If you are ever asked “Do you want to follow the accrual method of accounting or cash method”, your answer is going to be Accrual in a very positive and confident manor. Firstly because it makes you look smart and as if you know what you are talking about. Secondly (and perhaps most importantly) because the lovely people at the Canada Revenue Agency require you to file that way. <<For the most part anyway…… check out the fine print at the end.>>
It does take a little while to wrap your head around the accrual method of accounting, after all, you are always being told that “Cash is King” and “Cash Projections are the most important thing since the invention of the wheel”. Let’s see if we can get through this without sending you to sleep!
The official definition from the Canada Revenue Agency website is:
In most cases, as a self-employed person you report business income by using the accrual method of accounting. With this method, you:
- report your income in the fiscal period you earn it, regardless of when you receive the income; and
- deduct expenses in the fiscal period you incur them, whether you paid them in that period or not. Incur usually means you either paid or will have to pay the expense.
As income from professional activities is business income, you report it using the accrual method.“
Getting drowsy yet?
It really isn’t that difficult to understand when explained in terms that the rest of the human population use – as opposed to Accountant Speak.
So here is Donna’s definition:
When you receive a bill, you record it as an expense – forget the fact that you haven’t paid it yet. It doesn’t matter, it’s still an expense.
When you invoice a client, you record it as a revenue – forget the fact that your client hasn’t paid it yet. It doesn’t matter, it’s still revenue.
Now how difficult is that!
What does this mean for your business? Let me give you an example:
You need to file your first Goods and Services Tax (GST) return of the year. Assuming you file quarterly, when you complete your GST return you need to include all of the revenue recorded for the months of January, February and March. You need to include revenue on the invoices you have issued that have not been paid by your clients yet. Now this may sound like a blatant money grab by our federal friends however you also get to deduct the expenses that you have received but you haven’t paid yet. See how it works itself out?
This is the main reason why I recommend small business owners issue invoices at the beginning of the month rather than the end of the month. If you issue an invoice and give 30 day credit terms you are highly unlikely to receive payment before you need to pay the GST portion of your invoice over to the government. You are in effect handing over your own profits and then getting paid back by your client. This isn’t the best way to manage your cash flow. Instead issue the invoices that you would have sent out on March 31st a day later and send them on April 1st. (Okay, maybe send it dated April 2nd so your clients don’t think your invoice is a joke!) Now you don’t have to include the revenue in the first quarter GST return, you will include it in the 2nd quarter instead. Also you have given yourself the extra time needed to receive the funds from your client so you are using their money to pay your GST bill and not your own.
So with that little tidbit of information in mind “hooray for the accrual method of accounting.”
<<Fine Print bit at the end – also taken from the CRA website>>
If you are a self-employed commission sales agent, you can use the cash method to report your income and expenses, as long as it accurately shows your income for the year. With this method, you:
- report income in the fiscal period you receive it; and
- deduct expenses in the fiscal period you pay them.