The Co-operative Movement of the Russian Far East

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2.6. Financial stability - FARMER COOPERATIVES VERSUS COLLECTIVE FARMS American Studies on Ukrainian Problems Vitaly V. Zinovchuk

Cooperatives also have some distinctive features which are necessary to consider in the financial sphere. These differences arise from fundamental cooperative principles, and finances concern all of them. Members of cooperatives must have strong financial ties with their cooperative. Without that, the user-owner principle can lose a reason, the user-control principle can lose a force, and finally, members can lose their benefits. The success of cooperative organizations depends upon how actively their members use them. That is why financial policy of cooperatives is one more important mechanism to stimulate the usage of the organization. Cooperative ideology is opposed to the transformation of cooperatives as association for mutual gain from patronage to organizations oriented to return on investments. The most important aspects of financial management could be recognized in following:

- distribution of incomes, allocation of gains and losses;

- investments, formation of equity and growth;

- the role of cooperative banking;

- taxation.

Of course, as a business firm, every cooperative uses the same accounting methodology, practice and financial requisites. The balance sheet of the cooperative, as a main accounting document at a given point in time, contains four basic elements: value of assets which is controlled by cooperative, the size of liabilities or what the cooperative owes to others, the part of cooperative's property invested by cooperative member-owners or equity, and the amount of working capital engaged in this cooperative's business. The example of the Farmer Union Cooperative Elevator Company can illustrate that (Table 16). This balance sheet can already show the particularities of financing in cooperative. For instance, a certain part of assets is invested in the federated cooperative (Harvest States Cooperatives) as a intercooperative business; also, reflection of long-term liabilities to the St.Paul Bank for Cooperatives and patronage credits confirms how important cooperation between cooperatives is.

The annual operating statement of the cooperative also provides an opportunity to follow the distribution of the cooperative's income. As for an example, let's consider the case of the Farmers Union Oil Company of Moorhead, Minnesota (Table 17). The general scheme of distribution is quite simple, easily understood by each cooperative member (Figure 23). The total revenue of the cooperative is the basis for distribution. Total revenue less discounts and allowances is called net sales. After deduction of costs of goods sold connected with these sales, the rest is usually called gross income. Gross income less operating expenses leaves operating income. Operating expenses include distribution (salaries, payroll taxes, employee insurance, saving-sharing expense, delivery expense, advertising and promotion), general expenses (depreciation, insurance, property and business taxes, rent, supplies, repair and utilities), administrative expenses (professional services, bad debts, data processing, directors' fees and expense, educational expense, meeting and travel, office supplies, telephone), interest expense, service charges on accounts and other expenses. It is necessary to add for operating income other revenue including patronage refunds received and to subtract other deductions such as interest expense and loss on sale of equipment. The remaining part is net income before taxation. The Section 521 cooperatives1 can deduct from taxable income nonpatronage income distributed to patrons on a patronage basis and dividends on capital stock, in addition to qualified patronage refunds which are not included in taxable income for every cooperative [Royer, p.294].

Table 17. Simplified operating statement of Farmers Union Oil Company of Moorhead, Minnesota, 1993

Simplified operating statement of Farmers Union Oil Company of Moorhead, Minnesota, 1993

Source: Farmers Union Oil Company of Moorhead, Minnesota: Annual Statement (December 1,1992 - November 30, 1993).

Patronage refunds is net income of the cooperative created by patronage of its members, and distributed to them pro rata to their individual contribution in general quantity or value of business. This is the way the fundamental cooperative principle of member-benefits is realized. Patronage refunds can be qualified and nonqualified, cash and noncash. The distinction of qualified patronage refunds is in their exclusion from a cooperative's taxable income under an obligatory condition that patrons agreed to include these allocations in their individual taxable income. At least 20 percent of qualified patronage refunds must be paid in cash. If patronage refunds were included in taxable income of the cooperative they are called nonqualified. More often cooperatives try to avoid nonqualified patronage refunds in order to pay more cash to their patrons. These retained refunds increase the members' investments in the cooperative.

Another alternative for distribution of cooperative's net income is to pay dividends on equity. Equity is a part of property of the cooperative created by patrons' investments. Although dividends on equity have the same function as dividends in joint stock companies/ they are usually limited in cooperatives to 8% of equity value [Roy, p.255]. In some states other limits exist, for instance, 5-6%, 12%, or even without limitation. In some cooperatives dividends on equity are not paid at all. But when dividends on equity exceed limitations, voting must be one-members, one-vote. Geographically, the midwest cooperatives paid the lowest dividends, and Eastern seaboard - the highest [Cobia 1989, p.233-234]. Limited dividends correspond to the spirit of cooperation, and the existing legislation supports that by deduction of limited equity dividends from cooperative's taxable income. Sometimes the limitation of dividends is not popular among cooperative members because they do not feel they realize enough returns from their investments in the cooperative. This problem does not exist so much in cooperatives which use investments proportional to patronage.

It is important for cooperative to distribute a portion of its net income to unallocated reserves. This centralized fund is needed for covering possible losses. It is also helpful in relations with creditors as permanent net worth. Some cooperatives distribute net income from non-patronage business as unallocated reserves to avoid double taxation [Cobia & Brewer, p.25i]. Income sources for unallocated reserves may come from both patronage and nonpatronage sources such as rent, interests, etc. However, some experts feel that increasing unallocated reserves to a relatively large proportion of net worth leads to conflict with the fundamental cooperative principles. The user-benefits principle, or business-at-cost, is not observed when unallocated reserves are created at the expense of net income of member business. The user-control is weakened when management is given an additional source of unallocated equity. Mostly it's only an illusion because the board of director has the same control of unallocated capital as it does for other distributions of income. And finally, increasing unallocated equity means decreasing allocated equity, and this means to come in conflict with the user-owner principle.

Allocating losses creates special problems for cooperatives. Losses can occur in cooperatives because of both poor management and unfavorable external factors such decreasing farm support program, aggressive competition, and necessity to use more expensive technology and resources. The following issues are acceptable options for distribution of cooperative losses:

1. Losses may be distributed to unallocated reserves. This is the most popular and effective method.

2. Losses may be charged to patrons of the year of the losses in proportion to the business done during the year (the same approach as for patronage refunds). The disadvantage of this method is that it can redouble individual problems of farmers in an unfavorable year.

3. Losses may be carried as unallocated losses in the equity section of the cooperative. The disadvantage of this method is that no one ever receives an income tax benefit from the losses. But losses can be carried forward for tax purpose by the cooperative.

4. Losses may be allocated proportionally to individual shares in cooperative equity (the same approach as dividends on equity). In this case there is an obvious disadvantage for members who have individual share but currently are not actively patronizing the cooperative. At the same time new members, who have just started using the cooperative, do not share in the burden of losses associated with their patronage.

5. Losses may be carried forward to offset future net income. This means that present and future patrons will handle these losses in accordance with patronage for all years to which the losses are carried over [Kothmann, p.6i-62].

6. Losses may be allocated and collected from members as cash by deduction the amount from marketing proceeds, charging to members' individual account or billing them directly. Negative reaction of the members can be considered as a serious disadvantage of this method.

7. Losses from one operation can be offset by the net income of another one [Cobia 1989, p.239].

The next important aspect of cooperative financial policy is how cooperatives create and expand their member equity. Cooperatives need capital as any other business firms but the way in which they obtain needed funds makes them unique among the others. Generally, cooperatives have four principle sources of capital:

1. Member equity contributions.
2. Investments from unallocated reserves.
3. Investments from nonmember sources and reinvestment.
4. Debt capital.

The major investments in cooperatives are based on the idea of contribution to the member equity in proportion to the benefits from cooperative (already received, receiving now or expected for the future). The absence or limitation of incentives such as dividends on equity and capital appreciation which are normal for investor-oriented firms, create investment problems in cooperatives. The essence of the problem is the fact that members of cooperatives sometimes can not realize returns from investments they made. Economic incentives for cooperatives are not so obvious for them as for other advantages of cooperative activity. Nevertheless cooperative organizations have to acquire needed capital from their members. For this purpose they usually accept one of the following options:

- direct investment;
- retained patronage refunds;
- per-unit capital retains.

Direct investments are cash purchases of common or preferred stock, membership certificates, or other evidences of equity. Usually it happens when a cooperative is only going to start its activity. Some cooperatives continue this practice even after that. Over all direct investments have the smallest share in cooperative member-equity. Retained patronage refunds are the most popular source of equity. As a part of net income, patronage refunds may be retained by a cooperative for creation of member equity in the proportion to use by members. And the third method of equity creation is per-unit capital retains. Members may be assessed a fixed charge per unit of delivered product or inputs purchased from cooperative. Cooperatives establish individual accounts to reflect each member's contribution to the equity. These three methods of creating cooperative capital have certain advantages as well as disadvantages (Table 18).

Some cooperatives use unallocated reserves as the major source of net worth. Equity contributions required of members is reduced to the extent that its source is nonpatronage income. Like other equity accounts, unallocated reserves can be leveraged to obtain increase borrowing. They also can function as a reserve insurance account to be applied against the loss of uninsured property [Sieber, et al., p.25]. However, members of cooperatives whose financial structure is dominated by unallocated equity may become complacent about the cooperative's activities, because they have little apparent financial stake in the organization [ACS Report to Congress, p.4l].

There is also a way to enlist additional investments to the cooperative by using nonmember sources of capital. Cooperative patrons, who are not members but nevertheless often receiving patronage refunds, are the most convenient for this purpose. Also preferred stock can be sold at the capital market if the cooperative's bylaws permit that. Three main types of preferred stock programs can be noted: open investment, member equity reinvestment, and employee stock programs. Open investment means that preferred stock can be sold to anybody who wishes to buy it, even non-members and non-farmers. Members of cooperatives also may buy additional shares of capital or reinvest their equity. Some cooperatives offer stock to employees as investment in cooperative business or as a part of bonus or incentive program [ACS Report to Congress, p.42]. Of course, the sale of preferred stock has some disadvantages, and the main is that cooperatives have to pay significant amount of dividends to their stockholders before patronage refunds can be calculated.

Debt capital is also a possible source of capital. Under normal conditions it is a reasonable way for cooperatives to raise needed funds. Most of them use it quite often. The structure of cooperative capital, or the ratio between equity and borrowed funds, depends on different factors such as kind of cooperative business, expectations for growth, type of risk the cooperative takes, competition it faces, interest rates, inflation, etc. The share of borrowed capital can increase with demonstration by the cooperative of its ability to manage their financial resources more effectively. It is possible for cooperative to borrow funds from different sources. Among the most important are Banks for Cooperatives, commercial banks, government agencies, other cooperatives, and individuals.

Banks for Cooperatives are the primary lending institutions for farmer cooperatives. Their unique characteristic is that they are owned by those who use their service, i.e. cooperatives. The banks are also cooperative organizations with all attributes of this type of organization such as fundamental principles, organizational structure, democratic management, financial policy, and business philosophy. Two cooperative banks exist in the U.S.A. They specialize in making loans to agricultural cooperatives. The National Bank for Cooperative or CoBank is headquartered in Denver (Colorado) and has 11 regional offices, and the St. Paul Bank for Cooperatives (Minnesota) also offer a complete line of credit and leasing services to agricultural cooperatives (Box 14).

Box 14


Case of St.Paul Bank for Cooperatives

For more than 60 years the St.Paul Bank has combined sound financial performance with innovative service. It has been driven by two fundamental purposes. One is to support cooperative principles and the development of cooperatives as compatible business enterprises. The other is to consider the long-term best interests of customers and to give them superior service. The Bank is a member-owned cooperative that provides credit and credit related services to agricultural cooperatives and other eligible organizations. Gross loans outstanding at December 31, 1994, totaled 2.66 billion. Prior to 1989 the Bank was chartered to operate only in the states of Michigan, Wisconsin, Minnesota and North Dakota. Since receiving a national charter in 1989, loan volume from borrowers headquartered outside this original four-state area has grown to $319.0 million or 12.0%, of total gross loan volume. The contents of the Bank's loan portfolio can be aggregated into four major lending areas: 23.8% -federated/local cooperatives (which includes the farm supply and grain segments), 36.5% -marketing/processing (which includes sugar, dairy and most "other"), 39.7% - utility and finance. The number of customers in the federated/local cooperative segment of the portfolio has declined due to consolidations resulting in fewer but larger organizations. The Bank's 10 largest borrowers in the end of 1994 accounted for $1.5 billion (57.2%) of gross loans. In 1994 net income for the Bank reached $31.2 million (17.1% of gross income). Capital generated from operations totaled $30.6 million in 1994, consisting of $31.2 million from net income, plus $7.3 million from capital stock purchased by members, less cash patronage of $7.9 million. The Bank retired $14.0 million of stockholder equities during the year. Due to the continued strength of its capital position, the Bank continued its practice of paying 30% of patronage returns in cash [St.Paul Bank for Cooperatives: Annual Report 1994].

As a rule, member-patrons of the cooperatives have a right to get their share in equity back in cash when their patronage declines or ceases. The process of returning equity to members of cooperative is called equity redemption. There are four types of plans for that: revolving fund plan, percentage-of-all-equities plan, base capital plan, and special situation plan.

The most popular plan is based on the use of revolving fund. The basic idea is that equities are redeemed in the same chronological order they're allocated (Table 19). After creation of a needed size of equity capital ($1,500) the cooperative becomes able to redeem equities for members to avoid making them as overinvested patrons. The length of a revolving period varies from 18 months to 30 years, but is recommended to be less than 5-7 years [Cobia, et ai., p-24].

Table 19. How equity redemptions become available through
revolving fund

How equity redemptions become available through revolving fund

 

Source: Royer, Jeffrey S. and Gene Ingalsbe. 1987.
Equity Redemption Guide. Cooperative Information Report 31. Washington, D.C.: Agricultural Cooperative Service, USDA, p.3.

A second alternative for equity redemption is to use percentage-of-all-equities plan. This plan is based on the reducing of equity of all members by the same percentage. The percent of equity redeemable (Pr) can be calculated in following way:

Pr = (Ee - Er) / Eb,
where Ee - equity available at the end of the year,
Er - equity required, Eb - allocated equity at the beginning of the year.

Cooperatives can also use the base capital plan. Under this plan needed equity capital is distributed between members proportionally to their share of cooperative business over a base period. Then comparing this required member equity with actual one it is possible to state who of the members are underinvested and who are overinvested.

Sometimes cooperatives use a special equity redemption plan. It mostly occurs in following situations: a) death; b) termination of farming, ceasing patronage, or relocation; c) retirement or qualification because of age; d) patron call or on-call or on-demand by the patron; e) hardship, including bankruptcy [Cobia, Royer & ingalsbe, p.278]. The solution to method and limits on handling over- and underinvested members can vary from one cooperative to another. A special plan may be an alternative or supplement to other plans. Each plan of equity redemption has its own advantages and disadvantages (Table 20).

As any other business organization, farmer cooperatives have an obligation to pay significant taxes. They include real and personal property taxes; sales taxes; employment taxes; gasoline and diesel fuel taxes; license fees; motor vehicle registration fees; taxes on telephone, power, and other utility service. However, the most important particularity concerning cooperative taxation is that their net income is subject to a single income tax. Federal income tax law requires that net income of cooperative is taxed only once: at either the cooperative level or the patron level but not at both. The single-tax principle of cooperative income raises from essence of the price adjustment theory where cooperatives refund of net income to patrons on a patronage basis. Earnings from sources other than patronage not distributed in the manner specified by the law are generally not eligible for single tax treatment [Frederick & Reilly, p.12].

The general approach for calculation of corporate income tax can be summarized in the following formula: tax = (income - deductive expenses) x rate. For cooperatives patronage, refunds and per-unit retains allocated to members are included in deductions [Frederick, p.52]. Some cooperatives, which meet the requirements of Section 521 of the Internal revenue Code of 1986, are also allowed to deduct dividends paid on capital stock and distributions of nonpatronage earnings to the patrons on the basis of their patronage. The qualifying requirements for the section 521 status (in simplified form) include:

1. It must be a farmer cooperative organized and operated with the purpose to market the product of the members, or to buy supplies for members.
2. All of its voting stock must be owned by member-patrons.
3. The dividend rate on capital shares must not exceed 8% per annum.
4. Financial reserves of the cooperative are restricted to those required by state laws or those that are necessary, and must be allocated to patrons.
5. Business with nonmembers may not exceed 50% of the cooperative's total business, and purchasing for persons who are neither members nor producers may not exceed 15% of the cooperative's total purchasing.
6. Nonmembers are to be treated the same as members with respect to business transactions such as pricing, pooling, payment of sales proceeds, and allocation of patronage refunds.
7. The cooperative must maintain permanent records to verify above requirements.
8. The legal structure of the organization must be cooperative in character [Valko, p.72].

An important role in providing finacial stability of cooperatives belongs to planning of taxes. Cooperative can choose the most acceptable alternative for their taxation. Some available determinants should be taken into consideration (Figure 24). The decision to adopt an alternative variant for taxation is usually in the perview of the board of directors.