This time of year farm operators spend time in their office completing paperwork
for income taxes, preparing information for their lenders and hopefully spending
some time analyzing the performance of their business during the past year. Most
farm operators use a calendar year (January 1 - December 31) as their business
year for income tax purposes and also to prepare financial statements about their
operation. Even if a business is on a different fiscal year for tax reporting
purposes, they may still want to prepare financial statements based on a calendar
Some of the objectives of analyzing the farm business are to determine how
profitable the business has been and how much increase (or decrease) in net worth
occurred during the past year. The two financial statements that should be completed
to analyze these aspects of the business are an accrual income statement and a
balance sheet. The accrual income statement measures the profitability of the
business for the year. It provides a more accurate measure of profitability then
the income tax schedule F. The balance sheet measures the operator's level of
ownership or equity in the business. These statements should be prepared using
the same time period or point in time from year to year. The income statement
typically covers the January 1 through December 31 time period while the balance
sheet should usually be prepared as of December 31.
ACCRUAL INCOME STATEMENT
An accrual income statement matches revenues with costs for a given time period,
regardless of when revenue was actually received or when expenses were actually
paid. For example, plow down fertilizer applied and paid for in the fall of 2001
is considered a 2002 expense for business analysis purposes even though it will
be taken as an expense on the 2001 income tax return for a cash basis tax payer.
This is because it will be utilized for the 2002 crop.
To calculate accrual income, adjustments are made to cash income and expenses
for changes in values between the beginning and end of the year for grain and
livestock inventories, accounts receivable, accounts payable and prepaid expenses.
Depreciation on machinery and buildings is also subtracted off. If the accounting
system a producer is using does not generate an accrual income statement, the
schedule F tax form along with the beginning and end of year balance sheet can
be used to calculate accrual income. To cover a 12-month period, the balance sheet
should be completed as of the same date every year, preferably December 31.
Start with the net farm income figure from the schedule F tax form. This assumes
the schedule F is filed on a cash basis, not an accrual basis. Adjustments are
then made for the change in values between the beginning and end of year inventories
of grain and livestock, accounts receivable, prepaid expenses and accounts payable.
For example, if on January 1, 2001 you had $175,000 of grain inventory and on
December 31, 2001, your grain inventory was $200,000, you would have a $25,000
positive adjustment to your cash basis schedule F net income. Increases in inventory
values, accounts receivable and prepaid expenses result in positive adjustments
to income. An increase in accounts payable result in a negative adjustment to
income. Decreases have an opposite effect on income.
Additional adjustments need to be made if you have breeding and/or feeder livestock.
The gross dollar amount of breeding livestock sales on schedule 4797 should be
added in. The total cost of feeder and breeding livestock purchased during the
year should be subtracted off. The purchase cost of feeder livestock deducted
on schedule F should be added back in as well as the amount of depreciation for
purchased livestock that is included in schedule F depreciation.
VALUING GRAIN AND LIVESTOCK INVENTORIES
Grain and livestock inventories are generally the most significant item to
consider when making these adjustments. Therefore it is very important to estimate
the quantity and value of these items as accurately as possible. Grain should
be valued based on the local cash market as of the end of the year with a couple
of exceptions. Grain that is still eligible for government loans or loan deficiency
payments (LDP's) should be valued at the loan rate if the loan rate is above the
cash price. Grain in which the LDP has been taken should be valued based on the
local cash market even if this is below the loan rate. LDP's that have been established
but not received by December 31 should be listed as an account receivable. Grain
in which a Commodity Credit Corporation loan has been taken should still be shown
as an inventory item valued at the higher of the loan rate or cash price while
the loan amount should be shown as a current liability.
Determining the proper value for livestock can be more difficult. Again, it
is important to get an accurate estimate of the number and weight of the animals.
The current cash price can be used for estimating values for market livestock.
A conservative "base value" should be used for breeding livestock. A
conservative base value would reflect the value for slaughter purposes rather
than for breeding stock purposes. However, judgment should be used in how these
values reflect on individual circumstances. This base value can utilize local
cash prices but should not fluctuate significantly from year to year. This prevents
net farm income and net worth changes simply due to valuation changes in breeding
livestock, an asset that normally wouldn't be liquidated for an on-going business.
BALANCE SHEET STATEMENT
The balance sheet is used to determine the producers net worth or equity. It
is a listing of the producer's assets and liabilities. Traditionally in agricultural,
assets and liabilities have been divided into current, intermediate and long term
sections on the balance sheet. This division is useful in determining the liquidity
or ability of the farm to meet short-term obligations as well as comparing the
debt structure (short or long term) to the assets of the business. Another format
common in the business world is simply dividing assets and liabilities into a
current and non-current section.
Balance sheets are usually completed using a fair market approach to valuing
assets. This simply means that assets like land and machinery are valued at their
current fair market value. A modified cost basis balance sheet lists assets at
their cost or book value. For example, land is valued at original cost instead
of market value and machinery is valued at remaining cost basis instead of market
value. Net worth on a modified cost basis balance sheet is derived totally from
earnings while a fair market value net worth includes both earned and valuation
net worth or equity. A fair market value balance sheet sometimes can disguise
a business that is not generating sufficient earnings because of valuation increases
in assets. Earned net worth (income less withdrawals) may actually be decreasing
but fair market value net worth may be increasing due to increases in valuations
of land and other assets.
The accrual income statement and balance sheet are two key financial statements
to analyze the farm business. With the completion of these statements, key financial
ratios and other analysis can be completed to measure the direction the farm business
is going financially.
Farm financial analysis tools which will help you complete an accrual income
statement and balance sheet can be found at the University of Illinois farmdoc
Issued by: Dale Lattz, Department of Agricultural and Consumer Economics