Cash vs Accrual Accounting in Canada: What the CRA Allows

Can a Canadian sole proprietor use cash basis accounting on the T2125?

Generally no. The CRA says farmers, fishers and self-employed commission agents can use the cash method or the accrual method, and that all other self-employment income must be reported on the accrual method. Consulting, trades, retail and online-sales income reported on the T2125 (the business-income form in your personal return) are in that second group.

Accrual counts income in the year it is earned and expenses in the year they are incurred. Cash counts income when received and expenses when paid, by card, e-transfer or cheque as much as bills and coins. The CRA's rule turns on the kind of income. Its accounting-method pages for business income set no sales level below which cash is allowed.

Running a corporation or partnership? The answer is less settled: see the section on whether a corporation or partnership gets to choose, below. Rental income follows a different rule, in the last section.

A case is not simple when:

• the books were built from bank deposits, or your accountant says income must be accrued, and the returns followed the deposits.
• invoices or bills were unpaid at a year-end, especially large ones.
• you hold inventory.
• the business is a corporation or partnership.
• you have commission income and other business income.
• earlier years were already filed on cash.

Any of these can mean earlier returns need recalculating, not only the next one. Years already filed, a switch that needs the CRA's permission, and a corporation's books are the points where a professional's review matters.

Gather your sales invoices with the date each was paid, the unpaid invoices and unpaid bills at each year-end, inventory counts, and your prior returns.

What does accrual accounting mean for income, expenses and inventory?

Accrual accounting counts what you earned and owe, not what moved through the bank. The CRA says to report income in the fiscal period you earn it, no matter when you receive it, and to deduct expenses in the period you incur them, whether or not you pay them then. "Incur" usually means you paid or will have to pay the expense.

The Income Tax Act points the same way. Business income is the profit for the year (section 9). An amount receivable (money customers still owe you) for goods sold or services rendered in the year is included even if it is not due until a later year, unless the method the taxpayer adopted, and accepted for income tax purposes, does not require it (section 12(1)(b)).

Which year a December sale paid in January belongs to is in December sales paid in January. Money received before the work is done is in customer prepayments.

For inventory, the CRA says to list and count it at the end of each fiscal period and to use the same valuation method every year (T4002 chapter 2; accounting methods). Valuation and cost of goods sold are in cost of goods sold for a sole proprietor.

Who can use the cash method in Canada, and for which income?

For self-employment income, only farmers, fishers and self-employed commission agents, and only for that income. Everything else is accrual.

The CRA's pages do not define "self-employed commission agent". It says it treats self-employed commission income as part of business income, and asks you to keep track of how much of your business income was commission income (T4002 chapter 2). A reseller who buys and sells goods should not assume the exception covers that income. If you think you are in the commission group, gather the agreements or statements that show how you are paid, and keep commission apart from fees and product sales.

Cash covers only the commission income. Other business income of the same person is accrual, and the CRA says to keep a separate set of records for each accounting method used (T4002 chapter 1).

For farming and fishing, the cash method is an election in the Income Tax Act (section 28). Once a return has used it, later years stay on it unless the Minister agrees to another method. If the business is carried on jointly with others, the election works only if each of the other persons has also elected the cash method (section 28(2)).

Does a corporation or partnership get to choose cash or accrual?

Apart from farming and fishing, no CRA page gives a corporation a cash option, so a corporation should not assume one. The sources that do speak lean toward accrual, and the rest is a question to settle with a professional.

Farming and fishing are the exception the Act shows. Section 28 lets a taxpayer elect the cash method for a farming or fishing business, and a taxpayer includes a corporation (section 28; section 248(1)).

For a corporation, the Act includes amounts receivable for the year unless an accepted method does not require them (section 12(1)(b)). The T2 starts from the corporation's financial statements. Generally their net income is not the same as net income for tax, and Schedule 1 reconciles the two (CRA T2 guide, chapter 3). If your corporation's books are on cash, its year-end statements may need adjustments for unpaid invoices, unpaid bills and inventory before the T2 is prepared. Whether cash-basis books can support the return is not settled by a CRA page; settle it with a professional before you file. What the T2 needs from the statements is in year-end financial statements for a corporation, and the gap between book and tax profit is in tax income versus book profit.

For a partnership, the CRA publishes its accounting-method page under sole proprietorships and partnerships, and the Act computes a partnership's income as if the partnership were a separate person resident in Canada (section 96(1)(a)). That points to the same rule: accrual, unless the income is farming or fishing income (cash only if every member has elected it) or commission income. The page text itself does not mention partnerships, so this is a reading of the sources to confirm for your partnership.

Can I keep cash-basis books and have my accountant convert at year end?

Often yes, as long as the return is on the right method. The CRA does not issue record books or suggest any type of books (CRA). The Act asks for records and books of account in a form that lets the tax be determined, including an annual inventory (section 230(1)). The return must follow the required method, and the books must let the tax be determined.

A year-end conversion usually does three things:

1. Income: start with customer receipts, add year-end amounts receivable, and subtract the opening amounts receivable already counted in the preceding year.
2. Expenses: start with payments for deductible business costs, add year-end amounts payable, and subtract the opening amounts payable already deducted in the preceding year.
3. Goods for sale: add opening inventory to the year's purchases and other goods costs, then subtract closing inventory to get cost of goods sold. See cost of goods sold for a sole proprietor.

Two traps. Books built from bank deposits are not cash-method books: deposits can include loans and transfers, and the rebuild is in rebuilding books from bank statements. And a cash-basis setting or report in accounting software changes how the books are shown, not the method the return must use.

The work grows with the number of unpaid invoices, unpaid bills and inventory. Keep the conversion schedules with the books: they show how each return figure was built. Whether to keep your own books is in doing your own books or hiring a bookkeeper.

What is different for professionals with work in progress?

A professional's income normally includes the value of work in progress at year-end. The CRA defines work in progress as goods or services you have not yet finished providing at the end of your fiscal period.

Professional fees for the year are built from what you received in the year, plus amounts receivable at year-end, plus the value of work in progress at year-end for which you received nothing in the year, minus last year's receivables and last year's work in progress. Unbilled work therefore counts even though no invoice exists.

The CRA's wording is "professional", and the page does not list who is one. Whether your work counts, and what value to put on unfinished work, are questions to settle with a professional before you file. Gather time records and open engagements at year-end.

How do I switch from cash to accrual accounting, or back?

Cash to accrual needs permission. The CRA says to get permission from your tax services office, ask in writing before the date you have to file your income tax return, and explain in the letter why you want to change. For a self-employed individual the filing due date is generally June 15.

Accrual to cash is open only to those who may use cash. The CRA says to use the cash method on your next return. It names no permission step for that direction.

In both directions, the first return on the new method must include a statement showing each adjustment made to income and expenses. The two methods put the same dollars in different years, so a switch without adjustments can leave amounts uncounted or counted twice. Moving from cash to accrual with no adjustment, for instance, would leave the invoices unpaid at the start of the first accrual year out of income in every year.

1. Confirm the direction, and whether cash was open to you at all.
2. For cash to accrual, write to the tax services office before the return is due and give the reason.
3. At the changeover date, list money owed to you, bills you owe and inventory.
4. File the first return on the new method with the statement of adjustments.
5. Keep the request, the lists and the statement with your records.

If cash was never open to you, a request to switch does not fit your case. The question is whether earlier returns were built on cash.

What if I have reported on the cash basis for years?

If cash was not open to you and a return was built on it, that return followed a method the CRA's pages do not allow for that income. The question is then which years to recalculate on accrual, not a permission request for a switch.

A wrong method moves income between years. When unpaid invoices grew year by year, each return reported less than the accrual figure, and the invoices still unpaid at the last year-end have not appeared in any return. A correction can raise one year and lower another.

1. List each year's deposits, unpaid invoices, unpaid bills and inventory.
2. Recalculate each year on accrual and compare it with what was filed.
3. Before changing any filed return, settle which years add income and which reduce it, and in what order to file them.

A filed individual return is changed with "Change my return" in your CRA account, ReFILE in certified tax software, or Form T1-ADJ by mail (CRA). That route is for an individual's T1. This guide does not cover how a filed T2 or partnership return is changed, and a partner's own T1 may change too. A refund cannot be issued for an adjustment request made more than 10 calendar years after the end of the tax year. Adding income to a filed year can raise the tax owing for it, and the CRA's voluntary disclosure program grants relief case by case to people who come forward.

How long the CRA can reassess a filed year depends on the taxpayer and on exceptions; see how far back the CRA can reassess. Where the correction adds income to a filed year, see unreported income and voluntary disclosure.

Does cash or accrual change my fiscal period or GST/HST?

No. The method decides when a dollar counts within the fiscal period. The fiscal period is the business year, and it is a separate choice.

Self-employed individuals, and partnerships with an individual member, generally have to use a December 31 year-end (T4002 chapter 1; section 249.1). Choosing a year-end is in choosing or changing a year-end.

GST/HST is not tied to your income method. Tax on a taxable supply is payable on the earlier of the day the consideration is paid and the day it becomes due (Excise Tax Act, section 168(1)), so an unpaid invoice can carry GST/HST before you are paid. The CRA also tells farmers on the cash method to use the accrual method for GST/HST purposes. See GST/HST reporting period and fiscal year.

Example

These examples are illustrative; all amounts are in Canadian dollars.

A consultant invoices in December

A sole proprietor consultant with a December 31 year-end finishes the agreed work and invoices C$20,000 on December 10. The client pays on January 12. On the accrual method the C$20,000 is income of the year the work was done and the amount became receivable, though the bank shows it the next year. A return built from deposits puts it in the wrong year.

A commission salesperson and a reseller

A self-employed commission salesperson earns C$150,000 in commissions and reports them when received. The cash method is open for that income. A reseller who buys goods and sells them with C$150,000 of sales may not use it: accrual is the rule for that income, and the year-end inventory is counted.

Three years of books on bank deposits

A bookkeeper runs a sole proprietor's books on bank deposits for three years. The accountant converts each year to accrual. Income only. The business started in Year 1, so no invoices were unpaid at its start:

Accrual income is deposits, plus unpaid invoices at year-end, minus last year's unpaid invoices. Unpaid bills also need opening and closing adjustments. For inventory, opening stock raises cost of goods sold and closing stock lowers it. All three returns change, and in this example the C$15,000 still unpaid at the end of Year 3 has not appeared in any of the three returns.

Different for you?

• Your books are on a cash basis, your accountant says income must be accrued, earlier returns used deposit dates, or you have several years on cash with large unpaid invoices or inventory: the conversion needs each year's unpaid invoices, unpaid bills and inventory, and a decision on whether filed returns change; a correction can raise a filed year's income. See bookkeeping help and catching up on overdue books.
• The CRA has written to you about your income or your accounting method: keep the letter, and settle the years and the filing route before changing any return. See bookkeeping help.
• You run a corporation and keep cash-basis books: what the T2 needs from the statements is in year-end financial statements for a corporation; whether cash-basis books can support the T2 is not settled by a CRA page, so confirm it before filing. See bookkeeping help.
• You are in a partnership: the method is a reading of the sources to confirm for your partnership, and each partner's return is affected. See bookkeeping help and a general partnership's first-year return.
• You report rental income on the T776: the CRA says most rental income uses the accrual method, and cash is allowed only with almost no amounts receivable and no expenses outstanding at year-end, and only if net rental income or loss would be almost the same under accrual (CRA, Rental income). See rental income; a short-term rental may be business income instead, see Airbnb rental or business income.
• A client never paid an invoice you counted as income: see writing off unpaid customer invoices.
• You are a professional with unbilled work: unfinished work counts in income, and what value to put on it is a question to settle before you file. See bookkeeping help.
• A filed year left income out: see unreported income and voluntary disclosure.
• You also have a US business: see cash or accrual for a US small business.
• You live in Quebec: this guide covers the federal rules. Quebec residents also file a Quebec return with Revenu Québec, which this guide does not cover.
• You want the full picture of self-employed tax: see how self-employed income is taxed.