CONTENTS

Historical Perspective ............................... .2

Member Equity .................................... .4

Meeting the Capital Needs of Cooperatives ........ .4

Types of Member Equity ....................... .5

Forms of Allocated Equity ..................... .6

Base Capital Plan .................................. .8

Equity Redemption ................................. .9

Revolving Fund Considerations ................. .9

Special Equity Redemption Programs .............lO

Measuring Equity Performance ................. .ll

Debt Capital ..................................... .12

Short-term Debt ............................ .12

Long-term Debt ............................ .14

Sources of Debt ............................. .15

Cooperative Taxation .............................. .17

The Future of Cooperative Finance .................... .19

Appendix A - Glossary of Terms ..................... .22

Appendix B - Sample Financial Statements ......... w ... .24

Note: The material on cooperative taxation is presented only to provide information to

persons interested in the tax treatment of cooperatives and does not represent omcial policy of the U.S. Department of Agriculture, the Internal Revenue Service, the U.S.

Department of the Treasury, or any other Government agency.

Cooperative Information Report 1, Section 9

Issued February 198 1, revised July 1995
tures of

ments u

Cooperative

Financing

and Taxation

The field of cooperative finance is very specialized. The feaa cooperative make its fi

nique and, consequently, n

ancial

.ot we1

characteristics

1 understood by

and require-

’ many in the

financial community. Despite this, the general rules of finance apply

equally to cooperatives as well as any other business enterprise.

Specifically, a cooperative must have adequate equity capital and

maintain sufficient cash flow to service its debt.

The most unique feature of a cooperative, compared with

Investor Owned Firms (IOFs), is that a cooperative is organized by

and for its member/patrons. Its members are both the owners and the

primary users of the business. Members receive the benefits of the

organization and provide the risk capital to operate the business. In

an IOF, an investor is not necessarily a user of the firm’s products

or services.

Most farmer cooperatives begin as small businesses. Members

supply most of the startup capital to minimize the initial need for

borrowed capital. As the organization grows, however, the business

usually expands faster than the ability of members to meet the additional demand for capital. At this point, cooperatives may begin to rely

more heavily on debt to finance growth. As a cooperative’s business

grows, financial decisions become more and more important as a

key factor in the success or failure of the organization.

Many cooperatives today are very large businesses, with millions and even billions of dollars of revenue. Their operations sometimes span large multi-State territories and may even involve buying and selling in international markets. Financing modern

cooperatives can be a very complex undertaking.

1
This publication provides an overview of cooperative finance

and the characteristics of cooperatives that make their financial

requirements unique. It explores both the internal and external methods a cooperative uses to finance its business. Also, a section is

included that highlights tax laws and regulations under which cooperatives operate.

Historical Perspective

Agricultural cooperatives have had a significant impact on the

agricultural economy. The number of agricultural cooperatives in the

United States peaked at more than 14,000 in 1922. Since then, the

number has steadily declined to about 4,200 in 1993 and is expected to

continue declining as cooperatives merge, consolidate, and dissolve.

Table 1 shows the number of agricultural cooperatives, by

category, at the beginning of each decade during this century.

Despite cooperatives’ declining numbers, the dollar business

volume of those remaining has generally increased (figure 1).

Table l-Numbers and types of cooperatives since 1990, by decade1

Year

Marketing

Type

Purchasing Service2 Total

1900 1,167 56 1,223

1910 4,317 358 4,675

1920 11,269 1,943 13,212

1922 (Peak) 12,473 2,155 14,628

1930 11,272 2,288 13,560

1940 7,943 2,657 10,600

1950 6,519 3,283 262 10,064

1960 5,727 3,222 214 9,163

1970 5,097 2,73 1 167 7,995

1980 3,808 2,369 116 6,293

19903 2,519 1,717 427 4,663

1

2

3

2

Sources: Prior to 1950, Cooperative Historical Statistics, CIR 1, Section 26, USDA,

ACS, Washington, DC (revised October 1987). For years 1950 and after, Farmer

Cooperative Statistics, 1993, CS Service Report 43, USDA, RDAKS, Washington, DC

(November 1994).

Service cooperatives were reclassified from marketing to service cooperatives in 1989.

Cotton ginning cooperatives were reclassified from marketing to service cooperatives in

1989.
Significantly, the dollar volume nearly quadrupled during the 197Os,

in part because of the inflationary growth in agriculture. By contrast,

business volume during the 1980s decreased because of an economic retrenchment in the agricultural sector. By the first half of the

199Os, business volume returned to a steady growth pattern.

Total assets and net worth grew steadily through 1980, but

then deteriorated somewhat in the relationship of net worth to total

assets when cooperatives became more highly leveraged. In the late

1980s and early 199Os, net worth (member equity) positions strengthened, helping cooperatives to better withstand future economic downturns in agriculture. These trends are shown in table 2.

Figure 1 - Gross Business Volume

Billion dollars

70

60

50

40

30

20

10

0

1950 1970

L

1980

Marketing

Purchasing

Service

l Farmer Cooperative Statistics, 1993, CS Service Report 43, USDA, RDAKS,

Washington, DC (November 1994).

2 Gross business volume includes intercooperative transactions.

3
Table 2-Cooperative balance sheet data, selected years’

Year

Total Net

assets worth

Net worth as a percentage

of total assets

1954

1962

1970

1976

1980

1985

1989

1993

- Million dollars - Percent

3,35 1 1,914 57

5,323 3,057 57

8,477 3,950 47

18,554 7,727 42

29,416 10,591 36

27,779 12,053 43

29,649 13,313 45

33,446 14,812 44

1 Farmer Cooperative Statistics, 1993, CS Service Report 43, USDA, RDAKS,

Washington, DC (November 1994).

Member Equity

Meeting Cooperativeq’ Capital Needs

All businesses need capital to finance assets and operations.

Businesses, including cooperatives, derive capital from two primary

sources: (1) accumulating net worth (ownership capital), and (2) borrowing (debt capital). The difference for a cooperative arises in the

characteristics of the ownership capital. In a cooperative, net worth

is often referred to as member equity.

Equity capital in a cooperative is money obtained for acquiring assets without assuming a legal obligation to repay it at a stated

time, and under stated conditions. This factor differentiates equity

from debt. Member equity is the risk capital of the organization, in that

part or all can be lost if operating results are not profitable. Equity capital also provides the basis for membership control in the cooperative.

Several guiding beliefs affect the decisions a cooperative

makes in determining its capital policy. The first addresses the sufficiency of capital. Cooperatives must maintain adequate levels of

equity capital to ensure financial viability of operations. Each cooperative must determine its adequate level, but a rule of thumb is to

have at least $1 of equity capital for every $2 of assets. Member

equity should finance at least 50 percent of the operation.

4
Second, the membership must have control over the cooperative’s future. Voting control, represented by equity ownership, must

reside with

. Thi

the membership and not with outside interests.

.rd, equity ownership should be held by the current membership of the cooperative, namely those who have patronized it

recently, such as within the past 3 years.

If these beliefs are followed, then a cooperative has met the

most important standards for ensuring that its capital program is

being properly governed in accordance with time-honored cooperative principles.

Historically, cooperatives obtained the majority of their capital from member-patrons- individuals or firms that use the cooperative to market their products, purchase goods, or obtain various services. In today’s capital- intensive agribusiness industry, however,

agricultural cooperatives rely on m.ember (equity) capital for slightly less than half of their financial resou .

rces.

Types of Member Equity

Equity capital in a cooperative occurs in two basic formsallocated or unallocated. Each type has a number of variations,

depending on how the capital is acquired.

Allocated

Allocated equity is capital recorded on the cooperative’s

books which is assigned- or allocated-on a proportional basis to

each member. The proportional allocation is based on the amount of

patronage or business the member does with the cooperative.

Allocated equity is acquired by the cooperative in several different

ways: (1) by direct member investment, (2) through a retained

age refund, or (3) through the use of per-unit retains.

patronUnallocated equity is capital not assigned or designated to

specific member accounts. It may originate from nonpatronage or

nonmember business, result from patronage income not allocated to

members, or be obtained from a special event such as a merger, acquisition, or the gain on the sale of an asset.

Unallocated equity provides several benefits to the cooperative: (1) a permanent capital base that allows greater flexibility in

returning allocated equity to members in a more timely fashion; (2)

a capital reserve that may be used in emergencies if regular capital

5
accumulation methods are hampered, and (3) a source against which

operating losses may be charged. This last benefit provides an alteraccount.

The disadvantage in unallocated equity lies in the same characteristics as its advantages- the removal of the direct link between

an individual member’s ownership in the organization and the cooperative’s equity base. Unallocated equity is still owned by members

as a group, but without the assignment of specific ownership stakes

to individuals, members might become complacent regarding cooperative decisions.

Forms of Allocated Equity

The three basic forms of allocated equity a cooperative uses

to establish its ownership capital (net worth) depend largely on historical, geographical, and commodity precedent.

Capital Stock Purchases

Many cooperatives require members to purchase a small initial amount of capital stock as proof of their membership. This

becomes the qualifying share(s) of stock, usually classified as member’s voting stock. Under the one- member, one-vote rule, each mem-.

ber owns an equal amount of voting stock, having only one vote in the

affairs of the organization, regardless of the amount of business conducted with the cooperative.

This democratic cooperative principle is very different from

an IOF where the amount of stock owned translates into the number

of votes a stockholder can cast. Some cooperatives require members

to purchase additional capital stock so the member’s investment is

maintained in proportion to the amount of business the member conducts with the organization.

As a general rule, stock in a cooperative may earn dividends

at a rate not to exceed 8 percent. This limitation follows a long-time

cooperative principle of limited returns on investment. The 8 percent is a historical level contained in many State laws. This limited

rate of return is one reason why cooperatives are not viewed as an

attractive investment for outside investors. It also keeps the focus of

the cooperative’s operations on the objective of service to members

rather than return on investment.

6
Retained Patronage Refunds

Cooperatives commonly use retained patronage refunds to

acquire member equity. Patronage refunds are the net income allocated

to members on the basis of the business they have conducted with

the cooperative during the year. Net income is the earnings of the

organization after operating expenses, taxes, and other deductions

are subtracted from total revenue.

Patronage refunds are a flexible way to obtain equity capital.

Net income may be held as capital retains or paid to members in

cash. Certain rules apply, however, if a cooperative deducts these

retains from earnings for income tax purposes. At least 20 percent

of its patronage refunds must be paid in cash if the amount retained

is to qualify for the deduction.

The amount of patronage refunds retained by the cooperative as equity capital must be allocated to the members on the basis

of use. It is either retained as equity for an unspecified period or, at

some future date, revolved back to members. The decision to retain

or repay equity is always made by the cooperative’s board of directors.

Retained patronage refunds, while a common source of equity, are not always the most reliable. The amount available is determined by the cooperative’s business success each year. In good years,

a cooperative may have a large amount of capital to retain. In poor

years, little new capital is available. Retained patronage refunds are

frequently used by

ings are generally

cooperatives also

equity source.

Per-Unit Retains

A per-unit retain is based on the physical units handled by

supply or service cooperatives because their earnmore stable from year to year. Many marketing

use retained patronage refunds as their primary

the cooperative, or established as a percentage of sales or market

value of the product. Per-unit retains are typically used by marketing

cooperatives, particularly those that use the pooling method of

accounting for their product. Because per-unit retains don’t depend

on the level of cooperative earnings, they are considered a more stable source of equity capital. Like other retains, per-unit retains are

periodically repaid or revolved to members as determined by the

board of directors.
Base Capital Plan

A number of cooperatives have adopted a capital program

that uses the features of the retained patronage and/or per-unit retain

methods. But, because of the characteristics of a base capital plan, it

provides more reliability in managing the capital needs of the cooperative.

Several characteristics distinguish base capital plans from

other capital programs;

1 .

2.

3 .

4.

Periodically, a cooperative determines the base or minimum level

of capital the business requires.

Each member’s amount of required capital is determined by how

much business was done during the base period. The base period

usually ranges from 3 to 10 years, but varies among cooperatives

depending on the type of commodity or service.

Members’ current capital requirements are adjusted up or down

at least annually to meet their proportional share of the current

capital level established by the cooperative.

If members are underinvested, base capital plans provide a systematic way to increase their capital. Likewise, capital of overinvested members is returned, either in patronage refunds or retirement

of per-unit retains, to bring their investment in balance. A base

capital plan serves as a complete equity management tool because

it acts as both an equity accumulation and redemption plan.

In calculating its required base capital, cooperatives use several different measurements. A member’s investment requirement

may be stated in terms of so much money per physical unit of product

delivered, similar to the method used in establishing per-unit retains.

Both this method and per-unit retains have drawbacks-a wide fluctuation in the volume of product handled each year creates instability. An alternative method measures the amount required based on the

dollar value of the product or commodity. The benefit gained is that

when volume is low, per-unit value can be set at a higher amount,

and vice versa. This evens out the amount retained between high- and

low-volume years when price variations may occur.

Each cooperative calculates its needs differently depending on

the type of operation and the level of capital needed to support the

business. Product cycle, investment in plant and equipment, and the

pricing volatility of the product or service involved can all affect the

cooperative’s base capital requirement. A base capital system can

be more complicated to design and administer than other types of

8
capital plans. However, its ability to provide the cooperative with

flexibility and stability in meeting its capital needs far outweighs

this disadvantage. Most importantly, a base capital plan contains an

automatic mechanism for adjusting a cooperative’s equity capital to

keep ownership in the hands of current users.

Equity Redemption

A member’s equity capital investment may be repaid after a

number of years as an equity retirement or revolvement. The cooperative’s board of directors establishes the capital retirement period

or revolving cycle. Some cooperatives may retain member equity

for an unspecified number of years.

The revolving cycle method of returning member capital is

the most common system used by U.S. agricultural cooperatives.

Although not legally obligated to repay member equity within a specified period, cooperatives often establish a target period or revolving

cycle for returning capital. A reasonable target for most cooperatives

is 5 to 10 years, depending on the type of capital acquired and the

nature of the cooperative’s operation and business cycle. The objective,

regardless of the method used for acquiring capital, is to keep the ownership and control of the cooperative in the hands of current users.

Revolving Fund Considerations

Regardless of the method used to acquire equity capital, certain considerations affect how these equities are retired. It is important to include these considerations as part of the cooperative’s overall financial plan.

A cooperative should attempt to keep its equity retirement

or revolving cycle fairly short to assure members that their investment

in the organization is worthwhile. If too long or the cooperative has

no revolving cycle, members may feel that their investment has little or no value and may be less inclined to patronize the cooperative. A cooperative should have a specific plan and objective for

retiring equities. This plan should be clearly communicated to all

members and employees.

A cooperative must retain enough in its revolving funds to

provide adequate equity financing for the business. This is impor- .

tant for two reasons. First, the equity level must be sufficient to keep

operating expenses, including interest expense, low enough for the

cooperative to be competitive. Second, lenders may establish specific equity levels to be maintained.

9
Members sometimes find it difficult to understand the various

demands the cooperative has in maintaining adequate capital. The

member’s primary interest is to have equity funds returned as quickly as possible. Every cooperative must address this difficult balancing act. A cooperative needs to establish a realistic financial plan to

accurately esti’mate its capital needs. The financial plan and the cooperative’s need for capital should be regularly communicated to the

membership.

The cooperative must determine how much of its patronage

refund, or net income, to pay ‘to members in cash. This becomes an

important part of the financial planning process. A financial plan

addresses the amount of capital to be revolved, plus other sources and

uses of capital such as expenses for plant and equipment, and required

debt repayment. Next, the cooperative’s board, based on management’s

recommendation, can determine the amount of net income to be paid

in cash and how much should be retained as capital.

One argument for paying out only the minimum amount of the

patronage refunds in cash (20 percent) is to have the present membership carry the greatest responsibility for providing the cooperative with

its current capital needs. This way, more of the oldest revolving retains

can be retired. There is also a historical basis for setting the minimum

amount of cash patronage at 20 percent. Members must pay taxes on the

entire allocated patronage refund, and the 20 percent cash payment, as

a minimum, provides money to help meet the tax liability.

Special Equity Redemption Programs

Special equity redemption plans are based on events that happen to a member, the most common being when a member dies. A

board should have a specific policy dealing with this event. A cooperative may also have a policy dealing with equity retirement when a

member reaches a certain age, such as 70, or retires from farming.

The idea is to have an established method for more timely return of

equities than under the regular redemption program. Because of the

aging membership base of many cooperatives, such a practice provides several advantages. Estates can be settled more rapidly when a

member dies. For an older member who has retired from farming, the

investment can be returned so the individual can have use of the funds.

A cooperative that has formal plans for dealing with these

situations is addressing a significant sociological condition in today’s

farm population. Early retirement of equities under these circumstances also helps keep the investment in the hands of current users.

10
Some cooperatives have policies for early equity retirement

when a member’s farming operation is liquidated by foreclosure or the

operation is sold outright, regardless of the member’s age. This keeps

the investment in the hands of current members, and for the inactive

member, provides the opportunity to have an out-of-the-ordinary

transaction settled in a timely fashion.

While these special redemption programs have appeal, the

cooperative must avoid weakening its capital position. In some cases,

a cooperative may agree to retire equities early, but at a discount

from their face or book value.

As an alternative to early retirement of equities, a cooperative

may allow members to trade equities among themselves. This is usually limited to cooperatives operating on a pooling basis. Under most

circumstances, it is permitted where member equity carries with it

some type of delivery or purchase rights for product processed or

sold by the cooperative. The advantage of permitting this type of

trading is that the cooperative’s total amount of equity is not reduced.

Measuring Equity Performance

In a competitive financial environment, the investor will seek

the maximum return available consistent with the risk associated

with the investment. In a cooperative, the same criteria do not necessarily apply. While members may expect a reasonable return on

investment, it is difficult to determine the level of return received

from the investment because of intangible benefits from membership that cannot be easily measured in financial terms. For instance,

there is the more personal aspect of doing business with the cooperative. Cooperatives also provide a way to vertically access markets to improve the profitability of the members’ operations. In addition, the cooperative may enhance the functioning of the entire

marketplace. Another intangible is the member’s equal vote in the

affairs of the association. While these are clear benefits, they are

hard to measure in terms of return on investment.

Regardless, the member should still attempt to measure the

return provided by the investment in the cooperative. One measure

may be the lower price paid on products or services purchased, or

higher prices received for commodities marketed through the cooperative compared with noncooperative competitors. A member must

evaluate the transaction price, plus the value of cash patronage refunds

and the discounted value of retains to be received in the future, to

arrive at the total return on investment.

1 1
Debt Capital

Debt capital is money borrowed with a legal liability to repay

it under stated interest rates, terms, and conditions. The primary

sources of debt capital are banks, insurance companies, bonds and

notes, and specialty lenders such as government agencies and leasing

companies. Cooperatives may also borrow money from their members

and, under certain circumstances, from nonmembers.

Many cooperatives rely on equity for less than half of their

capital requirements. Therefore, the majority of the assets are financed

by debt capital. A recommended financial standard is a one-to-one

relationship between equity and total debt. Between 1970 and 1990,

cooperatives relied more heavily on debt capital to finance their operations. But the level improved in the 1980s and the trend has continued into the 1990s. As a result, cooperatives increased their equity holdings and reduced borrowings. Cooperatives recognized that

a more conservatively financed organization could better weather

tough economic times (table 2).

Debt capital is divided into two general categories-shortterm and long-term debt. Short-term debt is repayable in 1 year or less.

Repayment of long-term debt is scheduled over the life of the loan in

periodic installments.

Short-Term Debt

Short-term debt and other current liabilities on the balance

sheet include the common sources of short-term debt, as well as several other account items. Some are less formal types of debt, but provide important sources of financing. Current liabilities usually appear

on the balance sheet in the order of payment priority based on due

dates.

Accounts Payable

Although not generally considered debt, accounts payable

(or bills due suppliers) are a form of short-term borrowing. These

“trade” payables arise when a cooperative purchases supplies or services for use in its operations. Depending on terms negotiated at the

time, this type of credit can be an alternative to short-term borrowings.

Notes Payable

Notes payable usually represent the operating loans or lines of

credit that cooperatives obtain to supplement their working capital

12
during the operating year. Most cooperatives establish an annual shortterm operating line of credit with a lending institution. This helps

manage the day-to-day cash flow. The loan commitment is usually

established as a revolving line of credit. This means the cooperative

can borrow and repay amounts throughout the year up to the limit of

the credit line. This helps the organization meet its obligations in a

timely way. The money can be used to pay for supply purchases or

make payments to members on their product deliveries in advance of

when sales proceeds are received. When product sales are made, the

cooperative uses those funds to repay its operating loan.

As an alternative to obtaining a short-term loan from a financial institution, some larger U.S. cooperatives issue commercial paper.

This unsecured note is sold in the public debt market. Only a small

number of cooperatives use this financing instrument because the

money must be borrowed in large amounts and the commercial paper

issuer must be strong financially.

Another alternative is an operating lease or short-term rental

agreement for a seasonally used piece of equipment, such as a forklift. It can be a flexible option for financing day-to-day operations.

Current Portion, Long-Term Debt

Accounting practices require that a cooperative show, as a

current liability on its balance sheet, the amount of long-term debt due

in the current year. The remainder is shown as a long-term liability.

Repayment terms and other debt conditions are explained in the notes

to the financial statements. Terms and conditions of any short-term

loans also may be explained.

Other Short-Term Liabilities

Cooperatives may have several other categories of short-term

or current liabilities such as accrued expenses and taxes payable.

Patronage Refunds Payable

“Patronage refunds payable” is a current liability account

unique to cooperatives. This amount is owed to members in cash,

based on the amount of patronage or earnings the cooperative’s board

of directors has decided to allocate.

In a marketing cooperative, which operates on a pooling basis,

this category may be called “due members.” It reflects the amount

owed for product delivered, if the amount earned exceeds the amount

advanced.

13
Long-Term Debt

A cooperative acquires long-term debt primarily to finance the

purchase of fixed assets. Long-term debt may also be used to increase

working capital for general operating purposes. Repayment is often

scheduled over the useful life of the asset being purchased-7 to 30

years. In today’s competitive financial markets, many long-term

financing instruments are available.

Long-Term Loans

Long-term loans obtained from banks and insurance companies can be structured in many different ways to serve the needs of the

borrower and the lending institution. Generally, these loans will be

granted in an amount equal to 60-70 percent of the cost or value of the

asset being financed. The cooperative provides the rest from its equity capital. Repayment is usually scheduled in annual installments

over the life of the loan. The repayment period depends on the type

of asset being financed and its useful life. For example, equipment

loans may be for 10 years while a loan to construct a building may be

repaid over 30 years.

Depending on the financial strength of the cooperative, the

lender may require certain conditions as part of the obligation. A

financially stronger cooperative may encounter fewer conditions.

Conditions may call for minimum levels of working capital, require

certain minimum financial performance standards, limit expenditures for fixed assets, and require the lender’s approval to revolve

or pay equities. This protects the lender in case the cooperative’s

financial condition declines. Short-term debt may carry fewer conditions because it is renewed annually and permits a reevaluation of

the cooperative ‘s creditworthines s.

Leasing

Lease financing can be an attractive alternative to regular

forms of long-term debt. The leasing company purchases the asset

for the cooperative to use for a specific period of time. The cooperative pays the lease company “rent” in the form of lease payments. At

the end of the lease term, the cooperative either returns the asset to the

leasing company or purchases the asset for a price set at the beginning

of the lease. Leases generally range from 3 to 7 years, depending on

the type of asset involved. Financial leases can be used for such capital items as vehicles, computers, and processing equipment.

14
Many financial institutions offer lease financing in addition

to normal long-term loans. Specialized leasing companies, however,

deal exclusively in this type of financing. The advantage in leasing is

that it does not require investing equity capital in the asset being

purchased. This compares with the 30-40 percent investment of equity capital for a regular long-term loan. Another advantage is a lower

effective interest rate because the lessor can pass on to the lessee the

tax savings realized from depreciation and other expenses.

Cooperatives that must invest in expensive limited-use assets may

also find leasing advantageous because they are not left with an

investment in equipment that may rapidly become obsolete.

In deciding how to finance the acquisition of an asset, a cooperative needs to analyze the relative advantages of using traditional

debt financing versus some type of lease arrangement. This cost comparison must consider the impact each alternative will have on the

financial return to the membership, and the long-term impact on the

cooperative’s finances.

Sources of Debt

Agricultural cooperatives use many of the same debt capital

sources as other businesses. But, agricultural cooperatives have access

to a unique source of financing not available to other businesses

through the Banks for Cooperatives and the Farm Credit Leasing

Services Corporation.

Other sources include commercial banks, insurance companies, leasing companies, and specialized financing organizations such

as brokerage companies for unique types of financing requirements

like private placements of debt and the sale of commercial paper.

Banks for Cooperatives

The Banks for Cooperatives (BCs), part of the nationwide Farm

Credit System, have been financing agricultural cooperatives for more

than 60 years and also provide substantial loans to rural utilities.

The two BCs are chartered to provide short- and long-term

credit to agricultural cooperatives of all sizes throughout the United

States.

The National Bank for Cooperatives, also known as CoBank,

ACB, is headquartered in Denver, Colorado. It also has three regional Agribusiness Division offices located in Springfield, MA; St.

Louis, MO; and Wichita, KS. As a result of merger with the

Springfield (MA) Farm Credit Bank and Bank for Cooperatives,

15
CoBank now provides funding to the agricultural credit associations

in the former Springfield district.

The St. Paul (MN) Bank for Cooperatives is the other BC.

While primarily serving cooperatives in its geographic area, this BC

is authorized to lend and provide other financial services to cooperatives throughout the country.

Through these two BCs, the nation’s agricultural cooperatives obtain financing at variable and fixed interest rates. They also

receive a wide range of other financial services, including cash investment services, letters of credit, and interest rate risk management.

In addition, CoBank finances agricultural cooperatives’ exports and

provides international banking services. The banks also provide debt

financing to the Farm Credit Leasing Services Corporation on property leased to cooperatives.

The BCs and other banks in the Farm Credit System obtain

loan funds from the sale of securities to private, public, and institutional investors in the national and international markets. Farm Credit

securities enjoy ready market acceptance and, as such, supply the

banks with loan funds at attractive prices so they can provide members flexible terms at competitive interest rates.

Because the BCs are capitalized, owned, and controlled by

their cooperative borrowers, activities are specifically tailored to

respond to their needs. The BCs reduce members’ borrowing cost

through patronage refunds. The banks accept no deposits and depend

entirely on the debt market and internal sources for loan funds.

Farm Credit Leasing Services Corporation

Farm Credit Leasing, a separate entity within the Farm Credit

System, provides lease financing to agricultural producers (mostly

for farm equipment and vehicles) and their cooperatives.The more

complex leasing services for agricultural cooperatives involve both

operating and financing leases. The size of leases may range from

automobiles or forklifts, up to multimillion dollar pieces of processing equipment or facilities. Farm Credit Leasing, with headquarters in Minneapolis, has sales offices and representatives throughout the United States.

Farm Credit Leasing is organized as a cooperative, so its

board of directors is elected by the member Farm Credit System

institutions. Members invest capital in the leasing corporation and

receive patronage refunds based on the amount of business conducted

in each of the bank territories.

16
Banking laws differ from State to State, so the financial services available to cooperatives from commercial banks vary widely. Cooperatives use them primarily for short-term operating loans. A

commercial bank generally doesn’t make long-term loans because

it obtains most of its money for lending from short-term deposit

accounts and must keep its assets liquid. Banks also provide a number of other financial services for their cooperative customers, such

as checking accounts, fund transfers, cash management and investments, and account collection services. Cooperatives may deal with

local commercial banks or with larger regional or money center banks

if their financial service requirements are more complex, such as

international trade transactions.

Insurance Companies

l Insurance companies deal primarily in long-term financing

because they have a longer investment cycle for their assets than

commercial banks. They provide cooperatives with debt capital to

purchase or construct plants and equipment. They do not offer the

variety of financial services like commercial banks, except for investment help with pension plans. They also provide insurance coverage for fixed assets and general liability.

Cooperative Taxation

Contrary to popular notion, cooperatives pay taxes. The misconception that they don’t often leads to unjustified criticism of the

cooperative method of doing business. In fact, cooperatives are taxed

much like other businesses-a single tax is paid on earnings at the

ownership level. Individual proprietorships, partnerships, and small

investor-type firms also pay tax at the ownership level. With general investment corporations, such as General Motors and IBM, earnings are taxed at both the organizational and ownership levels.

Cooperatives, like other businesses, also pay property, sales, employment, and fuel taxes.

Cooperatives use a unique method to distribute earnings so the

tax is paid at the ownership level. Most States follow Federal rules in

taxing cooperative net income, so this discussion will focus on cooperative income taxation at the Federal level.

Tax code rules for cooperatives refer to “patrons” rather than

members. Some cooperatives conduct business only with members,

17
while others may do business with both members and nonmembers. The

term “patrons” applies to both members and nonmembers who use the

services of the cooperative on a cooperative basis. As long as the cooperative correctly refunds its net income to members and nonmembers, it

can deduct these patronage refunds from income for tax purposes.

A cooperative’s net income on business conducted with or

for patrons is not taxable to the cooperative if distributed or allocated to patrons on the basis of business done with the cooperative.

This complies with rules and regulations of the Internal Revenue

Code. These rules are based on the recognition of the cooperative

operating principle of providing services at cost. Therefore, net

income refunded to patrons on a patronage basis is taxable to the

patron and not to the cooperative.

One important characteristic that distinguishes the coopera-

.

tive way of doing business is that the distribution of net margins is

made on the basis of the quantity or value of business conducted

with or for patrons. If distributions to patrons are not made in this

manner, they are not considered patronage refunds by the Internal

Revenue Service (IRS). The cooperative may not deduct them for

income tax purposes.

For example, dividends paid on capital stock are not considered patronage refunds. They are determined on a basis other than

the amount of business done with the cooperative. Financial benefits

must be distributed to patrons based on their use of the cooperative’s

services, rather than on investment, as is the case in an investorowned firm (IOF).

Another important rule is that there must be a formal obligation by the cooperative to pay net income to patrons. This obligation must exist before patronage is distributed, it must be in writing,

and the patron must have knowledge of it. Usually this obligation is

found in a cooperative’s bylaws or marketing agreement.

Patronage refunds must result from business conducted with

or for patrons. Therefore, any income the cooperative earns from other

sources cannot be included as part of the patronage distribution.

How cooperatives distribute patronage refunds also affects

their deductibility for income tax purposes. Several options qualify

under tax code rules. A cooperative may either pay all of its patronage refunds in cash, or pay part in cash and keep the rest as allocated capital retains. Regardless of the option chosen, the cooperative

must pay the patron a minimum of 20 percent of the patronage refund

in cash for the refund to be deductible.

18
Patronage refunds are evidenced to the patron as written

notices of allocation. The cooperative has 8 l/2 months from the end

of its fiscal year to make this allocation. The cooperative deducts

the allocated patronage refunds from its net income in the year they

were earned. The refunds become part of the patron’s taxable income

in the year received.

If the cooperative uses per-unit retains, the tax treatment is

similar to patronage refunds if the amount retained is taken from sale

proceeds. In this case, there is no requirement to pay 20 percent in

cash. The patron, however, agrees to include the amount of the retain

as income for the year in which it was deducted.

Allocations are classified as either qualified or nonqualified.

In a qualified allocation, the members agree to include the allocation as income for the tax year involved. Consent can also be obtained, _

through a statement on the check issued for the cash portion of the

patronage refund, which says the patron consents by endorsing and

cashing the check. The certificates issued to evidence a per-unit retain

contain a qualification clause that achieves the same result.

Some cooperatives use nonqualified allocations. In this case,

patrons do not include the allocation as part of their income at the

time of the allocation. The cooperative pays tax on the amount being

allocated. When the cooperative redeems the patronage refund or

per-unit retain to members, it claims a refund for the amount of tax

it paid when the nonqualified allocations were issued. Patrons must

include this amount in their taxable income in the year received. This

method gives the cooperative considerable flexibility in managing

its tax obligations. For example, the cooperative may use nonqualified written notices to offset tax credits available to it.

Cooperative taxation issues can be very complex. Cooperatives

must plan carefully to minimize their tax obligations because any

taxes paid represent a decrease in member equity. This reduces the

return to members and makes the cooperative less competitive.

Cooperatives often use the services of accountants and attorneys, who

specialize in cooperative taxation, to minimize this liability.

The Future of Cooperative Finance

Cooperatives continue to change the methods and resources

used to finance operations. These changes are a result of increased

competition in the financial markets, capitalization innovations,

changes in the structure of the Farm Credit System (the Banks for

Cooperatives in particular), and deregulation in the banking industry.

19
These factors will continue to play a very important role in cooperative finance. Changes in the tax laws will also continue to have an

impact on cooperative operation and decisionmaking.

Competition, enhanced by further banking deregulation,

should continue to intensify. Cooperatives are increasingly becoming

large businesses and, thus, occupy an important segment of the middle market toward which many commercial banks target their services. In a more competitive environment, product and service innovation become major marketing tools. Commercial lending institutions

are increasingly tailoring lending services to cooperatives. This has

led the Banks for Cooperatives to expand their lending services and

develop innovative products. The expertise and long history of lending to cooperatives will help the Banks for Cooperatives preserve

their position as the major financing resource for cooperatives, but

they cannot take this circumstance for granted.

The challenge to cooperatives is to continue strengthening

their financial positions and to demand the best in service and product from their lenders. The cost of that service, in fees and interest

rates charged, is a secondary consideration provided that the product

and service are delivered in a consistent and timely fashion.

Innovations in cooperative finance will continue to occur.

Cooperative leaders today bring a much broader perspective to the

way cooperative operations are conducted. Younger members and

potential members are less likely to embrace traditional cooperative

principles. Instead, they will focus on a straightforward businesslike

approach that rewards only results. Financial innovations in existence today challenge some of the traditional cooperative principles.

Examples of these innovations and how they have an impact

on cooperative principles will illustrate the significance of the issue.

For example, public stock offerings have been used in limited cases

to provide additional equity capital. This financial tool threatens the

principle of member control as do joint ventures with noncooperatives.

There are a number of successful examples of this innovation, but

it is imperative that such arrangements be structured to avoid the

loss of member control.

Another financial innovation is the use of Employee Stock

Ownership Plans (ESOPs). Member control is definitely threatened

in this situation. More importantly, the employee ownership group’s

objective to realize a maximum return on its investment is contrary

to the limited-return feature in cooperatives. The members realize

their return through improved profits from the farming operation.

20
Employees have no such opportunity.

The future holds exciting challenges and opportunities for

today’s cooperatives. Professional and conservative fiscal management, prudent ‘action by boards of directors, and timely, relevant,

and straightforward communication with members will be the keys to

success.

Author: Robert C. Rathbone/Agricultural Economist

21
Appendix A - Glossary of Terms

Allocated Equity Equity assigned by amounts to a member’s

account.

Base Capital Plan A method for providing equity where a member’s capital obligation is determined by the

member’s share of total patronage over a prescribed period. Also known as an adjusted

balances or adjusted capital plan.

Equity Capital Member investment or ownership in the assets

of the cooperative. Equal to total assets less

total liabilities. Also known as member equity, patron equity, or net worth. It is the risk

capital of the cooperative.

Investor Owned

Firm(IOF) A business operating as a profit-keeping

enterprise. Capital is obtained by issuing

shares of stock to investors who buy for the

profit-making potential. An investor-oriented business versus a user-oriented business

like a cooperative. A business firm other

than a cooperative.

Member

Member

Equity

Patron

A person or entity that has met the membership requirements of the cooperative and is

entitled to voting privileges. An owner of the

cooperative.

See equity capital.

Any person or entity with or for whom the

cooperative does business. May or may not

be a member.

22
Patronage

Refund

Per-Unit

Retain

Unallocated

Equity

Working

Capital

Net income of a cooperative allocated to a

patron in proportion to the value or quantity

of patronage (business) conducted with the

cooperative.

Equity invested in a cooperative by a patron

based on the value or quantity of products

marketed by or purchased for the patron.

Equity not assigned to a member’s

account. Tax-paid retained earnings or

reserves.

Current assets minus current liabilities.

Measurement of a cooperative’s ability to

meet its daily operational expenses from its

own cash flow.

23
Appendix B - Sample Financial Statements

For illustration, figures Bl and B2 depict a sample balance sheet and

operating statement, respectively, for a fictitious agricultural cooperative. The purpose is to show the primary components of these

documents, particularly as they relate to cooperative finance.

24
Figure Bl - Sample Balance Sheet

ABC Cooperative Association

December 3 1,19Xx

Current Assets

Cash $73,200

Accounts Receivable 123,700

Inventory 139,500

Prepaid Expenses 42.900

Total Current Assets 379.300

Fixed Assets

Land 57,300

Buildings 177,200

Equipment 92.100

Total Fixed Assets 326,600

Less Depreciation 102.500

Net Fixed Assets 224.100

Other Assets

Investments in Other

Cooperatives 57,300

Miscellaneous 22.300

Total Other Assets 79.600

Total Assets $683,000

Current Liabilities

Accounts Payable $56,400

Accrued Expenses 27,300

Notes Payable, Bank 75,000

Current Portion,

Long-term Debt 30,000

Patronage Refunds

Payable 96.500

Total Current

Liabilities 285.200

Long-term

Liabilities 150.000

Member Equity

Common Stock 30,000

Allocated Equity 159,500

Unallocated Reserves 5 8.300

Total Member

Equity 247,800

Total Liability and

Member Equity $683,000
Figure B2 - Sample Operating Statement

ABC Cooperative Association

Operating Statement, December 3 1, 19XX

Gross Sales Revenue

Less Cost of Goods Sold

$970,300

732.100

Gross Margin 238.200

Operating Costs

Salaries and Benefits

Taxes

Utilities

Insurance

Depreciation

Legal and Auditing

Miscellaneous

12,300

11,400

5,200

10,700

7,600

6.900

Total Operating Costs

Net Operating Margin

203.600

34.600

Other Income and (Expense)

Patronage Refunds, Other

Cooperatives

Interest Income

Interest Expense

Other Expense

27,500

6,300

(18,700)

( 3.400)

Total Other Income

Net Income

11.700

$46.300

Distribution of Net Income

Cash Patronage Payment

Allocated Retained Income

Unallocated Reserves

$9,300

32,400

4.600

Net Income $46,300

26