‘Accounting’ for your income

January 17, 2008
Written by Liz Isaak
Did you know that persons engaged in a farming business can compute their income in one of two ways to the Canada Revenue Agency?

Most individuals and corporations are required to report their income on what is known as the accrual basis. Under this method, revenue is reported when it’s earned and expenses are deducted as they are incurred, regardless of when the cash is collected or paid.

For corporations and individuals engaged in the business of farming, there is a second method called the cash basis method. Under the cash basis method of computing income, revenue is reported when the cash is received and expenses are deducted as they are paid. The chart below summarizes the key differences between the accrual and cash basis methods of calculating income.
Here are some points to consider to assess whether or not the cash basis of income reporting makes sense for you.

Balance sheet at your year-end – If your year-end occurs when your accounts receivable or inventory are high, or accounts payable are low, then you would have a perpetual tax deferral on these amounts.

Long growing cycles – If your plants take more than one year to mature, using the cash method will enable you to take advantage of writing off the expenses as they are paid, rather than waiting for your crops to mature.

Growing business – If the size of your farm business is growing, the use of the cash method may help you to finance that growth through the deferral of taxes on the ever-increasing amounts of accounts receivable and inventory.

Fluctuating income levels – If your income is susceptible to significant fluctuations from year to year, using the cash method can allow you to even-out these fluctuations in your income for tax purposes through the use of the optional inventory adjustment. Using the optional inventory adjustment, inventory can be valued between nil up to the full fair market value of the inventory.

This flexibility in valuing inventory provides a significant tool in targeting a desired amount of taxable income each year. As a result, you can maximize the use of tax credits such as the small business deduction each and every year.

Books and records – In order to use the cash basis method, you need to be able to make an accurate estimate of your income prior to your year-end. Consequently, your books must be kept up to date. Any bonuses that you want to deduct in the year must be paid prior to your year-end.

Personal preferences – Some individuals have a personal aversion to the idea that they will have to pay taxes at some future date on the accumulating amount of accounts receivable and inventory, perhaps when they wish to retire. Also, the need to estimate the income and pay the bonuses prior to the year-end may create some frenzy at the year-end. Some business owners would prefer to avoid this frenzy despite any tax deferral benefits.

You can choose to adopt the cash basis method at any time simply by filing your tax return, whether individual or corporate, on the cash basis. If you want to change from the cash basis method to the accrual method, you must obtain permission from your tax office in writing in advance.

Income for tax purposes calculated under the accrual method can be very different from income calculated using the cash basis method. Ultimately, the choice between the accrual and cash basis methods of computing income should be based upon the particulars of your business at year-end, the stage of development of your business, and the length of your product cycles.

Questions or comments? Email greenhouse@annexweb.com

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