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Roatcap Cattle Company

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    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.

    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).

    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.

    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).

    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).

    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.

    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.

    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.

    Currently, RCC has the capacity to support 100 cows in the summer, but only 30 cows in the winter without buying additional hay. This means that at current levels hay must be purchased from an outside party (at $80.00/ton) to support any volume of cattle above 30 during the winter months. Recently, RCC has been faced with the opportunity to expand self-produced hay in two different manners. First, RCC can buy a parcel of land that will produce an additional 100 tons of hay per year. This would bring total winter hay production to 160 tons per year. Second, RCC can install an irrigation system on current hay producing land to maximize its hay producing potential. With an irrigation system you can produce an extra 40 tons of hay per year. This would bring total winter hay production to 100 tons per year

    The choice of what combination of purchased and self-produced hay effects the direct materials in the cost flow of cows. First, if RCC decides to continue purchasing all hay and not to expand self-producing capabilities at all, the variable rate for purchased hay will be the highest of the three scenarios. No new costs will be incurred except the variable price paid for every cow past a capacity of 30.

    Second, if RCC decides to purchase the adjacent land and raise the total capacity to 160 tons of winter hay the opposite effect on costs will occur. Since RCC will be able to self-produce hay for 80 animals (160 total tons of hay per year / 2 tons average consumption per year per animal unit) the step to reach the variable cost will be 80 animals rather than 30 animals. This means that of the three options, this will produce the lowest variable cost. Since the land is not depreciable the cost of its purchase would not be included in the overhead rates of the cows. However, the lease expense is a substantial cash outflow and its total expense (including interest) must be weighed in a final decision.

    Third, if RCC decides to install the irrigation system, winter hay production will increase to 100 total tons of hay per year. This option means that only hay for a herd in excess of fifty cows (100 tons/2 tons per animal) must be purchased from an outside party. The variable cost will begin when the herd reaches fifty cows instead of the current thirty-cow threshold. Also, the costs associated with installing a well are substantially lower than purchasing the large parcel of land. This means the overhead rate will increase above its current level because the depreciation of the land must be included in overhead.

    *From a cost perspective, the installation of the well seems like the safest of the three propositions. Direct materials costs decrease (due to a raised threshold) and overhead increases only marginally. However, if RCC wants to increase the current herd size, this does not seem like the best logical decision. The parcel of 160 acres that you purchased in 1995 for $240,000 has appreciated in two years to a fair market value of $320,000. It is our recommendation that if RCC wants to expand hay producing capacities that RCC purchase the adjacent parcel of land rather than install the irrigation system. Although operating overhead will be substantially higher, land in RCC’s area seems to be appreciating rather quickly and the cost could be looked at not only as an operating expense, but a long-term investment. Regardless of what the ultimate size of your breeding herd is, the purchase of the land should be considered for investment purposes if not for hay production. If RCC chooses to install the irrigation system, appreciation is not an option. There will be maintenance costs associated with the irrigation and well; at some point in the future the system will have to be scrapped and replaced. Other than the hay that is produced, RCC receives no return on its costs.

    Additional Information Necessary to Complete the Cost System

    In order to complete the cost system, further information is necessary. First, in order to calculate appropriate depreciation, the true useful life of the cows is necessary. Right now they are depreciated over a 5-year useful life in accordance with tax law. If the true useful life is longer that number should be used in place of the five-year figure for the cost allocation system. Second, in order to make a completely accurate estimation of the make or buy scenarios, the well depth must be pinpointed exactly. The current estimates of a necessary depth between 200 and 500 feet leaves an open cost margin for this project. Third, costs associated with self-produced hay must be determined. Whether these include seed costs, or routine land maintenance, the costs must be included in the various overhead rates. Fourth, the number of male calves sold and the price they were sold would be very helpful to determine future revenues. These numbers could be compared to the cost system to determine whether or not a true profit exists. Finally, the costs related only to specific animals must be identified. Certain costs are only attributable to breeding cows (birthing costs), male calves (freight-out expense), and bulls (extra hay). These costs must be identified and separated to the three cost flow systems.

    Determining Audit Risk and the Related Costs

    Estimating the audit risk and the cost of a first time audit of RCC involves an in depth look at potential areas of risk and the costs associated with identifying these risks, hrough planning and gaining an understanding of the business. In order to assess the audit risk of the RCC the auditor needs to:

     understand the environment and industry in which RCC operates

     apply the audit assertions to the material areas of RCC

     analyze the level of detection risk, control risk, and inherent risk of RCC.

    Gaining an understanding of RCC and the industry in which it operates is the initial step in planning the audit. Although this is not a major cost of the audit beyond the price of the auditor’s time, it is necessary before the audit can begin. Reviewing trade journals and publications of the industry provide the auditor with basic knowledge of the business. Potential problems that have future ramifications such as the environmental issues regarding grazing restrictions and leases, diseases affecting cattle herds, and market trends in cattle sales, are noted.

    Touring the cattle ranch allows the auditor to observe the cattle and other major assets including farm equipment and the land used for grazing. Material assets become the focus of the audit based on their monetary value either as an asset producer or a revenue producer. The breeding stock, the cattle held for sale, and the property, plant, and equipment owned by RCC makeup the largest portion of the company and are of concern due to the potential materiality of misstatements, errors, and exposure to risk.

    The audit objectives for the breeding cows include determining the existence, the valuation, and the proper classification of the cows on the financial statements. With the herd of currently at 50 cattle, taking an actual count to verify their physical existence is reasonable. Counting the cattle however, does not guarantee RCC’s rights to these animals. Cattle purchased or produced by RCC are accompanied by certification of the ownership of the cows. Reviewing these certificates, as well as checking ear tags and brands on the cows, would further identify RCC’s rights to these animals with more reliability due to legality of the certificates and the permanence of the brands. A confirmation should be sent to the State Board of Stock Inspection Commissioners to verify that RCC owns the rights to the brand and that it is properly registered. It is likely that much of the necessary information needed to read brands and test the validity of the certification process is beyond the level of the auditor and requires the assistance of a specialist (SAS 22).

    The breeding cows, either purchased or constructed, held for longer than a year, are classified as fixed assets. Valuation of these cows is based on their accumulated costs, depreciated over their useful life. Determining the amounts of costs allocated to such animals involves an understanding of the cost system and reviewing the costs accumulated and applied. The Depreciation schedule holds relevant information regarding the depreciation method and the determination of the cow’s useful life. Analytical tests and recalculations are effective in determining the accuracy of the depreciation methods, but RCC’s reasoning behind the depreciation choices should also be known.

    There are other factors influencing the valuation of the cows including the potential disease and fertility problems, which could result in unseen risk. Again, due to the limited knowledge of the auditor in this area, the assistance of a specialist is beneficial in identifying risks that might have gone unnoticed.

    The audit objectives for the male calves held for disposition include valuation, for the breeding cows, but applied differently due to the differences of the assets. The existence of the calves can be determined by taking a physical count. The valuation of the calves is based on the market value, not through Determining the existence of these calves


    Although the farm equipment owned by RCC is not directly used in the production of the cows, it is necessary and is a major asset on the financial statements due to its large monetary value. Potential risks involving this equipment include: the overstatement of the assets value on the balance sheet, the inclusion of nonexistent or impaired assets, and the improper application of depreciation methods of the assets. The main audit objectives regarding this equipment include verifying its existence and its proper valuation. Physically viewing the equipment is the initial step in determining its existence, but is not enough. Not only must the auditor have reasonable assurance that the stated equipment physically exists, but that it is in working condition and is used in the operations of RCC. Valuation of the equipment depends on the cost of the asset, less the accumulated depreciation. Reviewing the depreciation not only allows the auditor to verify which depreciation method RCC uses, but can also be used to gain a reasonable assurance that the depreciation is calculated properly.

    As a relatively small, family-owned operation, internal controls involving sales are minimal, and with few employees, the segregation of duties is limited. Although the internal risk level appears to be high, testing the audit assertions and forming an audit plan lowers the risk of not detecting errors due to the weak internal controls.

    Both the costs and risks of the audit are lowered if the auditor has adequate knowledge of the RCC. Gaining knowledge of the industry, applying audit assertions to the material assets of the company, and assessing the risk level based on the findings will be the major costs of the audit and require the most of the auditors time. The costs of the audit and determining the risks are not abnormally high, beyond the added cost of the specialist, which is minimal. The benefits of the initial audit of RCC will far outweigh the costs in future years.

    Our firm has been tasked with analyzing RCC’s propositioned acquisition of 70 permitted cows for $70,000 and the current possession of 30 leases for summer pasturage which were acquired in1995 from the U.S. National Forest Service for $7,500. These federal permits are attractive in the long run since the monthly grazing fee is a mere $2 per animal unit per month, rather than the $10 per animal unit per month fee for private land. RCC is currently subletting the 30 leases to another rancher for $1.35 per animal unit per month.

    The firm is tasked to research the proper treatment of the proposed acquisition of 70 permitted cows and the 30 federal permits already in possession. RCC is also seeking research regarding how much of the purchase price can be capitalized for tax purposes and over what period of time RCC can recover these costs as tax deductions.

    Regarding the proper treatment of the grazing rights acquired through permit by the U.S. National Forest Service. Section 1.167(a) of the Income Tax Regulations provides for the amortization of intangible assets known to be of limited use for a period of length which can be estimated with reasonable accuracy. An intangible asset, the useful life which is not limited, is not subject to the allowance for depreciation (FIC, 1137).

    In the tax court case Shuffelbarger v. Commissioner, the court held that federal grazing permits were of indefinite duration and not assets exhausted through use or the passage of time (Shuffelbarger v. Commmissioner). The grounds for cancellation or revocation were wholly contingent and might never happen. There was reasonable certainty of renewal of the permit or continuation of the permit. In Ranching Co. v. Commissioner, petitioners were not entitled to amortization of state or federal land leases because it was not established that such leases were of a limited duration which could be estimated with reasonable accuracy. The lessee had the preferred right to renew the lease (Ranching Co. V. Commissioner). In a similar case, Kimble v. Stuart, the leases and permits were limited to definite terms on their faces without expressing an absolute right of renewal for additional terms; but there was no basis for assuming that the State of Arizona or the Forest Service would refuse to renew the leases and permit. The court held that there could be no allowance for amortization or depreciation because there was a lack of evidence as to any correct amortization period (Kimble v. Stuart).

    Congress enacted §197 effective for acquisitions after August 10, 1993. All “Section 197 Intangibles” must be amortized over 15 years. Section 197(d)(D) of the Internal Revenue Code recognizes permits granted by a government unit, but the firm does not believe §197 provides an exception applicable to RCC’s disposition (FIC, 169). The 70 cows to be acquired would be classified as §1245 property, which includes livestock, irrespective of the use to which they are put or the purpose for which they are held.

    The firm believes that RCC will not be able to amortize $21,000 (70 X $300) of the proposed acquisition of 70 permits or the $7,500 expended for the 30 leases currently held. The purchase of 70 cows would be held in the Modified Accelerated Recovery System’s (MACRS) 5 year (01.21) asset class and be depreciated accordingly. Depending on which portion of the year the depreciable tangible personal property are acquired, you ma

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