How to keep the CRA ("the taxman") happy
Yuk! Paperwork. Even worse, accounting paperwork!
But we gotta do it. So this week I’m going to talk about what the CRA (Canadian Revenue Agency -- or "the taxman", for short) expects from you. It’s good information to know so that you can keep the CRA happy—and your accountant too, if you have one.
This stuff is a bit dry, but you really need to understand it because this is how the CRA says you need to keep your books. So let’s get started!
Basic rules
There are a couple of rules that the CRA has specifically for the self-employed. By self-employed I mean those who work for themselves but do not have an incorporated business. (If you do have an incorporated business, the rules are a bit different, and that’s not the focus of today’s article.)
Here are the basic rules:
Your fiscal year must end December 31. (You cannot have a fiscal year that ends e.g. March 31, or January 31.)
You must file your taxes by Jun 15. (However, if you owe any tax, it is due April 30).
You must use the accrual method of accounting
Points 1 and 2 are fairly self-explanatory. But point 3 is more complicated, and that’s what we’ll cover in today’s article.
What is the accrual method?
Let’s start with an example.
Sid is a lawyer, and it is December 10, 2021. One of his clients is planning on buying a new house within the next few months. The client is, of course, going to hire Sid ahead of time—before any work needs to be done. Let’s also say that Sid asks for a $500 retainer up front (a down payment on the services he will provide in the future).
Here’s the question: Does Sid record the $500 as income on December 10, the day he received it? The answer, probably surprisingly to you, is no.
That’s because of accrual accounting. This is a method of bookkeeping that says you must record income when it is earned (that means when you do the work), not when you are paid.
In our example, Sid probably won’t do any work until the clients are ready to make an offer on a house. Let’s say they find a house they like on March 15. They then call Sid, who then starts to do some paperwork over the next week.
Even though he received partial payment (the $500 retainer) in December 2021, it isn’t recorded as income until March 2022. Think about it this way: what if the client decided not to buy a house after all? Sid must return the retainer—because he never really earned it. It’s not until he does some work that the retainer is converted to income. In the meantime, it’s just money given to him in trust.
What about expenses?
The same thing happens with expenses. Let’s say the clients find a house and want to make an offer. In order to advise them on that offer, Sid has to obtain a report on the house’s history. He orders the report from the Land Registry Office on March 15. However, rather than paying on the spot, the cost is put on his monthly tab, which he doesn’t pay until he receives his statement at the beginning of the following month (April).
So, when does the expense get recorded? In April, when it is paid? No, it is recorded in the time period in which it was actually incurred, March.
What it means for you
As a self-employed person, the CRA requires that you use the accrual method. For the most part, it may not make much difference to you. However, it will definitely make a difference in two specific ways.
1. When (if) you do monthly statements;
2. When you do your taxes.
Probably the main affect accrual accounting will have on your business is on your taxes. That’s because you have to record your income and expenses in the year you earn/use them. Here are some examples of what that means.
Prepayments. If your client pays you up front, in 2021, for work that is to be done in 2022, that is 2022 income, not 2021 income. If you do part of the work in 2021, and part in 2022, then the revenue is recorded partly in each of those two years.
Subscriptions. If your business has a subscription to a monthly magazine, that expense is spread across 12 months. It doesn’t matter if you paid the whole annual fee up front. So if you pay $120 in November of 2021, for an annual subscription (12 issues) for the year 2022, that expense isn’t recorded in 2021, but in 2022, the year you actually get the magazines. If you do monthly financial statements, then each month would show $10 ($120/12) of expense for the subscription.
Courses. If you sign up for a course that goes from December 1, 2021 to January 31, 2022, then approximately half of the expense would be recorded as occurring in 2021, the other half in 2022.
Payments after the fact. If you offer services, and then get paid only when those services are completed, you still record the income as occurring in the time period you performed the services. So if Sid, our lawyer, performs services in December 2021, then bills the client on January 1, and gets paid January 15, the income is for 2021, not 2022, even though 2022 is when the money actually came in.
So those are the basics of accrual accounting. But you may be wondering: why do we have to do it this way? I’ll go into that in next week’s article!
Cheers,
Tim
Helping you engineer the business of you
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p.p.s. Information in this article is for general information and is not intended as professional advice.