Many farmers use the cash method of accounting; however, there are benefits to using the accrual method of accounting.
Farms Can Use Cash Method of Accounting
Farms, unlike many other businesses in Canada, can still use the cash method of accounting (aka cash accounting). Many farms find the accrual system a more useful business tool. The one you select depends on a several factors and decisions.
If your business meets the Income Tax Act definition of “farming” you are eligible to use the cash method of accounting for tax reporting. That doesn’t mean, however, that cash accounting is your best choice for effective business management..
The Advantage of the Cash Method
The cash method does have the advantage of allowing you to determine your potential tax situation before year end while you still have time to take steps to reduce your taxable income for that year. And generally speaking, your cash flow will be higher for the years in which you have tax payable. But when you are forced to sell inventories, cash accounting could leave you with unusually high taxable income.
The Main Difference Between Cash and Accrual Accounting Systems
The main difference between these accounting systems is the time at which you account for each income or expense item.
In cash accounting you record a sale or expense only when the cash is received or paid. Inventory is not included in the calculation of income.
With accrual accounting you record income and expenses when a sale or purchase is made, even if the money hasn’t yet changed hands. Change in value of all inventories, such as livestock, crops and purchased inputs, form part of the income calculation. It’s possible to use one method for tax purposes, and the other for accounting purposes.
Accrual account books can be a useful business tool.
Years ago, a farm’s financial reports were used mainly to determine income for income tax purposes. The data was seldom used to help assess how well a farm was doing, and bankers didn’t need financial reports to support credit requests. Land, equipment and inventory were put up as security to support loan approvals.
Things are much different now.
Many smaller family-owned farms have been consolidated into much larger commercial operations, often involving several distinct production enterprises and significant capital investment.
Today’s producers also face new challenges from globalization such as increasing operating and input costs, along with fluctuating prices for their products, both of which lead to inconsistent net income. Food production is risky business.
In light of such economic realities, detailed up-to-date financial information is essential in making sound business decisions and assessments. Such information shows you exactly how well your operation is doing at a specific point in time. You then can decide whether to discontinue a particular enterprise or look for ways to economize.
Canadian Government Support Programs Like Agristability
Government support programs like AgriStability also require a form of modified accrual information. Even if you file your income tax return using the cash method, your AgriStability program year margin will be adjusted for changes in inventory, accounts payable and receivable, and purchased inputs.
Financial Business Reports
Accrual accounting lets you produce a variety of business financial reports.
- A balance sheet lists business assets and liabilities as of a specific date, along with owner equity. This statement is useful in assessing a business’s risk position, solvency, ability to meet current debts, and changes in equity.
- The statement of retained earnings (capital) summarizes changes in earnings retained in the business during the period under review.
- A third report, the income statement, summarizes business income and expenses and provides a measure of profitability for the period under review.
- And the statement of cash flow helps in assessing business solvency and liquidity, as well as the ability to generate cash from internal sources, repay debt obligations, reinvest, and make distributions to owners.
Many of today’s farm operations include a number of different production activities or enterprises.
While some of these simply support other farm enterprises, others are pursued to diversify farm output and manage overall business risk. Each enterprise may have a unique set of production methods and costs.
To enhance the effectiveness of your business decision-making, you really should track the details of each enterprise separately:
- Output or production capacity
- Net income
Switching from Cash To Accrual Accounting
Switching from cash to accrual accounting really isn’t difficult, particularly if you set up your chart of accounts early in the year and start with an accurate list of accounts receivable and payable, prepaid expenses, inventory, etc.
You can follow either a manual double-entry bookkeeping system or choose one of several software packages for computerized bookkeeping. Some are even recommended specifically for farming.
The bottom line is that sound business management begins with accurate financial data. A good accounting system gives you the information you need to control cash flow, monitor business progress, and develop strategies to meet ongoing challenges.
Good records also help your tax professional access all tax credits, deductions and income deferrals available to you when completing your tax returns.
You’ll also find it easier to participate in government support programs like AgriStability. Finally, should you ever be audited by Canada Revenue Agency, you’ll be armed with detailed financial records to support your compliance filings.