FARE Blog

Food, Agriculture, and Resource Economics

Use Accrual Accounting to Better Gauge Farm Profitability

By Amanda R. Smith

Most farmers are familiar with the method of cash-based accounting. With cash-based accounting, a farmer records income when they receive a cash payment for their crops, animals or animal products. Furthermore, they record an expense when a payment is made by the farmer to the input supplier (fertilizer dealer, seed company, etc.). Cash-based accounting does not value accounts receivables and inventories as income, nor accounts payable as expenses, until cash is exchanged.

Accrual accounting, on the other hand, means a farmer records an income or expense transaction when it is incurred, regardless of when cash is exchanged. To expand on this, the accrual method records the income of the farm in the year it was produced by the farmer and also records the expenses incurred in producing that income. Accrual income can include cash from the sale of products, accounts receivables for products sold, and inventories of crops and livestock produced. Expenses measure the costs incurred to generate income for the year and may occur with or without an actual cash payment (accounts payable). Accrual accounting essentially matches income earned to expenses incurred, giving a more realistic reflection of net income for the year. Net income indicates profitability of the farm.

Cash-based accounting can be useful for managing taxes. For example, a farmer pays for his fertilizer and chemicals in October of year 1. These are considered expenses that lower taxable income in year 1. If the farmer has storage capabilities and sells their crop during January of year 2, that sales transaction will be considered taxable income in year 2 (not year 1).

The IRS allows farms to choose between cash-based or accrual accounting. A few exceptions apply; a family corporation with gross receipts over $25,000,000 must use accrual methods for taxes. Refer to IRS Publication 225, Farmer’s Tax Guide, for more information.

Despite the tax benefits of cash-based accounting, it does not give a clear picture of long-term farm financial health and profitability. Cash expenses for inputs may be pre-paid and revenues from last year’s crop might show up as income this year. This creates a lag in knowing if the farm was profitable during the year. Farmers can use cash-based accounting for tax purposes, but should also keep an accrual-based record to gauge the profitability of the farm from year-to-year.

Feedlot Conditions and Beef Prices

by Levi Russell

Any time I discuss economic conditions in the industry, I try to be as faithful as I can to forecasts and current conditions and avoid undue pessimism or optimism. The beef cattle industry from pastures to processors has had a pretty good year so far in terms of prices, international trade, and consumer demand. That said, one of the clearest threats to cow-calf producers in coming months is the potential for a slowdown in feedlot placements. Feedlot profitability (not considering any price risk management) has moved into the red recently, which will likely push feeder prices down. However, there is a more long-term issue to deal with: beef prices.

Lower Beef Prices

Based on forecasts of beef, pork, and poultry production for the next 18 months, we could see some downward pressure in beef prices. Indeed, we’ve already seen some weakness in wholesale beef prices in the last couple of months. If these trends continue, price reductions will eventually make their way to fat steers, then to feeders and, finally, calves. For cow-calf producers, the feedlot sector in particular is of concern. Feedlot placements have been significantly higher for much of this year compared with the same months in 2016. Feedlot marketings have kept pace with placements such that the number of feeders lingering in feedlots longer than 90 days has stayed relatively low. Though this is expected as beef cattle inventories have recovered over the past few years, this accelerated placement pace will not be sustainable if we start to see price weakness for fat steers.

In 2017, U.S. beef production will be at its highest level since 2010. It remains to be seen just how much beef consumers are willing to purchase, but we will find out over the next 18 months.

Planted Acres vs Base Acres

by Adam Rabinowitz

There have been some comments from policymakers regarding the upcoming farm bill and the debate between planted acres and base acres.  Here is an explanation as to why base acres have been used and the potential impact of using planted acres.

The 2014 Farm Bill contains provisions for Price Loss Coverage (PLC) and Agricultural Risk Coverage (ARC) commodity programs that are tied to a “base acreage” for which to compute payments. Base acres for a particular Farm Service Agency (FSA) farm depend on the past decisions by the farm to reflect either 1991-1995, 1998-2001, or 2009-2012 planted acres. Regardless of the specific base acreage determination, the common point among the commodity programs and farms is that base acreage is determined on historical planted acreage and not current year planted acreage. There are two main concerns over computing safety net program payments on current planted acres.

  1. Payments made on current planted acres means that newly planted acres are eligible for payments. This has the potential to distort market prices because planting decisions will be directly impacted by the eligibility for program payments. As planted acres increase, the market price will decrease, resulting in increased program payments, which may continue to perpetuate into a further increase in acreage, payments, etc.
  2. World Trade Organization (WTO) agreements contain limits on trade-distorting domestic support. When government safety net payments are tied to planted acres they would likely be reported as product specific crop commodity program payments. Product specific payments are viewed as potentially trade-distorting and thus subject to WTO limits.

Historical base acres have thus been used to mitigate the potential negative market distortion from government programs and potential violation of trade agreements. By determining safety net program payments on historical acreage, there is little (if any) incentive to make planting decisions based on the ability to receive government payments. With current safety net payments being issued in October of the following year after harvest, there is an even greater disconnect between planting decisions and government payments. Furthermore, ensuring that agricultural commodities maintain compliance with trade agreements is critical for continued expansion of demand and access to foreign markets for U.S. farmers.

Tool for Valuing Replacements

One important financial aspect of cow-calf production is evaluating replacement decisions. Whether you always hold back your own replacements or look for opportunities to expand when the price is right, it’s crucial to take an objective look at the profitability and feasibility of your investment.

To help producers with this task, we’ve developed a decision aid (available here) that will allow you to examine a range of replacement female scenarios. I recommend looking through the red triangles in the upper right corner of the key cells to get an idea of how the spreadsheet works.

Looking Ahead: Feed Costs This Fall

As we saw in 2013, corn price movements can have a big impact on steer prices. Feed prices are obviously important for feedlot operators, but they have implications for stocker and cow-calf operators as well. Recent crop condition reports and yield estimates, combined with a 3% reduction in planted acres versus last year, indicate that corn production will almost certainly be below last year’s. However, that does not doom us to higher feed costs in the coming months. There is still a lot of old-crop corn out there, indicating that the 17/18 ending-stocks-to-use ratio will be similar to 16/17. Thus, we are likely to see corn prices remain low through harvest this fall, assuming the weather holds in corn country.

Feed costs are especially important from an industry perspective this year because of drought conditions in the northern High Plains. Cattle in drought-stressed regions will likely move south early, meaning that they will be put on grass (instead of the wheat they would graze if they had come later) or will go directly to feedlots. Feedlot returns have been positive during 2017 thanks to both low feed costs and strong beef demand fundamentals. This is, of course, good for cow-calf producers and stocker operators, as positive feedlot profits have put upward pressure on calf and feeder prices as the herd has continued to expand.

For more on this topic, check out this month’s “In the Cattle Markets” publication from the Livestock Marketing Information Center.

Beef Exports to China – Webinar

Many folks in Georgia are interested in hearing about the possibility of exporting beef to China. Now that the first shipment has been made, I feel more comfortable discussing the economic impacts of this new market. The webinar, linked below, gives the details on the restrictions the Chinese government has put on the beef that they will import. As the video indicates, the restrictions are severe enough that the Chinese market will not be a major component of our exports. However, time will tell if those restrictions change or if production practices in the U.S. adapt to serve this market.

Webinar Link

First Shipment of Beef to China

I’ve been getting a lot of questions lately about opportunities for the US beef industry in China. Given the way these deals can go, I was hesitant to put a lot of faith in the  possibility of re-opening this market (after 14 years). But today we received news that Greater Omaha Packing will be shipping beef to Shanghai starting today. This represents an opportunity for US beef producers; another source of demand is certainly welcome and could help boost our already-strong international trade numbers. However, there is

However, there is reason to be cautious: Chinese officials have placed a number of restrictions on imported beef. One of those restrictions is that the location of birth of each calf must be verified. While this practice is not mandated by the US government, it could become the norm if domestic and international consumers of US beef demand it. I still think it’s a long way off, but the fact that we are now shipping beef to China under this requirement is an important development in the broader conversation of traceability.

Now is a Good Time to Lock in Profits for Spring Calves

by Levi Russell

The recent run-up in wholesale beef prices has sent cash and futures prices through the roof in the past few weeks. This provides an opportunity for producers with spring-calving herds to lock in a profit. For instance, right now producers can buy a put option on the September feeder contract at a strike price of $135/CWT for $1,375. This is relatively cheap “insurance” since we’re likely to see calf prices fall again in the near future as wholesale beef drops back down or feedlot margins are squeezed.

Today’s cattle on feed report is a good example of bad news at the feedlot level affecting marketing prospects. So far today we’ve seen a significant drop in feeder futures due to the slow pace of marketing relative to placements in April. Now is a good time to lock in profit as we’ll probably continue to see some downward pressure on feeder prices in coming months.

For more information on hedging and options, check out the following publications.

Understanding and Using Cattle Basis in Managing Price Risk
Using Futures Markets to Manage Price Risk in Feeder Cattle Operations
Commodity Options as Price Insurance for Cattlemen