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Cash vs. Accrual Accounting
There are two methods of accounting that can be used in keeping records and filing income tax. It is important to realize which method you are using and to understand the advantages and limitations of each method to ensure that you are getting the best information from which to analyze your records.
Canada Revenue gives farmers special treatment in that they allow them to file their income tax on the cash method whereas other businesses must use the accrual method. As its name implies under the cash method income is reported at the time you receive payment, and expenses at the time the seller you are purchasing from receives their payment. One advantage of this method is simplicity; however another is the control of taxable income by the timing of purchases and sales. Deferring income, pre buying inputs, and holding inventory are all means of controlling taxable income. For tax and simplicity reasons, all of our farming clients use the cash method to file their tax.
Why then should we even consider the accrual method? Think about the information the cash method gives you and ask yourself can you really judge the profitability of any given year under this method? Consider two different years back to back. The first year was an excellent crop, but not much of it was sold during the year. The second year was a complete disaster but most of the first year’s crop is sold in the disaster year. Do you get the picture? The cash method could easily account for higher income in the disaster year.
The accrual method matches the grain or livestock produced in any given year with the expenses incurred to produce that income. This is done by removing from income the value of inventory on hand at the beginning of the year as that was prior year production, then adding into income the end of year inventory value as that was current year production. Also accounts receivable, deferred grain, pre purchased inputs and accounts payable are all likewise matched to the proper production cycle.
Is this more complicated? Yes but it is also much more meaningful. Many farmers are now using both methods. The cash method is used to report to Canada Revenue but the accrual method gives them the management information they need.