The other day, an agricultural lender criticized me for continuing to discuss the fallacies of using income statements derived from Schedule F tax forms in credit analysis. He stated, “I have heard all of this before!” Perhaps he needs to hear it again because relying solely on the Schedule F, whether it is used in financial analysis for the lender or in business decision-making, is one of the 20 worst management practices of this century. Let's discuss some of the management mistakes that often occur.
Many businesses use adjustments in revenues and expenses, as well as accelerated depreciation methods, to reduce net income shown on the Schedule F. This, in turn, reduces income taxes and Social Security obligations. However, these changes to revenues and expenses in the absence of accrual adjustments can be detrimental in many ways.
First, it is more difficult to determine the true cost of production, whether it is for the whole farm or enterprise budgets. This information is crucial when developing projected cash flows and making business decisions.
Next, with little profits on the bottom line, contributions to Social Security are reduced. As agricultural producers’ retirement investments are often in farm assets and equity in the farm business, this reduces another possible source of income in retirement for the owners and their spouses. Granted, Social Security may be in jeopardy in the long run; however, if a qualified individual is disabled, Social Security is a possible income source, even when one is living.
Speaking of disability, a producer in the upper Midwest emailed me a number of years ago concerning his inability to obtain disability payments as a result of infrequently showing a profit. I suggested that he conduct an accrual analysis over five years using adjustments for inventory, accounts receivable, prepaid expenses, accounts payable, and accrued expenses. These accrual adjustments resulted in profits and he was able to receive disability payments. I received a big thank you from this producer!
Another mismanagement of the Schedule F is commingling business and personal expenses. Again, this practice can distort the true profitability of the business, which is often used in appraisals, in estate and transition plans, and when obtaining credit.
Finally, with the tax law changes and the tax wave that is most likely going to occur, we will likely see an increase in deferred tax obligations, particularly in the sale or partial sale of assets. In the end, the tax man will come, which can have implications in the continuation of the business, especially in farm business transitions.
Does this article suggest two sets of the books? Some producers keep cash basis financials for tax reasons and accrual-based financials for management decisions, which can be useful for both the lender and producer to provide a true assessment and transparency of business performance.
Source: Dr. David Kohl, which is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.