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The Cash vs. Accrual Accounting Difference
Most farmers and ranchers put bookkeeping at the bottom of the list of preferred chores. Producing crops and livestock is what they do best. It’s the rare producer who has a keen desire for record keeping.
However, one of the most important tasks bestowed upon small business owners at year-end is getting financial records in order for last-minute tax planning, tax preparation, and financial analysis.
There are two types of financials from which farmers typically choose:
1. Cash basis accounting
2. Accrual basis accounting
You’ve probably heard this accounting terminology mentioned at your accountant’s or lender’s office or at various farm workshops. However, you may not fully understand their relevance to your business.
For tax purposes, most farmers are allowed to report income and expenses on a cash basis for their business and individual tax returns. What exactly does that mean? Farmers are only required to report cash received offset by cash paid before year-end, typically December 31 each year. So in many cases, farmers wait to sell grain and cattle until after the first of the year to defer the reporting of income. Meanwhile, they can prepay certain expenses such as chemical, fertilizer, and seed that won’t be used until the next growing season. To answer the question looming in your mind: Yes, this is legal – just make sure your prepaid expenses don’t exceed more than 50% of other farm expenses in the year of deduction to remain deductible business expenses.
In the simplest of terms, a check written to your seed dealer for a specific purchase on December 30 is a deductible business expense in the year the check was written, even if the check has not yet had a chance to clear the bank before year-end. Similarly, a check you receive the second day of January for custom hire is income in the year received, regardless that it may have been written in the prior calendar year.
Also, for many capital purchases made on the farm, as long as the asset was purchased with cash or credit, it can be deducted in the current year, as long as the asset was placed in service. While the Internal Revenue Service defines placed in service as full operational use of the asset, a broader definition equates to when the asset is first placed in a condition of being ready or available for its specific function. To be safe, make sure the asset meets both definitions.
If cash basis is so easily calculated, why worry about accrual basis accounting and financial reporting for your business operation? Here’s the short answer: It’s the only true measure of determining profitability for your business.
Accrual Basis Accounting
Unlike cash basis accounting (where profitability can be skewed by prepaid expenses and deferred income), accrual basis financials hide nothing. Accrual accounting reports income when earned vs. received and expenses when incurred – not necessarily when paid. So, at year-end, an accrual basis farm operator reports the following: income on grain not yet sold coupled with expenses incurred but not yet paid. Accrual accounting usually takes into account investments made in cattle and growing crops on the balance sheet as an asset, rather than an expense deducted on the income statement.
While these may sound like fairly simple changes to the cash basis equation, they tend to be more complex in calculating. Yet, the impact from these changes can be significant in creating a more accurate picture of a business’s performance.
If you’ve always been a cash basis reporter of your income, give accrual accounting a chance. Plan a meeting with your accountant to adjust your financial statements from cash basis to accrual. This can help you become a better farm manager by looking at what segments of your operation are really generating a profit or a loss.
Once you get the hang of accrual accounting and realize the benefits, you will see that the information you derive from accrual basis financials is powerful and telling.