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Roatcap Cattle Company
Roatcap Cattle Company, Ltd. (RCC) faces changing the focus of its cattle operations. The options are (1) to maintain the cattle operations at the current level, (2) to expand to 100 cows, (3) to expand to 200 cows, or (4) to get out of the cattle business altogether. RCC currently uses a cash or tax based method to account for its cattle operations, RCC has employed our accounting firm to modify, based on RCC’s approval, its accounting methods for the following four objectives: financial, cost/systems, audit, and tax.
RCC recognizes that the company may require audited GAAP basis financial statements to secure financing for future operations. The following analysis contains our recommendation regarding how to set up GAAP based financial statements, the cost accounting system to support these financials, and the audit issues related to the financials. Additionally, RCC has requested our analysis of tax issues related to the company’s options for its cattle operations.
RCC has requested the financial experts of our firm to create GAAP based financial statements for 1996. Our primary concern is how to account for the cattle as assets. We have researched the AICPA's Audit and Accounting Guide for Audits of Agricultural Producers and Cooperatives (cited as AAG-APC) and developed these recommendations.
Balance Sheet Disclosure
RCC maintains two types of cattle operations—breeding and disposition. Bulls and mature cows produce calves. Female calves are held through maturity, at which point they are also used for breeding. All cattle intended for breeding should be classified as fixed assets. Male calves are sold at six months of age. The male calves held for disposition should be classified as inventory (AAG-APC 26, 29).
RCC would expend too much time accounting for each cattle unit individually. RCC should record the cattle assets in four major asset categories: bulls, breeding cows, immature breeding cows, and male calves. Bulls should be recorded separately from the cows because (1) the market value of each bull is substantially greater than that of each cow, and (2) costs associated with bulls are different than costs associated with cows (AAG-APC). Because there are only three bulls, we suggest that each bull be accounted for individually. However, breeding cows, immature female cows, and male calves should be recorded in three asset pools, rather than each animal recorded as an individual asset.
Total costs of cattle operations should be allocated on a rational basis to establish valuation amounts for young animals. Total costs of cattle operations include costs of feed, veterinary care, medicines, labor, land and pasture rent, and depreciation of the herd and facilities (AAG-APC). The costs of immature breeding cows prior to maturation should be accumulated and capitalized (AAG-APC). The capitalization of these costs parallel the capitalization of self-constructed assets as outlined in FAS 7. Capitalization periods should be determined as outlined in FAS 34 for capitalization of interest. These capitalized costs can be allocated on a per unit basis. Part of the total cattle costs should be allocated to inventory for the male calves. This allocation is subject to the lower of cost or market (AAG-APC).
Income Statement Disclosure
The cost of males calves sold is expensed as cost of goods sold once per reporting period. However, not all calves survive to maturity or disposition. Costs of maintenance and repairs that do not improve or extend asset lives should be expensed in the period incurred and reported on the income statement. These costs can be determined using a rational allocation of total cattle costs. Normal losses may be provided for in an allowance account or included in annual cattle maintenance costs, but abnormal losses of calves should be written off in the period in which the losses occur (AAG-APC).
The breeding animals, bulls and cows, are fixed assets and thus depreciated over their useful lives. Developing female calves are not considered to be in service until they reach maturity, at which time their accumulated costs become subject to depreciation. RCC should depreciate the bulls and mature cows using the straight line method (AAG-APC 82). Depreciation expense, cost of goods sold, and revenue from calf sales should be reported on the income statement.
Other Issues / Concerns
Discrepancy exists for breeding cow and immature breeding cows' valuation and depreciation. Each developing female calf and her mother is considered to be one animal unit, until the calf reaches maturity. Under the pooling method, the developing female calf's costs are included in the mature cow's costs, thereby subject to depreciation. This contradicts the valuation and depreciation procedures outlined in the Audit and Accounting Guide for Agriculture. We suggest that immature breeding cows be recorded separately from their mothers in a separate non-depreciable asset account. Upon maturation, immature breeding cows will be transferred to the breeding cows asset pool. This transfer amount, subject to the lower of cost or market, will be determined by the rational allocation of total cattle costs (AAG-APC).
Tax Expense Disclosure
Most agricultural producers receive special tax treatment, including the right to elect to use the cash method of accounting, the right to use certain inventory valuation methods not in accordance with GAAP, and the right to deduct certain capital expenditures. This special treatment may cause discrepancies from GAAP tax calculations. This discrepancy should be recorded as deferred income taxes in the financial statements (AAG-APC 37).
Cost / Systems
Relevant Costs Associated with the Cattle Business
Cattle industry costs can be broken down into two primary areas, direct materials and overhead. First, under the current herd size, direct materials would include only the hay eaten by the cows in the winter. Since RCC is able to self-produce an average of 60 tons of winter hay, the variable cost associated with hay would be only the hay consumed by the cows in excess of 60 tons during the winter (therefore making it a step variable cost). Second, overhead would include at least these four primary drivers:
Depreciation expense on purchased cows.
Depreciation expense on capitalized cows (those self-constructed).
Land maintenance expense on land purchased in 1995.
Veterinary expenses required for routine maintenance of the herd.
Current Cost System
The current cost system is a simple cash based system that incurs all expenses as they occur, depreciating only purchased assets as required under the uniform capitalization rules of the IRS. However, by incurring all expenses as they occur, no allocation of costs exists. This means that all expenses are spread over cows with different intended uses. The primary problem is the determination of what costs must be allocated to fixed assets (and therefore capitalized) and which should be allocated to inventory (and therefore expensed as cost of goods sold).
Concepts Underlying a Possible New Cost System
The male calves sold for revenues are the only products that RCC sells and therefore must be treated as inventory when created. The cows in the breeding herd which were not purchased, but born while on the ranch from the existing breeding herd must be viewed as self-constructed assets. The intent is to use these cows for breeding and not to actually sell them. The third classification is made up of the cows and bulls purchased in order to grow the breeding herd. Like the self-constructed cows in the herd, these cows and bulls are also treated as assets because the intent is to use them to produce more male calves. However, since these animals were purchased, a basis to depreciate from is available, and does not have to be calculated in order to allocate costs over the useful life.
Cost Flow under the New Cost System
The first type of cost flow is the cost attributable to the male calves sold by the farm. Since these animals make up all of RCC’s revenues, the costs attributable to them must be expensed as cost of goods sold. These costs include the direct materials and overhead previously stated. The important distinction is that they are ordinary and necessary business expenses to produce inventory and as such should not be capitalized.
The second type of cost flow is the cost attributable to those cows self-constructed through breeding. The intended use of these cows is not to generate revenues through their sale, but to create more male calves that ultimately create the revenues. However, under the current cost system, these cows have no basis and would not be classified as assets on the balance sheet. All of the expenses related to them have been expensed as incurred leaving no basis.
A possible solution to this problem is the capitalization of all costs associated with the creation of the cows put into the cattle herd through breeding. The capitalization period would begin when the rancher has intent to breed a cow and a bull to produce an offspring. However, it is impossible to determine whether or not the offspring will be a fixed asset (cow) or a piece of inventory to be sold (male calf). Regardless of this uncertainty, the costs would be tracked. If upon birth the offspring is male, all expenses accumulated up until that point would be transferred to inventory and expensed as cost of goods sold. However, if a female cow were born, the capitalization period would continue until the cow was ready to breed (thus fulfilling its intended use). At this point of maturity, the accumulated capitalized costs would be depreciated over the estimated useful life of the cow.
*From a management viewpoint, the costs attributable to those cows in the breeding stock would be valuable information. First and foremost, a proper allocation would paint a clear picture of whether growing the breeding herd through births or through purchases is better. If the costs required to self-construct the cattle exceed those of buying new breeding cows, then the best decision would be to sell all calves (both male and female) and purchase all cows for the breeding herd. However, if it is cheaper to grow the herd through breeding than through purchases, future purchases of cows should not occur and the growth should continue through births. Second, the allocation of costs allows RCC to see exactly where costs are flowing. This will allow RCC to see any inefficiencies and determine if the ranch as a whole is profitable.
The third type of cost flow would be those expenses required to maintain the cows and bulls which were purchased and not self-constructed. First the variable costs associated with the amount of purchased hay must be accounted for. These would include the cost of hay purchased in addition to the 60 tons you can currently provide. In the case of RCC, expenses have been incurred and completely depreciated based on the five-year tax requirement. The only purchased animal that is not completely depreciated is the bull acquired in early 1997. A better approach would be to adjust the depreciation expense to be taken for this animal based on its true estimated useful life (if different than the tax life) and not its tax life. Costs that can be attributed to the purchased cows and bulls should be expensed as incurred. These are ordinary and necessary operating expenses associated solely with maintaining fixed assets already paid for.
Different Herd Sizes and Cost Flow Implications
Based on the cost flow system with direct materials and overhead, any expansion of the herd will not effect the treatment of the costs. Costs of self-produced assets would still be capitalized and inventory calves would be expensed as cost of goods sold. However, if the herd expands, current constraints require that a new step variable cost be included in direct materials and additional costs be added to the operating overhead of the cattle ranch.
If the herd expands to a size in which US Forest Service permits must be used to accommodate summer pasturing of the cows, a step variable cost of $2.00 per month per animal unit must be introduced. However, this would only effect animals in excess of the current summer capacity of 100 animal units. Unless more private land is purchased, government grazing fees must be paid on all cattle using government land. This does not mean that all animals with government permits must pay the grazing fee. If RCC is able to purchase the 70 additional permitted cows, the herd size would be raised from 53 animal units to 123 animal units. However, current summer pasturage can support 100 animal units. This means that only 23 animals will be using their permits and the remaining 47 permits (70 total permitted cows – 23 permits actually in use) could be leased to another rancher or simply held for further expansion. The costs related to the unused permits, whether subleased or not, would not be included in overhead calculations until actually put into use. This would simply be looked at as a separate gain or loss, depending on if they are subleased for a gain.
The cost of the government permits must also be included in the overhead of the cattle ranch. Since a full payment is made at the beginning of the ten-year life of the permits, the cost associated with that payment must be spread over the ten years as a prepaid asset. Every year the expense will be incurred evenly as a fixed cost of operations and added to overhead.
Another possible concern would be the current manpower constraint on RCC. Current labor can support a herd of up to 100 animal units, but anything from 100 to 200 animal units would require one additional laborer. The $800.00 estimated yearly cost of the laborer would be a yearly fixed cost put into overhead. Since ranching work is seasonal and the worker would be doing different amounts of work during different times of year, it would not be cost effective to match his wages directly with the male calves produced and sold as a direct labor cost. The worker will require the same outflow of cash regardless of the time of year and the number of calves actually produced and sold
Expansion of operations means that more fixed assets would have to be produced and or purchased. Whether this is to increase winter hay production, increased fencing due to more animals, or new equipment to streamline operations, the costs must all be allocated to the overhead rates of the animals. This operation has only one direct material, which is hay. All other costs are indirect and as such should be allocated to overhead.
Make or Buy Winter Hay
Currently, RCC has the capacity to support 100
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