REVENUE RECOGNITION AND RESERVES

Business income is taxed in the year it is earned, not necessarily the year the cash arrives. This page explains when revenue counts as income for a sole proprietor, how amounts received in advance and amounts not yet collected are handled, and the reserves the Income Tax Act allows to defer or reduce income in specific situations. Every reserve deducted in one year must be added back the next, and a new reserve claimed if still justified.

THE ACCRUAL METHOD

• General rule: income is reported when it is earned, meaning when goods are delivered or services are performed and the amount is receivable, whether or not the customer has paid.

• Accounts receivable: an invoice issued in December 2026 for work finished in December is 2026 income even if it is paid in January 2027.

• Expenses match: costs are deducted when incurred, so a December bill paid in January is a 2026 expense.

• Cash method: only farming and fishing businesses may report on a cash basis. Other sole proprietors must use the accrual method, even if their own books are kept on a cash basis during the year.

• Year-end cut-off: sales and costs near December 31 should be checked against delivery dates and invoice dates so each lands in the correct year.

SPECIAL TYPES OF RECEIPTS

• Barter: goods or services received in exchange for the business's goods or services are income at their fair market value.

• Payment in cryptocurrency: income is the fair market value of the crypto in Canadian dollars when received. A later change in its value is a separate gain or loss.

• Tips and gratuities: tips received by a self-employed person in the course of the business are business income.

• Platform sales: income earned through apps and online marketplaces is business income. Since 2024, digital platform operators report sellers' income to the CRA each year, so this income is matched against returns.

• Personal use of inventory: goods taken from inventory for personal use are removed from cost of goods sold, or included in income at cost.

AMOUNTS RECEIVED IN ADVANCE

• Inclusion rule: deposits and prepayments for goods or services to be delivered later are included in income in the year they are received.

• Reserve for undelivered goods and services: a reasonable reserve can be deducted for the part of those amounts that relates to goods not yet delivered or services not yet performed at year end. The effect is to move the income to the year the work is actually done.

• Where to report: the reserve reduces income in the year it is claimed, and the same amount is added back the next year on line 8290 of Form T2125.

• Refundable deposits: a deposit that must be returned if the contract is not completed, such as a security deposit, is generally not income until it is kept.

WORKED EXAMPLE: ADVANCE PAYMENT

A renovation contractor receives a $5,000 deposit on December 10, 2026 for a project that will be done in February 2027.

• 2026: the $5,000 is included in income, and a $5,000 reserve is deducted because none of the work has been done. The net effect on 2026 income is nil.

• 2027: the $5,000 reserve is added back on line 8290. The project is completed, so no new reserve is claimed, and the income is taxed in 2027.

DOUBTFUL AND BAD DEBTS

• Reserve for doubtful debts: where an account receivable already included in income may not be collected, a reasonable reserve can be deducted for that amount. It should be supported by an account-by-account review, such as the age of the invoice and the customer's circumstances.

• Add-back: the reserve is added back to income the next year, and a new reserve is claimed if the doubt remains.

• Bad debt write-off: once a specific receivable is established as uncollectible, it is deducted as a bad debt on line 8590.

• Recovery: if a bad debt that was deducted is later collected, the amount recovered is income in the year received.

• Only amounts previously included: a debt can be reserved or written off only if it was previously included in income. A business on a cash basis has nothing to write off.

DEFERRED PAYMENT SALES

• Reserve for amounts not yet due: where property is sold in the ordinary course of business and part of the price is not due until at least two years after the sale, a reserve can be claimed for the unpaid portion.

• Time limit: the reserve can be claimed for no more than three years after the sale, so the full profit is taxed by the end of that period.

• Capital property is different: deferred payments on the sale of capital property use the capital gains reserve on Schedule 3, which can spread the gain over up to five years.

WHEN RESERVES ARE NOT AVAILABLE

• Year of death: reserves generally cannot be claimed on the final return of a proprietor who has died, except in limited cases where the right to the income passes to a spouse or common-law partner.

• Reasonableness: each reserve must be reasonable and supported. A reserve set as a round percentage of revenue, with no link to specific customers or contracts, is likely to be reduced.

KEY POINTS

• Earned, not received: income is reported when goods or services are delivered.

• Advances are taxed on receipt: unless a reserve is claimed for work not yet done.

• Reserves reverse: every reserve is added back the following year on line 8290.

• Bad debts: deductible only if previously included in income, and taxable again if recovered.

SOURCES

• Income Tax Act: sections 9, 12(1)(a), 12(1)(b), 12(1)(d), 12(1)(i) and 20(1)(l), (m), (n) and (p).

• Canada Revenue Agency: Guide T4002, Chapter 2, Income; and Line 8590, Bad debts.

• Canada Revenue Agency: reporting rules for digital platform operators.