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.