Cash vs Accrual Accounting for your e-commerce business
Just when you think you’ve established a stable eCommerce business, new decisions must be made. Just one of the many decisions an eCommerce owner has to make is determining what kind of accounting method they should apply.
There are 2 popular methods used for accounting, cash and accrual basis. The decision of choice often depends on the size of your business, your personal goals, and the level of reporting required.
In this article, we will discuss the difference between them, the advantages and disadvantages.
Cash basis accounting is a method that recognizes revenue and expense at the time cash is received or paid out.
This is used by sole proprietors and other small businesses whose inventory turnover is not as complicated.
Using the cash accounting method, you mirror the activities of your bank. At a glance, you will be able to see your cash flow in a given period. You recognize an expense as soon as cash leaves your bank and you recognize revenue as soon as you receive cash. This real-time accounting method helps you identify exactly when a transaction happened.
The key benefit of the cash basis is its simplicity. You will be able to track down what comes in and out of your business with little to no complication. You can even migrate some best practices from your personal finances.
It also provides real-time data that smaller businesses can easily follow. There is little timing difference between your bank account and books. Nothing is lost in translation from your bank statement data, making it easy to see your cash flow from your books alone.
Finally, this simplicity also affects your tax liability. You will have better control over the spikes in revenue and expenses. You will only pay taxes on revenue you have received instead of based on the invoices you issued. You can also decide when to make a big expense to lower your tax burden by making the purchase at the end of the year, instead of the beginning.
While the simplicity of the system is tempting for most of the small businesses, it is better suited for service businesses rather than eCommerce. This is because, in the latter, they have to pay for inventory and associated costs in advance of realizing revenue. It only makes sense to use accrual accounting to spread out the costs of purchases and get a better picture of the performance of your business.
The accrual accounting method is in contrast to the cash basis. It records transactions as they are earned regardless of when cash will be received.
For instance, you recognize Amazon Sales in December in full when you use an accrual basis. But on a cash basis, you will recognize them in January when you receive the payout.
The method is used by growing businesses with more transaction volume. As their business grows, transactions are not as straightforward as when they started. This method allows a more honest picture of the expenses the business incurs over time. It spreads costs incurred annually over the year and in turn, gives you a more truthful look into the business margins. In a sense, it provides a clearer insight into profitability.
The key benefit of this method is accuracy. It provides data for more useful business analysis and better planning. With more accurate data, you could make easy planning and create forecasting for your business.
On the other hand, the downside of accrual accounting is less awareness of your cash flow. Unlike the cash basis where cash flow is more obvious, accrual does not readily reflect it. You need an accountant to extract that data for you. On your financial statements you could be extremely profitable, but have zero cash in your bank.
When your business experiences peak seasons such as when the majority of your sales come from holiday shopping, accrual accounting will work better for you.
Let’s take a look at a scenario. You sent an invoice of $5,000 to a customer who has not yet paid; you received a bill of $1,000 of expenses this month and paid $75 for last month, and received $1,000 from a client invoiced last month.
If you are using a cash basis, the income for this month is $925. You only recognize the $1,000 income received this month and the $75 you paid for this month even though the expense was incurred last month.
With an accrual basis, the profit for this month will be $4,000. That is the $5,000 income you already sent an invoice for, minus $1,000 in bills you were billed for.
With this simple illustration, you can see just how choosing the accounting method can affect your income stream and cash flow. This could also affect your tax liability. That’s why choosing the right one matters.
Which is a better choice?
Either method is a viable option for any business and both are available in cloud-based accounting programs like Xero or QBO. The main difference will be how you recognize expenses and sales in your financial reports.
Both have their own advantages and disadvantages, but it is important to choose the best fit for your business.
For start-ups and eCommerce businesses making $100k or less in sales, it is better to stick to the simple mechanics of cash basis accounting.
However, if you consistently make 6 figures, you should consider having your accountant migrate you to an accrual basis so you can start collating better financial data for making long-term plans.
While accrual accounting needs more skill than cash basis, it pays off to start organizing your books early. If you are in it for the long run and you trying to expand your business, you should consider talking to your accountant about switching methods.
How to Switch
If you are planning to expand, I hope you have kept good books so far because you will need organized records to convert from cash to accrual. What you need to do is adjust records to account for incurred income and expenses.
For example, you could have some sales that have already been incurred but are still receivable. If you are using a cash basis, this transaction could not be recorded in your books but when you migrate, you need those receipts to know which ones have already been earned.
Accrued expenses are benefits you incurred but for which you have not yet paid whereas prepaid expenses are payments that were made to vendors for assets you haven’t yet used. All of which you need to add to your books.
If you find your sales have reached the threshold for compulsory use of the accrual method but are unsure how to handle it, or if you are just unsure if you qualify to switch to the accrual method, don’t hesitate to reach out to experts. Getting advice is better than operating blind.