CAL Module 2: The Income Statement and Statement of Owner Equity
The Income Statement and Statement of Owner Equity
Module Outline
Objectives
Introduction to the Income Statement
The Income Statement
Entity and Timing
Cash and Accrual-adjusted Income Statements
Cash to Accrual Analysis Case Example
Cash to Accrual Analysis Test Drive
Other Adjustments
Verifying Income Statement Information
Statement of Owner Equity
Statement of Owner Equity Case Analysis
Objectives
This module will focus on the income statement and statement of owner equity which
are critical in determining sources of earnings. The specific objectives are to:
•
•
•
•
Provide an introduction to the income statement and show how it is used by
producers and lenders
Second, illustrate how one can quickly convert a Schedule F Tax statement to an
accrual-adjusted income statement using beginning and ending balance sheets.
Understand the difference between cash and accrual statements and how
accrual analysis can be used to improve lending decisions.
Reconciling the information on the income statement and balance sheet through
the statement of owner equity.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Introduction
In agricultural credit analysis and in some cases small business loan analysis, decisions
for loan requests are frequently made by using solely the Schedule F: Profit or Loss
from Farming or Schedule C: Profit or Loss from Business tax forms. However, these
statements filed for Internal Revenue Service compliance can often be misleading when
evaluating the actual performance of a business, particularly in conducting commercial
loan analysis, where much of the portfolio risk exists.
The income statement, also called the profit and loss statement, is a better depiction of
financial performance. Income statements can be prepared in-house by the
businessperson or by a bookkeeper, accountant or CPA. Generally a higher level of
accounting sophistication is needed when complex business entities or large loan
requests are involved due to higher risk levels.
An income statement is used to measure revenue and expenses during an accounting
period. For agriculture it is generally dated January 1 to December 31; however, larger
more complex businesses may have quarterly statements or different fiscal years, such
as July 1 to June 30.
An income statement differs from the balance sheet in that it reports income measured
over a period of time, rather than at a specific point in time.
The Income Statement
The income statement can be used to:
• Determine income tax payments and develop tax strategies
• Analyze a firm’s expansion or growth potential and possible acquisitions
• Examine business transition and management succession
• Evaluate the profitability of business activities or a shift in enterprises
• Justify loan repayment ability, from a business standpoint
• Assist in establishing buy-sell agreements, business organization procedures
and possible exit strategies
Just as for the balance sheet, many different formats can be used in constructing an
income statement, but regardless of the format that is used, the statement should
include two major categories: revenues and expenses. Some categories of revenues
that may be included on the income statement are:
• Realized cash revenues from the sale of agricultural commodities
• Unrealized income resulting from changes in the quantity or price of crop and
livestock inventories
• Realized capital gains from the sale of capital assets, like machinery, livestock,
land and improvements
• Income from custom work and government payments
Most income statements do not include the rental value of farm dwellings as a measure
of income. Likewise, most preparers exclude unrealized changes in the value of capital
assets from an income statement. However, changes in quantity of crop and livestock
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CAL Module 2: The Income Statement and Statement of Owner Equity
inventories are included in the income statement. The Farm Financial Standards
Council (FFSC) recommends that a charge for unpaid family labor and management
should not be included on the income statement. Also, off farm earnings should not be
included on the income statement for the agricultural business because they were not
generated through the use of business assets.
The FFSC continues to recognize both the gross revenue and value of farm production
(VFP) approaches for preparation of the income statement. Value of farm production is
a measure of the value an agricultural operation has added to products sold and is
determined by subtracting from gross revenue the cost of purchased assets that were
subsequently sold to produce all or part of the total revenues. The most common
examples are the cost of feeder livestock purchased and the cost of feed purchased.
The gross revenue approach to presenting the income statement is the most common,
but the VFP approach still has merit for certain types of operations.
Entity and Timing
Like a balance sheet, an income statement can be constructed on a business, personal,
or consolidated basis. Because of the interrelationship between a balance sheet and
income statement, the balance sheet and income statement should be constructed for
the same entity; if a balance sheet is constructed for the business only, then the income
statement should include only business revenue and expenses.
As previously mentioned, the accounting period covered by an income statement can
be any length of time. The common period used by agricultural producers is one year,
but monthly and quarterly income statements are sometimes prepared as well. For
example, large, complex vegetable and horticultural operations may utilize monthly and
in some cases weekly statements. The accounting period covered by the income
statement should coincide with the time between the beginning and ending balance
sheets.
Cash and Accrual-Adjusted Income Statements
The two basic types of income statements are cash and accrual-adjusted statements. A
cash income statement measures revenues only when received and expenses only
when paid. The cash income statement is most commonly used by the smaller
traditional and lifestyle farm or segments. Since very few producers select the accrual
accounting option for tax preparation, the Schedule F is often referred to as a cash
based income statement. See Exhibit 1 for a typical example of a cash basis Schedule
F as presented for Ted Greene. This statement is readily available since the IRS
requires it if the business generates income.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 1:
Schedule F for Ted Greene
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CAL Module 2: The Income Statement and Statement of Owner Equity
A Schedule F tax statement can be valuable if three to five years of information are
analyzed and a farm has a stable existence, with no major adjustments or changes in
the Federal tax laws, like modified accelerated depreciation rules allowed by the IRS.
This is because the shifting of revenue and expenses will generally even out over the
years. However, rules regulating the completion of the cash basis Schedule F
statement allow a producer to utilize tax strategies to defer taxes to the future. Thus, a
single cash basis Schedule F is not a “good” indicator of profitability.
The use of depreciation on cash income statements is very controversial. Some argue
that is not a cash outlay and should not be included. Others state that depreciation is
merely a method of capitalizing the cost of capital assets over the useful life and should
be included. One must be aware that methods of depreciation and tax laws can
misconstrue the interpretation of the income statement from a cash standpoint.
However, because depreciation is included on the Schedule F it is commonly used on
cash statements.
An accrual-adjusted income statement measures revenue when generated and
expenses when incurred, even when revenue and expenses are not cash. Accrual
based statements are better indicators of profitability for the operating period.
Unfortunately, accrual based statements are only normally prepared for very large and
complex businesses. Thus, lenders often have to convert the cash based information
that is provided into an accrual-adjusted income statement.
Exhibit 2 illustrates the adjustments needed to convert information reported on a cash
statement to an accrual-adjusted income statement. This method, though not perfect,
provides a practical method for making the necessary adjustments.
This accrual-adjusted statement is recommended by the FFSC and is a must for
farmers making major adjustments, like expansion or contraction, or the larger, megafarm operations. It is recommended, if at all possible, that an accrual-adjusted
statement be used to obtain a more accurate picture of the profitability of the farm
business.
In order to prepare the accrual-adjusted income statement, it is necessary to have
consistently prepared balance sheets as of the beginning and ending dates of the
income statement period. If the balance sheets do not match the accounting period for
the income statement, one must have records that document transactions, such as
sales, inventory, production, and expenses, to ascertain the differences. This can be a
time consuming and painstaking process.
After the balance sheet adjustments are made, the gains and losses from the sale of
capital assets are added to or subtracted from the net farm income from operations
(NFIFO) to calculate net farm income. The resulting accrual-adjusted net income
should be similar to what an accountant prepared accrual based income statement
would reflect.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 2:
Adjustments Needed for Conversion From Cash to Accrual Basis
Year ending 12/31/YY
Schedule F Net Cash Farm Income (Profit or Loss)
Proceeds from sales of culled breeding livestock*
+
+
Big Three
Increase in inventory (livestock & crop)
Decrease in inventory (livestock & crop)
Increase in accounts receivable
Decrease in accounts receivable
Increase in accounts/rent payable
Decrease in accounts/rent payable
+
+
+
Minor Two
Increase in prepaid expenses (investment in growing crops, supplies)
Decrease in prepaid expenses (investment in growing crops, supplies)
Increase in accrued expenses (taxes, interest, etc.)
Decrease in accrued expenses (taxes, interest, etc.)
+
+
Accrual adjusted Net Farm Income from Operations
Gain/loss from sale of farm capital assets
excluding culled breeding livestock**
Accrual-adjusted Net Farm Income
$0
$0
*Found on tax form 4797 of income tax return "normal culling practices"
** Normal capital transactions (i.e. machinery, equipment, real estate)
*** "+" increases accrual-adjusted net income, "-" reduces accrual-adjusted net income.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Big Three and Minor Two
Dean Duelke, a former banker and consultant who currently provides training to lenders
on financial and cash flow analysis, refers to the five balance sheet accounts as the Big
Three and Minor Two. These five accounts are also the same accounts that he adjusts
in order to convert accrual profits to operational cash flow.
The Big Three are:
• Inventory (crop and livestock)
• Accounts receivable
• Accounts payable
The Minor Two are:
• Prepaid expenses (supplies, investment in growing crops)
• Accrued expenses (including interest, taxes, wages, and rents)
From a management standpoint, accrual taxpayers calculate taxes considering
adjustments to these five accounts. The cash basis taxpayer calculates taxes without
adjusting for these five accounts. This is an important concern to the customer and
lender in that the cash based taxpayer defers income taxes in times of growth and
repays them in times of constriction or profit suppression. This deferred tax is like an
interest free loan from the government so it is very attractive to the borrower. This
practice is particularly detrimental to an asset-based lender, who bases the loan
decision on collateral and balance sheet position rather than cash flow and earnings.
The producer who is facing financial stress can least afford to prepay expenses or forgo
collection of receivables and sale of inventory, creating a catch-22 in cash flow.
Exhibit 2 illustrates how a change in one of the five balance sheet accounts impacts
accrual-adjusted net income. For example, an increase in livestock inventory is treated
as an increase in revenue, even if that inventory is not sold. A decrease in inventory
likewise reflects a decrease in revenue. Changes in inventory can result from price or
quantity changes individually or combined. It is important for lenders to distinguish
among the reasons for the change. This is why schedules that list quantities as well as
prices or values placed on crop or livestock inventory should accompany the balance
sheets.
Exhibits 3 and 4 show beginning and end of the year balance sheets for Ted Greene.
These statements and the Schedule F tax statement will be used to illustrate cash to
accrual analysis.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 3:
Beginning Balance Sheet
Balance Sheet
Ted Greene
As of December 31, Year XX
ASSETS
LIABILITIES
CURRENT ASSETS
Cost
Market Value
CURRENT LIABILITIES
Cost
Market Value
Cash
Savings
Marketable securities
Accounts receivable
Livestock to be sold
Crops and feed
Cash investment in crops
Supplies
Prepaid expenses
$
$
$
$
$
$
$
$
$
2,000
5,000
4,000
2,000
50,000
70,000
4,000
2,000
2,000
2,000
5,000
12,000
2,000
125,000
70,000
4,000
2,000
2,000
Accounts payable
Operating loans due within 1 year
Principal portion of long-term
debt due within 1 year
Accrued interest & expenses
Estimated accrued taxes
Accrued rents payable
Deferred tax liability on current assets
including marketable securities
$
$
6,000
50,000
6,000
50,000
$
$
$
$
20,000
12,000
10,000
1,500
20,000
12,000
10,000
1,500
Total Current Assets
$ 141,000
224,000
Total Current Liabilities
$
99,500
143,555
$
$
50,000
10,000
50,000
10,000
NON-CURRENT ASSETS
Intermediate Assets
Machinery and equipment
Cost
200,000
Acc. Dep.
80,000
Breeding stock
Cash value in life insurance
Securities not readily marketable
Fixed or Long-Term Assets
NON-CURRENT LIABILITIES
Intermediate Liabilities
250,000
$ 120,000
$
40,000
$
10,000
$
4,000
Farm real estate and buildings
Land
Buildings and improvements
Cost
100,000
Acc. Dep.
30,000
$
Total Non-Current Assets
$ 644,000
Total Assets
44,055
40,000
10,000
4,000
700,000
$ 400,000
Machinery & equipment loans
(principal due beyond 12 months)
Life insurance policy loan
Deferred tax liability on:
Machinery
Breeding stock
Long-Term Liabilities
Real estate and building loans
(principal due beyond 12 months)
Deferred tax liability on:
real estate and buildings
42,900
13,200
$ 200,000
200,000
75,900
70,000
$ 785,000
1,004,000
1,228,000
Commercial Ag Lending Curriculum
Total Non-Current Liabilities
$ 260,000
392,000
Total Liabilities
$ 359,500
535,555
Owner's Equity
$ 425,500
692,445
Total Liabilities + Owner's Equity
$ 785,000
1,228,000
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 4:
Ending Balance Sheet
Balance Sheet
Ted Greene
As of December 31, Year YY
ASSETS
LIABILITIES
CURRENT ASSETS
Cost
Market Value
CURRENT LIABILITIES
Cash
Savings
Marketable securities
Accounts receivable
Livestock to be sold
Crops and feed
Cash investment in crops
Supplies
Prepaid expenses
$
$
$
$
$
$
$
$
$
3,000
6,000
4,000
3,000
45,000
65,000
4,500
2,000
2,500
3,000
6,000
13,000
3,000
120,000
65,000
4,500
2,000
2,500
Accounts payable
Operating loans due within 1 year
Principal portion of long-term
debt due within 1 year
Accrued interest & expenses
Estimated accrued taxes
Accrued rents payable
Deferred tax liability on current assets
including marketable securities
Total Current Assets
$ 135,000
219,000
Total Current Liabilities
NON-CURRENT ASSETS
Intermediate Assets
Machinery and equipment
Cost
220,000
Acc. Dep.
100,000
Breeding stock
Cash value in life insurance
Securities not readily marketable
Fixed or Long-Term Assets
Farm real estate and buildings
Land
Buildings and improvements
Cost
100,000
Acc. Dep.
35,000
Total Non-Current Assets
Total Assets
Cost
Market Value
$
$
2,500
60,000
2,500
60,000
$
$
$
$
30,000
13,000
11,000
1,500
30,000
13,000
11,000
1,500
43,890
$ 118,000
161,890
NON-CURRENT LIABILITIES
Intermediate Liabilities
270,000
$ 120,000
$
45,000
$
11,000
$
4,000
45,000
11,000
4,000
750,000
$ 395,000
$
Machinery & equipment loans
(principal due beyond 12 months)
Life insurance policy loan
Deferred tax liability on:
Machinery
Breeding stock
Long-Term Liabilities
Real estate and building loans
(principal due beyond 12 months)
Deferred tax liability on:
real estate and buildings
$
$
40,000
10,000
40,000
10,000
49,500
15,000
$ 190,000
190,000
95,700
65,000
$ 640,000
$ 775,000
1,080,000
1,299,000
Commercial Ag Lending Curriculum
Total Non-Current Liabilities
$ 240,000
400,200
Total Liabilities
$ 358,000
562,090
Owner's Equity
$ 417,000
736,910
Total Liabilities + Owner's Equity
$ 775,000
1,299,000
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CAL Module 2: The Income Statement and Statement of Owner Equity
Cash to Accrual Analysis Case Example
In the case of Ted Greene, the Schedule F shows net cash income of $49,500. Ted
generated $4,000 from proceeds from the sale of culled breeding livestock that was not
reported on the Schedule F. Please note that the figure is based upon normal culling
procedures as any deviation could distort a particular year’s income.
Next, an adjustment is made for livestock and crop inventory. The cost basis figures are
used in this analysis; however, in both categories, the ending balance sheet for Year YY
shows a $5,000 decrease in livestock and $5,000 decrease in crop inventory. This
would equate to a $10,000 reduction in revenue generated for the year (Exhibit 5).
This is a result of the sale of inventory, which overstates cash revenue on Schedule F.
Further examination of the Big Three finds accounts receivable increased by $1,000
from the beginning to ending balance sheet. This would equate to $1,000 of revenue
generated but not received in cash for that year, thus adding to the accrual-adjusted
income.
Finally, analysis of the accounts payable and rents finds that the Greene’s reduced
payables by $3,500 during the year. This improved the net income picture from an
accrual basis by $3,500. This is because after being paid, payables show as an
expense on Schedule F, therefore overstating the expenses on a cash basis.
Breaking down the Minor Two finds both prepaid expenses and investment in growing
crops increased by $500 each or $1,000. This is an increased expense on a cash basis
statement that increases net income on an accrual basis by $1,000, again because of
the overstating of expenses on Schedule F.
The other Minor Two adjustment accounts are for the change in accrued expenses. In
this case, the increase in accrued expenses and taxes of $2,000 would reduce the net
cash income when adjusted on an accrual basis.
The final adjustment would reflect the impact of normal capital transactions. The
Greene’s sold one acre of land for $5,000 to their son Dwight. They plan to continue
this practice for the next five years. Thus, this capital transaction is not abnormal.
In this illustration, the difference between cash and accrual income was only $2,500.
From the Greene’s Schedule F, net farm income from operations was $49,500 on a
cash basis, but $47,000 on an accrual-adjusted basis and $52,000 when the proceeds
from the sale of capital assets are included.
In practice, it is common to find a much larger difference between cash and accrualadjusted measurers of net farm income, particularly in periods of change in the
business. A study done recently by the University of Illinois found the discrepancy could
often be in the range of 30 to 70 percent. Practicing lenders have discovered similar
results.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 5:
Cash Conversion to Accrual-Adjusted Income for Ted Greene
Schedule F Net Cash Farm Income (Profit or Loss)
Proceeds from sales of culled breeding livestock*
+
+
Big Three
Increase in inventory (livestock & crop)
Decrease in inventory (livestock & crop)
Increase in accounts receivable
Decrease in accounts receivable
Increase in accounts/rent payable
Decrease in accounts/rent payable
+
+
+
Minor Two
Increase in prepaid expenses (investment in growing crops, supplies)
Decrease in prepaid expenses (investment in growing crops, supplies)
Increase in accrued expenses (taxes, interest, etc.)
Decrease in accrued expenses (taxes, interest, etc.)
+
+
Year ending 12/31/YY
$49,500
$4,000
Accrual-adjusted Net Income from Operations
Gain/loss from sale of farm capital assets
excluding culled breeding livestock**
Accrual-adjusted Net Farm Income
($10,000)
$1,000
$3,500
$1,000
($2,000)
$47,000
$5,000
$52,000
*Found on tax form 4797 of income tax return "normal culling practices"
** Normal capital transactions (i.e. machinery, equipment, real estate)
*** "+" increases accrual-adjusted net income, "-" reduces accrual-adjusted net income.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Cash to Accrual Conversion: Test Drive
Now let’s see how well you grasp the concept of converting cash statements to accrualadjusted income with a “but what if” scenario utilizing the Greene Case situation. Let’s
assume the beginning balance sheet and Schedule F tax statement remain the same.
However, analysis of the ending balance sheet finds that crop and feed inventory was
$95,000 and accounts receivable was $10,000 for hay sold, but no cash was received.
They decided to prepay fertilizer so prepaid expenses now total $10,000. However, the
Greene’s accounts payable skyrocketed to $15,000. All other categories remained the
same, including proceeds from the sale of breeding livestock and the sale of capital
assets.
Are you up to the challenge? Utilize the cash conversion to accrual-adjusted income
worksheet (Exhibit 6). Analyzing the Big Three we find accrual revenue generated by
inventory was an additional $20,000, the difference between beginning and ending
inventory. Similar calculations find that the change in accounts receivable had an
$8,000 positive impact on revenue. However, the $9,000 increase in accounts payable
equates to an increased expense on an accrual basis.
Shifting to the Minor Two, the increase in prepaid expenses with the fertilizer purchases
is another positive along with the previous increase in investment in crops, which
amount to $8,500. The increase in accrued expense, i.e. taxes and interest, remain the
same $2,000 which is an expense incurred.
If you are correct in your analysis, accrual-adjusted net income from operations is
$79,000. Accrual-adjusted net farm income is $84,000. This situation illustrated how a
build up of inventory and receivables with adjustments in payables can alter the net
income picture of a farm operation that only reports cash basis Schedule F income. In
the Greene case study, the difference between cash and accrual-adjusted income is
nearly 70 percent, which can have a significant impact on financial and credit analysis.
Let’s reinforce the fact that a lender would analyze each area to determine whether the
adjustments were due to changes in the amount or valuation of the inventory. Was this
a marketing strategy or a planned expansion that necessitated increased storage of
crops to feed livestock?
On the other hand, is the receivable collectable? Was the prepayment of expenses a
strategy to reduce taxes? Is the increase in accounts payable a special six month, nointerest deal or was it because the Greene’s cash flow was challenged? This conversion
is just another tool in the agrilender’s toolkit. This quick analysis can be useful in
developing questions in a business call with Mr. Greene.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 6:
Cash Conversion to Accrual-Adjusted Income: Test Drive
Schedule F Net Cash Farm Income (Profit or Loss)
Proceeds from sales of culled breeding livestock*
+
+
Big Three
Increase in inventory (livestock & crop)
Decrease in inventory (livestock & crop)
Increase in accounts receivable
Decrease in accounts receivable
Increase in accounts/rent payable
Decrease in accounts/rent payable
+
+
+
Minor Two
Increase in prepaid expenses (growing crops, supplies)
Decrease in prepaid expenses (growing crops, supplies)
Increase in accrued expenses (taxes, interest, etc.)
Decrease in accrued expenses (taxes, interest, etc.)
+
+
Accrual-adjusted Net Farm Income from Operations
Gain/loss from sale of farm capital assets
excluding culled breeding livestock**
Accrual-adjusted Net Farm Income
Year ending 12/31/YY
$49,500
$4,000
Test Drive
$49,500
$4,000
$20,000
($10,000)
$1,000
$8,000
($9,000)
$3,500
$1,000
$8,500
($2,000)
($2,000)
$47,000
$79,000
$5,000
$52,000
$5,000
$84,000
*Found on tax form 4797 of income tax return "normal culling practices"
** Normal capital transactions (i.e. machinery, equipment, real estate)
*** "+" increases accrual-adjusted net income, "-" reduces accrual-adjusted net income.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Other Adjustments
Lending institutions have historically relied heavily on agricultural producer’s tax forms
as the primary source of information on income. Often lending institutions have used
only Schedule F as the estimate of net farm income. However, as shown in Exhibits 5
and 6, often net farm income as reported on Schedule F does not agree with the
accrual-adjusted income. That is because Schedule F does not include sales of
breeding livestock and gains/losses from the disposal of capital assets. Further,
Schedule F does not take into account the adjustments needed to arrive at accrualadjusted income.
In the example for Ted Greene, the difference between the Schedule F measure of net
farm income and accrual-adjusted net farm income is more than $2,500 in the first case,
and $34,500 in the test drive case. Because differences of this magnitude are common,
Schedule F alone is not considered an accurate and complete measure of profitability
for farming operations.
Verifying Income Statement Information
Verifying the income statement is simpler than verifying information on the balance
sheet, because federal tax laws require the filing of income-tax returns. Thus, a cash
transaction shown in a cash income statement can be verified by information contained
in the income tax return. Expense items can also be verified directly from information
contained in the income tax return. Accrual adjustments can be verified by examining
the beginning and ending balance sheets. Generally speaking, farm expenses are
more consistent, while income will vary from year to year, depending upon the
producer’s tax and marketing strategies. In some cases, agrilenders are requesting the
IRS to provide copies of what was filed rather than rely on the borrower to provide
copies because of fraudulent activities. If credit decisions are based on fraudulent
information, the lender can incur significant losses and spend a great deal of time in
court to recoup monies loaned.
If income tax returns are unavailable, verification is more difficult. If the borrower
refuses to share income tax returns, the lender should not assume that the income
statement actually presented is inaccurate. However, such a situation should concern
the lender, because failing to provide such information could be due to failure to file
income tax forms or significantly underreported income on the tax form. Whatever the
case, the lender may not wish to deal with an individual or business that has failed to
establish sound and ethical business practices. As shown in the next section, a
statement of owner equity also can be used to help verify information reported on the
income statement.
Statement of Owner Equity
As previously mentioned, a fundamental accounting relationship links a beginning and
ending balance sheet to the income statement for that period of time. This relationship
is most commonly expressed in the statement of owner equity. This statement relies
heavily on information contained in the cost basis balance sheet and the accrualadjusted income statement. A detailed Statement of Owner Equity allows one to
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CAL Module 2: The Income Statement and Statement of Owner Equity
differentiate between what portion of equity is generated as earned net worth as
opposed to capital appreciation.
The following illustration is an example of the simple version of the statement of owner
equity. Beginning cost-basis equity is $425,500, found on Exhibit 3. The balance
sheet and income statement do not directly reveal the amount of gifts and inheritances
made or received; but in most cases the borrower knows the information, and it can be
obtained with few questions by the lender. Net income on an accrual-adjusted basis
was $52,000, as shown in the conversion statement in Exhibit 5. Income tax and
Social Security payments for the year are $14,500. Net income from the farm business
of $52,000, minus $14,500 income tax and Social Security payments equals $37,500.
Jeanette’s part-time position as school accountant contributes gross non-farm earnings
of $25,000. Owner withdrawals are unknown in this example, but ending owner equity of
$417,000 is known from the ending balance sheet (Exhibit 4). Given this information,
the lender can easily compute the amount of owner withdrawals:
Quick and Easy Statement of Owner Equity
If no gifts or inheritances are paid or received, only four items make up the statement of
owner equity: beginning owner equity, net income (farm and non-farm), owner
withdrawals, and ending owner equity.
For example:
Beginning Cost-basis Equity, plus Net Income After Taxes, plus Non-farm Income,
minus Ending Cost-basis Equity, equals Owner Withdrawals.
$425,500 + $37,500 + $25,000 - $417,000 = $71,000
Statement of Owner Equity Case Analysis (Deluxe Version)
A detailed version of the statement of owner equity is illustrated in Exhibit 7. This
statement allows an agrilender to calculate family living withdrawals and changes in net
worth due to earnings or capital asset appreciation.
Let’s walk through the Greene’s situation to show how this statement can be used as an
analytical tool in credit analysis. Line A finds beginning net worth cost basis $425,500
and market value $692,445. Accrual-adjusted net farm income was $52,000. Estimated
income and self-employment tax was calculated to be $14,500 with a net farm after tax
income, line D, of $37,500. Withdrawals in total were $71,000, line E; however,
$25,000 of non-farm income was contributed toward these uses. The owner’s
withdrawal from the business was $46,000, Line G. There were no gifts or inheritance.
Thus, the Greene’s living withdrawals cause earned net worth or retained capital, line J,
to decline by $8,500, which resulted in an ending net worth on the cost basis of
$417,000.
When one analyzes market value figures, a different ending owner equity results. In
this example, three assets – marketable securities, machinery and real estate – have
differences between their cost basis and their market value. The combined differences
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CAL Module 2: The Income Statement and Statement of Owner Equity
between market value and cost basis of these assets totaled $81,000, shown on line K.
(Beginning and ending figures for each account are calculated as market value minus
cost.)
The deferred taxes calculated with new valuation and other changes during the year
finds an increase of $28,035, shown on line L. Thus, the change in valuation equity is
$52,965, line K less line L, and the ending market value net worth on the balance sheet
is $736,910. This single analysis finds that the gain in market value net worth is due to
valuation adjustments since earned net worth is actually negative. One would question
whether living withdrawals will exceed net after tax income for an extended period or
whether it is a one-time abnormality.
Hopefully you have developed an appreciation for the linkages of the balance sheet,
income statement and statement of owner equity in enriching the value of information
and subsequent credit analysis. A few adjustments on the income statement, followed
by validation of equity changes through the statement of owner equity can provide
tremendous insight into commercial agricultural borrowers’ management strategies,
motivations and practices.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Exhibit 7:
Ted Greene (Farm Business Only)
Statement of Owner Equity (Deluxe Version)
For the Period January 1, YY through December 31, YY
Cost Market
$425,500 $692,445
A.
B.
C.
Owner Equity, Beginning of Period
Net Farm Income
Less: Income and S.S. Taxes
D.
Net Farm Income, After Taxes (B - C)
E.
F.
Withdrawals for Unpaid Labor & Mgmt.
Non-Farm Income Contributed to the Farm Business
G.
H.
I.
Owner Withdrawals (Net) (F - E)
Other Capital
Less: Other Capital Distributions/Gifts
J.
Additions and Reductions in Retained Capital (D + G + H - I)
K.
Change in Difference between Market Value and Cost/Tax Basis
Marketable Sec.
Mach. & Equip.
Real Estate & Bldg.
TOTAL
L.
N.
37,500
$71,000
25,000
-46,000
0
0
-8,500
-8,500
N/A
52,965
81,000
Ending*
Beginning* Change**
9,000
8,000
1,000
150,000
130,000
20,000
290,000
230,000
60,000
449,000
368,000
81,000
Less: Increase in Deferred Taxes &
Current Assets
Machinery
Breeding Livestock
Retirement Account
Real Estate & Bldg.
TOTAL
M.
$52,000
14,500
28,035
Beginning Change**
Ending
43,890
44,055
-165
49,500
42,900
6,600
15,000
13,200
1,800
0
0
0
75,900
19,800
95,700
204,090
176,055
28,035
Total Change in Valuation Equity
(K - L for Market Only)
Owner Equity, End of Period (A + J + M)
$417,000 $736,910
* Market Value minus Cost for each account.
** Ending Value minus Beginning Values for each account.
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CAL Module 2: The Income Statement and Statement of Owner Equity
Special Thanks to our Content Reviewers for this Module:
• Dr. Freddie Barnard, Purdue University, West Lafayette, IN
• David Walker, Farm Credit of the Virginias, Staunton, VA
• Bill Henley, Colonial Farm Credit, Hughesville, MD
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