CAIS CHALLENGES
POLICIES AND PROCEDURES

MODIFIED ACCRUAL CONCEPT

The most contentious issue with the CAIS program is how to deal with inventory change because the measurement of income is done on the accrual basis to properly match income against expenses in a given period. This is done to properly reflect income and prevent income distortions which could generate unwarranted payments to producers by delaying sales or accelerating cash purchases.
The Modified Accrual Concept for inventories employed by the CAIS program is not one used in Generally Accepted Accounting Principles. The Modified Accrual Concept (MAC) does not recognize the change in price of opening inventories affecting income in a current year. The dollar change for inventories under MAC is the change in quantity for the period times the ending price. Under GAAP the dollar change for inventories is opening price times opening quantity less closing price times closing quantity.

The effect of this difference has several characteristics. Under MAC the determination of income after the inventory adjustment does not recognize unrealized losses. A product has to be sold before a loss is effected. Now you have to look back in time to realize what circumstances developed this concept. MAC was incorporated in the original farm income disaster program which was developed due to the disastrous hog prices of the fall of 1998. The concern at that time was that that hog prices could rebound in the next fiscal year, as has happened in the past, and producers would collect large program payments and also collect recovered prices on inventory. At the time, this was envisioned by many as a one shot disaster program but the MAC concept stayed around and has morphed into the beast we have today.

The issue of inventory change should be broken down into its various components. Many producers are familiar with financial statements being prepared with inventory prices at fair market value. However this is not really conforming to GAAP. GAAP rules state that inventories are to be stated at cost. The real purpose of the inventory adjustment is to transfer the cost of purchasing or producing inventory from a prior accounting period to the period in which it is sold. This properly will reflect the profit for the period of income realization. The difficulty with farming is to practically determine cost for items produced as a result of a biological process.

When financial statements are prepared, many are done using fair market values and some are done using an estimated standard cost. Using fair market values for both opening and closing amounts may have the effect of incorporating an unrealized profit from a prior period into a cost for a current, possibly claim year. The effect of MAC when market prices are generally above the cost of produced items is not penalizing compared to using GAAP concepts. And this point is where the discussion needs to be broken down between those who want to be compensated for lost income due to marketing decisions that could have been implemented to realize their unrealized profits, and those who want to see at least all the costs incorporated into the income calculation of the CAIS program and at least the costs of a farm stabilized.

Let me show you in the following table, which assumes no quantity changes, where MAC fails miserably and leaves farmers with stranded costs that are never incorporated in the income calculations for a current claim year. The current economic environment in many sectors of farming is one where the fair market value of inventory is less than its cost. (I'll come back to this point later.) When there is a major shift in market prices as what has happened to beef cattle or recently to grains and oilseeds from market values above costs to values materially below cost, the difference between the cost of opening inventories (remember we're trying to use GAAP) and the realized value which is below cost, is lost and never recovered when sales occur.

For example, take a look at the corn producers best customer, the livestock farmer. Lets assume a common scenario where a beef feedlot buys a short keep steer in the fall for $1000.as what happened in 2002. By year end 2002 it may have had a fair market value of $1200.There is a year end inventory adjustment at year end to match the expense to when the animal is sold which can be done at cost or fair market value as shown in Table 1 as the opening $1200 value for 2003 (Period 1).
In 2003 there was a major decline in the price of cattle. Assume the steer is then sold for $500 and a replacement is bought for $400. Under MAC, since inventory quantity has not changed from start to end of year, the inventory dollar change is zero. Under GAAP the dollar change at cost is $600. Costs have been understated by $600 and never get incorporated into CAIS calculations. There is a remote chance of capturing the costs in the future if costs rise but then you have a timing mismatch to when income realization occurs.

You can see in the accompanying Table that in the program claim year, Period 1, net income using MAC is overstated or conversely costs are unstated. This has had huge ramifications in the beef feedlot industry where the stranded inventory costs of feed and feeder cattle have never been included in CAIS calculations and will never be made up in the future. You can also see in the Table that neither GAAP using cost nor MAC compensates for possible price recovery as shown in Period 2 (Price Recovery). At least GAAP recognized the cost in Period 1. MAC may attract some theorists as long as market prices fluctuate above cost, however it misses the mark with today's markets.


The same issues apply to grains and oilseeds. Take corn, which at the start of 2004 had a market price of approximately $160 per tonne. For arguments sake let's say the production cost is $140 per tonne. Today's market price is about $90. per tonne. GAAP using cost would recognize a loss of $50 per tonne in 2004 for the corn on hand at the start of the year. MAC will not recognize any loss if quantities haven't changed and you will never recover the lost costs ($50.) of growing 2003 corn on hand at the start of the year.

The net affect of this accounting methodology is to grind down losses in a current claim year and never let you rebuild margins for future reference periods. Not only does the CAIS program run the risk of stabilizing a downward trend in farm incomes it accelerates the decline in reference margins.

The counter arguments to this discussion, when talking to government economists, is that there are trade issues involved and they don't want to be seen subsidizing prices. Well there' s a bit of a consistency problem to this argument. When market prices are above cost for commodities, CAIS is still subsidizing prices, it's just that they have decided to subsidize at the year end price only instead of both beginning and year end prices. When market prices are below cost the CAIS program is neither subsidizing prices nor capturing all the relevant costs.

When much of Canadian agriculture is experiencing commodity prices below cost, it is quite evident why the CAIS program is failing to deliver the income support expected.

There is also the little problem of program fairness between those farmers who file their income tax on the accrual basis compared to those on the cash basis. CAIS allows those on the accrual basis to capture all the price declines on inventory in the income calculation. Although there are significantly fewer of these farms than those on the cash basis, these farms tend to be the larger farms and can do quite well under this program for income stabilization.

So what do you do to protect yourself from program deficiencies since it is "the only game in town". The simple solution is don't own inventories at year-end! This will synchronize the production cycle which has the costs, with the marketing cycle which realizes the income. This happens naturally with many vegetable and hort farms that don't store inventory over year-end. It is very difficult for livestock farms which are at a distinct disadvantage since they often have very high inventories at year-end relative to their sales and are very vulnerable to MAC in a year of massive price decline.

However all is not lost for grains and oilseeds producers. After discussions with your accountant you may want to change your fiscal year end to that time of the year when inventories are lowest. It may be worth the cost of incorporation since non-calendar fiscal year ends are not practical for proprietors or partnerships. Another tactic is to sell your crops before year-end and take a commodity futures position if you wish to remain price exposed.

Another action to seriously consider is to switch to accrual accounting for tax purposes. Many farms have such huge loss carry forwards that this might be accomplished without paying tax on deferred income. CAIS administration is married to the idea of matching income and expenses as reported for tax. Therefore any inventory decline is included in the CAIS calculations and MAC is not used. As one observer pointed out, producers are going to collect from CAIS on average one every two years. You are going to be either above or below your average reference margin. It may be a very worthwhile consideration to pay tax at 18.6%, if incorporated, when you are profitable and collect from CAIS at a minimum of 50% and possibly 80% of any income decline on your reference margin. Remember the reference margin, when calculated, is a much higher base number than that used in the calculation of taxable income, which includes all the non-allowable CAIS expenses and amortization of capital assets.

One of the objectives of any government income stabilization program is to minimize the influences on producer behaviour. Once people catch on, and if the current rules on inventory changes are not modified, this will stimulate more business changes at the farm level than anyone would have dreamed of. Producers know the industry has lost millions that have not been brought into consideration in the CAIS calculations. I believe the governments know this as well, since they were embarrassed enough to provide a "top up" to 2003 CAIS payments.

To its credit the federal government has commissioned a study which is due shortly on the methodologies of accounting for inventories for the CAIS program. I hope this will be a public document which will lead to a thorough discussion and better understanding by all stakeholders to this program.

REFERENCE MARGINS AND "OLYMPIC" AVERAGES

A change to the CAIS program from the Income Disaster Programs was the mandatory use of the "Olympic" average calculation and the fact that data in the reference years is by default, allowable cash incomes and expenses only. This can lead to situations which are problematic in some circumstances.

With theses two concept being employed together it is not hard to manipulate the reference margin. This was pointed out as a moral hazard in one study by the George Morris Centre. In a good year if a producer were to defer sales into the next year his calculations for the current program year would not generate a claim because the accrued inventory adjustment would prevent this. If sales for the inventory on hand were done in the next year, or years, the inflated sales if managed to not get dropped as a high year, will raise the reference margin by 33% of whatever the deferred amount. This will give you "topped up" margin protection for a really bad year. By not using accruals in the reference period years, cash income may be highly variable. Spreadsheet calculations bear out the fact that the higher the cash income variability, the higher the reference margin will be, even though accrued income will vary much less. This only really works if the year of deferred income gets dropped as a low year in the calculations.

This fact can easily work against you and has ramifications for grains and oilseed producers in 2004. Some producers will have low cash sales this fall due to a number of reasons. Some may have elected not to sell hoping for price recovery. Some may have corn still in the field due to high moistures and drying costs. If your cash income is low for 2004,but not low enough to get dropped from the Olympic average calculation which will determine coverage for 2005, this will drop your reference margin and your CAIS support level by 33% of foregone sales. This is because the calculations for historical reference periods are done on the cash basis. When filing your 2005 CAIS information have your accountant review whether it may be advantageous to elect to supply accrual information for the reference years to support as high a reference margin as possible for the probable dismal prices for the 2005 crop.

Returning to the issue of "Olympic" averages, the comparison of the income information of the current program year which is calculated on a flawed accrual basis to a historical average of probably disconnected years on the cash basis is comparing apples to oranges. There is an old accounting maxim that cash over a long enough period of time is accrual. The employed methodology of comparison prevents a reasonable calculation. A calculation in this manner on a mandatory basis, when not even called for in the trade agreements, leads to outcomes which quite bluntly are nonsense.

The "Olympic" average may be useful on an optional basis in some limited circumstances. However, using a five-year average with accrual in the reference periods will give a more accurate and representative average, even for expanding farms. This option should never have been removed from this program.

STRUCTURAL CHANGE ADJUSTMENTS

Structural change adjustments are a component of the CAIS program to assist giving a fair and representative income comparison when the physical attributes of the farm production unit marketedly change. Sometimes farms expand, sometimes contract or sometimes switch commodities, say from dairy to cash crop. The challenge is to provide a representative income comparison between years.

The CAIS program takes the production information from Schedule 1 of your application and for each commodity you produce derives a "margin" for each commodity unit of production based on industry averages. This number is called a "business production unit" and by the very nature of the calculation it is an accrual number.

So if your farm increased in size by 25 % in a claim year the commodity units in past years would be multiplied by 25% and this amount would be multiplied by the unit margin prevalent for that year. The amount calculated is then added to the production margin for that year and the margin adjusted up or down accordingly. The only problem is that there is now accrual numbers being added to cash numbers in the reference period producing an average subjected to an "Olympic" average selection process, being compared to a flawed accrual number in the current program claim year. Is it any wonder that people are dissatisfied with this mish mash of accounting concepts being used to determine reference margins and ultimately program benefits?

The whole concept of structural change adjustments should subjected to the same type of study as that under way for inventory adjustments. In the interim it should only be applied when reference period amounts are accrual numbers, particularly when adjustments are downsizing the reference margin and reducing a producer's calculated benefit.

Richard Wright P.Ag.
Richard worked ten years in the economics branch of Agriculture Canada and the last twenty years as an accountant at Brose & Co. Chartered Accountants in Waterloo, Ontario. He also operates a cash crop and livestock farm at Fergus, ON