How you record income and expenses determines how much tax you owe — and when you owe it. Canada allows two accounting methods: cash basis and accrual basis. Choosing correctly from the start prevents expensive restating later.
Cash Basis Accounting
Under cash basis, you record income when money is received and expenses when money is paid. If a client owes you $5,000 but hasn't paid yet, that $5,000 doesn't appear in your revenue — it doesn't exist in your books until the cheque clears.
Allowed for: Sole proprietors, partnerships, and some small corporations (with limitations).
Advantages: Simple to maintain, matches cash flow, straightforward for businesses with few receivables or payables.
Limitations: Can distort profit — a business with large unpaid invoices appears less profitable than it is. Also, the CRA requires certain income to be reported on accrual regardless of when payment is received (e.g., amounts billed but not collected must still be reported for most purposes).
Accrual Basis Accounting
Under accrual basis, you record income when it is earned (regardless of when paid) and expenses when they are incurred (regardless of when paid). That $5,000 client invoice becomes revenue the moment you deliver the service, even if they pay 60 days later.
Required for: All corporations filing a T2 return. Also the CRA's preferred method for any business with inventory.
Advantages: More accurate picture of profitability; required for proper GAAP/ASPE financial statements; banks and investors expect it.
The CRA's Position on Cash vs. Accrual
The Income Tax Act requires that income be calculated using the method that gives an accurate picture of the taxpayer's income. For corporations, this always means accrual. For sole proprietors, the CRA allows cash basis if it produces an accurate result — but it explicitly disallows cash basis for professionals (lawyers, doctors, accountants, engineers) who have significant work-in-progress.
Comparison: Cash vs. Accrual
| Factor | Cash Basis | Accrual Basis |
|---|---|---|
| Revenue recognized | When received | When earned |
| Expense recognized | When paid | When incurred |
| Accounts receivable | Not tracked | Tracked on balance sheet |
| Accounts payable | Not tracked | Tracked on balance sheet |
| Required for corporations | No | Yes |
| Required for inventory | No | Yes (CRA preferred) |
| Complexity | Low | Medium–High |
When to Switch from Cash to Accrual
Most sole proprietors start on cash basis because it's simpler. Switching to accrual is typically triggered by one of these events:
- Incorporating your business (switch is mandatory)
- Adding employees or significant inventory
- Applying for a business loan (banks require accrual financials)
- Revenue growing above $500,000 (complexity of cash basis increases)
Switching methods mid-year requires an adjustment entry. Work with your bookkeeper or accountant to avoid double-counting income or missing expenses during the transition year.
GST/HST and Your Accounting Method
Your GST/HST reporting method (invoice basis vs. payment basis) is separate from your income tax accounting method but related. Most businesses use the invoice basis (accrual equivalent) by default. Businesses with revenue under $1.5 million can elect the payment basis (cash equivalent), which means you only remit GST/HST on amounts actually collected. This option must be elected in writing with the CRA.
Not Sure Which Method Your Business Should Use?
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