For most farm and ranch owners, bookkeeping probably doesn’t top the list of their favorite chores. However, the financial health of your business depends on good financial records. Having your financials in proper order allows you to make better business decisions. Your accountant also appreciates accurate and complete records for tax planning and preparation as well as strategic planning purposes, and so does your lender.
When preparing financial statements, there are two basic accounting methods, accrual and cash. Let’s take a look at these two methods to help you understand their relevance to your business.
Cash Basis Method
Most farmers are allowed to use the cash basis method of accounting to report income and expenses for tax return reporting. In simple terms, this means you report transactions based on when the cash comes in or goes out. This method is the simpler of the two and is used by many of our ag clients.
Why? It allows you to change the impact of your taxable income in many ways. For example, many farmers wait to sell grain or cattle until after the first of the calendar year to defer reporting the income.
Meanwhile, you can also choose to pay certain expenses before calendar-year-end to offset income for that year; for example, chemicals, fertilizer or seed to be used in the next year. Prepaid expenses cannot exceed more than 50% of total expenses for the calendar year, and you have to purchase an amount — the payment cannot be just a deposit. Capital expenses also come into play, as purchasing equipment (as long as it is with cash or credit) can be deducted in the current year as long as it is placed in service that same year.
This cash method is straightforward and simple, so you may be asking yourself — why even bother with the accrual method? Because it’s truly the only way to measure the financial success of your business operations.
Accrual Basis Method
The accrual basis gives a better financial picture of your operations because revenue and expenses are better aligned with each other in the same reporting cycle. This method requires receivables and payables to be recorded when the transaction happens and not when the cash changes hands.
For example, if an invoice for seed is received, that would be recorded as a payable and either seed inventory or seed expense if used would be the offsetting entry. When the invoice is paid, the payable would be reduced to zero.
This method would also require inventory to be recorded. For example, this could be the amount of grain in storage at current market rates.
By recording all the inventory, prepaid expenses and payables, you can see a better picture of your assets and working capital.
Even if you keep your records on the accrual method, for many producers, the cash method is still allowed for tax reporting. But by using the accrual method of reporting, it helps you manage your operation’s cash flow and use the financials to predict future cash in and out.
Also, when applying for loans, this method is preferred by most financial institutions because it gives a better picture of the actual profitability of your operations. For tips about working with your lender, see our recent blog: Six Tips for Working With Your Ag Lender.
If you’re using the cash method and would like to discuss converting to the accrual method, contact your Wipfli relationship executive or one of our agribusiness professionals. I can be contacted at 715.858.6647 or email@example.com.