The extremely volatile economic situation experienced over the last few years underscores the need for effective record-keeping and sound business planning. The time to start is now. I have compiled a list of steps producers should consider taking as the year winds down. 1. Evaluate and reconcile your accounting system. The accounting system should be reconciled on a regular basis throughout the year, but on many dairy farms it isn’t completed until an accountant prepares the farm’s income taxes. Even then, depending on the firm you hire, a complete reconciliation may not be done.
I have reviewed numerous tax returns over the years and found errors when compiling information to conduct a trend analysis of the business. Taking the time to review a general ledger report for each month will improve the accuracy of the farm accounting data. Having accurate data will improve the quality of information used for financial reporting, tax preparation and, ultimately, decision-making.
Evaluate your accounting system. Does it provide you with the information you need to make timely and sound decisions? Is the chart of accounts set up to reflect management intent or is it simply set up to reflect the “Schedule F” lines of the tax return? Spending some “up-front” time to get your accounting system organized to provide you with management information will pay huge dividends down the road.
A standardized chart of accounts for dairy farm accounting systems is available on Penn State’s Dairy Alliance website in a PDF format or as a QuickBooks backup file that can be downloaded and installed on producers’ computers. This chart of accounts was developed with input from more than 100 industry professionals who work with dairy producers throughout Pennsylvania and the Northeast.
2. Review year-to-date performance and calculate your cost of production.
Although this may not be a fun thing to do, NOT knowing how bad it was is worse than knowing. Again, this should have been done on a regular basis, but if you have not done it for the year-to-date, make it a point to do so now.
Evaluate the following:
• Accrual profit and loss statement
This will allow you to evaluate the magnitude of the losses, or in some instances the profits, you incurred. Your cash basis income statement which your accountant will use to prepare your income taxes will provide little if any valuable feedback on how your business performed this year.
• Balance sheet
A cost basis balance sheet reflects the change in equity due to operational losses (or profits), while the market basis will reflect changes in equity due to operational profits/losses and market conditions. Most dairy farms took a hit in their equity positions this year due to lower cattle values and possibly lower real estate values, as well as from operating losses. Knowing how much equity you lost is not a fun thing to face; but realize as market conditions improve, so will cattle values (and real estate values). You will recover those equity losses.
The operating losses are a different story. Knowing how much you lost and how long it will take you to recover that equity, as prices increase, might help take some of the sting out. Remember, you are in this for the long term, so it is no different than someone losing equity in his/her retirement account. It will only affect you if you need or want to sell out or retire today.
• Statement of cash flows
This financial statement will provide you with a better understanding of where the money came from and where it went. Reviewing this report monthly is a best management practice that should be implemented, but if you haven’t, you really need to evaluate it at the end for the year. Understanding and using it can help improve the quality of your accounting records dramatically.
• Cost of producing 100 pounds of milk
Once you have done this you can determine how you might fare in the months ahead as milk prices begin to recover. Be sure to calculate your cost of producing milk on an accrual basis. The Dairy Alliance DairyCOP$ cost of production spreadsheet can be downloaded from the Dairy Alliance website and used to accomplish this task.
3. Begin planning for next year.
After you have assessed the financial condition of your business, start to develop your plan for next year. This includes developing a monthly cash flow statement to see when deficits will turn positive and the magnitude of the cash surpluses that the business will generate.
Establishing some key strategies as to where to apply and utilize the surpluses will be critical in helping your business recover and establish a sound financial base to help get through the next down price cycle. An Excel spreadsheet, which you can use to develop a monthly cash flow budget, is available on the Dairy Alliance Web site.
4. Don’t forget tax planning.
Producers might be inclined to forgo any year-end tax analysis and planning. However, because farms file taxes on a cash basis, they might owe taxes even in a bad year. In a cash accounting system, income is reported when it is received and expenses when they are paid.
In contrast, in an accrual system, income is reported when the right to receive it is established and expenses reported when they are incurred. We recommend producers use accrual accounting for evaluating business performance and cash accounting solely for preparing income taxes.
In light of this, several factors that could lead to a situation where a producer might owe taxes even in a bad year.
• Were any expenses prepaid in prior years?
• Did accounts payable increase?
• Were the majority of loan payments applied to principle?
The above are just a few of examples that could contribute to a situation where a farm might have a tax liability. Consulting with a tax advisor can provide producers with a clearer understanding of their current tax situation.
Effective business planning is crucial – in good years and in bad, for dairy businesses of any size. This is the perfect time of year to upgrade your accounting system, review your financial situation and begin planning for the upcoming year. PD
—Excerpts from Penn State Dairy Digest, December 2009