In order for farm businesses to even be considered businesses by the Internal Revenue Service (IRS), they need to have accounting records. Recordkeeping is obviously necessary to collect information for tax filing, but it is also important for tax planning and management. Using your records, you can track your progress, plan for changes, budget, and find your business’s strengths and weaknesses. Three other big benefits of keeping records include comparing your performance to that of other similar businesses, obtaining financing from lenders, and easing the transition of your business to family members or other business partners.
Recordkeeping is the foundation of accounting. An accounting method is a set of rules used to determine when and how the income and expenses that are being recorded will be reported on the tax return. There are two main accounting methods: accrual and cash. The IRS allows farm businesses to use either method; but once you pick one, you are required to get IRS approval to switch.
Under the accrual method of accounting, you report income in the year it was earned or due, even if the payment was not collected, credited, or otherwise made unrestrictedly available to you. Expenses in the accrual method of accounting are similarly deducted or capitalized in the year they were incurred. For example, if you used an item to provide services or goods to your clients, you would account for it even if you haven’t paid for it to your supplier yet. One good outcome of the accrual method is that it matches income and expenses for a certain production year, providing a more accurate assessment of profit. On the other hand, it is less flexible in terms of tax management, it requires more time and information, and it may result in paying taxes on anticipated revenue.
Most farmers use the cash method because they find it easier, and are able to better match farm cash flows with the taxes due. Under the cash method, income is reported in the year it is credited to your bank account or otherwise made available without restriction. Expenses under the cash method are deducted in the tax year the expense is paid. However, a cash-based income statement does not reveal true profit. Thankfully, you can convert the cash-based income statement to an accrual income statement by applying what’s called the set of “accrual adjustments to a cash-basis income statement.” The Farm Financial Standards Council recommends applying these adjustments to your cash-based income statement on an annual basis, so it is less time consuming than using the accrual method on a daily basis. This adjusted income statement takes the income and expenses, and adds or subtracts year-end inventory adjustments for grain, feed, livestock, receivables, and payables. The adjusted income statement also takes depreciation into consideration. By doing this, it attains true farm production and profit.
An accounting system is a set of devices, procedures, and controls designed to gather, record, classify, and analyze financial data. A good recordkeeping system is one that identifies sources of income, deductible expenses, asset-related transactions, and other items reported on tax returns clearly enough for the person in charge to understand and be able to explain to the tax preparer, a potential IRS auditor, and business partners.
Business transactions are normally first recorded in a journal fashion. Once entered in the journal, transactions for each specific account are usually grouped by account and summarized in a general ledger, showing a balance for each account.
Another term that you may hear in accounting is single or double entry. Historically, most accounting systems on farms and ranches have been single entry, while non-farm businesses generally have used a double entry system. Simply put, in a single entry approach, a single line is used to record each receipt or expenditure. Each entry is treated as if the offsetting account was the cash account. In a double entry system, two equal and offsetting entries are made for each transaction, with an account being credited and another one being debited. If you have several bank or cash accounts, a double entry system may suit you better.
Finally, apart from recording transactions in your journal, you must keep supporting documents such as invoices and receipts for any purchases, sales, payroll, and other business transactions. We suggest organizing them by year and type of income or expense. You may be asked for them by an IRS auditor, so keep them in a safe place, whether physical or virtual.
The first and most important financial management tool available to you is your records. With three to five years’ worth of records, either past or potential, you can analyze virtually anything in your farm -even productive matters, and make truly confident decisions.
Michigan State University Extension has many other resources available, including bookkeeping and financial analysis tools to help you with the important decisions you have to make as a farm manager. Many of these resources can be found at the MSU Extension Farm Management website. Contact your Farm Business Management Extension Educator if you need help finding the right resources for your particular situation. We suggest you consider filling in this form to receive updated resources, answers to common questions, notices of future farm business management events, and other useful information from Florencia Colella. Enjoy watching videos? Click here or here.
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