Publication Date - July 2006

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Table of Contents / Chapter 2
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Chapter One - The Audit Flow

• Purpose of Guide
• The Information Document Request
• The Pre-Audit
• The Initial Interview
• The Audit

The Audit

Crop Accounting Records

Always request crop accounting records in your IDR. If they are not provided, ask the farmer during the interview. A farmer may have these records, but may be unfamiliar with the accounting term/name used. The information contained in the crop accounting records can be used to adjust the scope of your exam to focus on areas with the most likelihood of adjustment.

At the beginning of the season, the farmers frequently need to prepare a budget for that year’s crop. Budgets are needed for a variety of reasons, including obtaining crop financing for the coming year. The budget usually includes estimated income and expenses for each crop produced. In most crop accounting systems, the budgets are compared to the actual year-end and any variances are noted. Many computer systems also include the actual amounts from the prior year. When a farmer grows a wide variety of crops, these records can be invaluable. The examiner can focus the audit on the accounts with substantial variances rather than the accounts that are within the budgeted amounts.

Crop Loans

Crop loan records can be used in a variety of ways during an exam. Crop loan records should include:

• Loan Agreement; including a statement regarding collateral.
• Loan History/Activity; including the month subsequent to the Fiscal Year End.
• Crop Budget or Financial Statements used to obtain the loan.

Crop loan records first need to be examined for any related party issues. Financing can be obtained directly from related parties or from third parties (such as banks) using “shared” loans for various related farms. Look at the loan agreement and see that the borrower is the farmer under exam and that the lender is truly an unrelated third party.

Unrelated Third Party Financing
Look at the loan activity detail. Since most farmers are cash basis always: TRACE THE MONEY.

1. Trace all reductions in the loans to actual payments by the farmer. Many crop loan agreements include payments to be made directly to the loan from the crop purchaser. These payments are never deposited to the farmer’s bank accounts and can be sources of unreported income if the farmer does not have double entry books.
2. The timing of the loan repayments may also be an indication of a potential issue. Repaying a loan in the month subsequent to the end of the fiscal year is an indication of a possible deferred payment contract (See Chapter 2, Income).

Related Party Financing
If the loans are obtained from related parties or the proceeds are shared by related parties, TRACING THE MONEY is even more important.

1. ALWAYS review both sides of these transactions. Use T Accounts or journal entries to visualize the tax consequences to both parties.
2. If a related entity is acting as a broker for the farmer, determine when payment was constructively received for the crops. The loan proceeds could be income to the farmer. This may sometimes involve reviewing the books of a related party, but the information may also be available from the farmer under exam. If the books of a related party need to be reviewed, that return can be opened for exam.
3. ALWAYS remember to review IRC § 267 to determine who is related. IRC § 482 is available to more clearly reflect income between related parties. The Substance vs Form rules should be reviewed when there is a question regarding whether a transaction between related parties is arms length.

Crop Contracts

Crop contracts should be reviewed for all crops produced by the farmer. Usually an entire crop is sold to one purchaser, but sometimes crops are sold to a variety of purchasers. Review crop contracts for quantity sold, payment terms and delivery terms.

Quantity Sold
The crop contracts will have some detail regarding quantity sold. Compare to industry averages to determine if the quantity is reasonable. The quantity detail on the contracts will vary by type of crop. It can include number of acres, bales, boxes or pounds of crop.

• If stated in acres, compare the acres on the contracts with the acres from the map.
• If stated in quantity, compare the quantity on the contracts with the quantity obtained using industry averages.

Payment Terms
If the payment is not being deferred, your next step is to compare the grower statements with the taxpayer’s books.

If payment is being deferred until after the close of the farmer’s fiscal year end, is this a valid deferred payment contract? (See Chapter 2, Income)

If the deferred payment contract is in question, ALWAYS get a photocopy for your workpapers. There are many factors to consider in determining if this is a valid deferred payment contract.

Do the payment terms include crop advances or payments on behalf of the farmer? If so, are these properly included into income when the money or the benefit is received?

Delivery Terms
One major factor in determining if a deferred payment contract is valid, is the date the contract was entered into versus the delivery date. A copy of the contract along with copies of delivery tags or delivery dates on the grower statements can be very important to answer some of these questions. (Chapter 2, Income Deferral)

Grower Statements

All purchasers of crops provide some form of grower statements. These can be provided monthly or at the end of the crop year. The grower statements will include:

Quantity Delivered

1. Compare the quantity delivered to the quantity described in the contract.
2. Compare the contract number with the grower number on the statement. Some farmers have multiple accounts with one purchaser.
3. Question any large variances in quantity delivered.

Quantity Accepted
If only part of the delivered crop was accepted or if there is a large unexplained variance between the quantity contracted and delivered, question the farmer. If a large amount of crop was rejected or not delivered, this should have been brought to your attention during the initial interview.

1. What happened to any rejected crop?
2. Was it reconditioned and resold to another purchaser?
3. Was it sold in another type of market for a lesser price? This would include sales such as winery use, juices, cattle feed, etc.
4. Was it disposed of? If so, how did the farmer dispose of it?
5. Was it insured? Certain crops like cherries can not be insured.

Gross Payments, Deductions and Net Amount Due

1. Review all statements for your crop year covering all payments until the balance owing to the grower is zero.
2. Review how your farmer reports his income. Some farmers report net payments into income while others report gross payments and claim as expenses the deductions to gross payments.
3. Review for the following:
   1. Were there advances - did the farmer report them as income when received?
   2. Were there payments made to third parties? These can be payments on loans, payments for farm expenses, capital asset purchases, or for any number of reasons, either business or personal.
4. Compare the grower statements to the contracts to see that the payment terms agreed to in the contract are actually being followed.

THE GROWER STATEMENT IS ONE OF THE MOST IMPORTANT DOCUMENTS IN THE EXAMINATION OF A FARMER’S INCOME.  If the farmer cannot provide the grower statements, copies can be obtained by following Third Party Contact procedures and requesting them from the packing house or broker.