Farm Accrual Adjustments to a Cash-basis Income Statement

In this video, we define accrual basis as a method of recording income and expenses. Each item is reported as earned or incurred, without regard as to when actual payments are received or made.
Farm Accrual Adjustments to a Cash-basis Income Statement - Videos

Description

We also discuss the adjustments to cash receipts and disbursements to arrive to accrual-adjusted net income.

The Penn State Extension Farm Business Management team recommends that farmers using cash accounting convert the resulting net farm income to an accrual net farm income at the end of the year.

Instructors

Miguel Antonio Saviroff, MS

View Transcript

- Hello, my name is Miguel Saviroff with Penn State Extension.

Most farmers use the cash-basis income statement.

A list of cash receipts from which cash disbursements and depreciation are subtracted to arrive at net cash income.

It is preferred by farmers for its simplicity and for income tax purposes, but a cash-based income statement does not reveal through profit as accrual farm income statement, thus, because these will include revenues for all that was produced during the year even if not all cash was received, and all the expenses incurred, even if not all were paid.

You can convert the cash-based income statement to an accrual-income statement by applying the accrual adjustments to the cash-based income statement, and this presentation provides the steps to do such conversions.

The main difference between accrual and cash basis accounting is the timing when revenue and expenses aren't recognized.

Cash-basis includes the cash transactions only.

It accounts for revenue only when the money is received, and for expenses only when the money is paid out.

Accrual-basis recognizes revenues when earned and expenses when incurred even if cash has not been received or no cash has been paid.

To illustrate the necessary adjustments to move from cash-based to accrual-based income statements, let's look at Richard's farm.

Richard has completed a cash-based income statement.

In this example, receipts are $250,000 dollars of cash sales and $145,000 dollars in expenses, including a no-cash expense depreciation.

Because it focuses on the cash in hand during the year, the value of items produced but not sold will not appear in this statement.

Likewise, any expenses that were not paid during the period are excluded from this statement.

We realize though that we want to have a more precise account of the values produced during this year, and that's why we need to adjust this adjustment to accrual-basis.

The Farm Financial Standard Council recommends applying accrual adjustments to your cash-based income statement on an annual basis.

This table shows the necessary adjustments that are calculated by comparing values in the ending balance sheet of the previous year with those in the ending balance sheet of the current year.

Asset and liability values are compared in different ways, depending on their category.

Because inventories of grain, market livestock, and raised breeding livestock were produced in the current accounting period, you must subtract the beginning inventory value produced in the previous year from the ending inventory value, and add that amount to the corresponding cash receipts, regardless of whether the payments for the sale were received in the current or next year.

In this example, ending crop inventories of $30,000 dollars minus beginning crop inventories of $25,000 dollars yields a change of $5,000 dollars to be added to the receipts for crops.

When we adjust disbursements, there are two different procedures.

If expense items were incurred but not paid, this is the case of accounts payables and accrued expenses that produced income this year, but cash would be paid for them in the next year.

So this type of expense needs to be adjusted by subtracting the beginning liability or accrued expense value from the ending liability or accrued expense value and adding that amount to the corresponding cash disbursements.

In this example, beginning accrued interest, $11,600, is subtracted from ending accrued interest, $12,000 dollars, resulting in a change of $400 dollars which is added to cash expense.

The second procedure is for expense items paid but not incurred.

Prepaid expenses, supplies, an investment in growing crops have a different adjustment because the timing of the cash expenditures is different.

Cash was spent during the previous accounting period, but this was used for production during the current year.

Therefore, the adjustment is made by subtracting the ending inventory value from the beginning value and adding that amount to the corresponding cash disbursement.

In the example, the ending prepaid expense, $1,000 dollars, is subtracted from the beginning prepaid expense, $800 dollars, to result in a change of negative $200, which, in effect, results in $200 dollars being subtracted from cash expense.

Following the procedure we just discussed, Richard converts his cash-basis income statement to an accrual adjustment statement using this beginning balance sheet created at the end of the previous accounting period, and the corresponding values in the ending balance sheet.

In the current year's ending balance sheet, we notice that the level of current assets and current liabilities are different than in the previous year's ending balance sheet.

The accounts to be adjusted appear in gray and green.

This table shows Richard's calculations of the changes that he needs to complete his accrual-income statement.

Inventory values are taken from the farm's previous and current balance sheets.

For example, crop inventories were valued at $25,000 dollars at the beginning of the year, and $30,000 at the end of the year, a $5,000 dollars increase.

This increase is shown as a positive number in the change in value column.

Similar calculations are made for all other accrual adjustments, except for prepaid expenses and unused supplies where the ending value is subtracted from the beginning value, resulting in negative $200 dollars and $400 dollars respectively.

After completing these calculations, Richard transfers all the changes in value from the previous accrual adjustments table to this accrual-income statement table.

Notice that now, that receipts and disbursements are called revenues and expenses.

Changes in crop inventories, $5,000 dollars.

Livestock inventories, $6,000 dollars.

And accounts receivable, $2,000 dollars, are added in the revenue column, sales in gray.

Under expenses, he lists the changes in accounts payable minus $200.

In accrued expenses, $500 and $400 in gray, and the prepaid minus $200 unused supplies minus $400, and investments in growing crops in zero in green.

Thus, cash basis net income of $105,000 has been converted into an accrual net farm income which has increased to $117,900, a number that more accurately represents the profitability of this production during the accounting year.

In conclusion, let's remember the following key ideas: Cash-based income statement just provides verification of cash receipts and payments during the year, and is mainly used for preparing the income tax schedule F.

Accrual-base shows production based performance.

It includes income and expenses in a specific period, plus inventory adjustments for grain, feed, livestock, receivables, and payables.

It shows true farm production and profit.

In our example, earnings were slightly understated by the cash method, but it can go either way, and often, by a larger amount than in this example.

It is important that farmers get the right signals about their performance and their accrual method provides that more accurate signals about farm profitability.

I would like to give credit to the USDA for the use of the Farm Income Graph, the use of adjustment tables from the Farm Management book authored by Edwards, Kay, and Duffy, Seventh Edition.

And thank you to my reviewers, Winifred McGee and Lynn Kime, from Penn State Extension, and Dale Nordquist from University of Minnesota Extension.

Thank you.

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