Deciding how we do something needs to be based on why we are doing it.
For a long time I was sure of this: we do the bookkeeping for the business owner first, not the CRA. When you’re running a business with a lot of moving parts, you need to see your revenue, your costs and your cash flow in real time. I saw that when business owners left bookkeeping to the end of the year for tax only, they lost a lot of insight.
Then I spoke to an incorporated contractor. There were no moving parts to monitor. For them, compliance really was the reason they were doing their bookkeeping.
It reminded me of a throughline when I taught bookkeeping to juniors: we need to understand WHY we do something before we decide HOW to do something. Not only does that make decisions much easier, it can help with both accuracy and efficiency.
That’s what this page is dedicated to.
On this page
Part of deciding how we do the bookkeeping is related to why we’re doing the bookkeeping.
One of the factors to consider is what the business owner needs to see in order to evaluate the financial health of the business and make useful plans. I’ve always said we’re doing the bookkeeping for the business owner. They need to see what their revenues are compared to their costs, their expenses and their overhead. This is why I use the measuring stick of getting as close to reality as possible.
Most business owners need a certain level of detail to properly evaluate their business. This is why I say compliance is the lowest bar, and we want to aim higher than that. We want to aim for insight.
But if the business is more of a contractor type business or a service business, the details required are a lot less. An incorporated contractor already knows what they are charging for their services. There may be some tools they need, such as monthly subscriptions. If somebody cleans homes and has no employees, they may purchase supplies. Outside of those aspects, a solopreneur service based business doesn’t need the in-depth, detailed bookkeeping that a more complex business with more moving parts needs. For these businesses there isn’t much insight to be had, and they really are only doing their books for CRA. Compliance is the only bar.
But compliance is important. And compliance is different in Canada than it is in the US. In Canada, CRA expects taxes to be filed on the accrual basis, unless you are a farm or a fishery. Even then, GST/HST returns still need to be filed on the accrual basis.
And the sales tax charged isn’t always the same. It feels like it’s mostly the same 80% of the time, but it can be different based on what you are purchasing, where you are purchasing it from, and how that business is registered. So you need to see the source documents in order to claim the GST/HST credits correctly.
Unless you are a business that is exempt from GST/HST. If you offer daycare services, or talk therapy services, do you really need to see what the GST/HST is on every transaction? No, because you don’t track it. That’s part of your expense.
Another important factor is whether the business is incorporated or not. If the business is NOT incorporated, then “you are the business”. If you take money out of the business bank account, you’re taking money out of your own bank account that you happen to be using for business.
If the business IS incorporated, that is no longer your bank account. The business is a separate entity with its own corporate bank account. If a shareholder takes money out of the corporate bank account, there could be some major tax consequences.
Because of this, it is imperative that the banks and credit cards are properly reconciled, that every transaction is accounted for, and that there’s a verifiable balance sheet. Friends don’t let incorporated friends use single entry list trackers.
Incorporating adds complexity to the bookkeeping, because the implications of personal use can have major tax consequences. And complexity adds more reasons to become more detailed with the bookkeeping, whether the business is incorporated or not.
So when evaluating the best way for a business to track its bookkeeping, understanding why we’re tracking it helps us decide how to track it.
It’s a bit of a curse, really. There is so much media bleed from the US to Canada, and a lot of our unspoken assumptions pull from it whether we are aware of it or not.
Vehicle usage? In Canada, the per km mileage rate is only for employees and shareholder employees of incorporated businesses. If the business is not incorporated, then for a mixed use vehicle, all vehicle expenses are tracked (often outside of the bookkeeping), and the mileage is tracked, and then the tax adjustment is a prorated amount of the total expense based on the percentage used for business. Annoying and more work? Yes. Closer to reality? Also yes. If your maintenance cost is high, or gas prices spike, that increased cost is now part of the overall calculation. You can see how incorporation constantly directs how we do the bookkeeping.
That’s one example. The biggest difference between US and Canadian bookkeeping is how we view source document bookkeeping versus cash accounting, and there are three big contributors to it.
Start with sales tax. In Canada, our federal sales tax is a VAT tax (Value Added Tax). This means the GST/HST paid on business expenses is a refundable ITC (input tax credit). It’s dollar for dollar important, and it is applied differently to different products and services. We need to see it to confirm it, and CRA requires full support. In the US, the taxes aren’t VAT taxes. A sales tax on a business expense is just more cost at the end of the day for a business. The GST/HST return is filed on the accrual basis, with no exception for the farms and fisheries that can file their income tax on cash.
Other Canadian businesses are expected to file their income taxes on the accrual basis, and that’s another way the US differs from Canada. In the States, the IRS doesn’t care nearly as much whether the books are done on a cash or an accrual basis. So in the US when they talk about categorizing from the bank feed, they are working within a system that permits it.
Our asset threshold is much lower too. In the US there’s an actual election available, a de minimis safe harbour, that lets a business expense items below a set dollar figure rather than capitalizing them. In Canada there’s no equivalent rule. We work from convention and judgement, which is why you’ll hear Canadian bookkeepers quote a $500 asset threshold and then immediately say “it depends.” Which means a $1,500 receipt from Staples in the States is just an office expense. In Canada, it could be a computer asset. We don’t know. We need to see the source document paperwork to be sure.
As you can see, source document accrual based bookkeeping is much more important here in Canada, and bank statement cash accounting carries much more risk and is making more assumptions here too. The US culture and media that speaks of the ease of bank categorization and quick accounting is much more applicable to US businesses, and only really applicable to lower risk businesses here in Canada, such as solopreneur service businesses with lower complexity. Bank feed cash accounting isn’t always the wrong choice, but it does come with more risk in Canadian business bookkeeping.
Source document based bookkeeping and bank feed/bank statement based bookkeeping are two different styles, and they correlate strongly with the accrual and cash accounting methods, which are worth understanding first.
We cannot say that one style of bookkeeping is correct and the other is wrong, but the lack of clarity to me is obvious. If you are just doing bank statement bookkeeping without the source documents, you are losing sight of exactly how much sales tax you are being charged and can claim as a credit, and you are missing the details of what was purchased. You are also trusting that the vendor isn’t double charging you. I’ve seen enough books to know that is not a risk I think people should be willing to take.
Accrual accounting gives you more financial details too. You can perform a better analysis of how your business is performing month over month, and it is a much better way to track outstanding receivables and payables and their ID numbers, especially if you are tracking those anyway.
On the other hand, if the business does not carry any balances with vendors or clients and the purchases are relatively standard, then source document bookkeeping can take longer than what the business needs. Though it does help verify that all the required receipts are present in the case of an audit or review.
Which style is right depends on why the business is doing bookkeeping at all, and interestingly, on whether your business is in Canada or the USA.
In both cases, what is most important is that the business’s bank account and credit card are dedicated to only business transactions. This is because an automagical list of everything supports accurate and efficient bookkeeping.
The goal of bookkeeping is to record what happened in real life. We want to record what happened so that the business owner can make informed decisions based on realistic data. Incidentally, this is also CRA’s goal: CRA wants to collect income tax on the profit of the business. Equally, interested third parties want to understand what’s going on in the business before they decide to invest or give a loan to the business.
So it always confuses me why a business owner would want to hide cash income. First of all, you’re not going to have helpful data to make business decisions if you don’t have all of the income recorded. Second of all, if you go for a loan or look for an investor, you want to show that the business is earning revenue and making a profit. So not only is it dishonest to lie about revenue to the CRA, it also makes no logical sense when it comes to presenting the business to investors or bankers.
On the flip side, nobody wants to give CRA more money than they have to. And so for the same reasons as above, we want the expenses to all be legitimate expenses, and not miss any of them. (See, Automagical List)
This is why it makes no logical sense to me when a bookkeeper claims to have “audit-proof” books. That is, they’re not claiming expenses that they don’t have a receipt for. This goes back to my assertion that we’re not doing the books for the CRA. We’re doing them for the business owner first. And I don’t believe a business should be paying income tax on income it didn’t earn.
If CRA asks for proof of those expenses and claims, then absolutely that supporting documentation needs to be provided upon request. And so it is very important to note what is missing, and to chase down the larger ones that will be very impactful if they’re unable to be sourced during a CRA audit or review.
Hiding income and audit-proofing are the same error pointed in opposite directions. Both of them move the books away from what actually happened.
But I don’t disagree with the goal behind “audit proof” books. Being able to support what is claimed is still very important. I just disagree that it should come at the cost of claiming what really happened. So what should a bookkeeper do when documentation is missing? Which brings us to Degrees of certainty and Materiality.
Bookkeeping’s goal is to represent reality as close as possible. It’s not about rules, it’s about principles.
But this can get tricky when reality gets gray and subjective.
CRA’s yardstick is pretty straightforward in theory. Is the expense incurred for the purpose of generating income? A business owner might say yes to a lot more than CRA would consider a legitimate claim. “I purchased these expensive shoes to look more professional to get more sales!” Sounds good to a business owner, not so good to CRA.
So I’ve found a very useful way to not only help myself in bookkeeping, but explain to business owners how we can apply a useful yardstick to measuring if the expense really is incurred for the purpose of generating income. It was a CRA rep explaining to me why business owners can’t claim the mileage to and from their place of work that made the lightbulb go off in my head.
A really good yardstick for deciding what is business and what is personal is to think, “Would a business owner reimburse an employee for that?”
For example, if a business owner asked an employee to pick up donuts for the entire office because of an office meeting, would the business owner expect them to pay for all the donuts? No, the business would have no issues with reimbursing the money to cover it. If the employee went out at lunch to buy themselves a fast food lunch, and brought back the receipts, would a business cover that? Probably not, especially if they did that every day. If there was a job site that was far enough away from home that the owner and crew needed to stay overnight in a hotel, would the business cover that for them? Yes. Also, because they could not go home to pack a lunch the next day, the business would cover their travel meals. Often, construction companies offer compensation for safety rated steel toed boots. In contrast, if a sales rep came into the office and said, “I need to have fresh breath for when I do my sales pitch to prospective clients, so I expect you to cover the cost of my toothpaste,” the owner would likely think he was crazy!
Notice the footwear. Steel toed boots, covered. Expensive shoes to look more professional, not covered. Same item, opposite answers.
Not every expense is a clear yes or no. Some of them are mixed use expenses.
Using the “would a business owner reimburse an employee for that” yardstick can be extremely helpful in deciding if it is an expense you believe is related to running the business or not. It also helps in considering if it is an expense that the CRA would allow if you are ever audited, because their goal is to find the number that is closest to reality too.
When it comes to claiming business expenses that don’t have supporting documentation, I am of the view: what is my degree of certainty?
One indicator is whether the business only uses the business bank account for business expenses, and whether they have a credit card that is dedicated to only business expenses. If I know that their pattern is that they keep their spending accounts clean, then I have a higher degree of certainty that a transaction on those accounts is business related. This is only one extremely useful benefit of having an automagical list of everything.
Another factor is whether I’ve seen receipts or bills from that vendor before. If I know there is GST on eleven bills that I have and I’m missing bill number twelve, I’m going to claim the GST on it, because I have a high degree of certainty.
There are actually two different certainties in one transaction, and they don’t always move together.
Take a restaurant that needs to run out to a grocery store to fill up on kitchen stock before their food delivery comes through. I have a high degree of certainty that this is business related, because I’ve seen that pattern before. But I have a low degree of certainty about whether there’s GST/HST on it, because we don’t know what they purchased at the grocery store.
Now take a contractor making a run to Home Depot. The majority of supplies from Home Depot do have GST/HST, so here I have a higher degree of certainty on both. This is one of the reasons it matters whether you are doing source document based or bank statement based bookkeeping.
My degree of certainty is the “why” of how I decide to book transactions without source documentation, and also how I decide to set up workflows. A monthly subscription? I want to see one vendor bill a year, and I’ll base the rest of the year on the rules I learn from it. From just one copy, I can confirm the bill-to name, the sales tax, and what is actually being purchased. (Requesting an updated one each year is a nice practice in case things change.)
But my degree of certainty isn’t the only thing that decides whether I chase down a missing document. That’s missing documentation.
My degree of certainty is the “why” of how I decide to book transactions without source documentation, but it isn’t the “why” of how I decide what missing paperwork I chase. There are always questions after the first “bookkeeping pass”. And whether or not I ask for the source documents is not only based on my degree of certainty. It’s also based on the risk. The bigger the number, the bigger the risk.
Many business owners feel that they can always request or find the paperwork if the period is audited by CRA. But this is more challenging than they may realize. I have done enough GST/HST audit supports to know that the initial audit happens after the year is done, and it takes a certain number of months to even get an auditor assigned. Then the auditor might disagree with or disallow certain claims. Then you appeal the assessment, and now you have to go back and find those missing bills, which are now from two or three years ago, because time is constantly passing. By then the contractor may have had a falling out with the business owner and they don’t talk anymore. Or the business owner has lost the password to their email. Or the vendor themselves has changed accounting systems and can no longer reprint bills from three years ago. (All three real experiences I’ve come across during audit support.)
Another important consideration is that sales tax and income tax don’t cost you the same. A missing expense only costs you a fraction of itself in income tax, because it’s reducing taxable profit and the tax is calculated on the profit. But an ITC (input tax credit) is dollar for dollar. Every dollar of that ITC is a claimable credit, and if you don’t have that receipt, you lose every dollar from the claim.
Because GST/HST ITCs are dollar for dollar important, and because they offset the sales tax collected on behalf of the government, I see GST/HST reviews come up more often than audits. And during a review, the CRA is looking for those big numbers and the support for them, which includes seeing the sales tax noted as well as the GST/HST number of the business collecting it.
So the sales tax side is worth chasing harder than the income tax side, but only if the business is registered for GST/HST. Which takes us back to why defines the how.
Part of my own bookkeeping process involves the questions I send out to the business owner after the “first pass” of bookkeeping. I send them an “NR List”. NR stands for either “no receipt” or “needs receipt.” I separate missing paperwork into three different categories, ordered by how urgently I need the business owner to track them down.
The first category is called “HIGH PRIORITY (The Stoppers).” These are transactions that I have no idea about, and they are preventing me from finalizing the bookkeeping period. The business owner can supply the source documents and/or tell me what the transactions are. Preferably, supplying the source documentation is the safest approach.
The next category of missing paperwork is called “High Risk (Exposure).” This category consists of things where I have a high degree of certainty about what they are, but there is a high risk if we do not have the documentation on hand now, because the numbers are larger. If we can’t find them and submit them in the case of an audit or review, that’s going to represent a large chunk of money that is owed to CRA, plus interest on top.
The final category of NRs in the list is called “Low Risk (Please Confirm).” These are items that I have a high degree of certainty on, and that are small enough that I don’t really need the business owner to waste their time chasing them down. With the caveat that these will be disallowed in a CRA audit, chasing down one $40 Staples receipt is likely more work than it’s worth.
On the other hand, if the business owner is missing a hundred $40 receipts, that’s now $4,000. So you can see there is even nuance in terms of how many missing receipts change the risk level.
Here is a link to download my template of the NR list that I send out to my clients. NR list template
True, I’m guessing that the $40 Staples receipt is an office expense and HST. Whether something is worth getting exactly right in the first place is a different question. That one is materiality.
Materiality is the idea that some differences between what the books say and what actually happened are too small to be worth chasing. It’s the part of “as close as possible” that stops representing reality from turning into perfectionism.
It’s worth knowing that the accounting definition isn’t about size at all. Under Canadian GAAP, an item is material if it is probable that omitting it or getting it wrong would influence or change a decision. IFRS and US GAAP say the same thing in their own words. So materiality is a question about consequences, not about dollars.
Which is why materiality is not a number. There’s no threshold that makes something material. It’s always relative to the business. $5,000 is nothing in one set of books and is the whole quarter in another.
Size isn’t the whole story either. A one cent difference sounds like the definition of immaterial. But a penny out can be the symptom of two missing transactions, a debit of $5,000 and a credit of $4,999.99. The penny isn’t the problem, it’s the flag. So it’s always worth a look to see whether there’s something underneath it. If the look turns into an afternoon, that’s when materiality comes back into the conversation.
Materiality is also about efficiency, not just accuracy. It’s part of why some transactions get entered from the bank feed instead of from the source documents. If seeing the detail on a small, predictable, low risk transaction wouldn’t change anything anybody does, then the faster route can be the right route. Remembering though too that quantity plays a large role. Many small transactions add up. When deciding on workflows, not only do we consider accuracy, efficiency, risk, and materiality, we also are guided by why we’re doing the bookkeeping in the first place, and on which style of bookkeeping the business actually needs.
Canada and the US have handled materiality differently, which is telling. In the US there’s an actual election available, a de minimis safe harbour, that lets a business expense items below a set dollar figure rather than capitalizing them. In Canada there’s no equivalent rule. We work from convention and judgement instead, which is why you’ll hear Canadian bookkeepers quote a figure like $500 as the asset threshold, and then immediately say “it depends.” One country legislated its materiality threshold. The other left it to the person doing the books.
Also, when it comes to decisions of materiality, it’s not always my call alone. When I find something that would cost real hours to unravel, I explain the situation to the business owner, along with the benefits and risks as I see them, and let them choose whether they want to pay me to figure out what the mistakes were, or let sleeping dogs lie. Often, input from their accountant is helpful also. This is ultimately the business owner’s money and their risk tolerance, not mine.
Bookkeepers are often cut from the same cloth. We have that drive to make sure every penny is accounted for and supported. And as the penny example shows, that drive is well founded. A single cent really can be reflective of something much bigger.
But stepping back is a discipline too. Materiality isn’t a shortcut, it’s a documented principle in GAAP (Generally Accepted Accounting Principles). And it’s what lets us weigh the time, effort and cost of chasing something against the risk and the impact of leaving it alone.
Mixed use expenses have a portion of business use and a portion of personal use. We can’t claim it all, because all of it is not business related. And we don’t want to claim none of it, because there is a portion that is incurred by the business.
The rules depend on whether the business is incorporated. How we book them is driven by how we can get the bookkeeping as close to reality as possible.
The business income goes on the personal tax return as self-employment income, and the mixed use expenses related to vehicle and home office are entered as a tax adjustment. That generally makes sense, because you’re going to have to pay for your house and your car anyway. You’re using the business use of your personal assets to reduce the taxable profit of your business. And the way we treat vehicle expense here is very different from the way they treat it in the US.
Other mixed use expenses aren’t a tax adjustment at all, but are prorated within the actual profit and loss. Your cell phone, or your internet. If you know what percentage is used for business, you can claim that business portion only, directly on the profit and loss.
So how do we account for these in the bookkeeping? The percentages below are my own rules of thumb, not rules. If the business usage is over 75% of the bill, I don’t mind putting the full bill in and doing an adjustment at the end of the year. If it’s less than half the bill, it makes no sense to put the full bill in and leave the adjustment to the end of the year, as it will skew the numbers in the meantime. In between 50% and 75%, I’d put in only the portion that represents the business use. That’s the cleanest option for prorated bills like cell phone and internet.
For the car, over 90% business use and you can treat it as a business vehicle. Below 50% I wouldn’t include it until the year end adjustment. In between, decide based on what the least amount of work is. But generally, mixed use vehicle usage for an unincorporated business is tracked outside of the bookkeeping and done as an adjustment at the end of the year.
Now everything’s different. If your business is not incorporated, then you are the business. But once your business incorporates, you are no longer your business. It is a separate entity, and you are a shareholder in that entity. And as such, you need to view yourself as more of an employee.
A business is not going to pay an employee’s electricity and utility bills and their property taxes. That’s how you need to view an incorporated business with mixed use expenses. Business use of home works very differently here, and you need to speak to your accountant about what works best for the business in question.
An employee doesn’t claim their vehicle expense to the business in the same way either. An employee uses the per kilometre mileage rate as prescribed by CRA, and a shareholder can claim their vehicle usage the same way.
And you can’t put a shareholder’s cell phone bill into the bookkeeping of the corporation, in the same way that you can’t put an employee’s cell phone bill in, unless it’s a corporate issued phone used only for business. But you can reimburse an employee for their cell phone usage if it’s a reasonable amount, and that’s the same for a shareholder.
Mixed use expenses are squishy, and they get squishier the more mixed they are. Which is why the reimburse an employee yardstick only gets you so far.
There are two camps of business owners in the world. The magic camp and the molasses camp. The people in the magic camp often don’t realize they’re living there. They just think this is the way everybody does it. They’re almost right. It is the way that everybody should do it.
Here’s what it is. A dedicated bank account and a dedicated credit card, used only for business. Do that and you have a list of every business purchase you’ve made since the day you set it up. You don’t have to think about it, work at it, or do anything for it. It automagically happens.
Everybody has heard “keep a separate card.” Let me highlight exactly why it matters so much:
The alternative is the molasses camp. Imagine having a credit card you share with your neighbour. You both use it, you both pay into it willy nilly throughout the year, and at the end of the year you have to figure out which transactions are yours and which are theirs. It dramatically decreases the accuracy of your bookkeeping. And sorting through the mess isn’t a little harder. It’s EXPONENTIALLY harder. That’s why I call it the “Molasses Camp”. It’s literally like wading through molasses. It doesn’t make things a bit slower, it makes it excruciatingly slow. And somebody has to do it. Either that’s you, and your time is money, or it’s a professional at fifty to seventy dollars an hour. There’s no law mandating a dedicated account, but there’s no law against eating raw chicken either.
Setting one up is easy. It doesn’t have to be a business-type card. All that matters is that it starts at zero, because if it starts at zero as of today, you know everything after that date is business related. Don’t be tempted to use your personal card because it’s easier in the moment. You’re just causing headaches in the future. And don’t use cash. There is no automagical list that happens with cash.
If you need to pay for something personal out of business money, the way to do it is a transfer from the business account to your personal account, and then buy it from there. Not a direct purchase on the business card.
It also raises my degree of certainty as your bookkeeper. If I know the accounts are clean, then a transaction on those accounts is business related, and I can say so even when the paperwork is missing.
What the automagical list does not do is replace the paperwork. You still need the receipt to support the expense in an audit. A line on a statement doesn’t count. It can’t show what was actually purchased, and it can’t show whose name the purchase was in. How can CRA know if you used your business account to pay for a personal bill or someone else’s expense? Plus, you can walk into Canadian Tire and buy anything that may or may not have HST on it. In Canada, that matters more than it does in the US.
If you don’t realize you’re in the molasses camp, no shade. Many people still think that a dedicated account only applies to bank accounts, and don’t even consider the amount of time and money they’re wasting with a mixed use credit card.
But no one needs to stay in the molasses camp! Pick a card, any card, get it to zero, and use only that one from now on. You’ll still have molasses behind you to sort out, but there’s a lot less of it than there would have been.
Shout out to Kellie Parks, CPB, FCPB, of Calmwaters Cloud Accounting, who I first heard the phrase “Automagical List” from. Pairing “automagical” with “list” to describe a dedicated bank and credit card account perfectly encapsulates the biggest reason for dedicated business accounts.
One of the things I’ve noticed over the years as a bookkeeper is that businesses tend to have complexity drivers. That is, situations, either avoidable or unavoidable, that drive up the complexity of the bookkeeping. The more complex the bookkeeping is, the longer it takes, and the more risk there is to the accuracy of the entries.
All complexity drivers drive up complexity. But not all complexity drivers are unavoidable.
Some are just part of running a business. Employees. Accounts payable. Accounts receivable. Inventory. E-commerce. If the business has these, this is just how the business is being run, and the bookkeeping has to handle them.
What people don’t necessarily realize is that there are some very impactful complexity drivers that are completely under the control of the business.
One of the biggest is when personal transactions and business transactions are mixed together within a bank account. Or if business transactions are paid from a personal bank account. Or if there’s no dedicated credit card. The solution to that one is the automagical list.
The workflow for communicating source documents to the bookkeeper is another one that’s under the control of the business. So is cash. Cash transactions drive up bookkeeping costs and drive down accuracy, and should only be used out of necessity.
Something else I’ve noticed about complexity drivers is that they don’t add up. They multiply.
Your complexity quotient is “inherent complexity” to the power of “induced complexity”. This is not a linear relationship. It is exponential. And you have complete control over the exponent variable, and some control over the base variable.
The complexity you were handed is the base. The complexity you chose is the exponent.