Developing a Chart of Accounts for the Farm or Ranch

Transcription

1 Developing a Chart of Accounts for the Farm or Ranch EB 132 April 1995

2 Developing a Chart of Accounts for the Farm or Ranch by Genice Garner and Duane Griffith* Keep receipts Memo on checks Track only cash transactions Record in record book When you make the decision to create and use a record-keeping system for your farm or ranch, the first step is to establish a chart of accounts. A chart of accounts is a list of expense, revenue, asset, liability and equity account names. Each individual farm or ranch has different asset and liability configurations and different sources of revenue and expenses. While there are many similarities among agricultural operations, each will need its own specific chart of accounts. The chart of accounts also establishes the level of detail tracked in the record-keeping system and the extent to which a fully implemented recordkeeping system is utilized. Record-keeping activities can be viewed as a continuum (Figure A). At one end is the most elemental record-keeping Figure A: Record-Keeping Continuum Record only cash transactions Separate into income/ expense and nonincome/expense categories Use asset and liability accounts plus income and expense accounts Use asset, liability, income, expense and EQUITY accounts Capture all financial and physical inventory information of the operation *Montana State University Department of Agricultural Economics and Economics, Bozeman, MT system, the shoe-box method, consisting of keeping receipts and writing a memo on a check to indicate the purpose of the expenditure. At the other end is a record-keeping system that captures all management information, including purely financial information and data regarding physical inventories and the production process. As you begin to formalize your recordkeeping system, you should determine where you presently are on the continuum and where you would like to be. This will enable you to set up a chart of accounts which suits the level of information gathering you wish to accomplish. There are two basic reasons for keeping records: to provide information for tax reporting, and to provide information for management purposes. Since most farm/ranch businesses will file tax returns, there are accounts common to most operations. Tax-oriented records usually are limited to a checkbook register where each cash transaction is recorded. This generally suffices for tax reporting purposes. This method, however, tracks only a portion of information required for good management records. If you want a good set of management records, you will have to add details beyond those needed for tax records. A management-oriented record-keeping system provides enough information to generate an accrual adjusted income statement and both cost and market value balance sheets. Chart of Accounts - Page 1

3 Although the term accrual may cause prospective users to cringe, current computerized record-keeping systems minimize the effort required for management records. The primary difference between the accrual method and the cash method is the timing of when income and expenses are recognized and recorded in the record-keeping system, and hence, on financial statements. Whatever method you choose, cashbased or accrual, the starting point is the construction of a chart of accounts. This publication illustrates the items that need to be considered when setting up a chart of accounts for either method. It also discusses differences in some of the accounts used in various types of business organizations: sole proprietorships (individuals), partnerships, corporations and subchapter S corporations. The Chart of Accounts for Tax Purposes If your primary purpose in recordkeeping is for tax reporting, the recordkeeping system used should produce enough information to complete the basic tax forms for the appropriate type of business ownership. Figure B identifies and describes typical tax forms for four basic types of business ownership. A sample chart of accounts is included as Figure C. This chart of accounts lists the items that provide the basis for a good set of tax records and was developed using the Figure B. Typical Tax Forms INDIVIDUAL Form 1040 General Return Schedule A Itemized Deductions Schedule F Profit or Loss From Farming PARTNERSHIP Form 1065 General Return Schedule Profit & Loss Schedule K Partners Share of Income CORPORATION Form 1120 or 1120A General Return Schedule J Tax Computation Schedule L Balance Sheet Schedule M-1 Reconciliation Schedule M-2 Retained Earnings Analysis SUBCHAPTER S CORPORATION Form 1120S General Return Schedule A Cost of Goods Sold/ Operations Schedule K Shareholder Analysis Schedule L Balance Sheet Schedule M-2 Adjustment Analysis line items on typical tax forms for individuals. It also lists items that help provide a more complete set of management records (the additional accounts necessary for management information have been italicized and their headings are shaded). Setting up a chart of accounts using the appropriate tax forms as a guide will provide: the basic tax information required, and a basic income and expense summary. Taxable income, which most producers compute on a cash basis, is often used as a measure of business performance. Unfortunately, this can be very misleading. A business can be going broke and still generate a positive cash basis income for several years. This can happen when accounts payable are allowed to grow substantially because expenses are not paid, or when depreciable capital assets are not replaced in a timely manner. Keeping accounting records solely on a cash basis is not sufficient if good financial management is a goal. An annual cash flow statement gives an indication of a business ability to cover its cash flow requirements, its margins of safety for debt service, and its ability to finance new debt. The cash flow statement alone does not provide the management information necessary for complete financial analysis. For that you will also need an accrual adjusted income statement, beginning and ending balance sheets, and a statement of owner s equity. The Chart of Accounts for Management Purposes With the addition of appropriate accounts, a record-keeping system can generate both an accurate income (profit and loss) statement and an accurate balance sheet (listing all assets and liabilities of the business), in addition to providing accurate tax and cash flow information. A chart of accounts can also include details for different enterprises within the farm or ranch business, such as cow/calf and wheat enterprises. Allocating transactions to various enterprises allows for better management decision-making. Records organized by enterprise can be used to address questions such as, Was the spring wheat Chart of Accounts - Page 2

4 Figure C. Sample Chart of Accounts Revenue Categories Expense Categories & Subcategories Asset/Liabilities Business Revenue Agricultural Program Payment CCC Loans Under Election CCC Loans Forfeit-Repaid Crop & Disaster Insurance Custom Work Income Dividend Income Hedging Income/Loss Interest Income Livestock & Other Resale Long Term Capital Gain Other Revenue & Gas Tax Refunds Miscellaneous Income Other Tax Related Income Quantity Increase/Raised Realized Gain/Loss Sales/Barley Grain Sales/Raised Livestock Sales/Purchased Livestock Sales/Raised Hogs Sales/Wheat Short Term Capital Gain Total Cooperative Distribution Unrealized Gain/Loss Unrealized Market Gain/Loss Personal Revenue Dividend Income Interest Income Investment Income Miscellaneous Income Off-Farm Wages Business Expenses Bad Debt Breeding Fees Chemicals Conservation Expense Cost of Goods Sold Custom Hire Depreciation Feed Purchased Fertilizers Gas, Fuel & Oil Diesel Gasoline Oil & Lube Hedging Insurance (not health) Interest/Mortgage Interest/Other Investment Interest Miscellaneous Dues Payroll Co. Medical Contribution Co. FICA Contribution Co. FUTA Contrib. Co. St. Unemployment Gross Wages Pension & Profit Sharing Rent & Lease Machinery Rent & Lease Other BLM Leases Forest Service Leases Private Leases Repairs Baler Pickup Swather Tractor A Tractor B Seeds & Plants Storage & Warehouse Supplies Taxes Federal Personal Property Real Estate State Income Tax Trucking & Freight Utilities Electricity Natural Gas Veterinarian & Medical Personal Expense Auto Expense Bank Charges Charitable Contribution Childcare Clothing Dining Out Dues Education Entertainment Gifts Groceries Household Expenses Insurance Interest Investment Expenses Medical Miscellaneous Mortgage Interest Recreation Subscriptions Supplies Taxes Telephone Utilities Owner s Equity Wheat Winter Spring Hay Alfalfa Grass Owner s Equity Enterprises Assets Accounts Receivable Breeding Herd Buildings Bulls Cash Cooperative Stock Deferred Tax Asset Futures Margin Inventory/Barley Invent./Purchased Steers Inventory/Wheat Land Money Market Raised Hogs Replacement Heifers Savings Swather Tractor A Tractor B Vehicles Accumulated Deprec. Vehicles Buildings Swather Tractor A Tractor B Liabilities Accounts Payable Accrued Interest Capital Leases Deferred Taxes Notes Payable Mortgage Liability Operating Lease Payroll Taxes Payable Unearned Revenue Hogs Cattle Cow-Calf Replacement Heifers Feeder Steers Dairy Chart of Accounts - Page 3

5 enterprise as profitable as the winter wheat enterprise? This level of detailed recordkeeping (enterprise records) requires more effort in the day-to-day record-keeping process. You would only keep enterprise records if you feel comfortable with the increased level of detailed record-keeping. As an example, if you spend 15 minutes a day recording transactions for your tax records, expect to spend 20 to 30 minutes a day on enterprise records. When designing a chart of accounts, it is important that the integrity of major categories relating to tax reporting or line items on financial statements be maintained. In other words, under the title of Miscellaneous, there may be items such as postage or office supplies, or under Rent & Lease the sub-categories of BLM permit payments, Forest Service permit payments and private leases. These subcategories must be maintained as subcategories under the main headings to facilitate tax and financial reporting (see Figure C). Moving from the General to the Specific Start your set-up of the chart of accounts with general areas of expense and revenue, such as repairs and seed. These general categories are all that are required for tax reporting and come directly from the tax forms appropriate for your type of business ownership. However, to aid in determining profitability of selected activities or enterprises within your business, it is a good idea to divide each general category into more specific subcategories. For example, under the general category Repairs, you might have the subcategories: Chevy Truck, Ford Truck, J.D. Tractor, Toolbar, Swather, etc. Under the general category of Hired Labor, you might have FICA, State Withholding, Federal Withholding and Medical Insurance categories. In the case of hired labor, your record-keeping system then helps track information needed for state and federal payroll tax obligations. The additional detail under repairs is not required for tax purposes; however, the additional detail for hired labor is needed for tax reporting. In addition to separating your expenses and revenues into more specific categories (i.e., Chevy repairs, winter wheat seed, etc.), you may wish to divide expenses and revenue according to the enterprises, or segments, of your business to which the expenses or revenues pertain. For example, does income generated relate to your wheat operation or cattle operation? If wheat, is it spring wheat or winter wheat? Allocating each income or expense item to an enterprise within the business will provide for enterprise analyses at year end, helping to determine which enterprises are profitable. Examples of possible enterprises for the farm/ranch are: Wheat Alfalfa Oats Barley Dairy Hogs Cow-Calf Additional detail can be added to the enterprises listed above. For example: Wheat Winter Wheat Spring Wheat Beef Cow-Calf Fed Steers Replacement Heifers Hay Mixed grass hay Alfalfa hay You might consider breaking down these enterprises into even more specific classifications. For example, instead of simply using the enterprise Winter Wheat, you could classify it as Winter Wheat/Field 5, or Winter Wheat/Dryland. This allows you to track revenue and expenses for each sub-classification separately. A computerized record-keeping system should allow you to easily add as many levels of detail as you desire, and whenever you wish. It should not force you into an all or nothing record-keeping mode. Remember, record-keeping is a continuum and you can do more as you feel comfortable with increased record-keeping activity. Each additional level of detail does require additional effort in the day-today record-keeping process. For example, to track repairs for tax purposes, you simply have to keep track of total repairs. If you keep enterprise records, each repair expense must be allocated to the appropriate enterprise(s). If the repair bill is for a tractor that is used on the winter wheat, barley, summer fallow and spring wheat enterprises, you must split the repair bill Chart of Accounts - Page 4

6 four ways. This requires four separate expense items to be entered into your records. Only one entry is needed for tax reporting. Computerized record-keeping systems can usually help by storing this extra detail after the initial transaction and allowing you to reuse it at a later date. In addition to the revenues and expenses for tax purposes, accounts should be set up for each of your business assets and liabilities if you want management information. Typically, assets are recorded at their purchase cost, and liabilities are recorded at the amount owed. For long-lived assets, you must keep accumulated depreciation accounts to track yearly depreciation expense, and to compute the book value (cost + capital improvements minus depreciation) of the assets. The asset and liability accounts can provide information for the preparation of balance sheets using either cost or the current fair market values. It is recommended that you do not try to track both cost and fair market value in your computerized record-keeping system unless it is specifically designed to track both. Tracking the cost basis of assets provides the most information for measuring business performance and it also is more closely related to tax record-keeping requirements. Each move to a more specific revenue or expense item provides more detail and better management records, but it also requires increased effort to record daily activities in the record-keeping system. Cash vs. Accrual Records The distinction between cash and accrual records is important. Cash records recognize income and expense only when cash or property is actually received or paid. In contrast, accrual records recognize income and expense when they are constructively incurred, and not when they are actually received or paid. For example, seed is purchased on account and used in September, but not paid for until the following February. Under cash basis record-keeping, the expense is not recognized until it is paid in February, affecting the following year s taxes and profit and loss figures, assuming a calendar year is used. Under the accrual method, the expense is recognized and reduces profit for the current year when it is incurred, even though it is not paid until the following year. To be helpful for both tax reporting and management purposes, your recordkeeping system should distinguish between cash transactions and accrual transactions. An appropriately-designed chart of accounts, in conjunction with a good recordkeeping system, will allow for this type of separation. Such a system will generate cash-based tax information and accrualbased management information, the best of both worlds. The sample chart of accounts (Figure C) lists the minimum additional accounts necessary to move toward accrual based management record-keeping. The additional accounts are in italics in Figure C. Expenditure vs. Expense A distinction must also be drawn between the terms cash expenditure and business expense. A cash expenditure is a cash outflow to cover a business or personal expense, or a purchase of a capital item. The mere expenditure of cash may not decrease the profit of a business. When a piece of farm equipment is purchased, cash is decreased, but there is no decrease in profit because cash was merely exchanged for another asset. Additionally, non-business expenditures may not be tax deductible. A business expense, unlike an expenditure, may not involve actual cash outlay (such as when repair expenses are put on credit), but nevertheless decreases the profit of a business. An expense may or may not be tax deductible, depending on whether cash is disbursed or not. It is important to remember these distinctions when setting up and using your recordkeeping system. Figure D shows a few common examples of expense/expenditures and the financial statements in which they Figure D. Common Expenses and Where to List Them Example Business Cash Financial Statement Expense Expense Statement Depreciation Yes No Profit & Loss, Balance Sheet Principal payment No Yes Cash Flow, Balance Sheet Owner draw* No Yes Cash Flow, Balance Sheet Gift of fully-depreciated No No Balance Sheet equipment Interest Yes Yes Profit & Loss, Cash flow and Balance Sheet * In a sole proprietor form of business Chart of Accounts - Page 5 Chart of Accounts - Page 1

7 would be listed. The design and detail of the chart of accounts will help track relevant cash inflows and outflows (expenditures), and will track those that are actually tax-related. Whether an item is a business expense or simply an expenditure will vary by the type of business ownership. Sample Chart of Accounts The sample chart of accounts for a sole proprietorship, Figure C, will require modification to suit your particular business; however, it provides a basis from which to start. This example includes business and personal accounts. Most are self-explanatory; however, some may require additional clarification. An accrued liability occurs, for instance, when a customer pays you for a product in advance. Under accrual accounting the amount received should not be included in income until the product is delivered to the customer. If the product has not been delivered at the time financial statements are prepared or at year end, a liability for the amount of pre-payment should be noted on your books. Prepaid expenses result when you pay for a product or service in advance. A good example of this is hazard insurance. If you pay for coverage for a year in advance, you would include a prepaid asset on your books until all of the coverage is used up. For example, consider that in November you purchase a year s worth of hazard insurance. At year end, only one month of the coverage has been used. Therefore, the remaining eleven month s worth of insurance for which you have paid would be considered an asset at December 31 and must be so reflected in the balance sheet. The accrual adjustments are made for situations like this at year end when the balance of the prepaid expense account is changed to reflect the situation appropriately. This allocates the expense correctly and provides better financial management information. However, it also increases the effort required to keep accurate records. This publication includes samples of financial statements which show how the different accounts in the chart of accounts are organized for financial reporting. These illustrate that there are some accounts required in the financial statements which are not shown on the tax forms (for a sole proprietorship). For example, asset accounts such as Savings, Prepaid Insurance, or Deferred Tax Asset, or liability accounts such as Accounts Payable or Accrued Interest appear on the financial statements but not in the tax forms. (See Sample Financial Statements.) The sample financial statements show only one of many ways in which statements are prepared; others may contain more or fewer individual line items and may be organized differently. However, if you wish to prepare financial statements from your accounting records, the easiest way is to include all of the desired line items of the financial statements in your chart of accounts. If you need, for example, to track BLM Rent Expense separately for financial reporting, it should be kept under the general category of Rent & Lease Other for tax reporting. Preparing Financial Statements from The Chart of Accounts As mentioned above, the basic tax forms do not include all of the accounts, or line items, required on a set of financial statements. If only tax-related items are included in a chart of accounts, the following items must be tracked separately if you wish to prepare financial statements: A list of the operation s assets, including their purchase price, and a list of the operation s liabilities. (Refer to sample Financial Statements at the end of this publication for details.) Modifications to Chart of Accounts for Other Business Forms If your business form is not a sole proprietorship, but a partnership or corporation, a few additional accounts should be included. The main differences arise in the equity or capital accounts. Equity accounts are those that keep track of the difference between total assets and total liabilities, the net worth of your business. In contrast to the sole proprietorship type of business, which typically has only one owner s equity account, corporations and partnerships generally have a more complex capital structure and therefore, different equity accounts. For example, if your ranch is a corporation, you should add the capital accounts Capital Stock and Additional Paid in Capital. If your farm is a partnership, you must keep capital accounts for Chart of Accounts - Page 6

8 each partner. Additionally, if the operation is a corporation, balance sheets are required in the tax forms; therefore, it is important to include the assets and liabilities of a corporation in the chart of accounts and to track them accordingly, instead of just tracking revenues and expenses. The accountant who prepares your taxes can help you fine-tune a chart of accounts for your particular business. You will need to modify the sample chart of accounts given in this publication to conform to your business needs. Remember, whether you wish to maintain records solely for tax purposes or for tax and management purposes, the chart of accounts is your starting point for establishing good financial records. Summary Determine the type of records desired for tax reporting only or tax and management records. Develop a chart of accounts using tax forms and financial statements as per objectives specified in this publication. Move from the general to the specific by adding detail to your chart of accounts. Keep the major categories of revenue, expense, assets, liabilities and equity related to line items on either the tax forms and/or on the financial statements. Check that your finished chart of accounts will produce the information your tax accountant requires to complete your taxes. Chart of Accounts - Page 7

9 The programs of the Montana State University Extension Service are available to all people regardless of race, creed, color, sex, disability or national origin. Issued in furtherance of cooperative extension work in agriculture and home economics, acts of May 8 and June 30, 1914, in cooperation with the U.S. Department of Agriculture, Andrea Pagenkopf, Vice Provost and Director, Extension Service, Montana State University, Bozeman, MT 59717