases accordingly. The preparation of financial statements requires that the Income Statement be prepared first so that the Statement of Owner Equity can also report Accrual Adjusted Net Income. Other transactions also affect owner equity.
PRACTICE WHAT YOU HAVE LEARNED You should be able to complete Problem 1-5 at the end of the chapter at this point.
The general format for the Statement of Owner Equity is as follows:
Equity at the beginning of the year
= Equity at the end of the year
Equity at the beginning of the year is the amount of equity that the owner had when the year began. It comes from the amount of equity that the owner had in the farm business at the end of the previous year. Investments represents any additions of cash or other personal assets that the owner (or others, such as family members) contributed to the farm business since the beginning of the current year. Many owners begin their farm operations by contributing some personal items (such as a vehicle) for use in the farm operation. From time to time, the owner may add more money or other personal items to the farm business. The farm owner should keep separate the farm business items and activities from the owner’s personal items and activities. This separation is highly recommended so that the financial performance and financial position of the farm business is not compromised by any personal financial activities. Owners or managers of farms and ranches have a need to know the financial status of the agricultural operation as a “stand-alone” entity, even though the owner also owns the assets of the farm. (For example, when personal expenses are included with farm expenses, the farm business may appear less profitable than it really is.) Withdrawals is any cash or other assets used by the owner for personal purposes, for example, when the owner uses farm cash to pay for personal expenses. Equity at the end of the year is computed by adding Equity at the beginning of the year to this year’s Net Income, plus any additions of cash or other personal assets that the owner contributed this year to the farm business, minus any cash or other assets used by the owner for personal purposes.
Table 1-4 displays an expanded format for the Statement of Owner Equity, which the farm accountant can use when additional information is needed.
In this format, the withdrawals of money by the owners for personal use are called Owner Withdrawals. The next item on the statement, Non-Farm Income, refers to any money from other jobs or businesses that the owner earned and contributed to the farm business during the current year. For example, in many farm families, one or more of the owners may have another job to supplement the farm income and to fulfill personal career goals. From time to time, some of this money might be used in the farm business for various expenses instead of using it for personal expenses and activities. When this occurs, the amount used in the farm business should be reported on the Statement of Owner Equity, but should not be reported in the Income Statement because the Income Statement should report only the farm business income. (See Appendix B at the end of this book for more information about Non-Farm Income and related topics.) Other Capital Contributions/Gifts/Inheritances are contributions to the owner’s equity by the owner, when a personal item is put to use in the farm business, or a contribution from someone other than the farm owners, such as when parents in a farm family transfer the ownership of land or other assets to children as a part of an inheritance. In the year that such events occur, the value of the items contributed can be listed as shown in Table 1-4. Changes in market values of assets (a concept that will become clearer as you study the rest of this book), called Change in Excess of Market Value over Cost/Tax Basis of Farm Capital Assets in Table 1-4, result in increases (or decreases) in equity, and should be reported on the Statement of Owner Equity. (20) Another item in this format represents a tax effect associated with these changes in market values, called Change in Non-Current Portion of Deferred Taxes in Table 1-4, and is also reported. Chapters 4 and 9 present discussions of deferred taxes in more detail. Each of these items affects the amount of the owner’s interest in the farm business. The Statement of Owner Equity reports the changes to the owner’s interest during a given year. In some years there may not be any Non-Farm Income or gifts and inheritances contributed or distributed, so these items would not be reported in that case.
Exercise 1-3 Can you identify each of the equity items in the Farmers' Statement of Owner Equity? How much are the Investments and how much are the Withdrawals? Answer: (See Appendix A).
Learning Objective 12 * To state the Accounting Equation and the general format for the Balance Sheet and to define or describe the items or categories in the Balance Sheet.
The Income Statement and the Statement of Owner Equity report the results of activities over a specified period, usually one year. A farm’s fiscal year can begin at any month of the year or on January 1, whichever is most feasible for the owner to make decisions. At the end of every year, the farm accountant compiles these statements. The next year, a new Income Statement and Statement of Owner Equity are prepared. The Balance Sheet, on the other hand, reports the financial position of the farm operation on a specified date. It reports the values of all of the assets being used in the farm operation, not just the new assets acquired during the past year. Assets disposed of are not included. The Balance Sheet also reports all of the outstanding liabilities (debts not yet paid off). The performance of the farm operation is accumulated in the Equity section of the Balance Sheet and is reported along with the other items that constitute owner equity.
The Balance Sheet contains an equation, called the Accounting Equation, which shows a relationship between Assets, Liabilities, and Equity.
Assets = Liabilities + Equity
Equity on the Balance Sheet is the same as the Owner Equity at the end of the year from the Statement of Owner Equity.
If the farm business has investments in cooperatives, life insurance, or other types of investments, they are also listed on the Balance Sheet as "Investments" and are typically categorized as non-current assets.
The first items listed on the Balance Sheet are the Assets; Current Assets are first, followed by Non-Current Assets. Current assets are those assets expected to earn money or produce other benefits within one year. Examples of Current Assets are cash (which is listed first on the Balance Sheet), Receivables (which are cash, goods, or services owed to the farm business), Inventory (feeder livestock, feed, and crops on hand), and Prepaid Expenses (which are expenses paid in advance, such as insurance).
Typical Non-Current Assets for a farm business are land, buildings and improvements, machinery and equipment, breeding livestock, perennial crops, and natural resources; they are expected to provide benefits to the operation for more than one year or at some future date.
The next items listed on the Balance Sheet are the Liabilities, usually in the order in which they are expected to be paid off. Current Liabilities, listed first, are debts that are expected to be paid off within one year. Examples of Current Liabilities are debts owed to suppliers for purchased items not yet paid for, taxes owed to government agencies, interest, and principal owed to lenders that will be settled within the next year.
Non-Current Liabilities will not be paid in full during the next year but will be paid off over a number of years; these include mortgages and other debts for purchases of assets, also deferred taxes and capital leases. Equity is listed last on the Balance Sheet. It indicates the difference between the Liabilities and Assets, and thus represents what is left over for the owner after all debts are paid off (hence, the owner’s interest).
A typical format for a Balance Sheet lists the Assets on the left side of the page and the Liabilities and Equity on the right side. Sometimes Assets are listed at the top of the page, the Liabilities are listed underneath them, and Equity is listed under the Liabilities. The following is a general format for the Balance Sheet using the left side/right side display. Mathematically, the Total Assets equals the Total Liabilities and Equity.
Assets: Liabilities: Current Assets: Current Liabilities: Cash Accounts Payable Receivables Interest Payable Inventory Taxes Payable Prepaid Expenses Short-Term Notes Payable Total Current Assets Total Current Liabilities Non-Current Assets: Non-Current Liabilities: Land Real Estate Notes Payable Buildings Notes Payable Machinery and Equipment Deferred Taxes Breeding Livestock Total Non-Current Liabilities Orchard Total liabilities Total Non-Current Assets Equity Total Liabilities and Equity Total Assets
The types of assets and liabilities will vary for each farm operation, so the format displayed here might not apply to every farm or ranch. This format offers the general idea of what to expect when you read a Balance Sheet.
The Balance Sheet usually displays subtotals for various categories of items. For example, the Current Assets are listed as a category with a subtotal. There is also a subtotal for the Non-Current Assets. The subtotals are used in some aspects of financial analysis, which you will learn about in Chapter 10. Similarly, the Liabilities are displayed in two categories, Current and Non-Current, along with subtotals. These subtotals are especially useful because they can be used to assess the debt position of the operation.
PRACTICE WHAT YOU HAVE LEARNED At this point, you should be able to complete Problem 1-6 at the end of this chapter. Learning Objective 13 * To identify the components of equity.
The equity section of the Balance Sheet could contain two categories (not shown above), one for an item, called Valuation Equity, and another for Retained Capital. Valuation Equity refers to the differences between cost and market values for Non-Current Assets. These would be primarily breeding livestock, land, buildings, machinery and equipment, orchards, and natural resources. Retained Capital is the equity from the accumulated Net Income of the farm operation (retained earnings) and the net contributions as seen on the Statement of Owner Equity. Figure 1-2 depicts these items.
[FIGURE 1-2 OMITTED]
The reader of the financial statements can refer to the Statement of Owner Equity to see the details concerning the changes in the owner’s interest since the beginning of the current year. The Balance Sheet displays the total Equity at the end of the year, without the details displayed in the Statement of Owner Equity.
Additional details about assets and liabilities are also at the discretion of the farm manager or owner or accountant when the financial statements are prepared. Table 1-5 depicts an example of an expanded, more detailed Balance Sheet for a farm business with several items listed for inventory.
Exercise 1-4 Can you identify each of the assets, liabilities, and equity items on the Farmers' Balance Sheet? What is the amount of their total assets? What is the amount of their Total liabilities and Total equity? Answer: (See Appendix A).
STATEMENT OF CASH FLOWS
Learning Objective 14 * To name the three categories of activities reported on the Statement of Cash Flows, to provide examples of each category, and to state the general format for the Statement of Cash Flows.
The Statement of Cash Flows displays the sources and uses of cash for the year and is organized according to the three activities indicated earlier in this chapter. Generally, operating activities involving cash are listed first, followed by cash investing activities, and finally cash financing activities. Any cash transactions that involve the ordinary operations of the business in producing and selling farm products are considered operating activities. Examples of these would be selling crops or livestock and receiving payment for the sale, receiving government payments, paying hired help, paying for seed and fertilizer, paying veterinary bills, and so on. Investing activities would include cash payments for new equipment, land improvements, major building repairs, new breeding livestock, and the sale or trade-in of these assets. The sale of culled breeding livestock is considered an operating activity. Financing activities involve borrowing money and making loan payments to lenders and cash contributions from the owner to the farm business (such as Non-Farm Income), and cash withdrawals from the farm business to the owner for personal expenses. The interest payments, however, are considered an operating activity. The net increase or decrease in cash from all of these activities is added to the amount of cash on hand at the beginning of the year to compute the cash on hand at the end of the year. This amount is the same amount for Cash that is found on the Balance Sheet.
The general format for the Statement of Cash Flows is as follows:
Cash flows from operating activities
+/- Cash flows from investing activities
+/- Cash flows from financing activities
= Net increase or decrease in cash
+ Cash at the beginning of year
= Cash at the end of the year
The Statement of Cash Flows summarizes information about cash transactions for each of the type of activities involved. The expanded format provides more details about each of the activities. The Income Statement provides a more accurate assessment of the financial performance of the farm business for the year, but the Statement of Cash Flows tells us how cash was used during the year. Table 1-6 displays an expanded format for the Statement of Cash Flows for a farm business.
Exercise 1-5 What is the amount of the cash flows from operating activities on the Farmers' Statement of Cash Flows? How much cash did they use for investing activities? How much cash was provided from their financing activities? Answer: (See Appendix A).
Farm Financial Statements provide information about farm financial activities, including financing, investing, and operating activities. The Income Statement reports revenues, expenses, gains, and losses. The Statement of Owner Equity reports in detail the financing activities that pertain to the owner interest in the farm business. It contains information concerning the effects of Net Income, owner withdrawals from and contributions to the farm business, gifts and inheritances received and distributed, and changes in market value of farm assets and the non-current portion of deferred taxes. The Balance Sheet reports the assets, liabilities, and equity of the farm business. The Balance Sheet lists all Assets, beginning with Current Assets followed by Non-Current Assets; all Liabilities, beginning with Current Liabilities followed by Non-Current Liabilities; and Equity, which may be divided into Valuation Equity and Retained Capital. The Statement of Cash Flows reports on all financing, investing, and operating activities involving cash. The Statement of Cash Flows lists all cash activities classified into operating, investing, and financing categories; additionally, it reconciles the cash balance from the beginning of the year to the end of the year.
Presenting financial information in terms of dollar value might seem like an obvious statement, except when you realize that in the 19th century, farmers presented balance sheets in terms of the number of acres, pounds, bushels, head of livestock, and so on. Agricultural producers understand the need for production records that use these modes of measurements. Sometimes the dollar value is a difficult measure, for reasons that are clarified throughout this book.
1-1 * Matching exercise. Match the following terms in the left column to the definitions in the right column by writing down on a sheet of paper the letter of the definition that most closely describes the terms.
Terms Definitions Financial accounting a. Financial reports that summarize the financial activities of an entity. Financial performance b. System that produces reports for outside parties. Financial statements c. Procedures to evaluate financial performance and financial position. Financial position d. Financial state on a specified date. Financial analysis e. Measures of profitability for a given time period.
1-2 * Identify each of the following activities as a financing (F), investing (I), or operating (O) activity.
a. Selling hay to a neighbor.
b. Borrowing money for Operating Expenses from Farm Credit Services.
c. Paying the vet bill.
d. Paying back part of the money borrowed from Farm Credit Services.
e. The farm owner decides to use a personal computer for farm record keeping.
f. Spending money from sale of grain to pay off personal credit cards.
g. A young farmer receives 40 acres of land from parents.
h. Buying feed for the entire winter.
i. Buying a new tractor.
j. Buying diesel fuel and storing it on the farm.
k. Selling an old truck.
l. Spouse deposits money from part-time substitute teaching job into farm bank account.
1-3 * On which financial statement would you find the following financial statement categories?
1-4 * Calculate Net Income for each of the situations below. a. Revenues = $1,350,000; Expenses = $950,000. b. Revenues = $1,350,000; Expenses = $950,000; Gains = $10,000. c. Revenues = $1,350,000; Expenses = $950,000; Gains = $10,000; Losses = $5,000. d. Revenues = $1,350,000; Expenses = $950,000; Losses = $35,000. e. Revenues = $1,350,000; Expenses = $1,450,000; Gains = $10,000. f. Revenues = $1,350,000; Expenses = $1,450,000; Losses = $10,000. 1-5 * Explain the concept of equity. 1-6 * Identify the category on the Balance Sheet (Current Assets, Non-Current Assets, Current Liabilities, Non-Current Liabilities, Equity) in which each of these items is located. Accounts Receivable Fences Barns Insurance paid for in advance Bill owed to utility company Land Breeding cattle Machinery Cash Shed Debt owed to bank for Tractors 30-year mortgage on land Feed Inventory Vehicles
Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. Naperville, IL, 1997. Also available online at http://www.ffsc.org.
Financial Accounting Standards Board, “Qualitative Characteristics of Accounting Information”, Statement of Financial Accounting Concepts No. 2 (Stamford, CT: May, 1980).
Financial Accounting Standards Board. “Recognition and Measurement in Financial Statements”, Statement of Financial Accounting Concepts No. 5 (Stamford, CT: 1984).
(1.) Financial Accounting Standards Board. “Recognition and Measurement in Financial Statements,” Statement of Financial Accounting Concepts No. 5 (Stamford, CT: 1984).
(3.) Financial Accounting Standards Board. “Qualitative Characteristics of Accounting Information,” Statement of Financial Accounting Concepts No. 2 (Stamford, CT: May, 1980).
(10.) Financial Accounting Standards Board. “Recognition and Measurement in Financial Statements,” Statement of Financial Accounting Concepts No. 5 (Stamford, CT: 1984).
(11.) Financial Accounting Standards Board. “Qualitative Characteristics of Accounting Information,” Statement of Financial Accounting Concepts No. 2 (Stamford, CT: May, 1980).
(13.) Financial Accounting Standards Board. “Recognition and Measurement in Financial Statements,” Statement of Financial Accounting Concepts No. 5 (Stamford, CT: 1984).
(20.) Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. (Naperville, IL: 1997).
TABLE 1-1 * Types and examples of farm financial activities. Financing Activities Investing Operating Activities Activities Capital contributions Purchase of Production/sale of assets farm products Gifts and inheritances Sale of assets Purchase of inventory --received Purchase of supplies --distributed to heirs Purchase of services Non-Farm income Payment of wages contributed Withdrawals by owners Payment of interest Borrowing money Payment of taxes Paying back loans TABLE 1-2 * The four primary Farm Financial Statements and their elements. Income Statement of Statement of Statement Owner Equity Balance Sheet Cash Flows Revenues Net Income Assets Operating activities Expenses Investments Liabilities Investing activities Gains Withdrawals Equity Financing activities Losses TABLE 1-3 * Expanded format for the Income Statement. Gross Revenue - Operating Expenses +/- Adjustments - Depreciation Expense - Interest Expense +/- Change in Interest Payable = Net Farm Income from Operations +/- Gains/Losses on the Sale of Farm Capital Assets +/- Gains/Losses Due to Changes in General Base Values of Breeding Livestock = Accrual Adjusted Net Farm Income + Other Revenue - Other Expenses = Income before Taxes - Income Tax Expense (farm business taxes only) +/- Change in Taxes Payable = Accrual Adjusted Net Income Source: Adapted from Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. (Naperville, IL: 1997). TABLE 1-4 * Format for Statement of Owner Equity for the Farm Business. Owner Equity, beginning of year Accrual Adjusted Net Income or Net Loss - Owner Withdrawals - Non-Farm Income + Other Capital Contributions/Gifts/Inheritances Received - Other Capital Contributions/Gifts/Inheritances Distributed = Changes to Retained Capital +/- Change in Excess of Market Value over Cost/Tax Basis of Farm Capital Assets +/- Change in Non-Current portion of Deferred Taxes = Change in Valuation Equity +/- Total Change in Retained Capital and Valuation Equity = Owner Equity, end of year Source: Adapted from Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. (Naperville, IL: 1997). TABLE 1-5 * Balance Sheet format for a farm business. Assets Liabilities Cash Accounts Payable + Accounts Receivable + Taxes Payable + Inventory Raised for Sale + Interest Payable + Inventory Raised for Use + Notes Payable due within one year + Inventory Purchased for + Real Estate debt due Resale within one year + Inventory Purchased for Use + Current Deferred Taxes + Prepaid Expenses = Total Current Liabilities + Cash Investment in Growing Crops = Total Current Assets Breeding Livestock Notes Payable-Non-Current + Machinery and Equipment + Real Estate Note Payable--Non-Current + Buildings and Improvements + Non-Current Deferred Taxes + Perennial Crops, Orchards, = Total Non-Current and Natural Resources Liabilities + Land Total Current and Non-Current Liabilities + Investments in Cooperatives and Other Investments = Total Non-Current Assets Equity: Valuation Equity + Retained Capital = Total Equity Total Current and Total Liabilities and Equity Non-Current Assets Source: Adapted from Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. (Naperville, IL: 1997). TABLE 1-6 * Format for the Statement of Cash Flows for the farm business. + Cash received from sale of livestock - Cash received from the sale of crops - Cash paid for feeder livestock, purchased feed, and other items for resale - Cash paid for all other Operating Expenses - Cash paid for interest - Net cash paid for taxes - Cash received from other miscellaneous farm income - Net Cash Provided (or Used) by Operating Activities Cash received from the sale of breeding livestock (other than culled breeding livestock) - Cash received from the sale of machinery and equipment - Cash received from the sale of land and buildings - Cash received from the sale of investments - Cash paid for the purchase of breeding livestock - Cash paid for the purchase of machinery and equipment - Cash paid for the purchase of land and buildings and improvements - Cash paid for the purchase of investments - Net Cash Provided (or Used) by Investing Activities Proceeds from operating loans + Proceeds from real estate and other term loans + Cash received from gifts and inheritances + Cash received from contributions by owners + Principal payments for loans + Repayments for operating and CCC loans - Cash paid out for gifts and inheritances - Owner withdrawals - Net Cash Provided (or Used) by Financing Activities = Net Increase in Cash from Operating, Investing, and Financing Activities - Cash Balance at Beginning of Year - Cash Balance at End of Year Source: Adapted from Farm Financial Standards Council. Financial Guidelines for Agricultural Producers. (Naperville, IL: 1997).
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7913 / How is gain taxed when breeding cattle are sold?
Gain from a sale or disposition of cattle depreciated under the ACRS method is generally recaptured as ordinary income to the extent of all depreciation deductions previously allowed. Amounts expensed under the provisions of IRC Section 179 (discussed in Q 7911 and Q 716) and the adjustments to basis that resulted from claiming the investment tax credit (see Q 7894) are treated as depreciation deductions. 1 If there is a loss on sale of the property, no recapture is necessary. 2
Gain (in excess of amounts recaptured as ordinary income) from sale or disposition of cattle held for breeding purposes (including cattle inventoried by certain accrual basis taxpayers), and which are held for 24 months or more from the date of acquisition, is “IRC Section 1231” gain, eligible for long-term capital gain treatment. 3 For this purpose, the holding period of an animal born into the herd begins at birth. 4 For a discussion of “IRC Section 1231” gain, see Q 7834.For the treatment of long-term capital gain, see Q 702.
Gain from the sale of cattle held for sale in the ordinary course of business is ordinary income. Uncertainty often arises as to the treatment of cattle periodically culled from the herd because of their unsuitability for breeding. (However, annual disposition of steer calves and of animals clearly unsuitable for breeding from birth results in ordinary income since these animals are destined for sale.) Whether an animal is held for breeding is determined from all the facts and circumstances. Although the purpose for which an animal is held is ordinarily shown by its actual use, a breeding purpose may be present if an animal is disposed of within a reasonable time after its intended use is prevented or made undesirable by reason of accident, disease, drought, unfitness of the animal for breeding, or similar reasons. An animal is not deemed to be held for breeding merely because it is suitable or merely because it is held for sale to others as a breeding animal. Even if an animal has been bred, it may not be considered to be held for breeding if use of the animal for breeding is negligible or if the animal is bred in order to provide desirable characteristics. 5
In order for a cash basis taxpayer to determine gain from the sale of cattle born into the herd, the gross sale price is reduced by any expenses of sale (such as sales commissions or freight or hauling from the farm to the commission company). Such animals have a zero basis if the costs of raising them were deducted while the animals were being raised. Gain or loss from the sale of purchased livestock is determined by subtracting the adjusted basis and the sale expenses from the gross sale price. 6
Accrual basis partnerships, S corporations, corporations, and individuals directly engaged in cattle breeding may either capitalize the cost of breeding cattle (and take deductions for depreciation) or value cattle according to an inventory method. 7 Gain from the sale of inventoried breeding cattle held for 24 months or more is eligible for capital gain treatment under IRC Section 1231. 8 Four inventory methods are available for livestock: the cost method, lower of cost or market method, unit-livestock-price method, or farm-price method. 9 (For more information about these methods of valuation, see IRS Publication 538 (Accounting Periods and Methods).) Gain is determined by subtracting the animal’s last inventory value (used instead of basis) and sale expenses from the gross sale price. 10 The amount of gain received depends on the inventory method used, as a low valuation method will result in a higher amount of gain.
3. IRC § 1231(b)(3); Treas. Reg. § 1.1231-2(a).
4. Greer v. U.S., 408 F.2d 631 (6th Cir. 1969).
5. Treas. Reg. § 1.1231-2(b)(1).
6. See Farmer’s Tax Guide, IRS Pub. 225 (2019), p. 52.
7. Treas. Reg. § 1.61-4(b).
8. U.S. v. Catto, 304 US 102 (1966), 66-1 USTC ¶ 9376 (U.S. 1966).
9. See Farmer’s Tax Guide, IRS Pub. 225 (2019), p. 7.
10. Carter v. Comm., 257 F.2d 595 (5th Cir. 1958).
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