Income Statements

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06/19/2020 Added

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By Glennis McClure

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[00:00:00.244](upbeat music)
[00:00:08.000]Hi everyone, I am Glennis Mcclure
[00:00:10.130]with Nebraska Extension.
[00:00:12.470]In this short video I'm going to provide
[00:00:14.840]an overview of the income statement.
[00:00:17.670]Once we have determined
[00:00:19.020]an actual net farm income for the year,
[00:00:21.620]we can understand more
[00:00:22.830]about how profitability relates
[00:00:25.230]to whether we are growing net worth
[00:00:27.480]or not from year to year.
[00:00:29.970]Keeping good farm and ranch records is essential.
[00:00:33.730]Entering cash receipts
[00:00:35.150]and expenses is the easy part.
[00:00:37.800]Did you know that all
[00:00:38.920]of your accounting records
[00:00:40.500]and figures used on the beginning
[00:00:42.520]and ending balance sheets,
[00:00:44.570]the cash flow statement
[00:00:46.020]and income statements all interrelate?
[00:00:49.360]If all cash accounts, inventories,
[00:00:52.230]equipment, loans, income
[00:00:54.350]and expenses are accounted for accurately,
[00:00:57.750]you can measure the true profitability
[00:01:00.200]of your business.
[00:01:01.730]Many of us are good at tracking sales
[00:01:04.220]and recording expenses
[00:01:05.700]in our farm and ranch records.
[00:01:08.869]However, simply subtracting cash expenses
[00:01:10.910]from cash income to reach net cash income,
[00:01:14.890]as shown on our schedule app
[00:01:16.800]or a cash flow statement does not tell us
[00:01:19.610]the true story of profitability for the year.
[00:01:22.760]In this introductory video,
[00:01:24.460]we're going to discuss how to develop
[00:01:26.887]an accrual adjusted income statement,
[00:01:30.560]preparing an income statement
[00:01:32.080]using accrual adjustments
[00:01:34.100]will tell us more about our operations,
[00:01:36.790]profitability and performance.
[00:01:39.870]An income statement measures farm
[00:01:41.650]and ranch profitability or net income
[00:01:44.130]for a given length of time,
[00:01:46.000]most generally on an annual basis.
[00:01:48.560]The income statement tells
[00:01:49.860]the story of revenue and expenses
[00:01:52.290]between the beginning of your balance sheet
[00:01:55.500]and the end of the year balance sheet.
[00:01:57.610]Hence an important use of
[00:02:00.030]the income statement is to relate
[00:02:01.810]true profitability from the beginning of
[00:02:04.480]the period to the end,
[00:02:06.520]as we observe changes in the balance sheets.
[00:02:10.170]Income statements can be prepared using
[00:02:12.520]a cash or accrual accounting method.
[00:02:15.720]Since most farm and ranch managers
[00:02:17.960]keep their own records
[00:02:19.137]and generally do not pay
[00:02:20.740]for an accountant to keep the books,
[00:02:22.880]records are kept using cash accounting.
[00:02:25.870]The cash method recognizes revenue when
[00:02:28.730]the payments are received,
[00:02:30.610]and when expenses are paid.
[00:02:32.690]And you may be asking,
[00:02:34.380]then what is accrual accounting?
[00:02:36.640]The accrual accounting method
[00:02:38.220]recognizes revenue when it's earned
[00:02:41.330]and expenses when they're incurred,
[00:02:43.620]giving a more accurate picture of profitability.
[00:02:47.550]A simple example demonstrates
[00:02:49.570]how accounting transactions can differ
[00:02:52.080]when comparing cash to accrual accounting.
[00:02:55.220]So let's say you hauled some grain from
[00:02:57.240]the field to storage
[00:02:58.580]for a neighbor last year during harvest,
[00:03:01.280]that would be last year year one,
[00:03:03.660]and they didn't pay you
[00:03:04.870]until the next year or year two.
[00:03:08.040]Using the accrual method,
[00:03:10.150]your income from this work would have
[00:03:12.100]been recorded in year one right after you hauled
[00:03:14.780]the grain whether they paid you or not?
[00:03:17.580]Using cash basis accounting
[00:03:19.730]as most farm operations do,
[00:03:21.970]the income from hauling the grain
[00:03:24.160]would be recorded the following year or year two
[00:03:26.980]when you actually receive the payment.
[00:03:29.520]And accounts receivable
[00:03:30.720]would be recorded on your ending balance sheet
[00:03:33.050]for year one, showing that
[00:03:34.750]your neighbor still owed you for hauling.
[00:03:37.870]To be clear, we are not encouraging you
[00:03:40.420]to change your accounting method.
[00:03:42.690]Just know that cash basis income statements
[00:03:45.630]do not provide
[00:03:46.610]an accurate picture of profitability.
[00:03:49.290]The good news is that you
[00:03:50.750]can adjust your income statement
[00:03:52.670]using accrual adjustments
[00:03:54.460]to determine your true profitability.
[00:03:57.500]The schedule F IRS Form prepared to figure
[00:04:00.220]your annual income tax is an example
[00:04:02.580]of a cash basis income statement
[00:04:04.940]with depreciation expense as the only exception.
[00:04:08.620]Think about the cash accounting figures
[00:04:10.480]that go into your schedule F each year.
[00:04:13.200]Using some typical accrual adjustments,
[00:04:15.700]to the number reported on the schedule F,
[00:04:18.270]allows us to reach a true profitability figure
[00:04:21.750]or what is otherwise known as net income,
[00:04:24.710]or the bottom line on a net income statement.
[00:04:29.410]Let's look at three common accrual adjustments
[00:04:31.990]to the schedule F accounting totals
[00:04:34.030]including accounts receivable,
[00:04:36.280]changes in grain or livestock inventory,
[00:04:39.010]and prepaid expenses.
[00:04:41.270]Then we'll discuss how actual depreciation
[00:04:43.810]of farm and ranch assets can be different
[00:04:46.720]than the depreciation figure on the schedule F.
[00:04:52.080]Using an accrual adjustment,
[00:04:53.840]here's an example of accounting
[00:04:55.640]for an accounts receivable change
[00:04:57.820]from the beginning of the year to the end of the
[00:05:00.070]year balance sheets
[00:05:01.450]and how it could affect net income for the year.
[00:05:05.270]If you have an accounts receivable
[00:05:06.870]at the end of the year.
[00:05:08.400]This means you earn more income
[00:05:10.300]than your cash record total
[00:05:11.810]on the schedule F maybe showing.
[00:05:14.150]Using the custom hauling example
[00:05:16.130]described earlier,
[00:05:17.430]the neighbor still owed you 1500 dollars
[00:05:20.440]for hauling at the end of the year.
[00:05:22.550]For the accrual adjusted net income statement,
[00:05:25.230]we would add 1500 dollars
[00:05:27.090]to the custom work revenue figure.
[00:05:31.060]The next accrual adjustment
[00:05:32.650]we will demonstrate is how inventory values,
[00:05:35.420]affect true net income calculations.
[00:05:38.700]The most common inventory changes
[00:05:40.840]to account for our grain inventory,
[00:05:43.300]livestock inventory, and prepaid supply expenses.
[00:05:47.690]These changes can be significant
[00:05:49.880]and need to be considered
[00:05:51.620]using accrual adjustments to reflect
[00:05:54.440]a true picture
[00:05:55.380]of net farm income for the annual period.
[00:05:59.110]So let's say at the beginning of the year,
[00:06:00.740]you carried over
[00:06:01.573]$19,500 worth of corn in the bin.
[00:06:05.170]Sometime during the year
[00:06:06.480]you sold all of that grain
[00:06:08.800]that you're holding on to plus after harvest,
[00:06:11.420]most of the new crop production
[00:06:12.920]was sold for a grand total of $100,000
[00:06:15.470]in corn sales.
[00:06:16.960]At the end of the accounting year,
[00:06:18.580]you still have 4000 bushel of new crop corn
[00:06:21.370]in the bin with 14,000.
[00:06:23.660]So there's a difference of $5,500 worth
[00:06:26.810]of corn inventory from beginning of year
[00:06:29.120]to the end of the year.
[00:06:31.560]Remember that the $19,500 worth of corn
[00:06:34.530]you started with
[00:06:35.480]was from the prior year's production,
[00:06:38.490]but it made up part
[00:06:39.500]of the hundred thousand dollars
[00:06:40.980]that you sold for the year.
[00:06:43.040]The difference in grain
[00:06:44.230]or corn inventory from the beginning
[00:06:46.180]of the year to the end is a negative $5,500.
[00:06:50.800]So we would subtract
[00:06:52.270]or adjust out that amount of grain
[00:06:56.191]from the sales for this
[00:06:57.024]accounting year by showing
[00:06:57.930]the accrual adjustment.
[00:06:59.610]With accrual adjustments, we're trying to capture
[00:07:02.140]true revenue generated from one year to the next
[00:07:06.650]within the window of the accounting year.
[00:07:09.720]Now, here's an example
[00:07:10.810]of prepaid expenses as noted on the beginning
[00:07:13.360]and ending balance sheets.
[00:07:15.210]A difference, either positive
[00:07:16.523]or negative reflects on adjustments to expenses.
[00:07:21.120]In this example,
[00:07:22.270]the operation paid more prepaids
[00:07:24.550]in total before the end of the year.
[00:07:27.270]So in effect,
[00:07:28.630]they inflated their expenses
[00:07:31.010]that must be adjusted back down.
[00:07:34.910]However,
[00:07:35.743]to be exact two of the expense categories,
[00:07:38.440]are showing a negative adjustment
[00:07:40.180]and the feed expense adjustment is positive.
[00:07:43.490]The negative $2,000 adjustment towards seed
[00:07:46.830]is necessary.
[00:07:48.200]So the records for the year reflect
[00:07:50.090]the proper seed expense.
[00:07:52.030]Same with feed, although this difference
[00:07:54.180]is a positive number meaning that in effect,
[00:07:57.630]we used more feed than what is showing on
[00:08:00.090]the cash accounting books
[00:08:01.310]is paid for for the year.
[00:08:03.220]In the case of fertilizer in this example,
[00:08:05.940]if we did not subtract $10,000
[00:08:08.270]of prepaid fertilizer,
[00:08:09.970]our books would look like we bought
[00:08:11.630]and used too much fertilizer.
[00:08:13.847]$10,000 worth of fertilizer
[00:08:15.980]that we paid for early, will be used next year.
[00:08:21.750]Other inventory changes
[00:08:23.100]may include hedging account,
[00:08:24.820]gains or losses, accrued interest
[00:08:27.470]or just other inventory changes in assets.
[00:08:31.370]The final accrual adjustment made
[00:08:33.220]on the farm income statement is depreciation.
[00:08:36.070]The schedule F is typically prepared
[00:08:38.540]using cash accounting total
[00:08:40.540]and very simply noting cash income received
[00:08:43.570]and cash expenses paid for the year.
[00:08:45.970]However, there is one caveat to this
[00:08:48.470]and that depreciation
[00:08:49.810]is added on the expense side
[00:08:51.770]and it's a non cash expense.
[00:08:54.720]Depreciation used in figuring
[00:08:56.630]income taxes can vary from year to year
[00:08:59.100]and can be widely inflated,
[00:09:01.300]depending on the method used
[00:09:02.670]for the calculation
[00:09:04.000]and aligning with IRS regulations.
[00:09:06.620]For example,
[00:09:07.790]expense in purchasing a farm implement,
[00:09:10.360]maybe all or just partially included
[00:09:13.751]in the tax depreciation amount for the year.
[00:09:15.890]Using the IRS allowance for 179 expense election,
[00:09:20.330]the purchase cost can be written off
[00:09:22.670]as an expense all in one year.
[00:09:25.530]While, in a truer sense,
[00:09:27.080]the useful life of the implement
[00:09:28.860]maybe seven to 10 years or more.
[00:09:31.550]The decrease of the value of
[00:09:33.070]the implement would be gradual over time
[00:09:35.290]and reflected assets on the balance sheet.
[00:09:38.270]For the purpose of reaching
[00:09:39.530]a true accrual adjusted net farm income,
[00:09:44.030]a reasonable change
[00:09:45.150]in values of machinery and equipment,
[00:09:47.490]vehicles and buildings
[00:09:48.880]and improvements is generally used.
[00:09:51.650]It is the more gradual use
[00:09:53.600]based depreciation
[00:09:55.780]that should be reflected
[00:09:57.120]in figuring depreciation expense as an
[00:10:00.000]entry on the income statement.
[00:10:01.903]The depreciation adjustment
[00:10:02.736]section of the income statement
[00:10:03.569]considers the beginning and ending year values,
[00:10:08.560]adding in purchases
[00:10:10.240]and deducting sales of capital goods.
[00:10:14.560]So, using the depreciation example here,
[00:10:17.360]the tax basis depreciation of $90,000
[00:10:20.390]is used as an expense on the schedule F.
[00:10:23.460]The $90,000 includes $40,000
[00:10:26.310]of depreciation on the existing list
[00:10:28.660]of buildings and equipment noted
[00:10:30.840]on the current tax depreciation schedule.
[00:10:33.510]Plus, during the accounting year,
[00:10:35.940]the farmer purchased
[00:10:37.000]a used spray rig for $50,000.
[00:10:40.250]In consultation with their accountant
[00:10:42.740]and to reduce current income taxes.
[00:10:45.160]They decided to write off
[00:10:46.650]or depreciate the entire $50,000.
[00:10:49.677]$50,000 plus the existing $40,000
[00:10:53.010]on the depreciation schedule,
[00:10:55.060]totals in $90,000 schedule F
[00:10:57.570]depreciation expense that they'll use.
[00:11:00.940]Aside from tax depreciation rules and allowances,
[00:11:04.010]machinery equipment that is normally used
[00:11:05.960]seven to 10 years, and buildings
[00:11:08.120]that may depreciate over 20 years or more,
[00:11:11.180]actual depreciation expense figure
[00:11:13.850]is more like $43,000 for the year,
[00:11:17.040]using this example.
[00:11:19.060]A difference of $47,000
[00:11:21.027]less depreciation can make a huge difference
[00:11:25.700]in the calculation of true profitability.
[00:11:31.050]So, now, farm income is
[00:11:32.850]the profit or loss figure for
[00:11:34.670]the farm operation that we strive to determine
[00:11:37.460]with adjustments similar to what we have covered.
[00:11:40.570]Net farm income reflects
[00:11:42.060]on return on unpaid labor and management
[00:11:44.930]and a return on equity capital investment.
[00:11:48.060]For any business,
[00:11:49.430]profits are necessary to pay an owner operator
[00:11:52.640]for their labor and management.
[00:11:54.480]Unless a farm business is set up
[00:11:56.250]as a corporation that pays wages
[00:11:58.460]and those wages are included in expenses,
[00:12:01.270]then paying yourself
[00:12:02.490]for your time and management,
[00:12:04.260]needs to come from the net farming configure.
[00:12:08.950]Net income is a key figure
[00:12:10.750]that tells us a lot about our farm business.
[00:12:13.720]If the numbers have gone into
[00:12:15.100]the income statement are accurate
[00:12:17.710]and match the period of time
[00:12:20.420]between the beginning and ending balance sheets,
[00:12:22.960]then we can calculate
[00:12:24.090]and analyze how net worth changed.
[00:12:26.350]Whether it grew or declined for the year.
[00:12:29.530]Off farm revenue is added to net farm income,
[00:12:32.760]whereas family living or owner withdrawals
[00:12:35.460]and income taxes
[00:12:36.370]are deductions of net farm income.
[00:12:38.580]The net result after these adjustments
[00:12:40.800]reflects earned net worth growth.
[00:12:45.280]So in summary,
[00:12:46.580]there are several checks and balances,
[00:12:48.100]we can do using the beginning
[00:12:49.690]and ending figures off the balance sheet,
[00:12:52.020]the statement of cash flow
[00:12:53.510]and the income statement.
[00:12:55.250]In addition, there are financial ratios
[00:12:57.540]and standards that can provide guidance
[00:13:00.120]on measuring business stability and growth.
[00:13:02.920]It is worth the time and effort
[00:13:04.680]to keep good track of revenue
[00:13:06.340]and expenses and to take careful,
[00:13:08.930]physical inventory of assets
[00:13:11.080]at the beginning end of the accounting period.
[00:13:14.390]Preparing the essential financial statements
[00:13:17.130]including the income statement
[00:13:18.900]will assist in providing you
[00:13:20.490]with a clear picture
[00:13:22.230]of financial strength of your farm
[00:13:24.410]and ranch operation.
[00:13:27.303](upbeat music)

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