If you carry on business and receive income in a year in respect of goods or services that will be delivered or rendered after the year, or income that is not otherwise earned in the year, you must nonetheless include the income in that year for tax purposes.
However, you are allowed an optional reserve to offset the inclusion in the year. The allowable reserve is basically the amount of income that is not earned in that year. The reserve is added back into income in the next year, and another reserve may be claimed to the extent of the income previously included that is still unearned. The process can continue until all of the income is earned, e.g. when all of the goods are delivered or the services are rendered.
In year 1, you receive $100,000 on account of goods to be delivered in years 2 and 3 – $50,000 of goods in each of those years.
In year 1, you will include the $100,000 amount in your income, but can deduct the entire $100,000 reserve amount to offset that. In year 2, you will add back $100,000, but you can deduct $50,000 in respect of the year 3 goods, leaving a net inclusion of $50,000. In year 3, you will add back the remaining $50,000 into income.
The reserve is optional. For example, in year 2 you may decide not to claim a reserve such that the entire $100,000 would be included in income in year 2. This could make sense if you had losses that could offset the $100,000 inclusion, or if you knew that your marginal tax rate would be higher in year 3 than in year 2.