How to Choose Between Cash and Accrual Accounting Methods
One of the fundamental decisions Ontario business owners must make is which accounting method to use: cash basis or accrual basis. This choice affects how you record income and expenses, prepare financial statements, and report taxes to the CRA. While it may seem like a technical accounting detail, your accounting method significantly impacts your financial picture and tax obligations.
At BBS Accounting in Toronto, we help business owners understand these methods and choose the one that best suits their operations, industry, and goals.
Understanding Cash Basis Accounting
Cash basis accounting is straightforward: you record income when you receive payment and record expenses when you pay them. If a client pays you $5,000 on March 15, you record $5,000 income in March, regardless of when you did the work. If you pay a $1,000 bill on April 2, you record that expense in April, regardless of when you received the bill or incurred the expense.
Advantages of Cash Basis:
The primary advantage is simplicity. Cash basis accounting is intuitive—if money comes in, it’s income; if money goes out, it’s an expense. Most people naturally think in cash basis terms because it mirrors how we manage personal finances.
For small Ontario businesses without inventory, cash basis often provides adequate financial visibility. You know how much cash you have and where it came from. For service businesses, freelancers, consultants, and other professionals, cash basis can be perfectly adequate.
Cash basis accounting typically requires less bookkeeping time and expense. You don’t need to track accounts receivable, accounts payable, or make complex accrual entries. This translates to lower accounting costs, whether you handle bookkeeping yourself or hire professionals like BBS Accounting.
Cash basis also offers tax planning flexibility. Since income isn’t recorded until received, you can delay invoicing until January to push income into the next tax year. Similarly, you can accelerate expenses by paying bills in December rather than January, increasing current-year deductions.
Disadvantages of Cash Basis:
The major disadvantage is that cash basis doesn’t provide an accurate picture of business performance. If you complete $50,000 of work in March but don’t receive payment until April, your March financial statements show no income even though you had a productive month.
This timing mismatch makes it difficult to assess profitability, track trends, or make informed business decisions. Your financial statements show cash flow, not business performance.
Cash basis can also create misleading financial statements. If you pay an annual insurance premium of $12,000 in January, cash basis records the entire $12,000 as January expense. Your January income statement shows a large loss, while February-December show artificially high profits because no insurance expense appears.
For businesses that extend credit to customers or purchase on credit from vendors, cash basis provides limited visibility into obligations. You might have $20,000 in unpaid invoices and $15,000 in unpaid bills, but none of this appears in your cash basis financial statements.
Finally, many lenders, investors, and potential buyers prefer or require accrual basis financial statements. If you’re seeking financing or planning to sell your business, cash basis statements may be insufficient.
Understanding Accrual Basis Accounting
Accrual basis accounting records income when earned (regardless of when payment is received) and expenses when incurred (regardless of when payment is made). If you invoice a client $5,000 on March 20 for work completed, you record that income in March even if the client doesn’t pay until May. If you receive a $1,000 bill in December but don’t pay it until January, you record the expense in December.
Advantages of Accrual Basis:
The primary advantage is accuracy. Accrual basis provides a true picture of business performance by matching revenue with the expenses incurred to generate that revenue. This allows accurate assessment of profitability and trends.
Accrual basis financial statements are more useful for decision-making. When you can see revenue earned and expenses incurred in the same period, you understand which activities are profitable and which aren’t.
For businesses with inventory, accounts receivable, or significant accounts payable, accrual basis is essential. You can track what customers owe you (accounts receivable) and what you owe vendors (accounts payable), providing complete financial visibility.
Most lenders require accrual basis financial statements for business loans. Accrual statements give lenders better insight into your business’s true financial position.
As your business grows, accrual basis becomes necessary. Once you have employees, significant inventory, or complex operations, cash basis becomes inadequate.
The CRA generally accepts either method for small businesses, but certain situations require accrual basis. Corporations must use accrual basis. Businesses with inventory generally must use accrual basis for tracking inventory costs.
Disadvantages of Accrual Basis:
The main disadvantage is complexity. Accrual accounting requires tracking accounts receivable, accounts payable, and making period-end adjusting entries. This requires more sophisticated bookkeeping and often necessitates professional help.
Higher accounting costs follow from this complexity. Whether you’re doing it yourself with more time investment or hiring professionals at BBS Accounting, accrual basis requires more resources than cash basis.
Accrual basis also creates a potential disconnect between reported income and available cash. You might show $100,000 profit on your accrual basis income statement but have limited cash because customers haven’t paid yet. This requires careful cash flow management separate from profitability analysis.
Tax planning is less flexible with accrual basis. Once you’ve earned income, it must be reported even if not yet collected. You can’t defer income by delaying invoicing since you’re supposed to accrue income when earned regardless of billing.
CRA Requirements and Restrictions
The Canada Revenue Agency allows most small businesses to choose their accounting method, with some exceptions:
Corporations: All corporations must use accrual basis for tax purposes. Even if you maintain cash basis records internally, your corporate tax return must be prepared on an accrual basis.
Inventory: Businesses that buy or manufacture products for resale and maintain inventory must generally use accrual basis for tracking inventory and cost of goods sold, though some small businesses may qualify for simplified inventory methods.
Professional Corporations: Designated professionals (doctors, lawyers, accountants, dentists, veterinarians) could historically use modified cash basis accounting, but rules have tightened. Many professional corporations must now use accrual basis.
Once you choose: Your accounting method must be applied consistently year to year. Changing methods requires CRA approval and specific procedures. You can’t flip back and forth between methods to manipulate taxable income.
At BBS Accounting, we ensure our clients’ chosen methods comply with CRA requirements for their specific business structure and industry.
Industry Considerations
Certain industries naturally lend themselves to one method or the other:
Better suited for cash basis: Service professionals (consultants, freelancers, coaches), small retailers with minimal accounts receivable, contractors receiving progress payments, professional services firms, and personal service businesses.
Better suited for accrual basis: Manufacturers, wholesalers and distributors, businesses with significant inventory, companies extending credit to customers, businesses seeking financing or investment, and rapidly growing companies.
Many Ontario businesses start with cash basis for simplicity and transition to accrual basis as they grow and their needs evolve.
Hybrid Approaches
Some businesses use hybrid approaches, maintaining cash basis for simplicity but adjusting to accrual basis for specific purposes:
You might keep cash basis books for day-to-day management but prepare accrual basis statements annually for tax purposes or lender requirements.
Or maintain cash basis internally but make accrual adjustments at year-end to properly report inventory, significant receivables, and payables.
While hybrids can work, they create additional complexity. Often it’s simpler to fully commit to one method or the other.
Tax Planning Implications
Your accounting method affects tax planning opportunities:
Cash Basis Tax Planning: Delay sending December invoices until January to defer income to next year. Prepay January expenses in December to accelerate deductions. Time large equipment purchases for year-end to claim immediate deductions.
These strategies are legitimate tax planning, but have limits. You can’t unreasonably delay invoicing for work completed. The CRA expects businesses to invoice in reasonable timeframes.
Accrual Basis Tax Planning: Less flexibility in timing income and expenses, but opportunities still exist. You can manage inventory valuation methods (FIFO vs. average cost). You can strategically time when work is completed and thus when revenue is accrued. You can prepay certain expenses if they relate to the current year.
Making the Decision
Consider these factors when choosing your accounting method:
Business structure: If incorporated, you must use accrual for tax returns regardless of your internal method.
Inventory: Significant inventory generally requires accrual basis.
Credit terms: If you extend credit to customers or purchase on credit from vendors, accrual provides better visibility.
Complexity tolerance: Are you comfortable with more complex bookkeeping, or do you need simplicity?
Financial statement users: Do lenders, investors, or potential buyers need accrual statements?
Business size: Larger businesses typically need accrual basis for adequate financial management.
Growth plans: If you’re planning significant growth, accrual basis scales better than cash basis.
Bookkeeping resources: Do you have the time, skills, and tools for accrual accounting? Can you afford professional bookkeeping help?
At BBS Accounting, we assess each client’s unique situation and recommend the method that best serves their needs.
Transitioning Between Methods
If you start with cash basis and later transition to accrual, the process involves:
Adjusting entries: Record all accounts receivable as of the transition date (income earned but not received). Record all accounts payable (expenses incurred but not paid). Adjust inventory to proper levels. Create opening balances for all accrual-basis accounts.
CRA requirements: Technically, changing accounting methods requires filing Form T1139 and receiving CRA consent. The CRA generally allows the change if legitimate business reasons exist, but proper procedures must be followed.
Comparative periods: Your first full accrual-basis year should include prior period comparisons, even if those prior periods must be converted from cash to accrual for comparison purposes.
The transition can be complex. At BBS Accounting, we handle transitions for clients, ensuring proper accounting treatment and CRA compliance.
Software Considerations
Your choice of accounting method affects your software needs:
Cash basis software: Many simple programs can handle cash basis, including spreadsheets, Wave, FreshBooks, and basic QuickBooks.
Accrual basis software: Accrual basis requires more robust accounting software like QuickBooks Online, Sage, or Xero that can properly track receivables, payables, and inventory.
Most modern accounting software defaults to accrual basis but can run cash basis reports. This provides flexibility to maintain accrual basis books while viewing cash basis reports for management purposes.
Real-World Example
Consider a Toronto consulting business:
Cash Basis Scenario: You complete a $10,000 project in December but don’t receive payment until January. You pay $2,000 in December expenses. Your December cash basis income statement shows $0 revenue, $2,000 expenses, and a $2,000 loss. Your January statement shows $10,000 revenue, minimal expenses, and a large profit.
Accrual Basis Scenario: Same facts, but your December accrual statement shows $10,000 revenue, $2,000 expenses, and $8,000 profit. January shows minimal activity since both the revenue and related expenses were recorded in December when earned and incurred.
Which statement more accurately reflects your business performance? Clearly the accrual statement, since you did the work in December. The cash statement makes December look terrible and January look artificially strong.
However, from a cash flow perspective, the cash basis statement accurately shows you need to fund December’s $2,000 in expenses without December revenue coming in.
Ideally, you’d use accrual basis for profitability analysis and maintain separate cash flow statements for cash management.
The Recommendation from BBS Accounting
For most Ontario businesses, we recommend:
Start-ups and very small service businesses: Begin with cash basis for simplicity, but plan to transition to accrual as you grow.
Any business with inventory: Use accrual basis from day one.
Corporations: Use accrual basis as required by CRA.
Growing businesses: Transition to accrual sooner rather than later. Making the switch at $500,000 in revenue is easier than at $5 million.
Professional services: Consider modified accrual where you accrue revenue when invoiced rather than when work is performed, and track payables on accrual basis while maintaining cash basis for other transactions.
Ultimately, the right choice depends on your specific circumstances. At BBS Accounting in Toronto, we provide personalized advice based on your business structure, industry, growth trajectory, and financial management needs.
The Bottom Line
Cash basis and accrual basis accounting aren’t just technical choices—they affect how you understand and manage your business’s financial performance. Cash basis offers simplicity but limited insight. Accrual basis provides accuracy but requires more sophistication.
Most businesses eventually adopt accrual basis as they grow, whether by choice or requirement. Starting with accrual basis from the beginning often proves wise, as it scales with your business and avoids difficult transitions later.
Contact BBS Accounting today to discuss which accounting method is right for your Ontario business. We’ll assess your specific situation and ensure you’re using the method that provides the best combination of simplicity, accuracy, and compliance with CRA requirements. Our goal is ensuring your accounting system serves your business needs both now and as you grow.
