There are two primary accounting methods in use in Canada today: The cash method and the accrual method. The difference between them is in when small businesses recognize revenue and expenses. With the cash method, both revenue and expenses are recognized when cash actually changes hands. Under the accrual method, the business recognizes revenue and expenses when they’re earned, rather than when they are paid.
For example, suppose you enter into a contract to sell 1000 widgets in December 2020, to be delivered and paid for in January 2021. You have a calendar tax year.
Accrual Method Example
Under the accrual method, you recognize the revenue in December 2020, even though you haven’t actually received the cash yet. You have the account receivable generated, and that places the revenue into your current tax year. You would report the revenue in tax year 2020, even though you won’t actually receive the cash until into 2021.
But you can claim expenses in the current year, using the accrual method as well, even though you won’t actually pay the cash until the following year.
For example, you know you need to order $10,000 worth of supplies to build and deliver the 1,000 widgets. So as soon as you received the order, you entered into a contract to purchase the $10,000 worth of materials. But you don’t expect to receive or pay for the materials until next year.
Under the accrual method, you account for the expense when you took on the obligation to pay, not when you actually pay. You take the expense when it becomes a liability on your books, not when you actually write the check.
So both the revenue and your expense for the December 2020 1,000-widget order are booked for your 2020 calendar year returns.
Cash Method Example
Under the cash method, on the other hand, you would not book the revenue until you actually get paid on the order. Likewise, you would not book any expenses until you actually paid them out. So in the widget example, both your revenue and expenses would be reported in Q1 2021, not in 2020.
Almost all small business owners in Canada require the use of the accrual method for filing tax returns, with the exception of farmers, fishers and commissioned salespeople. If you fall into one of these categories, you can choose between the accrual or the accounting method. For more information on the cash method of accounting, Contact us.
You cannot mix methods. That is, you cannot use the cash method for your expenses and the accrual method for your revenue. You have to be consistent.
Accrual Method Advantages
The accrual method is preferred because it more accurately reflects the long-term health and viability of the business. For example, a business that has a lot of cash on the books but an even bigger set of liabilities in the next quarter can look very good using the cash method of accounting. But using the accrual method, the business’s short-term difficulties would be more evident.
Accounting Tips:
- Keep a daily journal of all receipts and expenses.
- Store it along with cancelled cheques, bank statements, duplicate deposit slips, receipts and other documents that support the amount and timing of all transactions.
- Upload them all to the Cloud as they occur, so they are securely stored offsite and safe from theft, fire, flood, vandalism, hard drive crashes and other mishaps.
Changing Accounting Methods
If you’re eligible for the cash method, you can change methods as follows:
To change from the accrual to the cash method:
- File your return under the cash method.
- Attach a statement that lists all adjustments to income and expenses due to the change in method.
To change from the cash to the accrual method:
- Send a request to do so to your TSO in writing prior to the date on which your tax return is due.
Contact us or learn more about our affordable bookkeeping services and see how we can help you reduce costs and improve your financial controls, regardless of your location, size or industry.
