If you carry on a business, the Income Tax Act requires you to include any amount that you receive in the year even if you have not “earned” it yet. In particular, you must include any amount received in the year that is consideration for services not rendered or goods not delivered before the end of the year.
However, you have the option of deducting a reserve for the amount of services or goods to be provided in a later year, which has the effect of deferring that portion of the unearned amount to the later year. The mechanics of the reserve are illustrated in the following example.
Example
You carry on a business. In year 1, you receive $10,000 for goods to be delivered to a customer in years 2 and 3 – half in year 2 and the other half in year 3.
In year 1, you must include $10,000 in income. You decide to claim the maximum reserve, so you deduct the full $10,000 amount because that reflects the consideration for goods to be provided after year 1.
In year 2, you have to add back into income the $10,000 you deducted in year 1. But you can claim a reserve of $5,000, reflecting the consideration for goods to be provided after year 2.
In year 3, you include the $5,000 reserve you deducted in year 2.
Net effect: You received $10,000 in year 1. You included the net amount of $5,000 in each of years 2 and 3.