Basic Accounting: Guidance for Beginning Farmers
By Hannah Lewis, NCAT Agriculture Specialist
Good bookkeeping is critical to financial well-being for any business. It allows the business owner (the farmer) to see whether the business is profitable, set and monitor progress toward goals, and, above all, plan for the financial stability of the farm household. The purpose of this publication is to make basic accounting approachable for people with little or no accounting experience and encourage new farmers to develop good recordkeeping habits at the outset.
In addition to growing great food and fiber products and taking care of the land, farmers need to be good financial stewards of their business and household. This requires being organized, keeping track of all income and expenses, and having a grasp of basic principles of accounting.
For instance, if you can predict the months when your major expenses will occur, you’ll be better able to ensure that you have the cash on hand to pay for them. This is especially important for farmers, who tend to have high costs in the spring and don’t get paid until later in the year. You can better manage your cash by creating an annual cash-flow budget. Or if you’ve spent a few years building your farm business without paying yourself for your labor, you may be wondering just what you have to show (financially) for all those hours of “sweat equity.” You can answer that question by looking at a few years of annual balance sheets for your farm placed side by side. Finally, if you have a goal for how much household income you’d like to draw from your farm operation, you need a clear picture — in the form of an income statement — of your farm’s annual expenses in relation to annual sales. This can help you determine how much more you need to sell, increase your prices, and/or reduce your expenses in order to make your desired amount of take-home pay.
Furthermore, if you are comfortable answering these questions about your financial situation for yourself, you will be able to answer the same questions for a lender. The bank will want to know that you have a realistic understanding of your financial situation, of where you’re headed, and of what it will take to pay back your expenses, including the loan, in a timely manner. While good financial management won’t make your business succeed on its own, it will help you avoid unnecessary costs, expand your business predictably, and ensure a financial cushion against unexpected events.
Annual Cash Flow Operating Budget
A complete picture of cash flow involves all sources and uses of cash for a farm household. We will examine this complete view later.
First, let’s look at cash-flow budgeting, which allows farmers to track or project cash flow by month over the course a year in order to see when cash-flow is negative and to plan for those times. The table below shows cash flow for a hypothetical farm, which we will call Big Beet Farm. These numbers are based on an actual farm — a small, start-up operation just outside of Bozeman, Montana.
|2012 Cash flow budget||Jan||Feb||Mar||Apr||May||Jun||Jul||Aug||Sep||Oct||Nov||Dec||Total|
|Operating receipts and cash inflows|
|Total cash inflows||3060||210||435||120||220||196||186||336||141||4904|
|Operating expenses and cash outflows|
|Fuel and oil||100||100|
|Utilities: farm share||10||20||20||20||20||20||10||120|
|Total cash outflows||570||1497||840||114||166||189||194||115||30||3715|
As you can see, this is a monthly breakdown of the cash into and out of the Big Beet Farm bank account on a particular year. If they owned farmland and had a mortgage on it, they would add lines here for real estate tax payments and debt repayment (principal and interest). If they had sold a piece of equipment (or any other capital asset) during the year or received a new loan, they would add lines for those items under cash receipts in the cash-inflow section.
The most valuable information in this sheet is the cash-balance line at the bottom. Note that while the cumulative cash balance at year’s end is positive, some months show a negative amount of cash. In March, May, and July, Big Beet expects to spend more money than it takes in. The question for the farmers to ask themselves: Where will they come up with the money to pay those bills? Maybe they can get a line of credit from the bank or tap into their off-farm income. Perhaps they have a large enough cash balance from savings in the farm checking account to cover the season’s early expenses. If not, maybe they’ll consider requesting CSA payments in March instead of April. The point is to anticipate and plan for these potential cash-flow constraints.
To create this table, the farmers sat down at the end of 2012 with all their receipts and sales-log information and entered the totals month by month according to the type of expense or market venue. They will use this information to create their 2013 cash-flow budget. Looking at cash flow from 2012 helped to establish a baseline for cash inflows and outflows for the 2013 season, with adjustments to be made for planned changes, such as expanding both the vegetable and flower CSAs.
For a farm just starting its first year, putting together an operating budget is likely to be a time-consuming yet invaluable task. It calls on a beginning farmer to set an income goal and to figure out what prices to set and markets to pursue to achieve that goal. It also requires the farmer to be specific about the equipment, supplies, and other expenses needed to produce and market a particular variety and volume of farms products. For guidance on this planning process, refer to the ATTRA publication Evaluating a Farming Enterprise.
Statement of Cash Flows
The statement of cash flows, which is a required component of a loan application, helps to answer whether and how all expenses will be covered over the course of a year. It shows total annual cash into and out of the farm household from operations, financing, investing, and nonfarm activities.
A cash-flow statement considers inflows from farm sales, bank loans (financing), off-farm income (financing), and selling capital assets (investments), as well as outflows from family living expenses, paying down a loan, and buying a new capital asset (such as a tractor or walk-in cooler). The bank needs this information to be assured that cash will be coming in from somewhere (if not from the farm operation itself) to pay bills, including servicing the loan. In evaluating a small, nontraditional, and/or beginning farm, a banker may insist that the farm household have off-farm income as a safety net in case the operation doesn’t generate as much cash as planned.
The income statement has the same income and expense categories as the annual cash operating budget above — minus the capital-purchases line and with the addition of depreciation expense and interest. Also, instead of a monthly breakdown, the income statement shows total sales (or gross revenue) for a year of operating your farm, along with all the expenses and what’s left over in net farm income.
The expense categories listed down the left side of the income statement are based on the IRS Schedule F form “Profit and Loss from Farming,” and adapted to better fit this particular operation. Also known as a “chart of accounts,” the list of operating expenses that you use for your income statement also can be used for your cash-flow budget and statement.
IRS Schedule F Lines include the following:
PART I Farm Income
- Sales of Livestock and other items you bought for resale
- Cost of other basis of livestock or other items reported on Line 1
- Subtract line 2 from line 1
- Sale of livestock, produce, grains and other products you raised
- Cooperative distributions
- Agricultural program payments
- Commodity Credit Corporation (CCC) Loans
- Crop insurance proceeds and federal crop disaster payments
- Custom hire (machine work) income
- Other income, including federal and state gasoline or fuel tax credit or refund
- Gross income
Part II Farm Expenses
- Car and truck expenses
- Conservation expenses
- Custom hire (machine work)
- Depreciation and section 179 expense deduction not claimed elsewhere
- Employee benefit programs
- Fertilizers and lime
- Freight and trucking
- Gasoline, fuel and oil
- Insurance (other than health)
- Interest a Mortgage (paid to banks)
- Labor hired
- Pension and Profit-sharing plans
- Rent or lease (see instructions) a. Vehicles, machinery or equipment b. Land, animals, etc.
- Repairs and maintenance
- Seeds and plants
- Storage and warehousing
- Veterinary, breeding, and medicine
- Other expenses (specify):
|Income statement 2012|
|Fuel and oil||100|
|Repairs and maintenance||45|
|Utilities: farm share||120|
|Interest on loans|
|Net income (profit)||1509|
The income statement allows you to see whether the farming operation is making money and to examine the relationship between gross and net income. In this example, in order to make $1,509 in take-home pay (or profit), Big Beet had to sell $4,904 worth of flowers, vegetables, and poultry. This is a 30% income ratio (net income is 30% of gross income), which is a good rate. However, note that the farmers have not taken on any debt, which could increase their expenses, or hired workers or paid themselves an hourly rate for labor. These factors may ultimately limit their production capacity and how much income they can achieve through farming.
On the other hand, as they invest in the farm and figure out the production and marketing systems that work best for them, the farmers will become more efficient and will likely maintain or increase their ratio of net-to-gross income. A ballpark income ratio for farmers is 20% (net income is 20% of gross income), although this varies greatly according to the type of operation and how long it has been in business. Small, diversified, direct-market farms can achieve higher income ratios.
Depreciation is a way to express the everyday wear and tear on equipment. It spreads the cost of replacement over the useful life of the product. For example, if the Big Beet Farm owners purchase a tractor for $10,000, the first step toward calculating its depreciation would be to subtract its residual value from that price. (The residual value is the amount you expect to be able to sell the used equipment — or scrap metal — for when you no longer need it.) Dividing the result by the number of years they expect to use the tractor would determine its depreciation.
If the Big Beet Farm tractor’s residual value were $1,000 and the farmers expected to use it for 10 years, its depreciation would be $900: One thousand dollars (residual value) subtracted from $10,000 (purchase price) equals $9,000. Nine thousand dollars divided by 10 (number of years) equals $900.
The Big Beet farmers get to decide what to do with that $1,509 profit. Some beginning farmers would decide to invest all of this money back into the farm right away (by buying needed equipment, say, or building a pack shed) rather than take it out as “owner’s draw” or household income. Beginning farmers also may choose to put the profit into a reserve account for a future capital investment such as buying land. Keeping a comfortable buffer of cash in the farm checking account can keep you prepared for unexpected events, like a tractor breaking down or someone getting sick.
Note that equipment, buildings, and land are not listed as expenses in the income statement. The values of these capital investments are shown as assets in the balance sheet and are not included in the income statement. For the income statement, the relevant expenses related to land, buildings, and equipment are the interest on the loan you received to purchase these items, the costs of repairing them, and their annual depreciation. Similarly, any principal payments made this year are not included in the income statement. That value will show up as equity in your balance sheet, just as the amount of principal still due is listed as a liability in the balance sheet.
A balance sheet is a summary of the total financial worth of the farm (assets). This includes your own investment (equity), and what you owe (liabilities). It shows how much money you could keep if the farm were sold. The income statement covers a period of time (a quarter or a year), whereas a balance sheet is a snapshot of your financial position on one single day. It can be any day, but it is often created at the end of the year.
A balance sheet does exactly what its name implies: it displays a balanced equation in which assets (left side) = liabilities plus equity (right side). If you reflect on this for a minute, you’ll see that the assets include all the items on your farm that have a dollar value. Chances are you borrowed money to buy some of these assets; liabilities are what you still owe your lenders on those assets. Equity is everything you’ve already paid off and/or money saved from prior years’ net income. If the farm shown in the example below were sold today for $86,075, the farmer could keep about $23,075 depending on market prices.
Equity is the amount of wealth you’ve built — your investment in the farm.
Some key information the balance sheet shows includes solvency, liquidity, and your financial progress over time. The latter is shown by comparing your equity (or net worth) from one year to the next. If you compare two or more annual balance sheets (always created at the same time of year), with luck you will see your equity increasing each year as you pay off your loans.
Solvency refers to your ability to pay off all debt if the farm were sold today. We hear a lot about homeowners who are “under water” since the mortgage crisis. In other words, their liabilities are greater than their assets and they have a negative net worth. This would describe the condition of being insolvent.
Liquidity, which refers to your short-term financial well-being, also is extremely important. It tells you whether you have enough money coming in from your business over the next 12 months to pay all your bills due in the same time period. A common guideline is that you should have roughly twice as much in current assets as in current liabilities.
To create a balance sheet, start with the blank template in Appendix 3 of this publication. Put today’s date at the top of the page. This is important because a balance sheet is meant to capture your financial position at a particular moment in time. Next, assemble your data. For the assets side, you’ll need a current monthly statement from your farm checking account. You’ll also need to take an inventory of the supplies you have on hand, such as seeds, tools, and livestock feed. You also will need to list the cost value minus depreciation (except for land, which doesn’t depreciate) of such large, intermediate, and long-term assets as farm buildings, vehicles, and land.
Valuing Assets by Cost Versus Current Market Value
— By Craig Chase, Iowa State University Extension Farm Management – Food Systems and Alternative Enterprises
“I have always told the people I work with to put machinery at cost less depreciation and land at cost. A major part of the problem in the 80s came in when farm equity was rapidly increasing in the 70s and farmers were borrowing money against that rising equity. The trouble was that the equity was a result of rapidly increasing land values and not from profits earned by the business. So when land prices suddenly fell, the farms were upside down in that they owed more than what their assets were worth. The same type of thing happened in the recent housing market.
“If you are going to keep income statements year after year and compare them, then calculating net worth this way will allow you to see if the business is actually growing in equity or not due solely by what is happening within the farming business rather than due to market fluctuations. Because current assets will be turned to cash within 12 months, I do put those in at market value.
I know a lot of people recommend that farmers and other business owners put all assets in at market prices. … A compromise would be to keep track of both.”
For the liabilities side, you’ll need statements showing your loan balances. In addition, you’ll need to determine the amount of principal due this year. Subtract that amount from your long-term liabilities and put it into current liabilities. Do not include interest in the balance sheet — that belongs in the income statement.
Recordkeeping has two parts: collecting source data (receipts or bills) and entering the data into a paper journal or computer software program spreadsheet. An advantage of using computer software is that some programs will prepare income statements and balance sheets on demand. Whichever method you choose, both collecting and entering data are simple tasks, but they require diligence. Think of ways that you can capture receipts and keep them together so you don’t accidently throw them away — or have to go searching for them later.
In the photo on the front page of this publication, you see several envelopes labeled with different expense accounts, such as supplies, seeds, and car and truck maintenance — again based on expenses listed in the IRS Schedule F form. These envelopes are being used to store receipts. If you buy stuff in town, keep a bin in the car to collect receipts to take into the house periodically.
Be sure the date, vendor, and item are noted on the receipt before you put it in the folder for storage. You will need this information, along with the amount of the purchase, to make a journal entry. You can wait to the end of the year to add up and enter all this information directly into a cash-flow-from-operations table, or you can log it as frequently as every week or month when you sit down to pay bills.
On the revenue side, a convenient way to record your transaction is to use duplicate invoices. Simply drop off one of the two copies along with your delivery to a wholesale buyer such as a grocery store or restaurant. For direct-sales venues like a farmers market, where you don’t use receipts, you can enter the total for the day directly into the sales log. (See Appendix 4.)
This publication is meant to get you started on the path of good farm accounting. As you become more comfortable crunching numbers, you can begin to develop more sophisticated accounting systems that will provide you with more and better information about your business — which in turn supports good planning and decision-making. For instance, once you get the hang of using an income statement, start making accrual adjustments — not just for depreciation but also for inventory changes, changes in the value of growing crops, prepaid expenses, and accounts payable and receivable. These adjustments will provide a more accurate picture of profit and loss for the year.
You also can keep track of sales and expenses for each enterprise (instead of just by market venue), including labor hours expended per crop. This will allow you to develop enterprise budgets and thereby get a clear sense of profitability by crop. Finally, by doing a few small calculations using numbers on your financial statements, you can measure your farm’s financial health against established benchmarks. Resources to help you learn about these accounting practices and more are listed in the Further Resources section.
Ag Decision Maker. An agricultural economics and business website create and maintained by Iowa State University Extension and Outreach. The following are among its features that apply to accounting for farmers:
- Farm Financial Statements. 2008. William Edwards. 2008. File C3-56.
- Selected Alternative Agricultural Financial Benchmarks. Craig Chase. File C3-65.
- Twelve Steps to Cash Flow Budgeting. 2008. William Edwards. File C3-15.
- Using Financial Records to Answer Questions. 2012. Craig Chase. File C1-41.
- Your Farm Income Statement. 2008. William Edwards. File C3-25.
Building a Sustainable Business: A Guide to Developing a Business Plan for Farms and Rural Businesses. 2003. Gigi DiGiacomo et al. Minnesota Institute for Sustainable Agriculture (MISA).
Fearless Farm Finances. 2011. Jody Padgham et al. Midwest Organic and Sustainable Education Service (MOSES).
Organic Farmer’s Business Handbook. 2009. Richard Wiswall. Chelsea Green Publishing, White River Junction, Vermont.
Basic Accounting: Guidance for Beginning Farmers
By Hannah Lewis, NCAT Agriculture Specialist
Published December 2012
This publication is produced by the National Center for Appropriate Technology through the ATTRA Sustainable Agriculture program, under a cooperative agreement with USDA Rural Development.