Accrual vs. cash
As a CPA and consultant with Centrec Consulting Group, LLC, Don Gillings has worked with producers across the nation who use accrual accounting. They include Christine Hamilton's Christiansen Land and Cattle Company in South Dakota. (Learn more about Hamilton's operation on page 34.) Another client has used the information to its advantage in negotiating contracts with processors, Gillings says.
"They know their costs. They don't have the processor telling them what their costs are," Gillings says.
Agriculture uses three levels of accounting, he says.
The simplest and most widely used is cash accounting. In essence, it's a check register that tracks cash flowing in and out of your business. It's popular because it allows you to juggle sales or supply purchases between tax years. That's ideal for attempting to reduce taxable income reported on your Schedule F.
Unfortunately, it's not an accurate account of your profitability.
"You never really know where you are," says Hamilton.
In fact, some studies have shown that profitability problems can be masked for two years or more with cash accounting, according to the Farm Financial Standards Council. (Gillings is past president of the Council.)
The next step up - and it's a big step - is accrual accounting. This system posts expenses and revenue as they are incurred even if you haven't sent a check or gotten one.
"If we go back to one of the core concepts of accounting, it's the matching concept - to match the value of the products produced with the costs incurred in producing them," Gillings says.
Accrual accounting, used in nearly all of the business world, can be applied at the whole farm level. And a few larger operations, including some of Gillings's other clients, have been using it for years.
Most ag-specific accounting software that generates accrual reports will also produce cash reports for tax purposes, so the tax benefits of cash are not lost.
Managerial accounting, which includes cost accounting, is the next step up. It requires accrual accounting.
"Managerial accounting is a whole other magnitude of complexity and sophistication of management information," Gillings says.
Manufacturers use it to track the value of a work in process. Costs are tracked from one cost center to another, then revenue is posted after the factory item enters a profit center where it's sold. On Hamilton's ranch, costs follow a calf from the cow-calf cost center, to a backgrounding lot cost center, and possibly a stocker cost center before the calf is sold from the beef sales profit center.
"A managerial accounting system is really a model of the business itself," Gillings says.
Unfortunately, many farmers and ranchers will find shifting to accrual accounting and managerial accounting (MA) daunting. Compared to most accounting software, MA-compatible programs can run around $5,000. That's nothing compared to machinery these days, but it's a lot more than off-the-shelf programs at your local office supply store. And it helps to have at least a part-time accountant on retainer.