Cash vs. accrual basis accounting – which is right for you?
Only two types of businesses in Canada can use the cash basis of accounting for tax purposes: farmers and fishermen. All other businesses must file their tax returns using an accrual basis of accounting.
Cash basis accounting is where income for tax purposes isn’t formed until products are sold and paid for. Incurred unpaid expenses also can’t be deducted from the taxation.
Accrual accounting, however, is an accounting method where payments and expenses are credited and debited when they are earned and incurred rather than when money is exchanged.
Combined, cash basis and accrual basis accounting give the full financial picture of your operation.
There are several reasons why farmers might be allowed the cash basis for tax purposes, but the most likely is because the value of their products can fluctuate drastically from one year to the next - or even one week to the next. The flexibility to file tax returns using cash basis accounting has many advantages, but it’s important to understand its limitations when assessing your farm’s financial performance.
Cash basis pros:
- It’s relatively simple to calculate taxable income: money received from sales less expenses paid to produce a saleable product.
- Income can be deferred to future years, resulting in an averaging of income over multiple years.
- Annual tax bracket planning can be maximized regardless of the accrual profit of the business. That is, you can ensure full utilization of the low-rate tax brackets every year.
Cash basis cons:
- Income isn’t matched with expenses incurred to produce a product, so it’s challenging to get an accurate profit or loss report for a fiscal year.
- Taxes can be postponed by carrying forward income or prepaying expenses that can result in higher taxes being paid in later years.
- It may be possible to transfer a significant tax burden to successors of the operation.
Accrual method pros:
- Incurred expenses match the income for a specific fiscal year.
- Accurate planning and assessment of the profitability of a farm operation can be done. There’s also the ability of specific enterprise analysis.
- The farm operation will have full financial status, allowing ratio analysis to assess operational performance.
Accrual method cons:
- Compiling all the information to be accurate is more complicated and expensive.
- The valuation of assets such as inventory is at a specific point in time, which can change materially over a period, which may result in skewed assessments.
- Users of the financial information will need to determine the accuracy of the financial information since accrual accounting relies on estimates by management.
If the accrual financial statements include a deferred tax balance, an estimate of the total taxes owing based on historical profits of the business will be reported, and a plan can be formulated to deal with them.
Overall, ag producers should continue to file their tax returns on a cash basis to allow for maximum flexibility in the amount of tax payable on an annual basis.
At the same time, accrual financial statements must be prepared annually to monitor your farm’s financial health and profitability. Combined, these statements will give the full financial picture of your operation.
Taxable income: The portion of your gross income on which you are required to pay tax.
Tax bracket: Created by the Canada Revenue Agency, tax brackets determine how much money you must pay in personal income taxes. Each bracket has its own tax rate, depending on the income range.
Incurred expenses: Fees your farm business hasn't yet paid for items or services purchased on credit.
Article by: Lance Stockbrugger