As people who live in rural areas, we are all used to the potholes that jar our vehicles and rattle our teeth. Likewise, the financial statements that measure the position and performance of our dairy businesses have potholes that are sometimes difficult to navigate.
The balance sheet is one of the four recommended financial statements by the Farm Financial Standards Council (FFSC), an organization that provides standards for the creation and analysis of farm financial statements (ffsc.org).
Balance sheets have three major sections – assets, liabilities and owner equity. While there is more to it, owner equity is generally a residual after subtracting liabilities from assets. Liabilities are fairly straight-forward. How much do you owe others? That leaves the last section: assets, fraught with pits and potholes on how to determine a reasonable, accurate and consistent value.
Cash is easy: $100 of cash is a $100 asset value. However, what is the reasonable, accurate and consistent value for the 10,000 bushels of stored grain, the bunker full of corn silage, feeder cattle, raised breeding livestock, a tractor, land or an open hedge position?
Basis of balance sheets
Complicating matters is that there are two recommended balance sheets:
- Cost-basis balance sheets generally value assets at their cost or cost less accumulated depreciation. The cost-basis balance sheet does not include asset appreciation and thus shows financial position with respect to operations only and not any appreciation of assets.
- The market-basis balance sheet is the most common and shows assets valued at what they could be sold for in today’s market. The market-basis balance sheet does include appreciation of assets and shows your financial position with respect to both operations and asset appreciation (or depreciation).
The challenge in reasonably, accurately and consistently valuing assets is that cost is not always used for cost-basis balance sheets, and market value is not always used for market-basis balance sheets.
Table 1 is a crib sheet of how assets are valued for the cost- versus market-basis balance sheets.
Assets above the bold line are current or market assets, and those below are non-current or capital assets. The non-current (capital) assets behave fairly well in terms of cost value being used for the cost-basis balance sheet and market value being used for the market-basis balance sheet. However, the current (market) assets are not as well behaved and show several exceptions. One of those is how to value inventory.
Think about the variety of ways you could have an inventory asset of corn.
- Corn growing in the field, not yet harvested
- Raised and harvested corn in storage intended for sale
- Raised and harvested corn in storage intended for feed use
- Purchased corn for later resale (not common)
- Purchased corn for use as feed
- Purchased and raised corn that have been commingled
- Raised corn you have forward contracted, hedged or have secured by a put option
Each of these types of corn inventory can be valued differently for the balance sheet.
The Farm Financial Standards Council (FFSC) provides guidelines for how to value inventory and other assets. The FFSC follows Generally Accepted Accounting Principles (GAAP) until the unique characteristics of production agriculture suggests an exception. Raised crops and livestock intended for sale is one of those exceptions. GAAP requires that inventories be valued at cost. However, for inventories of harvested crops and livestock held for sale the FFSC Guidelines state:
“[A]gricultural producers may value those inventories at the current estimated selling prices less cost of disposal when all of the following conditions exist:
- Reliable, readily determinable and realizable market price
- Relatively insignificant and predictable costs of disposal
- Available for immediate delivery.”
Four categories of inventory
The FFSC separates inventory into four categories, A through D. Category “A” are those crops and livestock that were raised on-farm with the intent to sell. This category meets the criteria listed above, and therefore the recommendation is to use current market price (less any cost of selling) as the value of the asset.
Category “B” is also products that were raised on-farm, but the intent is not to sell them, rather use them as an input in another production process. Crops raised for feed is a common example. Generally, these products do not meet the criteria, and the FFSC recommends the lower of cost or market value. This can be a dilemma because there is no purchase cost, only the cost it took to raise the product, which may not be easily determined.
Category “C” is purchased inventory but a specific kind of purchased inventory, which is that it could also have been raised. Purchased feeder cattle and purchased corn (for feed) are two examples of purchased products that could have been grown on-farm. Category “C” includes two subcategories. The first (C1) is products purchased with the intent to add value and resell (feeder cattle). The nature of this type of inventory is: It changes in value as more pounds are put on, and the balance sheet should recognize the increased value versus its original cost. The second (C2) is products like corn purchased with the intent to use as an input (feed). The FFSC recommendation is the lower of cost or market value. Table 2 reflects my personal preference, which is to value at cost.
Category “D” is purchased raw materials for use as an input and is inventory that could not be grown such as seed, fertilizer and fuel. There is a definable purchase price, and the FFSC recommends using cost value on the balance sheet.
These recommendations are rife with questions that start with “but what if ….” For example, “but what if the corn I purchase with an intent to use as feed is commingled with corn I raised?” In the case of commingled products, the FFSC recommends assuming that all raised product is used first and what is left is purchased product. If more inventory is available than the amount of purchased product, then use a prorated value.
However, let’s refrain from chasing the squirrels of the “but what if …” questions and instead recall three important words – reasonable, accurate and consistent. The last of these words, “consistent,” may be the most important. Over time, you want your balance sheet to show “real” changes in financial position. If you are consistent in how inventory and other assets are valued, then the “change” in owner equity is more likely to be “real” versus just a reflection of changing valuation methods.
Conclusion
What does this mean for you tomorrow after breakfast? Talk to your records/bookkeeper and find out how different kinds of inventory are valued. Are different kinds of inventory categorized and valued differently? If so, what is the categorization and how is it valued? Is it done the same way every year? What are the standard operating procedures for determining quantities of inventory and appropriate prices? Are those procedures in writing? If changes are warranted, then you may want to change the past couple of balance sheets as well so your trends are comparable. Finally, be sure to provide footnote explanations of any changes in procedure written for all to see.
An accurate balance sheet can be used together with other financial statements to determine where the balls and chains holding back profitability might be. However, valuing assets is fraught with potential pits and potholes. One can fix those pits and potholes through establishing accounting procedures and practices that are reasonable, accurate and, most importantly, consistent.
PHOTO: Mike Dixon.
