Cash vs Accrual Accounting.
Cash and accrual are two different methods of accounting that serve different purposes. You might have heard of the terms before but never knew what they meant or how they impacted your agricultural operation. This month we’ll attempt to provide you with a clearer description of each and why it’s important, as a producer, for you to understand what information the two reporting methods provide.
First, let’s start with the cash method. The cash method is fairly straightforward; revenue is reported when received and expenses deductible when paid*. This method allows for the deferral of income and deduction of prepaid inputs/supplies (within certain limitations) and thus can give producers flexibility on the timing of taxable net income. Farming operations are unique as it relates to the cash method as they are one of the few types of businesses allowed to use this method for tax reporting purposes to the Canada Revenue Agency (CRA), be it as an individual sole proprietor, partnership, or corporation. Although a producer can opt to use the accrual method to report to the CRA, it is seldom seen and currently, none of our clients use it for tax reporting purposes. Once the cash method is chosen with CRA a special request is required to convert to the accrual method. Given its simplicity and flexibility for tax planning, the cash method is usually the preferred method of accounting for tax purposes.
The accrual method of accounting on the other hand is a little more complex, but in our opinion much more useful from a management point of view. Accrual accounting consists of recognizing revenue when it’s earned and recording expenses when incurred. The definition of earned revenue includes any sale or service that was made/provided but payment not yet received (i.e. crops delivered but payment deferred to the following year or custom work provided for which funds have not yet been collected) or inventory produced but not yet sold (i.e. crops produced in one year but only being sold in the next). The definition of an incurred expense is any input/supply consumed or service received during the year that relates to the production cycle, but that was not yet paid for by the end of that year (i.e. a repair bill for machinery done in fall but only paid for in the following year). This method does a much better job of matching the revenues and expenses to the production cycle that they relate to. As such accrual accounting is the preferred and accepted method for financial statement reporting. Using financial statements prepared on an accrual basis allows producers to better gauge profitability from one year to the next (regardless of the timing of sales or expenses). Having financial statements prepared on an accrual basis also better prepares producers when it comes to financing requests as bankers will often require information to bridge the gap between cash and accrual.
At Talbot & Associates when preparing financial statements for any of our agricultural clients we ensure they are prepared on an accrual basis to meet management and financing needs while providing an additional statement to reconcile on a cash basis for tax purposes, thus allowing our clients’ full needs to be met. If after reading this newsletter you are not sure of the current method your operation uses, please don’t hesitate to contact our Ag Team. Or if you find that you’re constantly asked multiple questions from your banker as it relates to inventory, prepaid expenses, accounts receivable, or accounts payable, you’re most likely not using the accrual method to report to your banker and you should consider contacting us to see how we can help alleviate some of that burden.
*Note that the definition of “paid” would include expenses paid with a line of credit or credit card (even when the balance of the credit card is paid off in a subsequent year).