FREE ESSAY ON ROATCAP CATTLE COMPANY

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.
FINANCIAL
Heading Here
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.
Cattle Valuation
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 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.
AUDIT
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.
HEADING HERE
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.
Auditing the Major Assets
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
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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.
Assessing the Audit Risk
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.
HEADING HERE
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.
TAX
Facts
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.
Authorities
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.
Analysis
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