From Cash to GAAP: Improving Credit Assessment in Agricultural Lending

In the U.S., there are just over 2 million farms, with only about 20% of them having sales of more than $100,000. And while not all farms use external financing, those that do account for more than $500 billion of debt outstanding in the form of real estate, capital, and operating loans. Farm credit banks and commercial banks are the main lenders to production agriculture. In a recent RMA Community Banking Survey, 46% of respondents reported involvement in agricultural lending. 

With factors such as inflation, oil prices, the globalization of crops, and changing weather patterns bearing down on U.S. farm production, it’s important for lenders to understand as much about a farm’s real operating numbers as possible. Sometimes that can be difficult.   

When it comes to tax reporting, for example, most farmers do things a little differently than other businesses. Using the cash method of accounting, they can book expenses when they pay them and defer crop revenue until actual cash changes hands. While that simplifies bookkeeping and creates favorable tax management scenarios, it also can be a headache for agricultural lenders evaluating creditworthiness. Because the timing of income and expense recognition can be managed, the cash method can cloud the picture of how a farm is performing.  

What’s the solution? If farmers shifted to GAAP-compliant accrual accounting it would iron out some of the irregularities in measuring earnings —and help lenders “understand the true profitability,” said Todd Doehring, Director at Centrec Consulting Group, a management consulting and agricultural lending education company.  

Short of farmers making this seismic change, lenders need methods to better evaluate agricultural borrowers for a clear measure of credit risk.   

Often, lenders put stock in local banking relationships that can span generations—like the farms themselves—and provide a deeper understanding of the borrower and the assets. Character, one of the “5 Cs” of creditworthiness—capacity, capital, collateral, and conditions being the other four—often has a big impact on lending decisions. “You don’t want to just go lend money to someone based on a projection,” Doehring said.  “Have they shown the ability to withstand the ups and downs of agriculture” and make money over the long-term? 

Another credit-risk concern is skyrocketing equipment costs, making agriculture even more capital-intensive. That, in turn, means more debt and the need to better understand whether that debt can be serviced. 

Despite these and other challenges, the fact that so much of the sector’s asset value is in real estate makes it a relatively safe long-term asset. In the past 10 years, land prices have more than doubled, a boon for long-time farmers but a barrier for would-be competitors hoping to start farming or grow their acreage.