Take Another Look at Accrual Accounting | FBC, Canada's Farm & Small Business Tax Specialist

Take Another Look at Accrual Accounting

It'll be an eye-opener. Once an accrual accounting system is up and running, you'll be amazed by what it can tell you about your farm business.

Many farmers continue to report farm income on the cash method. If your farm is small and its activities don't change much from year to year, cash accounting can be quite adequate.

On the other hand, if your operation is growing and you're adding or changing your product mix and production processes, accrual accounting will be quite beneficial - if not essential - in managing your business effectively.

The main difference between these accounting systems is the time at which you account for each income or expense item. In cash accounting you record a sale or expense only when the cash is received or paid, and inventory is not included in the calculation of income.

With accrual accounting you record income and expenses when a sale or purchase is made - even if the money hasn't yet changed hands - and the value of all inventories, such as livestock, crops and purchased inputs, form part of the income calculation.

Accrual accounting involves a double-entry system of debits and credits. It lets you balance your books and ensure no sales or purchases are missed. And you can produce different financial statements and reports for various periods at specific points in time rather than just a simple cash profit and loss statement.

Years ago, a farm's financial reports were related mainly to determining income for income tax purposes. The data was seldom used to help assess how well a farm was doing. Nor did bankers require financial reports to support credit requests since loans were usually made on the security of land, equipment, and inventory. Lenders tended not to focus on current and projected profitability of a farm operation, or on its projected ability (cash flow) to repay the loan.

Things are much different now. Many smaller family-owned farm businesses of the past have vanished under consolidation pressures to create larger, more commercially viable operations. These operations often involve several distinct production enterprises, as well as significant capital investment.

In addition, today's producers face challenges such as increasing operating and input costs, along with fluctuating prices for their products, both of which lead to inconsistent net income. Food production is risky.

As an example, in 2003 some Canadian livestock producers lost complete access to their traditional markets due to the BSE crisis.  It took almost 5 years for the markets to recover to what producers felt might be an acceptable level.  Even today we continue to feel the effects of the BSE crisis. 

In light of such economic realities, detailed up-to-date financial information is essential in making sound business decisions and assessments. Such information shows you exactly how well your operation is doing at a specific point in time. You then can decide whether to discontinue a particular enterprise or look for ways to economize. You also have greater access to borrowed capital, since lenders want to see such an assessment before they grant credit.

Accrual accounting lets you produce a variety of business financial reports, in particular balance sheets, which list business assets and liabilities as of a specific date, along with owner equity. This statement is useful in assessing a business's risk position, solvency, ability to meet current debts, and changes in equity.

Another report, the statement of retained earnings (capital), summarizes changes in earnings retained in the business during the period under review. A third report, the income statement, summarizes business income and expenses and provides a measure of profitability for the period under review.

And the statement of cash flow helps in assessing business solvency and liquidity, as well as ability to generate cash from internal sources, repay debt obligations, reinvest, and make distributions to owners.

To repeat, many of today's farm operations include a number of different production activities or enterprises. While some of these simply support other farm enterprises, others are pursued to diversify farm output and manage overall business risk.

Each enterprise may have a unique set of production methods and costs. To enhance the effectiveness of your business decision-making, you really should track the details - output or production capacity, costs, net income, and so on - of each enterprise separately.

That may sound like a tall order, but switching to accrual accounting really isn't difficult, particularly if you set up your chart of accounts early in the year and start with an accurate list of accounts receivable and payable, prepaid expenses, inventory, etc.

You can follow either a manual double-entry bookkeeping system or opt for computerized bookkeeping. Several software packages are available, some specifically recommended for farming.

Here are a few of these packages. Check out their websites for more information:

  • AgExpert Analyst provide farm-specific cash- and accrual-based reporting. It has sophisticated features such as automatic splitting of entries among farm enterprises, but is quite complicated to learn and use (www.settler.com).
  • Quickbooks Basic or Quickbooks Pro can be customized to farm accounts, but provide only single-entry systems and can't track farm inventory or do enterprise analysis (www.intuit.ca).
  • Sage Simply Accounting Pro provides a double-entry system that can be customized to meet the needs of most operations, but it does require some accounting knowledge (www.NA.Sage.com/Sage-Simply-Accounting).

The main message is that sound business management begins with accurate financial data. A good accounting system gives you the information you need to control cash flow, monitor business progress, and develop strategies to meet ongoing challenges.

Good records also help your tax professional access all tax credits, deductions and income deferrals available to you when completing your tax return.

Finally, should you ever be audited by Canada Revenue Agency, you'll be armed with detailed financial records to support your case.

"Without continual growth and progress, such words as improvement, achievement, and success have no meaning." — Benjamin Franklin