Tools:

Farm Records Can Improve Profitability

Farm managers need a complete and accurate farm records system in order to make informed management decisions that will help maintain or improve farm business profitability. Records systems have four functions: (1) as a service tool (to assist in reporting to the Internal Revenue Service and other taxing entities, creditors, other farm asset owners, and to others who have a vested interest in the financial position of the business), (2) as an indicator of progress, (3) as a diagnostic tool for identifying strengths and weaknesses, and (4) as a planning tool.

Records can also help the manager plan and implement farm business arrangements and do estate and other transfer planning. Furthermore, farm managers can use records to determine what the efficiencies and inefficiencies are, measure progress of the business, and plan for the future.

Farm business managers do not need to be accomplished accountants or experts on taxes and law. However, they do need to know how to keep the required records for their businesses; they must realize that all business decisions have income tax consequences; and they must be able to evaluate the accounting and legal professionals who serve their businesses.

Choosing a Records System

There are many farm records systems. They range from simple, hand accounting systems using pencil and paper to sophisticated double-entry computer accounting systems. Some require a mix of hand and computer operations.

Choose a system that is user friendly and designed specifically for farm managers. It should not only meet the accounting and planning needs of the farm operation, but it should also satisfy income tax, legal, and other outside reporting requirements. Select a program with good detailed instructions for use. Buy your system from a reputable, reliable, and accessible person, organization, or company. Particularly in the case of computerized systems, the supplier should provide training for first-time and experienced users.

Selecting a Specific System. The first step is to determine your objectives for the system both personal and business. For farm managers who do not want or need a system for business and financial management, a relatively simple system that satisfies income tax reporting requirements may be adequate. For those who are heavily in debt or who want to improve profitability, a more complete and detailed system is probably required.

There are some highly simplified farm accounting books and systems, and there are some systems that are complicated and difficult to use effectively. Consider beginning with a basic system and working up to a more complex and useful system. Choose a system that enables you to expand the amount of information you use, that provides ease of entry, and allows you to retrieve crucial data in a useful form. At a minimum, the system must satisfy all income tax reporting requirements, including maintaining documentation of transactions for as long as such information is required by income tax regulations and other laws.

Use generally accepted accounting principles adapted to the farm business. For some farm operations, a simple, single-entry, cash-basis accounting system will be adequate. For others, a more complicated accrual system (which allows for inventory changes) with double entry (a debit and credit for each entry) will be required. For many farms, the recordkeeping system should be able to accommodate different types of business arrangements. It is vital that the organization or company from which You purchase the system be available to keep you and the system up-to-date on changes in tax laws and accounting procedures.

Look for a system that efficiently transfers information from a check or invoice to the income tax records, to business and financial reports, to a complete business analysis, to a forward plan, and which provides a pro forma financial statement.

All of this should be accomplished with the least possible data manipulation. With an effective system, a major portion of the needed data gathering, assembling, and validating is completed by the time the income tax work is properly done. From there, it is only a short step to having a data set that can help you improve business decisionmaking and increase profitability.

The system that you select should show the past and present financial status of the business and serve as a tool for the ongoing processes of planning, controlling, and decisionmaking. Do not keep records for the sake of recordkeeping. Gather information that is useful and that can help you in making decisions. Do everything with the goal of meeting your business and personal objectives.

When trying out a records system, it is helpful to enter a list of typical transactions from your farm over the span of a year into the system. Think of this as a field test to determine if you, your business, and the record system are compatible. Each user will have to weigh his or her needs and wants against different system capabilities. Selecting the most appropriate records system for your business is like any other investment decision. You have to ask yourself whether the cost of additional capacity and complexity is worth the added returns.

Accounting Methods

Here are explanations of the two types of accounting methods that are used in farming.

Cash-Basis Accounting. This method is used primarily for income tax reporting purposes in service industries. Generally speaking, in cash-basis accounting, income is recorded as income when it is received and expenses are recorded as expenses when they are paid. (However, there are some exceptions to this rule in the income tax regulations.) Cash-basis accounting is simple and can provide some income tax advantages for businesses that are heavily dependent on inventory changes.

However, this method also has drawbacks. Cash-basis accounting can grossly distort the financial position, profitability measures, and operational results of the farm business. It is necessary to convert cash-basis accounting to accrual accounting for analysis and decisionmaking purposes. This can readily be done by making some adjustments at the end of the accounting period so that both economic and financial feasibility can be measured.

Accrual Accounting. This method is required for tax purposes for most trading and manufacturing businesses. However, it is not required for most farms. In accrual accounting, expenses are considered expenses when they are accrued (or committed) and income is counted as income when it is earned. This includes changes in inventories. This method does not depend on how the cash moves in the business. Expenses incurred are matched with related income to determine net income. This approach provides a better continuous picture of profitability. However, an assessment of cash-flow is still needed to determine the financial feasibility of the business.

Basic Recordkeeping for Your Farm Business

Recordkeeping need not be a complex managerial activity if some simple rules are followed. Of course, a well designed farm record system can make the job easier as well as more efficient.

Tips for Better Recordkeeping. Here are six suggestions for better recordkeeping in your farm business:

1. Never, never net it out. Always record the gross or total amount.

2. Always go through all the steps for each transaction.

3. Run everything through a checking account.

4. Separate business income and expenses from personal income and expenses. Have separate checking accounts.

5. Do periodic accuracy checks.

6. Staple your calculator tape to each page as you total your book so that you can refer back to it. Do not do your work twice once is enough!

Note that items one and two fit together as do items three and four.

Tax Records

The Internal Revenue Service requires that you have a set of farm records to show all taxable income and expenses that are deductible. This can be done in many different formats. But however it's done, the farm manager or recordkeeper must maintain accounts to show the three different types of farm income: sale of "resale" (purchased) items, other ordinary income, and sale of capital items. Records must also be kept of the two types of expenses ordinary expenses and capital expenses along with some expenses that could be classified in either category. Included in the expense category is the annual depreciation record.

Your record system should support items on your tax return. It must provide evidence of the types of income and expenses, that the bill was paid, and that the bill was for business expenses. For this, you need sales slips, invoices, receipts, deposit records, and canceled checks. Your income and expenses should be clearly identified. It is important to separate business expenses from personal expenses. The best way to do this is to maintain separate checking accounts for the family and the farm business. Be careful to identify loans, debt repayment, and interest expenses. These records must be kept as long as they have any income tax or legal ramifications.

Other required records might include capital item records, Social Security records, Occupational Safety and Health Administration (OSHA) records, Federal Unemployment Tax records, worker's compensation, retirement plans, health insurance, operating agreements, carryovers and carrybacks, net operating losses, and income tax credits. (The Farmers' Tax Guide, IRS Publication No. 225, can provide current information on all of these requirements.)

The Complete Farm Records System (ALERE)

There are five basic accounts in any complete financial records system. They can be easily remembered by the learning the nonsense word ALERE. The five accounts are assets, liabilities, equity (net worth), receipts (income), and expenses (costs).

Assets, liabilities, and equity are the three parts of the balance sheet (or net worth statement). Revenue and expenses are the two components of the earnings statement (also called the profit or loss statement, operating statement, or income statement). The cash part of revenue and expenses are recorded in the cash-flow statement (sources and uses of funds). These "big three" financial statements are the heart of any basic accounting system.