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How Good Is Your Accounting System?

Posted: October 13, 2008

Accounting is probably one of the most misunderstood concepts of our society, yet it affects the lives of virtually every person on a daily basis.

Accounting! Just the mention of the word can elicit reactions ranging from boredom to fear in people. Accounting is probably one of the most misunderstood concepts of our society, yet it affects the lives of virtually every person on a daily basis. From paying family bills to corporate accounting scandals, which have robbed millions of lifetime investments, accounting impacts individuals and society in general. Possessing some level of understanding of accounting is very important to everyone, but it is especially important to business owners. Dairy producers are no exception! Simply put, accounting is a measurement and communication process. Thinking in these terms we begin to see the importance of implementing sound accounting practices in our businesses. If our measurements are wrong because of inaccurate accounting practices, the information we communicate to others is meaningless. On the other hand, we can measure everything in sight, but if we fail to communicate it to the right people, our efforts are wasted. Accounting is information management.

There are different forms of accounting, but all conform to the previous definition in that measurement and communication are the primary objectives of each. The two forms of accounting most commonly utilized by dairy producers are tax accounting and financial accounting. Others include managerial accounting and cost accounting. Many businesses fail to venture beyond the most basic accounting function, tax accounting, which measures and communicates the information necessary for filing federal, state and local tax returns. This level of accounting has limited value in managing a complex dairy business. Tax accounting, on most dairies, is simply cash accounting, which means income and expenses are recorded when they are received and paid, respectively. No adjustments for changes in inventories, accounts payable or accounts receivable are required. A tax preparer usually handles the more complex aspects of accounting such as capital sales and purchases, depreciation and breaking interest out from total loan payments. Farm accounting systems that are simply set up for tax accounting do not provide adequate information for securing financing or management of the operation.

Financial accounting is used to measure and communicate business performance to individuals outside the business, such as lenders, investors and advisors. With the increased levels of investment on larger farms this function has become more important than ever. Increased skill levels are required to implement this level of accounting as lenders want accrual based reports, which include adjustments for inventories and changes in accounts payable and receivable. Lenders also require balance sheets and in some cases, a statement of cash flows, which documents the sources and uses of all the cash that flowed through the business.

From a tax standpoint, most farming businesses should be on a cash accounting basis. This system offers substantial flexibility in income tax planning. However, analyzing the financial performance of the business requires a more detailed picture of the financial status, which is accomplished utilizing accrual accounting. In accrual accounting systems, income is reported when “the right” to receive it has been established and expenses are reported when they are incurred. Most dairy businesses carry a level of accounts payable, which are true expenses of the operation. In addition, dairy businesses experience annual changes in inventories. If these transactions are not accounted for, the information communicated to others, both within and outside the business, is inaccurate. Modern accounting software programs enable producers to employ both systems simultaneously, thus allowing the business to reap the benefits of cash accounting for tax purposes and accrual accounting for managerial purposes.

Managerial accounting is a more advanced form of accounting. It is implemented to measure and communicate business performance to individuals inside the business for the purpose of decision-making. This is the minimal level of accounting that all dairy businesses should strive to achieve. Data is organized and reported in a manner that relates back to the management intent of the business owners. Cost accounting is a form of managerial accounting that is a level higher. Cost accounting measures and communicates information based on the costs associated with various products or processes of the business. Examples of process cost accounting include the milking center, feeding operation and dry cow management. Examples of product cost accounting might include milk production, replacements and the various crops raised. This information is used by the decision makers of the business to evaluate the impact of the various commodities raised and/or management activities on overall business performance. A good example would be the process of harvesting milk from the cows or milking center ownership and operation costs. In a managerial cost accounting system this cost could be reported and benchmarked against other farms to determine how the business compares to well-managed operations. It could be compared over time within the operation to see if management changes were effective in improving performance of the milking center.

Managing the accounting system in many dairy businesses is viewed as a boring task that is often thrust upon the person of “least resistance”. Others may take on the task and find out they enjoy it, yet they have little knowledge of basic accounting principles and practices. As a result, the chart of accounts is poorly organized, attention to detail is lacking and mistakes in data entry are made. Information supplied by the accounting system is inaccurate and useless for making management decisions. In addition, many businesses incur additional professional fees as accountants sift through the data in an effort to recreate the financial transactions of the business to ensure a reasonable level of accuracy in the information they have been hired to report. Having information that enables the business owner to make timely decisions increases the probability that the business will be profitable. Research conducted at Cornell indicated that dairy farmers who utilized a professional record keeping service were more profitable than those who did the record keeping on their own, even those using computers. They theorized that the business owners who hired outside accounting services had better information and spent more time utilizing that data as it should be utilized; to evaluate management decisions.

As dairy businesses become larger, and more complex, having accurate data on which management decisions can be based is critical to operating a highly profitable business. Penn State Dairy Alliance is once again offering a two day course to those who are responsible for handling the accounting responsibilities of the farm. The course utilizes a unique and highly effective method to teach proper accounting principles and practices to non-accountants. “Accounting Methods for Progressive Dairies” will be held at the Penn State Campus in Middletown on November 10-11, 2008. Details on the program can be found on the Penn State Dairy Alliance website at http://dairyalliance.psu.edu/education/advanced-accounting/. Past participants have not only significantly improved their knowledge of accounting principles, they have been able to successfully implement their newly acquired skills back home on the farm, enabling them to improve the information they provide to the decision makers of the business. Make the time spent on accounting worth it by practicing sound accounting practices. In the long run it could be the difference between owning a profitable dairy and working for one.

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Bradley J. Hilty
Business and Information Management Specialist
Penn State Dairy Alliance