Expense in Accounting, Budgeting Examples Defined Explained Capital expenditures and capital budgets. Where do expenses appear on the income statement? Expenses impact all of the major financial accounting statements, but especially the Income statement (or Profit and Loss statement, P&L, or Statement of operations). The Income statement reports financial performance for a specific time period. For profit-making companies, of course, the highest level performance measure is profit. The income statement equation shows how profits result from the period's incoming and outgoing funds: Profit = Revenues – Expenses Income statements typically include just one or a very few revenue lines, but many expense lines. Note especially that each expense line represents an expense category account (or group of accounts) from the accounting system's chart of accounts . What are the important income statement expense headings? Expense items can appear under any of the five major Income statement headings. 1. Expenses for Cost of goods sold (COGS). Cost of Goods Sold (COGS or CGS) is the total cost of acquiring raw materials and turning them into finished goods. COGS normally does not include costs which apply to the whole enterprise, or to selling, or administrative expenses. For firms outside the financial industries, COGS also excludes interest expenses and costs due to extraordinary items.

COGS for manufacturing firms usually has three parts: direct labor, direct materials, and manufacturing overhead. Firms that sell services report the costs of service delivery as Cost of Services instead of COGS. Firms selling both services and goods may instead report their direct costs for services and products as Cost of Sales. Example COGS expenses include the following: Direct materials for manufactured goods. Direct costs of service delivery (for example, direct labor). Indirect costs of service delivery. Purchase merchandise inventory for sale. Direct labor for manufacturing. IT support (when IT supports the entire organization). Depreciation for Property, Plant & Equipment assets, and other assets not solely dedicated to manufacturing or sales. Categories 2 and 3 above sometimes appear as a single heading Selling, General and administrative expenses (SG&A). And, these expenses appear on some Income statements all under a single heading "Operating expenses." 4. Financial Expenses. These are costs associated with borrowing or earning income from financial investments. Note that this category exists only for firms that are not in a financial industry. For these firms, therefore, financial expenses are incurred outside the firm's normal line of business. For firms not in financial industries, these expenses may include the following: Loan origination fees.

Interest on borrowed funds. 5. Extraordinary expenses. These are costs for large one-time events or transactions, outside the firm's normal line of business. These may include costs of: Workforce reduction, laying off employees. Sale of land, buildings, or real estate. Sale or disposal of other significant assets . Selling a business. How do expenses impact profits? It is important to know which income statement category a given expense item belongs in for at least two reasons: Firstly, the category determines which budget includes this item. Secondly, the category determines whether the expense item impacts Gross profit, Operating profit, or only Net Profit. Cost of goods sold impacts profits Gross profit is the difference between total COGS and Net sales revenues. Gross profit, of course, is an amount, expressed in currency units. Business people often find it helpful to deal instead with Gross margin, which is Gross profit as a percentage of Net Sales. The high level income statement shows Gross profit for the entire reporting firm. The firm's leaders, however, have a keen interest in "drilling down" from the high level figures. They may need especially to uncover actual Gross profits for individual products, services, and product lines.

These figures may show, for instance, that some products are very profitable while others are not. This information is crucial for effective product management and product strategy decisions. To find product Gross profits, the firm can estimate sales revenues, direct materials costs, and direct labor costs rather easily and rather directly. However, it is not always so easy to estimate "indirect" or "overhead" expenses. This is especially true when overhead or indirect activities support multiple products or product lines. Actual product overhead expenses can be very uncertain, where firms rely on traditional costing methods. In those cases, reported overhead figures often derive from allocation rules that are somewhat arbitrary. These may or may not reflect actual overhead resource usage for different products. When firms must know exactly which products are making money and which are not, they may turn instead to activity based costing (ABC). ABC calculates the so-called "indirect" and "overhead" expenses from actual resource usage metrics. Besides impacting Gross profit, COGS also impacts Income statement "Profit" results that appear below Gross profit. This means, of course, that Operating profit and Net profit reflect the impact of Cost of goods sold (or Cost of Services, or Cost of Sales).

Operating expenses impact profits The Income statement category Operating Expenses normally appears with two main sub-categories: Firstly, Selling Expenses Secondly, General and Administrative Expenses Note that some statements replace the heading "Operating Expenses" with Selling, General, and Administrative Expenses, or SG&A. In all cases, nevertheless, operating expenses are subtracted from Gross profits to produce Operating profit . Note especially that the term Operating margin refers to Operating profit as a percentage of Net sales. These expenses do not impact income statement Gross profit. This is because they appear below (after) the Gross profit line. For this reason, these expenses are sometimes called "below the line" costs. Operating expenses, however, do impact Operating profit and bottom line Net profit. Financial and Extraordinary item expenses impact profits Extraordinary expenses and Financial expenses normally appear below Operating profit on the income statement. Only when the firm operates in the financial industry, do financial expenses appear higher on the Income statement. For financial firms, these expenses may rightfully appear under "Cost of Services" or "Operating Expenses. Outside the financial industries, of course, these expenses impact only one profit result, bottom line Net profit. What are non cash expenses?

Non cash expenses are charges against earnings which exist solely for the purpose of reducing Net profit (thereby lowering taxes). They do not represent actual cash flow. Note that non cash expenses are not an income statement category. They are instead a kind of expense that can appear in any of the major categories above. Depreciation expense is probably the best known non cash item on the Income statement. Others include amortization and writing off of bad debts. Note especially that each non cash expense must also conform to the "expense" definition above: An expense is a decrease in owner’s equity caused by using up assets . Income statement depreciation is therefore rightfully called "expense," even though it does not result in cash flow. This is because a depreciation charge brings instead several other non cash actions: Firstly, a debit to a Depreciation expense account increases that account balance. Secondly, a credit to a contra Asset account, Accumulated depreciation, increases that account balance. Thirdly, on the Income statement, the book value of the asset base decreases by an amount equal to the Accumulated depreciation balance. Example income statement Expenses are center stage in daily operations, budgeting, planning, and preparing the income statement report. What are "expense" category accounts?

Organizations track and report spending by recording transactions in Expense category accounts. Accounts are the fundamental building blocks of the organization's accounting system, and the complete list of named accounts for the system is the organization's Chart of accounts . This chart lists accounts under five category headings, one of which is Expense accounts. Chart of Accounts: "Balance Sheet" accounts and "Income Statement" accounts The chart of accounts for organizations that use double-entry accounting includes the following kinds of accounts A. "Balance Sheet" accounts: 1. Asset accounts: Items of value owned for operating the business. Example: Cash on hand 2. Liability accounts: Debts owed by the business. Example: Accounts payable 3. Equity accounts: The owner's claim to business assets. Example: Owner capital Evaluation of the options available Single Double This dissertation has been submitted by a student. This is not an example of the work written by our professional dissertation writers. Introduction There are a few options for S.B. Ltd to consider getting through difficult times.

The five main options are firstly, to discontinue the Nottingham division and Leicester and Loughborough divisions could use their spare capacity to produce 60% of Nottingham’s 2010 output in addition to their own 2010 output, close the Nottingham division and outsource Nottingham’s 2010 output, to launch a major campaign for all 3 products to increase their sales, to introduce a transfer pricing system between the division and the head office to increase motivation among the staff in each division and rightsizing the organisation. Discontinuation As seen Nottingham is not making growth, in response to market forces, the first option is to discontinue Nottingham division by selling its assets and settling its liabilities and shifting production from Nottingham to Leicester and Loughborough. The discontinuation decision is a decision when the division profitability highlights the potential of unprofitable (Drury, 2010, pp.91-92). In this option, assuming that Leicester and Loughborough have some spare capacity to produce 60% of Nottingham’s 2010 output on top of their own 2010 output.

According to Drury (2010, p.92), discontinuing the Nottingham division could aid the company in eliminating cost of goods sold, and other variable costs in the division. Leicester Net Profit - Other cost such as advertising costs, distribution costs and Head Office costs remain unchanged and is not affected by the discontinuation of the Nottingham division. O’Hare (2010, Management Accounting Lecture 3) suggested other factors which will affect an organisation to discontinue a division, the division is making a loss, to identify avoidable costs or to discover other saving. Outsourcing Outsourcing option is also known as sub-contracting option has become increasingly common in organisations, which enables organisations to concentrate on their core performance while outsource other specialist their secondary activities (Collier et al, 2007, pp.220-221). In S.B. Ltd case, according to Oxford University Press (2009), outsourcing could help to get through this hard time by going on a process of business process downsizing. Outsourcing allows operations that have seasonal demands to bring in additional resources in time of needs. Other advantages of outsourcing are, outsource activities will allow S.B.

Ltd to focus on important functions without sacrificing quality or service, outsource specialist could help improve the quality and standard of the jam. It may also be able to purchase the jam more cheaply or perhaps more quickly. Assuming the outsource price for raspberry jam is 20% more then the cost of goods produced and sold for raspberry jam. Hence, the sales of raspberry jam remains the same and Leicester division and Loughborough division have spare capacity which gives them room for expansion of 30% more sales each. All other expenses remain the same for both Leicester and Loughborough divisions. This gives the Head Office a net profit of £76,000 Leicester Net Loss 76.00 On contrary to the advantages, outsourcing the jam to some specialist could lead to risk of unsatisfactory quality and standard of the jam. Other disadvantages could be leak of procedures and techniques of making the jam, outsourcing usually focuses on short-term cost-saving, and ignores the unchanged overhead burden. Major Campaign Another option is to launch a major advertising campaign for all three products to increase their sales and keep all three divisions. Advertising could boost awareness and generate demand of the sales of jams of S.B. Ltd. and hence acquiring more orders.

In the advertising campaign, assuming the advertising cost increase by 20% and it bring the sales of each product to an increase of 20% each. It simply boost up the profit of the company to £96,000. Leicester 66.00 Transfer Pricing The other option is when an organisation chooses to decentralise its divisions, transfer pricing helps decide what price to charge for in-company transactions (Collier et al, 2007, p.38-39) and as a form of promoting divisional autonomy (O’Hare, 2010, Management Accounting Lecture 8). It is useful when goods are transferred between divisions; hence, the performance measurement of each division is not prejudiced by the corporate objectives. The profitability of each business units will be affected and according to Solomon (1965 cited in Collier et al, 2007, pp.38-39), companies might take advantage of the transfer pricing which are suitable for evaluating divisional performance for the corporate interest, instead of the business units. Transfer pricing strategies and can produce substantial tax savings in addition to enhancing operational performance and improving cash flow.

In many organisations, in order to avoid de-motivating effects on different business units, negotiated prices are adopted. Say, each product is transferred to Derby division and it pays each division 70% of the sales it made from selling all the jams and yet still bare the cost of advertising, distribution and the head office costs. The local administrative expenses shall be bare by the respective divisions. Leicester 18.00 (26.00) There are downsides of transfer pricing. The political process in an organisation might affect the transfer pricing between divisions. Incorrect prices adopted can distort reported performance, by making some divisions more profitable at others expense. Opportunities exist to avoid taxes using artificial transfer prices to transfer profits from a high tax division to a low tax division. Rightsizing Rightsizing, or corporate restructuring, with the aim of reducing costs and improving efficiency and effectiveness is also one option in difficult times. Rightsizing is downsizing in the belief that an organisation really should operate with fewer personnel. The primary reason to engage in rightsizing is to make the daily operations of a business more productive. For example, a company may be able to replace assembly line employees with machines which will be quicker and less prone to error.

In addition, rightsizing increases profits by reducing the overall overheads of a business. S.B. Ltd operates a full cost (TAC) standard costing system. The standard costs set fot the year 31 March 2010 and information about future costs and selling prices are in Appendix 2. Part 2 (700) Assuming the company decided to go for the option of keeping all divisions open and launching an advertising campaign, you are required to produce a standard cost card for each product and a budget for the company showing clearly the costs attributable to each division for the year to 31 March 2011. State clearly all assumptions made.

Appendix 2 - Standard cost data Standard cost cards for the year ended 31 March 2010 (per batch of 40 jars each of 500 grams) Strawberry Jam Discounts on all fruit can be negotiated if quantities increase Labour rates per hour have been the same for the last 2 years Variable costs may rise by up to 5 % Fixed overheads may rise by between 5 and 10% Standard Cost Card A standard cost card can be defined as ‘a detailed listing of the standard amounts of materials, labour and overheads that should go into a unit of product, multiplied by the standard price or rate that has been set for each elements’ (Anon 2, 2010). A standard cost card, for example must include the price, specifications, quantity and quality of material required, as well as such factors as the period of credit allowed from suppliers, cash and quantity discounts, spoilage due to wastage and deterioration. A standard cost card demands an investigation of all contributing factors that can constitute a cost before the cost is adopted.

According to Drury (2010, p.278), standard costs are ‘predetermined costs’ and they are the target costs that should be incurred under efficient operating conditions. The standard cost card will be subjected to updating caused by revision of standards such as changes in prices, discounts, etc. Standard costing is a control system which sets standards that are ideal, expected and achievable (O’Hare, 2010, Management Accounting Lecture). Collier (2007, p.36) put forward that standard costing is a control technique which compares standard cost and all of production revenues with actual results. It is to obtain variances of each division and product (O’Hare, 2010, Management Accounting Lecture 8), which are used to stimulate improved performance and to increase motivation of staff in each division. It is a detective control used to prevent problems from reoccurring as it measures variances as it occur, thus allowing management to take necessary corrective action.

The standard cost card for the year ended 31 March 2011 (per batch of 40 jars each 500 grams) for Strawberry Jam, Raspberry Jam and Orange Marmalade are as below: Strawberry Jam 16.60 Budget The principal tool in planning is called ‘a budget’. A budget is a collection of predictions. It is an estimation of the revenue and expenses over a specified future period of time. There are three purposes of budgets as identified by Emmanuel et al (1990 cited in Collier, 2007, pp.39-40), ‘as forecasts of future events’, ‘as motivational targets’ and ‘as standards for performance evaluation’. Budget is a financial plan or qualitative statement for implementing the various decisions to be pursued during a specific accounting period, that management has made in the previous period. Collier (2007, pp.39-42) suggest that budgets provide a control mechanism through both the feed forward and feedback loops. The control mechanism in the budget is to provide a performance monitoring function to the appropriate managers who are responsible for implementing the various decisions by producing and presenting the performance reports.

According to Drury (2010, pp.8-9), the performance report provide feedback information by comparing planned and actual results. Generally, a functional budget is drawn up for each division of S.B. Ltd. These budgets are, then, merged together into a single combined statement, which is known as the master budget, of S.B. Ltd’s expectations for the future periods. The master budget consists of budgeted profit, which it is expected to convey to everyone in the organisation the part that they are expected to achieve in implementing management’s decisions. The master budget, usually, consists of a budgeted profit and loss, a budgeted balance sheet and a budgeted cash-flow statement. In order to finalised a budgeted profit and loss, other budgets for the individual divisions and produced, such as the sales budget, direct materials usage budget, direct materials purchase budget, direct labour budget, and selling and administration budget. Master Budget 15,120.00 40,320.00 It is now April 2011. The actual results for the year 31 March 2011 are in Appendix 3.

Part 3 You are required to: (a) Produce an operating statement for each division based on your own budgets. (b) Write a report to the board appraising the performance of each division using whichever indicators you feel are appropriate. You should also suggest what other information should be obtained in order to improve your appraisal. (c) Write a report to the company management accountant on whether the company should change their traditional approach to accounting for overheads to one based on Activity Based Costing. Appendix 3 S.B. Ltd - Trading results for the year ended 31 March 2011 Leicester Note Sales = Production (a) According to Anon 3 (2010) and Anon 4 (2010), an operating statement is a detailed periodic report of the financial reports or a financial statement of a firm’s operations. In many organisations, management rely on the financial and quantitative statement provided to record performance achieved by that area of the operation, for a selected budget period, for which the management is responsible (Oxford University Press, 2009). S.B. Ltd practices a decentralised control over its responsibility centres where Derby division is delegated as the controlling costs centre.

Decentralisation means there is a delegation of authority in decision making in the organisation. According to CIMA Official Terminology (Collier, 2007, pp.13-14), the financial control in divisionalised businesses is the divisional performance control by producing a budget and the monitoring of actual performance towards the budget. Each division management will carry out a significant function in analysing and interpreting financial information and will achieve the target given. Below is the operating statement for the individual division based on the budget prepared in part 2. Operating Statement for S.B. Ltd Description 91,680 25,768 Solomon (1965 cited in Collier, 2007, pp.13-14) highlighted three purposes for financial reporting at divisional level; to guide divisional managers and top management in decision making, and to enable top management to appraise the performance of divisional management. (b) TO: The Directors of S.B. Ltd From the earlier budget, the performances of all four divisions are appraised. The overall company’s performance as seen on Derby division operating statement seems to have achieved the budgeted gross profit.

However, all the other costs, such as the advertising costs, distribution costs, local administration expenses and head office costs, influence the net profit not achieving the budgeted figure. The overall sales, although did not attain the budgeted sales, did make a good number and managed to produce the goods at a much lower price compared to the budgeted figure. Operating Statement for Derby Division Description 14,000 25,768 The performance of Leicester division is seen not to be performing to the budgeted figures in the operating statement. The actual sales of the strawberry jam was just £6,000 less than thee budget and managed to pull off a noteworthy net profit, although not as expected as in the budget. According to ACCA (1988, p.54), preparing a set of costing will be a waste of time unless it has a purpose. Comparing the current period figures with the budgeted figures, in order to establish costs control and efficiency in the division and to prevent unnecessary use of services.

Operating Statement for Leicester Division Description (c) TO: The Management Accountant Traditional Costing System The traditional costing approaches were developed in the early 1900s and they are still widely used by organisations today. They rely broadly on arbitrary cost allocations. These approaches rely on an essentially arbitrary allocation of indirect costs. Such approaches do not give managers accurate product cost information; therefore, accurate production profitability calculation is not possible. The overhead rate in traditional costing approaches would typically by calculated using direct labour hours, machine hours or units. Consequently, this could lead to accurate product costs when direct costs were high and indirect costs were low. According to Collier (2007, p.60), under the traditional costing approaches, organisation production runs to obtain the lowest unit of cost production and support the mass production model that seeks economies of scale. The overhead rates calculation to the traditional costing approaches is relatively straightforward; hence, they are widely understood in the business. Although, they are relatively cheap to operate and were seen as fairly accurate until the rise of activity-based costing in 1987, many other organisations are using them after many decades.

Traditional costing approach is a systematic costing approach that prevailed before the rise of the activity-based costing in 1987. Since then, the traditional costing approaches weaknesses were fairly visible. Their reliance on arbitrary rather than cause-and-effect allocation of overheads and their inability to produce accurate product costs in multiproduct companies were very much clearer. Their failure to analyse non-manufacturing costs made it less appropriate for modern costing approach in organisations. Activity-based Costing As proposed by Professor Johnson and Kaplan in their book Relevance Lost: The Rise and Fall of Management Accounting (1987 cited in Oxford University Press, 2009), they question the widespread misconception exists that using accounting information and the inadequacy of conventional approaches arises from a lag in replacing the modern cost accounting approach. The new approach is designed with modern information and accounting systems for financial reporting and tax purposes, hence it recognises that costs are incurred by each activity that takes place within the organisation and that products should bear costs according to the activities use. In Professor Johnson and Kaplan’s method, the cost drivers are identified, together with the appropriate activity cost pools, which are used to charge costs to products.

The fundamental of this approach is the view that the forces which drive overheads, undeniably most organisational costs arise from specific activities (Miller and Vollmann, 1985, p.144 cited in Ashton, 1991, pp.52-32). As a result, overheads control must focus on the management of these activities. The purpose of the activity-based costing approach are to stabilise unit costs of production per period and the reported gross profit per unit will be comparable from one period to the other by stabilising unit costs. Comparison In this time of rapid technological change, vigorous global and domestic competition, and enormously expanding information processing capabilities, management accounting systems are not providing useful, timely information for the process control, Johnson and Kaplan (1987, pp.144-146) suggested that the activity-based costing approach has catalysed an enthusiasm for motivating every member of the business organisation to meet profit goals. Also according to Johnson and Kaplan (1987, pp.144-146), present-day critics often note that successful Japanese and German manufacturing firms use this approach.

Both traditional costing and accounting-based costing vary in their level of sophistication (Drury, 2010, p.165). The traditional systems often tend to be simple and straightforward while activity-based costing tends to be sophisticated and more accurately assigning indirect costs to cost objects. Although the traditional accounting is simpler to prepare while the activity-based costing is highly sophisticated to prepare, the activity-based costing tend to result in lower costs of errors and high level of accuracy. The downside of activity-based costing is that it is expensive to operate and they are sophisticated. However, they minimise the costs of errors which will save the company a lot in profit in the longer run. The activity-based costing extensively use the cause-and-effect cost allocations compared to the traditional costing approached extensively use the arbitrary cost allocations. Recommendation ACCA (1988, p.171) recommended that the choice between the traditional costing approaches and activity-based costing approach in budgetary control depends on the method of accounting used in S.B. Ltd’s cost accounting system. If the operating expenses were charged to the respective divisions, it would reflect the use actually made by each division. Then, the overhead costs of the divisions will be established more accurately.

Traditional cost system often report inaccurate product costs and the company tend to lose out due to over priced products, incur hidden losses due to under priced products. The benefit of activity-based costing is that when it comes to improving productivity, it opens up for a much wider array of measures or methods. By examining the activities systematically, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the customary way, but might as well lead to a reallocation of capacity to where it is needed most which will yield better productivity. The rapid pace of today’s technological change continues to shorten product life cycles, thus our company do not have the time to make cost adjustment once errors are detected. Today computer technology prices are decreasing and are more affordable, the cost of adopting and operating an activity based costing system has also decreased. Therefore, the company should adopt the activity based costing in order to facilitate cost management and improve financial management. According to Karolefski (2004, p.18) “activity based costing works better if it is kept simple”. Nevertheless, when implemented properly activity based costing yields benefits to the company, its business partners, and to consumers.

Reference O’Hare, J. 2010. Lecture Notes: Management Accounting Drury, C. 2006. Cost and Management Accounting. Sixth Edition. London: Thomson Learning Anon 1. Topic 9: ACCA – F2: Lesson 9 Relevant Costing. Online. Retrieve from: World Wide Web: [25/04/10] Drury, C. 2010. Management Accounting for Business. 4th Edition. Hampshire: Cengage Learning EMEA Collier, P. M. and Agyei-Ampomah, S. 2007. Management Accounting – Risk and Control Strategy. Oxford: CIMA Publishing, An imprint of Elsevier Oxford University Press. 2009. Oxford Dictionary of Business and Management. Oxford: Oxford University Press Anon 2. 2010. Standard Cost Card Definition. Accounting for Management. Online. Retrieve from: World Wide Web: [02/05/10] Anon 3. 2010. Operating Statement. The Free Dictionary by Farlex. Online.

Retrieve from: World Wide Web: [02/05/10] Anon 4. 2010. Operating Statement. Business Dictionary.com. Online. Retrieve from: World Wide Web: [02/05/10] ACCA. 1988. ACCA Study Text: 2.4 Cost and Management Accounting II. First Edition. London: BPP Publishing Limited Johnson, H. T. and Kaplan, R. S. 1987. Relevance Lost: The Rise and Fall of Management Accounting. Massachusetts: Harvard Business School Press Ashton, D, Hopper, T. and Scapens, R. W. 1991. Issues in Management Accounting. First Edition. Hertfordshire: Prentice Hall Karolefski, John. 2004. Time Is Money: How Much Are Your Customers Costing You?. Food Logistics.

Issue 69 p.18-2224 Establishing and Using a Farm Financial Record-Keeping System - eXtension Establishing and Using a Farm Financial Record-Keeping System Dairy July 06, 2012 Introduction For years farmers have been reporting financial information on a variety of forms for various reasons. Effective management of a farming operation today requires that records be kept so managers can make informed decisions affecting the profitability of their farms. Some lending institutions require detailed business and personal information on everything a farmer owns, as well as the status of unpaid loans. They may also require production records and an estimate of expected sales and expenses for the next year. Increasingly, regulations point toward the keeping of chemical application records and soil and water conservation plans for environmental concerns. The Internal Revenue Service (IRS) requires farmers to report cash sales, expenses, depreciation and information on government program participation. Farm records are often maintained only for IRS filing purposes. While tax records are necessary, additional information may be needed for informed management decisions. Farm business decisions that are not based on accurate farm records may lead to less profit. The efficient management of a farm operation requires sound record-keeping and record analysis.

Records are important for many reasons: Proof: The IRS can ask for proof of income, expense and inventory items reported on tax returns. Decision-Aids: Farm managers use records to construct balance sheets, cash flow and income statements, and other financial aids for making more informed decisions in such areas as machinery purchases, adding or deleting enterprises, size expansion, etc. Institutional Requirements: Some lending agencies and governmental bodies require financial and/or production records be maintained over a number of years. For example, the government farm program requires certain production and acreage records be reported and maintained by the farm owner. Also, “planning” for conservation compliance and other aspects of soil and water management essentially become historical records over time. Environmental Regulations: Increasingly, farm owners are being asked to keep records about chemical use, livestock waste applications and irrigation water use on their farms. In this publication, both hand and computerized record-keeping methods are introduced. Not all record-keeping systems allow records to be kept for all the reasons stated above. The farm owner or manager needs to decide on the system which best fits his/her farm situation. Terms in bold print are defined further in the appendix section of this publication. Record-keeping or record analysis?

Record-keeping refers to keeping, filing, categorizing and maintaining farm financial and production information. Record-keeping can be accomplished through a variety of methods, from a basic hand record-keeping method to an elaborate computerized system. Record analysis refers to evaluating farm records. The evaluation process allows a farm manager to make informed decisions based on actual (or projected) farm performance. Obviously, record analysis cannot take place without first keeping records. Therefore, establishing and using an effective farm record-keeping system for an ongoing farm operation aids in farm planning, informed decision-making and analysis of both production and financial records. Production or financial records? On the farm, there are two distinct types of records—financial and production. Financial records relate primarily to money or the financial interactions of the farm. Financial records justify or prove farm income or expense transactions. Product sales, operating expenses, equipment purchases, accounts payable, accounts receivable, inventories, depreciation records, loan balances and price information are all examples of financial records. Production records are items that relate to quantities of inputs and levels of production by enterprise and/or by resource type. They consist of crop yields, plant populations, calves born, pounds of milk produced, weaning weights, death loss, etc.

Both production and financial records are important to the efficient management of today’s farm business. When such information is accurately maintained and categorized, it can be used to produce useful decision-making information. Keeping and analyzing accurate production records are important and essential aspects of farm management; however, this publication will only address financial records. Therefore, all references to records in the remainder of this publication refer specifically to financial records. Selecting a record-keeping system Selecting a record-keeping system should depend on the expected use of the records. There is no “best” record keeping system for all situations, but, at minimum, a farm records system should: provide accurate and necessary information fit into the farm organization or framework be available in a form to aid decision-making The person responsible for keeping the records should develop a habit of regularly and accurately posting transactions. Making all financial transactions through a bank (checking) account can be useful. For an accuracy check, the monthly statement should be reconciled with the checkbook and record-keeping system. A double-entry accounting system provides the most detailed accounting of farm business transactions. A significant amount of time is usually needed to learn and implement such a system.

The simpler cash accounting system, with inventory adjustments, will suffice for most farm operations, and is an accepted method of reporting income and expenses for tax purposes. Comparing the hand and computer system The use of computers and computer software has expanded on farms in recent years. However, a hand recording system is still useful for many farmers. When selecting a record-keeping system, both hand and computer systems should be considered. Some characteristics of each are as follows: A hand system A large number of hand systems are available. One of the simplest systems involves the recording by hand of all financial transactions in a journal format. Purchase and sales activities are listed by hand as they occur. The entries show 1) the date, 2) the item involved (quantity, size, etc.) and 3) cash involved in sale or purchase. For example, figure 1 portrays a wholefarm recordkeeping system. The date and a short description of each transaction are listed first, followed by the dollar amount of each transaction under the appropriate income or expense category. The number of income and expense categories depends on the amount of specificity desired by the farm manager. Figure 2 is similar to figure 1, but adds an enterprise accounting section.

In addition to the income and expense categories, the transaction is also listed in an enterprise category. For example, the “purchased supplies” expense of $165 is first listed under the “supplies” category. But $125 of the expense is listed under “Cow/calf” expenses, and $40 is listed under “Corn” expenses. Again the number of enterprises used depends on the amount of detail desired by the farm manager. To learn how the farm business stands on a cash basis, income and expense categories can be totaled weekly, monthly or during any time period desired. The difference in the two totals is the cash balance. A number of record-keeping manuals or record books can be obtained from private or government lending agencies. Regardless of the system selected, entries should be made regularly. In addition, disciplining oneself to make every transaction through a bank checking account will ease record-keeping difficulties. Reconciling bank statements with farm records insures accuracy. Computerized record-keeping system Historically, many farm managers have found keeping and analyzing financial records a challenge. However, a number of challenges have been addressed through computerized record-keeping systems.

The advantages of using such a system depend on the expectations of the accounting system , the amount of time available to keep records and the attitude toward initial investment costs. While a computerized recordkeeping system may make entering income and expense items easier, it may also take several days to learn the computer software. There is also a cost to purchase both the computer and the record-keeping software. In a 1994 report, Pena, et. al., evaluated six computerized farm record-keeping programs. The range of prices among the six programs was $6.95 to $79.95. Each program had unique features, but all six performed the basic recordkeeping functions. Selecting a computerized record-keeping program should be done on the basis of features needed. Some programs will allow for enterprise accounting. Some programs will calculate payroll reports for employees. Many will have income tax options, but may vary on the completeness of the tax information supplied. Few financial record-keeping programs allow for production records to be kept simultaneously with financial records. For example, in many programs, sales of grain or livestock can be reported in dollars only, with no accounting for bushels or pounds. A computerized record-keeping system will not necessarily save time.

Its real advantage is in record analysis. Once the information is posted in the computer software, reports and analyses can be created, changed and printed. Computerized systems quickly and accurately sort and report a great deal of information. They can also provide monthly or annual summaries for identifying strengths and weaknesses of an operation. If a hand system can provide the detailed information required by the manager to make quality farm decisions, it may be the best choice. However, if a hand system does not give the desired level of financial information, a computerized system should be considered. Analyzing farm records Once a farm record-keeping system has been established, analyzing the records can begin. Decision-making can be greatly enhanced by analyzing both production and financial records and their impact on profitability. A number of financial analysis tools can be used when accurate and complete farm records are available. These tools include the balance sheet, income statement and projected monthly cash flow statement (including family living expenses). These three financial statements provide information for making short and long term financial decisions. Table 1. Financial Statements and List of Required Records Statement Interest Payments Depreciation Schedule The balance sheet gives the farm manager a “snapshot” of the net worth on a specific date.

The net worth is the value of all assets on the farm less the amount of money owed against those assets. Year-to-year profits are calculated on the income statement, also known as the profit/loss statement. The income statement is used to calculate net cash income, adjusted by changes in inventories and capital items. The projected monthly cash flow statement is used to look ahead to the next year of operations. By projecting a cash flow for the next year, potential cash shortfalls can be noted and appropriate changes in the farm operation can be analyzed. Table 1 was constructed to illustrate the kinds of records that go into the making of financial statements and production summaries. The left column contains the financial or production statement desired by the farm manager. The right column contains the records required to complete the statement. Records can be used for more than one statement. For example, “Debt Payments” are used in the Income Statement, Cash Flow Statement and in Income Taxes. Likewise, “Farm Income and Expenses” are used in the Income Statement, Cash Flow Statement, Enterprise Analysis and Income Taxes. Summary Keeping and analyzing farm financial records are essential to the efficient management of a farm business.

Accurate records and resulting analyses help farmers make financial and production decisions, comply with tax laws and other governmental regulations and support loan applications. Traditional hand record-keeping systems continue to work well for many farmers. Computerized record-keeping and analysis programs have been accepted and used by a number of farmers also. Developing and using a farm record-keeping system will allow the farm manager to make more informed decisions affecting the profitability of the farm. Additional information on keeping and using farm records is available through the MANAGE program of The University of Tennessee Agricultural Extension Service. Contact your local Agricultural Extension office for more information. Appendix Defining The Terms Balance Sheet - Also known as the financial statement or statement of net worth, the balance sheet provides an overall financial snapshot of the farm business on a specific date. It lists all of the assets (property) and liabilities (loans) of the business as of the balance sheet date. Income and expense records are not needed for the balance sheet. A value for each asset and the outstanding balance for each liability is given in the balance sheet.

Ideally, the balance sheet should separate assets and liabilities into current (less than one year of life), intermediate (one to seven years of life) and longterm (longer than seven years of life, mainly buildings and land) categories and should list cost (original cost less depreciation) and market value (current expected sale price) for each. Cash Accounting System - Cash accounting systems list income and expense items in a general ledger framework. Individual income and expense accounts are not used or reconciled. Enterprise analysis can be achieved, however, and inventory adjustments allow for accurate calculations of an accrual income statement. For accuracy, reconciling records back to a bank statements is important. Double-Entry Accounting System - Double-entry accounting contains individual income and expense chart of accounts. Each income or expense entry is actually entered twice, reconciling individual accounts back to the general ledger. While accurate and detailed, these systems can be tedious and time-consuming to maintain. Enterprise Accounting - Enterprise accounting requires that income and expense information be assigned to the farm enterprise that generated that income or expense. “Enterprise,” as used in this publication, refers to the different kinds of farm production. For example, a farm may have a corn enterprise and a soybean enterprise.

Enterprises may be divided within one single commodity, such as dividing a corn enterprise between no-tillage and conventional tillage fields. This division may be helpful in deciding which production system is more cost-effective for the farm. In addition, records of farm-produced feeds fed to livestock and crop acres and yields must be reported within appropriate enterprise accounts. Income may include produce grown but not sold. For example, corn grown and fed to livestock would be credited as income to the corn enterprise and an expense to the livestock enterprise. Expenses - These items include direct production expenses, fixed or overhead expenses, capital expenditures and personal and family living expenses. Basically, expenses refer to any and all money spent. Direct production expenses are also referred to as variable expenses because they vary with the amount and level of production. Feed, seed and fertilizer expenses are examples of costs that will vary as the production program changes. Fixed expenses have to be made each year regardless of the production level. That is, these expenses will be incurred whether anything is produced or not. Such items include taxes, insurance, interest and rent. Capital expenditures are for items that have a useful life of more than one year. Such items include machinery purchases, breeding stock, facilities and structures, equipment and land improvements.

Personal expenditures may also be referred to as family living expenses. These items, such as food, clothing, donations, etc., are not necessarily related to the farm operation, but do have a direct impact on the financial condition of the farm. Income - This term means money received for selling product or service(s). It includes sales of purchased, breeding or raised livestock. It also includes sales of crops, government program proceeds and proceeds from cost-share projects. Custom work by the farm owner and family members would also be included as income. In short, all income that is generated by the farm or farm family is included as income. Income Statement - Also known as the profit and loss statement, the income statement lists all expenses and income for the farm during an accounting period. In addition, the income statement accounts for changes in certain inventory items. For example, for a cow/calf operation, if heifers were held in the herd for breeding, cash income would not reflect their worth. But the change in the value of the cow herd would reflect their worth. This change in the inventory would be included on the income statement as farm revenue. Income, direct expenses, depreciation expenses, gains or loss on liquidated assets and non-farm income and expenses are included in the income statement.

Net Worth - The net worth is calculated on the balance sheet. It is the value of everything a business owns, less any loans or liabilities the business incurs. In essence, the net worth is the value of total farm assets minus total farm liabilities on a given date. Projected Monthly Cash Flow Statement - The projected cash flow statement indicates the source and amount of income and expense activities for a given period. It also shows when money will be borrowed and when it will be repaid. The cash flow demonstrates the ability to repay a loan in a timely manner. Author Information Delton C. Gerloff, Associate Professor, Agricultural Economics Robert W. Holland Jr., Assistant Area Specialist - Farm Management The University of Tennessee Agricultural Extension Service Reference Pena, Jose, “Financial Record-Keeping Software Review,” Texas Agricultural Extension Service Bulletin B-5089, Texas A&M University System, May, 1994.

PB 1540 PB1536-2M-5/95 E12-2015-00-249-95 A State Partner in the Cooperative Extension System The Agricultural Extension Service offers its programs to all eligible persons regardless of race, color, age, national origin, sex or disability and is an Equal Opportunity Employer. COOPERATIVE EXTENSION WORK IN AGRICULTURE AND HOME ECONOMICS The University of Tennessee Institute of Agriculture, U.S. Department of Agriculture, and county governments cooperating in furtherance of Acts of May 8 and June 30, 1914. Agricultural Extension Service

Question: In business accounts and financial reporting, expenses which change according to scale of performance or usage or demand are known as what?
Answer: Variable Costs