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					Canadian Federation of Agriculture

 Inventory Valuations under CAIS
        Discussion Points
OBJECTIVE

Agriculture and Agri-Food Canada has undertaken a study to understand the
impacts of inventory adjustments under CAIS. These inventory adjustments can
have significant impacts on program payments and program effectiveness and as
such AAFC and industry both have vested interest in understanding the issues.

The work commissioned by AAFC has defined several principles that must that
any inventory adjustment must adhered to:
- the method must minimize program overpayments and underpayments due to
   unrealized gains or losses;
- The method must avoid paying on book value changes in a single period for
   breeding herds that are normally retained over many periods;
- The method must avoid influencing purchasing and marketing decisions by
   treating farms who buy, sell or hold inventory consistently;
- The method must treat all farmers and commodity groups consistently; and
- The method must not create undue administrative burden to farmers.

In their study, AAFC has commissioned the study to survey industry stakeholders
to define industry concerns. The objective of this discussion paper is to outline
some of the issues and raise awareness of the possible concerns industry may
have with current inventory valuations.

It must be noted that this paper is a discussion only. This paper will also only
focus on the question at hand – the use of different pricing mechanisms to
account for inventory values. Structural change calculations are also an integral
part of the inventory debate but will not be covered here. The CFA needs to
undertake more detailed discussion and debate on the inventory valuation issue
to develop a policy position and provide eventual input to the AAFC study.


BACKGROUND

The CFA has continually stated that the primary objective of Business Risk
Management programs is to provide risk management tools to stabilize incomes
from severe declines caused by factors outside of farmers’ control such as
unpredictable weather, disease and market distortions.

Under CAIS, gains and losses are calculated using claim year and reference
margins. Gains and losses are also adjusted for changes in inventory. This
adjustment however, is complicated by the various methods of calculating
margins. Under CAIS, current year Production Margins are calculated on a full
accrual or modified accrual basis, but Production Margins for reference years are
calculated on a full accrual basis if the current year was calculated on a full
accrual basis, or on a cash basis if the current year was calculated on a modified
accrual. Therefore farmers can either:
1) Report Reference Margins under accrual accounting and therefore report
   current year Production Margins under accrual accounting as well; or
2) Report Reference Margins under cash accounting and therefore report
   current year Production Margins under a “modified accrual” basis.

It is not well understood how cash and accrual methods will affect CAIS
payments. It is theorized that because Reference Margins are averaged over
history, there will be little difference in margins when comparing cash vs. accrual.
This may be the case if inventories and production remain relatively constant but
for those with variable storage over time, cash vs. accrual methods could create
significant differences. For example a grain farmer could sell on spot markets
one year, store and sell on futures the next, delay again the next year and spot
market again the year after that. Depending on cash or accrual, income could be
evenly spread throughout the years or bunched in a few particular years. This
could create significant differences in the averaged Reference Margin
calculation. Further, with the CAIS 5-year Olympic average, cash vs. accrual
methods could create even larger differences when considering the lowest and
highest extremes are eliminated.

Beyond Reference Margin calculations, current year Production Margins are
reported on a full accrual basis or a modified accrual basis. For those reporting
Reference Margins under the cash basis, current year Production Margins must
be “modified” to accrual. In this modification process inventories are adjusted by
calculating the change in inventory quantity over the period multiplied by the per
unit market value at the end of the fiscal year. Note that under the modified
accrual, only a single price for valuing inventories is used. This is significantly
different than for those who are fully using accrual accounting. Inventories valued
under full accrual will adjust inventories by subtracting the beginning inventory
quantity multiplied by the lesser of the per unit market value (as at the beginning
of the fiscal year) or the production cost of those inventories, from the ending
inventory quantity multiplied by lesser of the per unit market value (as at the
ending of the fiscal year) or the production cost of those inventories, as under the
Generally Accepted Accounting Principles (GAAP). Therefore those using full
accrual will face a 2 price system for valuing inventories while those using
cash/modified accrual use only a 1 priced system.

The 1 price or 2 price systems have the potential to create significant differences
in CAIS program payments depending on how prices differ from the beginning of
the fiscal year compared to the end of the fiscal year.

What does this all mean? The main issues revolving around inventory
valuations are rooted in the reporting of margins using cash accounting. Issue
#1) Reference Margins are skewed when comparing cash to accrual numbers,
causing possible differences in program payments; and Issue #2) current year
Production Margins are skewed when converting cash to modified accrual
because the modified accrual system uses only one price to value inventories,
again affecting program payments.

In an effort to narrow the discussion, it is clear that some producers are not in a
position to convert their reporting to accrual from cash reporting especially for the
reference years. AAFC also clearly wants the CAIS program to be reported on
accrual or modified accrual basis, at least for the current year Production
margins. Therefore, the concerns of CAIS payments raised by Issue #1, cannot
be resolved in the short term. Although going forward, governments could
consider allowing the year 2003 modified accrual production margin to be used in
the calculation of the reference period for the 2004 current year in lieu of a 2003
cash production margin.

The topic at hand is Issue #2, the inventory valuation impacts when converting
from cash to modified accrual in the claim year. Should we change the
modification to accrual to be based on a 2 priced system such as P1-P2 or
GAAP? Or maintain the 1 priced system? Each have their own pitfalls. In the
words of AAFC: “Each method could result in under payments and overpayments
because they do not capture the actual value received by the producer”.

In broad strokes, agricultural commodities see large swings in prices. Prices rise
and then fall. Prices fall and then rise. Depending on the circumstance, the
interaction between CAIS inventories and these price changes can result in
distorted CAIS payments.

Let us use as an example a producer that will likely trigger a CAIS payment in the
current claim year and has a relatively constant inventory stock. Under the
current one priced system, fluctuations in inventory prices during the year will
have no effect on the producer’s eventual CAIS payment. Under a two priced
system however, fluctuations in inventory prices may have significant effects on
CAIS payments.

Let us consider two simplistic scenarios:
Under a two priced system, if inventory prices fluctuate up during the claim
year, the producer’s inventory value will increase and this will offset any
potential CAIS payment the producer will receive. Under this circumstance,
it is possible that CAIS would result in an “underpayment” of lost income.

Under a two priced system if inventory prices fluctuate down during the
claim year, the producer’s inventory value will decrease and will increase
any potential CAIS payment a producer will receive. The CAIS program will
essentially compensate the producer for unrealized losses on their
inventory. This in itself is not necessarily bad but if inventory prices
rebound in the following year, the CAIS program will have compensated for
unrealized losses that were never realized. This would result in an
“overpayment” by CAIS.
While a one priced system does not result in some of these “distortions”, there
exist real impacts due to inventory price fluctuations. The current BSE crisis is a
prime example. Crashing prices for cattle have significantly decreased the
inventory values of producer herds. Cattle producers face strained cash positions
due to reduced sales and increased debt pressure to lenders. Their reduced
equity position due to falling prices heightens these pressures. For those filing
under the cash methodology for CAIS, the one price system will not account for
this loss in equity and provide needed funds. The only way for these producers to
gain more CAIS dollars would be to make their unrealized losses into real ones –
by selling at low prices. It is argued that a two priced system for these producers
would mitigate these problems.

If a generalization can be made on this inventory issue, as prices decline a one
priced system does not account for the immediate, short-term hardship put on
producers. CAIS does not address these hardships by providing cash support for
producers to wait out the price decline. Producers only option may be to realize
those unrealized losses. Alternatively, a two priced system for valuing inventories
would provide immediate support for equity losses but may underestimate or
overestimate CAIS payments in the long-term.

Overall, when considering this inventory issue, it is necessary to always keep in
mind the principle objective of the CAIS program – to stabilize farm incomes and
provide disaster assistance. Clearly, price drops and their consequences have
large impacts on farm management beyond simple farm incomes and production
margins, and it is unclear whether a one or two priced accounting system would
account for all the objectives of stabilization. Perhaps other instruments could be
used to mitigate the impacts of price declines. Cash advances or loan
guarantees outside of CAIS could be used to help producers weather short term
problems caused by price declines. Perhaps different rules could be applied to
different sectors such as cattle. Should different rules apply to breeding stock
than to other types of inventory? Grain farmers produce grains using machinery –
an input not used in inventory calculations under CAIS. Cow-Calf operators
produce calves using their breeding stock, yet breeding cows are included as
inventory. Perhaps breeding stock should not be included as eligible under
inventory calculations. These options and others need to be analyzed for their
potential. This discussion paper has only scratched the surface of some of the
potential implications of inventory valuations. Before industry can provide
complete input into this AAFC inventory study, CFA needs to more deeply
consider some of these alternatives and develop a policy position.

				
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