Decision Making Based On True Profits

Ask any farmer or rancher how profitable they are, and the response is usually “according to my taxes, I lose money most years.” However, the producer purchases new equipment, land and in some cases, personal assets, such as a new truck or car, or a vacation. How can this be? Many businesses are being managed using tax statements rather than an accrual-adjusted income statement.

Studies by Purdue University and University of Illinois find that over a five-year period, the difference between cash tax profits and accrual-adjusted profits is 64%. The big concern is that farm businesses are making five, 10 and even 20-year decisions based upon records that can show this much divergence!

So, if you are a producer, how can you adjust your financials to determine the true accrual profit?

1. First, you must have a beginning- and end-of-year balance sheet. Next, find your tax records for the year between the balance sheets.
2. Now, adjust your beginning and ending inventories of feed, crops and livestock. If the item increases, add to the income. If it decreases, subtract. By the way, 70% of the difference between cash and accrual adjustments is usually in inventory, particularly for grain producers, feedlots and hog confinement operations.
3. Next, adjust beginning and ending accounts receivable. Again, an increase adds to income, and a decrease is deducted from income.
4. Many producers prepay for expenses such as fertilizer, feed and other inputs. If prepaid expenses between the beginning and ending balance sheet increased, add to income; if these expenses decline during the year, they are deducted. A similar calculation can be made for supplies to be used for future production.
5. On the liability side, examine accounts payable and accrued expenses such as wages, taxes and interest. In this case, if the payables or accrued expenses increase, it is deducted from income. If these expenses decline during the year, they are added to income.

On another note, many are taking Section 179 accelerated depreciation which can be written off in one year. This can really distort the bottom line. A truer measure of the asset’s life is to depreciate equipment over five to seven years and buildings and improvements over 10-20 years.

In the example below, the difference between cash farm income on the Schedule F (-$50,000) and accrual-adjustments for the various categories of $115,000, indicates a $165,000 difference in net income as an illustration.

If the producer had used Section 179 accelerated depreciation versus a standard write-off, the difference could even be larger. For 2012, businesses need to start doing accrual-adjusted statements and make decisions based on true profits versus tax profits.

Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at sullylab@vt.edu.