Cash basis or accrual.

The difference, briefly

Cash basis records a sale when the money arrives and a cost when it is paid.

Accrual records the sale when the work is done and the cost when it is incurred, whenever the money moves.

The idea behind accrual is that a sale and the costs of earning it should land in the same period. Sell something in March and the materials, the labour and the delivery belong in March as well, whenever those invoices happen to be paid. This is often called the matching principle, and it is why accrual can tell you whether a particular job made money and cash basis cannot.

The important thing is that this is not one question. It is three, and only one of them has a fixed answer.

Your bookkeeping	Your choice. Nothing obliges a Canadian business to record transactions on an accrual basis through the year
Your financial statements	Depends on the framework. Statements prepared under Canadian accounting standards are accrual, but a compilation can be prepared on a cash basis so long as that basis is disclosed
Your tax return	Accrual, with narrow exceptions. Always accrual for a corporation. This is the layer that is not a matter of preference

So a Canadian business genuinely can work on a cash basis for its own accounting. What it cannot do is file that way.

Why advice written for the US differs

Most people arrive at this question because something they read did not match what their accountant said. Usually the reason is that what they read was written for the United States.

The IRS allows a business to work out its taxable income using any of four approaches:

• The cash method
• The accrual method
• Special methods for particular items of income and expense
• A hybrid, combining elements of the above

Small businesses there may also elect the cash method, below a gross receipts threshold set well above what most owner-managed firms earn. So in the US, cash basis is not a corner cut. It is a legitimate choice, and mixing methods is permitted on top of it.

That is why American guidance so often reads as choose whichever suits your business. For its intended audience, that advice is correct.

	Canada	United States
Methods available	Accrual	Cash, accrual, special methods, or a hybrid
Small business cash election	None	Available below a gross receipts threshold
Exceptions	Farmers, fishers and self-employed commission agents. Never a corporation	Certain businesses required to use accrual

Almost no accounting content online is written for Canada. Videos, blog posts, courses and software help articles are overwhelmingly American, and accurate for their readers.

Notice where the divergence actually falls. Someone who reads that guidance and keeps cash-basis books has done nothing wrong, because that layer is a free choice here too. The gap opens only at the return.

What the return requires

Income for tax purposes is computed on ordinary commercial principles, which means accrual. Receivables count as income when earned. Payables count as expenses when incurred. Work finished and not yet invoiced still counts.

This applies whatever your bookkeeping looked like during the year. Cash-based records are not a problem in themselves; they simply have to be converted before the return is prepared.

Where the exceptions exist depends on how the business is structured.

Corporations	Accrual. There is no cash option
Sole proprietors and partnerships report on the accrual method, with three exceptions who may choose either:
Farmers	May use the cash method
Fishers	May use the cash method
Self-employed commission agents	May use the cash method

All other self-employment income is reported on the accrual method. So an incorporated business has no choice at all, and an unincorporated one has a choice only if it falls into one of those three.

Using the cash method on a farm

For farms this is a real exception rather than a technicality, and it is why farm accounting looks different from everything around it. Used deliberately it is a planning tool, because the timing of purchases and sales either side of a year end changes the reported result. Used without attention, it produces a picture of the operation that swings on when the cheques happened to clear.

Three conditions come with it:

• It applies to the farming activity only. A separate business is reported on the accrual method
• GST and HST are accounted for on the accrual method regardless
• Separate records are kept for each method in use. One set of books is not enough

Inventory is normally excluded from income under the cash method. The optional and mandatory inventory adjustments are the exception, and they are one of the few real timing levers in farm reporting.

Switching methods

Accrual to cash	Use the cash method on your next return. Include a statement showing each adjustment made to income and expenses
Cash to accrual	Get permission from your tax services office first. Ask in writing, before your filing due date, and say why

The direction you can take freely is the harder one to reverse. Decide at the outset rather than after a year on the wrong one.

Professionals and work in progress

There was once an election that let designated professionals leave work in progress out of income. It was eliminated and has since been fully phased out, so unbilled work now counts like anything else. It matters most to incorporated professionals carrying real WIP at a year end.

Modified cash basis

You will hear this term more than you used to, so it is worth knowing what it is and where it can be used.

Modified cash basis is cash basis with a few accrual elements added back. The usual additions are capitalizing equipment and taking amortization on it rather than expensing the purchase, and sometimes recording payroll liabilities or inventory. Everything else stays on cash.

It exists because pure cash basis produces some odd results. A business that buys a $90,000 truck shows a $90,000 expense in one month and nothing thereafter, which financial statement users do not find useful. Adding back the fixed assets fixes the worst of it while keeping the simplicity.

For your accounting	Permitted. It is a recognized basis, and statements can be prepared on it provided the basis is described
For your tax return	Not permitted. There is no partial or blended method. The return is accrual, subject only to the three exceptions above

Why you hear about it now

CSRS 4200 replaced the old Notice to Reader for periods ending on or after 14 December 2021. It requires compiled statements to include a note describing the basis of accounting used. That basis was often unstated before, and a reader had to infer it.

So the term is not new. Its visibility is. A basis that was always permitted now appears in writing on statements clients actually read.

Keeping cash books and converting at year end

Keeping cash-based records through the year and converting to accrual at the year end is a normal arrangement. Plenty of small businesses run this way and it works.

What has to be brought on at the year end, and taken back off at the start of the next one:

• Accounts receivable, being work invoiced and not yet paid
• Work in progress, being work done and not yet invoiced
• Accounts payable and accrued liabilities
• Prepaid expenses, such as insurance paid for a year in advance
• Inventory on hand
• Deposits taken from customers for work not yet performed

Two things about that conversion are worth knowing. It is real work, and it is priced accordingly, so cash-basis bookkeeping is cheaper during the year and more expensive at the end of it. And it is where errors sit. An adjustment brought on at one year end and not reversed at the start of the next puts income in the wrong year, and the mistake shows up twice: once where it lands and once where it should have been.

The opening balances are the thing to check. If last year's accrual adjustments were not reversed properly, this year starts wrong before a single transaction is recorded.

What each one shows you

Cash basis tells you about the bank account. Accrual tells you about the business.

A contractor with $180,000 of work finished and not yet billed shows none of it on a cash basis. The month the money lands looks extraordinary, and the months of work that earned it look thin.

Costs move the same way. Pay a year of insurance in January and cash basis puts the whole amount in January, where accrual spreads it across the twelve months it covers. Buy $40,000 of materials in December for work you will do in February and cash basis records the cost in one year and the revenue in the next, which makes the first year look worse and the second look better than either really was.

Two consequences follow:

• Lenders generally want accrual figures, because cash basis understates a business that is owed a great deal and overstates one that has just collected
• Job costing needs accrual. Knowing which work makes money depends on revenue sitting in the same period as the costs that produced it, which is what accrual does and cash basis does not. See accounting solutions for what that makes possible

Where cash basis still earns its place

It is simpler, cheaper to maintain, and easier for an owner to follow without training. For a very small operation with no receivables, no inventory and no work in progress, the two methods produce close to the same answer, and the argument is largely theoretical.

It is also the honest answer for anyone who will not keep accrual records accurately. Cash-basis books that are current and correct beat accrual books that are neither.

The other choices behind your statements

The basis of accounting is the largest of a set of choices, not the only one. Where the framework permits more than one treatment, somebody picks, and the pick usually persists for the life of the business.

Income taxes	The taxes payable method or the future income taxes method. The first avoids carrying deferred tax balances at all and is simpler to read
Long-term contracts	Recognizing revenue as work progresses, or on completion. This decides which year the profit lands in, and matters most to contractors
Inventory	First in first out, weighted average cost, or the retail method, and how write-downs to net realizable value are handled
Capitalization threshold	The dollar figure below which a purchase is expensed rather than added to fixed assets
Depreciation	Method and useful life. This is the accounting figure and is separate from the capital cost allowance claimed on the return
Investments in other companies	Whether a subsidiary or investee is consolidated, equity accounted, or carried at cost
Leases	Whether an arrangement is treated as a purchase financed over time or as a rental

Three things worth knowing about them

Some change the tax and some do not. Depreciation does not: capital cost allowance is claimed on its own schedule whatever figure appears in the statements. But the treatment of inventory, long-term contracts and leases, and the point at which a purchase is capitalized rather than expensed, can each affect when income is taxed. A choice that is purely presentational and a choice that moves a tax bill deserve different amounts of thought.

They are supposed to be consistent. Changing a policy later generally requires a reason and a restatement of the comparative figures, so the choice made early is the one you tend to live with. That argues for deciding deliberately while the business is small rather than inheriting a default.

One choice moves several numbers. Capitalizing rather than expensing changes assets, equity and the profit for the year.

Two things that follow their own rules

HST has its own timing rules, which do not automatically follow whichever basis you keep the books on. Assuming the two match is a common source of filing differences.

Compilation engagements disclose the basis of accounting used, so anyone reading the statements can see which one they are looking at. That disclosure exists precisely because the choice is not obvious from the numbers. See financial statements.

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