How To Use a Farm Accounting System To Help Analyze Your Finances

Planning and financial control are two of the most difficult and troublesome tasks faced by modern farmers and ranchers, but they are also the cornerstones of the management process.

Management usually is defined in three steps: planning, implementation, and control. This chapter focuses on how an accounting system can help you develop the information necessary for planning and controlling your farm business activities.

Purposes of Accounting Systems

Before decisions can be made or analyzed, the information necessary for the decisions must be available. The primary goal of any farm or ranch accounting system should be to provide business management analysis and control. The accounting system should be geared toward the farm or ranch manager; if the accounting system is not used, it is for all practical purposes worthless. Many uses of the accounting system relate to individuals other than the manager, so the system must be able to provide financial information for them too. The accounting system supports major management functions by providing the information necessary for making decisions. The accounting system should supply three types of information:

Scorekeeping, or evaluating performance (generally a retrospective look available in the financial statements);

Attention directing, to flag ongoing operating problems, inefficiencies, and opportunities (identified through analysis of the financial statements); and;

Problem solving, or analyzing the relative merits of alternative courses of action.

The accounting system provides information the farm manager needs for external reporting for tax and credit purposes; financial control of routine operations; business management analysis; and reporting to multiple owners for example, in corporations and partnerships.

Tax Requirements. The Internal Revenue Service (IRS) and most State income tax authorities require that enough business records be kept to justify all income and expense claims reported on an income tax return. The lack of standardized requirements for a minimum acceptable set of records has led some farmers and ranchers to store their cash register receipts, invoices, bank statements, and canceled checks in a box or file drawer and to do little more. Legally, such records are sufficient. This system can become an extremely expensive one, however, during an IRS examination, if the manager is called upon to substantiate claims made on an old tax return.

Other Taxes and Investments. If complete and accurate records are maintained, problems with estate, gift, and property taxes can be minimized. Furthermore, the ability to participate in investments outside of normal farm or ranch business activities can be enhanced by having the information readily available to determine whether a particular investment opportunity is financially feasible.

Credit Application. In recent years, lenders have come to stress repayment capacity of loans, as well as collateral security. Most borrowers now need to show that the investment for which the loan is intended will be able to generate enough income to pay back the interest and principal owed within the specified time period.

Financial Control of Routine Operations. Just as lenders are concerned with cash flows and repayment capacity, astute business managers have also become greatly concerned with cash-flow management. How much to borrow, either in long-term credit or in operating credit, is only half the story. When and how much to pay back is just as important as tight control of cash reserves. Paying operating money back after a sale may not be the wisest option if it puts the business in a cash-flow bind later. Interest charges must he analyzed in addition to liquidity needs of the business and of the family. Preparing a realistic cash-flow budget is one of the vital steps in the annual recordkeeping process. A cash-flow budget is a projection of anticipated cash receipts and cash expenditures, by category, for a future time period typically 12 months. Borrowing and repayment plans are included. Cash budgeting involves all the steps required in the whole farm or ranch planning process: marketing (including price projections for inputs as well as outputs), yield projections, and enterprise combinations.

Despite the difficulty of preparation, the cash-flow budget helps document managerial abilities and loan repayment capacities. Furthermore, the cash-flow budgeting process can be extended one more step to provide an extremely effective financial control device. If monitored monthly, or even quarterly, the cash-flow budget can indicate potential problems before they arise. This ability to foresee problems allows the manager to adjust before the fact rather than react afterward.

Business Management Analysis for Strategic Planning. If a farmer or rancher is disciplined enough to develop and maintain a records system to meet income tax reporting and credit application needs, then virtually all the needed information will be available to meet what is probably the most important goal of a farm or ranch records system: business management analysis. Good farm or ranch business managers know exactly what their variable and total costs of production are. They know whether they are meeting the goals of their marketing plans or their cash-flow budgets. They have analyzed their strengths and weaknesses, both in physical terms and financial terms. They know where their business has been where it is now, and where it is going.

Corporations and Partnerships. Multiple-owner forms of business organization require more detailed records because of more intricate tax reporting requirements, State corporation laws and additional documentation needs of lenders. Perhaps the most important need for more detailed records in partnerships and corporations comes from the likelihood of problems and potential conflicts among the individuals involved.

Lease and Family Distributions. Individuals involved in informal family partnerships, joint ventures, and share leases need to rely on a detailed records system to ensure fairness in distribution of profits and contributions.