In farming, it’s common to use a cash-based accounting system versus a so-called traditional “business-based” accounting system. Why is that, especially when farms are businesses that are worth several million dollars? In the day-to-day of farming, cash-based accounting does have its advantages. It’s the best method to optimize tax expenses, not to mention the best accounting method to determine cash-flow health. Sticking to just one can be limiting.
Cash-based vs. accrual-based accounting in ag
Understanding the differences between cash-based accounting and accrual-based accounting can help you better understand what you’re getting out of your current financial system.
Why farmers favor cash-based accounting
The cash-based accounting system is all about the transaction. When cash changes hands, the check is written and handed over, that’s when it goes into the ledger. This is a common accounting method for small businesses, which explains in part why it’s favored by farmers. If the cash is in, then you can sweep some of it into your personal accounts and pay other bills.
More importantly, cash-based is optimal for tax planning, and the IRS generally accepts this method of accounting in most circumstances. Timing a sale or purchase before or after Jan. 1 can make a big difference in your tax bill. With the razor-thin margins we experience in agriculture, it’s a smart method to manage your money.
Cash flow and tax planning are the two core reasons why growers and producers have widely adopted cash-based accounting. But the downside to cash-based accounting is it can hide the fact — or delay the truth — that your operation has entered troubled waters.
The accrual-based accounting method is widely used in business accounting because it offers a comprehensive look at the organization's financial health.
Why farmers should also adopt accrual-based accounting
What is accrual-based accounting? It records transactions based on the completion of the work and the delivery of goods and services. For revenues, you’d record commodities before they are sold, and the inputs when they are ordered. When you’re talking about an operation with several departments, payrolls and other moving parts, accrual is common sense. As expenses and revenues show up right away, it brings transparency to the organization. One source describes these as “economic events,” and logging them gives you a big-picture look at your financial health.
When it comes to tax planning, accrual-based accounting offers a lot less flexibility, and fewer opportunities to optimize your expenses. For that reason alone, it doesn't make sense to stick to one method.
When to convert a cash-based system to accrual-based
One thing that ag accounting experts recommend is practicing both cash-based and accrual-based accounting.
Use cash-based throughout the year as a part of your cash-flow and tax strategy. Then, a few times a year, convert your cash-based accounting system to accrual, so you can see the bigger picture.
The University of Minnesota Extension Services recommends completing an accrual-based adjusted income statement and explains how in FINPACK. It takes your cash-based farm records along with the inventory noted in your balance sheets so you can get a true picture of your operation’s profitability.
The accrual-based adjusted income statement shows:
- Ratios and measurements on profitability
- Your capacity to repay loans
- Overall operational efficiency
For another perspective, this publication from the University of Iowa Extension Office walks you through a deeper look at the advantages and tax considerations that come with converting your cash-based system to accrual, along with a worksheet that shows you how to do it.
Turn to the experts for the best outcome
As you can see, using more than one accounting method can reveal different truths about the performance and solvency of your operation. Working with a skilled agricultural accountant and other financial professionals can go a long way in helping you make the best financial decisions for your operation.
As you become a savvy farm business manager, there's a wealth of resources in your community you can turn to, including Minnwest Bank. As a preferred FSA and SBA lender in Minnesota and South Dakota, our experienced ag lenders can help you apply for the solution that fits your unique needs.