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Stocker Cattle| October 2012

Cash vs. Accrual Accounting

By Lorie Woodward Cantu

Editor's Note: This is the 10th installment in a 12-part series on stocker cattle management. This series has been created in partnership with Chris McClure, Gold Standard Labs (bvd-pi.com), a lab services company based in Hereford that specializes in BVD-PI testing and blood pregnancy tests; and Danna Schwenk and Karla Whitmore, CattleXpert Management Software (cattlexpert.com), a software company based in Elkhorn, Neb., that specializes in feedlot and stocker management applications.

When profit margins are razor-thin, producers can't afford to overlook any facet of their business, including their accounting systems.

"The agriculture industry is the only industry that the Internal Revenue Service allows to use cash record-keeping versus accrual accounting," says Stan Bevers, professor and Extension economist-management for the Texas A&M AgriLife Extension Service at Vernon.

With cash accounting, revenues are booked when producers get paid and expenses are recorded when they write a check. In comparison, the accrual method recognizes revenue when the sale is made and expenses when they are incurred, regardless of when the bills are paid. Cash accounting is simple to implement and it gives an accurate picture of a producer's cash balance regardless of the amount of sales or expenses.

Cash accounting is also very flexible. For example, producers can easily defer or lower income taxes by depositing a check in the bank on Jan. 1 as opposed to December or prepaying invoices due in January in December to reduce taxable income.

"While cash accounting has some benefits, today's volatile business realities are making its shortcomings much more obvious," says Bevers. "The first downside is that cash accounting can make operations appear financially healthier than they are."

An example from the construction industry demonstrates how this can happen. A contractor gets a $20,000 remodeling job and orders $8,000-worth of supplies on credit. He starts the job on March 1 and receives a $5,000 deposit before beginning his work. With cash accounting, it appears that he has made $5,000 revenue in March. Despite appearances of being in the black, he is actually in the red $3,000 because he still has to pay for his supplies.

"People have maintained that cash accounting works over time, but that's a fallacy," Bevers says. Studies have shown that cash income can lag behind accrual by 2 to 3 years, which is too late to take corrective action should something be going wrong, he says. Recently, the Center for Farm Financial Management at the University of Minnesota found low-income farms using cash accounting reported average losses of $3,742 for the 2008 to 2010 years, when they actually lost on average $51,336.

A second problem with cash accounting is that it makes it easy to confuse cash flow with profit.

"If producers are able to pay their bills, many assume that they are making a profit, when actually they're just experiencing cash flow," Bevers says. "True profit occurs when a producer has paid all of the expenses including depreciation and has built wealth."

He continued, "Often times the disparity between cash flow and profit first shows up as a gut feeling that something just isn't right. On paper, the operation appears okay, but when the producers look around the fences are old, the pickup is worn out, the cow herd is aging, and there's not as much money in the bank. What the numbers are telling them is not the same thing that their eyes are telling them."

Another problem with cash accounting is that it is difficult to go back to a set of records and extract meaningful data, which is crucial for making business decisions.

"In the not-so distant past, it was possible to clear $100 per head on stockers fairly easily," he says. "Today, though, the cost of inputs has skyrocketed and margins are so thin that producers have to scrutinize every single dollar. The very nature of cash accounting makes that difficult."

For example, if producers buy fertilizer in September 2012 to put on winter wheat pastures, they can claim that expense in 2012, although the wheat won't be sold until 2013. Using cash accounting, it is difficult to analyze the entire wheat production year (September through June) because it crosses 2 calendar years.

"Because expenses and revenues do not have to be claimed in the same year, it's hard to come up with true costs for any given enterprise at the end of the year, so producers end up with numbers that don't tell the real story," Bevers says. "Then they find themselves in a situation of trying to make decisions based on bad information. Personally, I'd rather make a decision with no information than bad information."

Match expenses and revenues
Accrual accounting works on the "matching principle," meaning that the system is set up to match expenses and revenues, providing a clearer picture of where a business stands, he says.

In the case of the $20,000 remodeling job used as a previous example, accrual accounting would record the revenue when the contract was signed and the cost of the materials when they were purchased. Contract labor would be expensed at the time the sub-contract was signed and profit would only appear on the financial statement when it was actually earned.

"In cash accounting, producers may have a good handle on how much they spent on feed for a year, but they may not know what percentage of the feed budget they spent on their cow-calf operation versus their stocker operation versus their wildlife operation," he says. "Accrual accounting can take it to the next level, allocating expenses right where they belong. The first step to acquiring wealth is knowing exactly how much things cost."

For people who already have a cash accounting system, the transition to accrual accounting requires identifying all of their enterprises, particularly those that will cross a calendar year, and determining how they will allocate expenses across the enterprises, Bevers says. An enterprise is defined as anything that requires management and needs to be tracked. Enterprises can include: a cow-calf operation; retained calves; stocker calves; a hay operation; a hunting operation; and hospitality enterprises like nature photography or guest lodging.

Your living expenses fall into the support category
To organize the accounting system, Bevers suggested that each enterprise be divided into 3 centers: profit, cost and support.

A profit center is an enterprise where things are sold such as cows, stocker calves, hay or hunts.

Cost centers contain information on anything that accumulates expense, but is used within the enterprise. One example would be hay that is raised on the property and fed to the cows and stocker cattle.

The support center is subdivided into 4 categories:

  • machinery and equipment, which includes fuel, repair, insurance and other related expenses
  • labor and management, which includes all payments for both contract and owner labor (Note: People who earn their sole income from their ranching business must capture their family's living expenses under this category and allocate the expenses across all enterprises at the end of the year.)
  • general and administrative, which includes a wide variety of expenses ranging from magazine subscriptions to legal and accounting fees
  • interest, which includes all interest paid for that enterprise.

While this system provides a strong organizational framework, it is not rigid because each year the profit and cost centers can be changed to reflect the enterprises undertaken in a given year, he says.

Consistent system to gather information on flexible business
"Producers need a consistent system to gather information, but it has to be flexible enough to reflect the changes in their business," Bevers says. "The cost and profit centers are unique to each and every ranch each and every year."

For instance, Ranch X may have profit and cost centers for cow-calf, stocker and hay operations, and its neighbor Ranch Y may have cow-calf, club calves and hunting profit and cost centers. The next year, Ranch X may have gotten out of the stocker business, so it has profit and cost centers for cow-calf and hay operations, while Ranch Y may have put its hunting operation on hold and has profit and cost centers for cow-calf and club calves.

"From an accounting standpoint, it doesn't matter whether the information is gathered using a 15-column pad or a computer, because the important thing is the quality of the numbers," Bevers says. "But from a management standpoint, it's important to gather the information in a manner that makes it accessible and easy to evaluate. The numbers won't help you if you can't or won't use them." While there are many solutions available, Bevers' go-to accounting program is QuickBooks.

Ultimately, though, financial information alone is not enough.

"People often ask whether they need to gather financial information or production information, and the answer is both," Bevers says. "By concentrating on one or the other, producers only get half of the picture." For instance, if you are a stocker operator and your calves have been traditionally underperforming, the financial information will tell you that something in the operation is not working because you are not generating enough income, but the production information will help you pinpoint exactly where the problem is.

Once you have collected solid data, the next step is integrating the production information with the financial information to create meaningful reports. This is where computers can make a big difference, Bevers says. Generally, production data, which is compiled using a program such as CattleXpert, is integrated into a compatible financial program, such as QuickBooks.

"The thought of establishing a good, integrated record-keeping system can be daunting, but it is an essential part of being a profitable operator in the 21st century," Bevers says.

"Stocker Cattle: Cash vs. Accrual Accounting" is from the October 2012 issue of The Cattleman magazine.