Last week I introduced you to the accrual method of accounting. In this method you:
- Record income and expenses in the time period in which they were earned/used, not in the period in which the money was received/paid.
This week we’ll talk about the why behind this practice.
The matching principle
There’s an important aspect of accounting that is related to the accrual method: the matching principle.
This is a rule that states that you record your expenses for a certain activity in the same time period that you record income for that same activity. To illustrate, let’s revisit Sid, our lawyer from last week’s article.
Let’s say he is hired by clients in November of 2021. In December he performs 6 hours worth of work for them. To do that work, he had to spend $200 for expenses.
Sid would record those expenses ($200) and the related income (6 hours x Sid’s $100 hourly fee = $600), as occurring in December 2021. If he doesn’t get paid by the client until, say, January 2022, it doesn’t matter. The expense time period is matched with the income time period: 2021. He may have more income from the same client in January, and more expenses in January, and those would both be recorded as January 2022 events.
This is a fairly straightforward example, as both the expense and work done to earn income were performed in the same year. But what if the expense and the income don’t occur in the same year?
Let’s say that Sid’s clients buy a house in December of 2021. The first thing Sid does is order a report on the house’s history (cost: $100). The report arrives in a few days, but Sid doesn’t study it until January. So he incurred an expense in 2021, but didn’t do any work (studying the report) until 2022.
Because of the matching principle, the expense ($100) is recorded in the same time period as the income earned from that expense. That means both the cost of the report and the fee Sid charges the client for studying the report must both be recorded as occurring in the same year, either 2021 or 2022. Often, in cases like this, they are both recorded in the later year (so 2022 in this case).
Why Accrual?
You may be wondering why the CRA expects you to use accrual accounting. It’s actually because the Accounting field recommends this method. That’s because it gives a better picture of the overall performance of a company. Here’s an example.
Let’s say you started up a new snow removal company in the fall of 2021. You got your first 3 clients in October–all big box malls. You sold them each a contract for $10,000 to remove snow from January 1 – March 31, 2022. In October, you went ahead and purchased the sand and salt you would need, for a total of $1,000. Between January and March of 2022, you spent $2,000 on gasoline for the plow.
Here’s a summary of what your company would look like on paper if we don’t use the accrual method.
| 2021 | 2022 | |
| Gross Income | $30,000 | $0 |
| Expenses | $1,000 | $2,000 |
| Net Income | $29,000 | -$2,000 |
It looks like your company made money in 2021, but is going down the tubes in 2022. But that’s not the case!
Now let’s see what the same information would look like using the accrual method.
| 2021 | 2022 | |
| Gross Income | $0 | $30,000 |
| Expenses | $0 | $3,000 |
| Net Income | $0 | $27,000 |
This gives a much more realistic picture of your company’s operations. And that’s why the accrual method is recommended. In this case, it accurately shows that your company grew from 2021 to 2022.
Imagine you are trying to sell your business, and you show a prospective buyer financial statements done the first way. Would they think your business was worth buying? Probably not.
However, if you showed them statements based on the second method—accrual—they would be much more likely to consider buying. That’s because it provides a better picture of what is actually happening.
* * *
So those are the basics of accrual accounting. If you do your own bookkeeping, you need to know about this because it is what the CRA rules say you need to be doing.
If you have an accountant who does your paperwork for you, it will of course be easier, but I still recommend you understand how this works, so that you can better understand what your accountant is doing, and what your financial statements are really telling you.
Note: While this article is mainly intended for the self-employed, not for those who have an incorporated business, accrual accounting is the norm for both.
