Unless you decided to dive into an accounting career, most of us aren’t aware of the difference in accounting methods and how that impacts our ability to understand our business’ financial health.  In the world of accounting for eCommerce retail, you have the choice to use cash basis accounting or accrual basis accounting.  It’s important to understand the difference between the two so you can ensure your books are telling you what you need to know to effectively manage your business. 

CASH BASIS ACCOUNTING

Cash basis accounting is like counting the dollars in your pocket, plain and simple. It's all about recording revenue and expenses when the cold, hard cash changes hands. So, if a customer buys a product from your online store and pays immediately, that's when you recognize the revenue. It's a straightforward approach, capturing the cash flow as it happens.

ACCRUAL BASIS ACCOUNTING

There's another method called accrual accounting that takes a broader view. With accrual accounting, you record revenue and expenses when they're earned or incurred, regardless of when the cash actually comes in or goes out. It's about capturing the true economic activity of your business.

So, in the realm of eCommerce, imagine a scenario where a customer places an order for your delightful merchandise but pays at a later date. Accrual accounting says you recognize that revenue when the order is placed, not when the payment arrives. It gives you a fuller picture of your financial health, reflecting the value you've created even if the cash hasn't arrived yet.

COMPARING THE TWO: ACCRUAL VS CASH

Cash basis accounting is simple and mirrors the actual cash flow. It's good for small businesses that want a clear picture of their cash position. On the other hand, accrual accounting provides a more comprehensive view of your business's performance, capturing the revenue you've earned and the expenses you've incurred, even if the cash is still on its way.  Accrual accounting can also provide a clear picture of the cash position using the Statement of Cash Flows. 

Using an everyday example, let’s say you are driving to a meeting.  In the “cash basis” scenario, you are about 10 miles away and everything is going smoothly.  Now let’s switch to the “accrual basis” scenario.  With this scenario, you have more information.  You have used your navigation app which has alerted you that in 5 miles (which you cannot physically see) there is an accident, and the traffic is at a standstill.  Now that you have this information, you may decide to take a turn onto a different route to get to the meeting without delay.  In the “cash basis” scenario, you only see what’s happening in your eye’s view and you aren’t aware of what’s coming ahead.  This would likely cause you to continue down the path and hit the traffic, causing you to be late to the meeting.  Which scenario would you choose?   

In your business, it’s similar.  Using the accrual basis of accounting, you’ll be able to know what expenses and income you have earned or incurred and that are coming your way, even if the cash hasn’t been exchanged yet.  Accrual accounting also avoids the peaks and valleys that often occur with cash basis.  One example is business insurance expenses.  Sometimes there are annual premiums that cover an entire year.  This is considered a pre-paid expense and the proper way to account for it is to divide the total by 12 and record the monthly expense for the next year.  This way, instead of seeing a $1,200 one-time expense in January and $0 for the remaining months, you can see that the cost for your insurance is $100 each month. This makes is easier for budgeting and understanding what your average monthly net zero position is each month.   

One big difference when it comes to eCommerce businesses is handling inventory on a cash basis versus accrual basis.  The proper way to account for inventory is on the accrual basis.  When you purchase inventory, it goes onto the Balance Sheet as an asset.  Then, once a customer buys the product, it decreases the inventory account and hits the income statement as a “cost of goods sold”.  In this way, it properly aligns the sale of the product (let’s say you sold a product for $99) with the cost of that product (let’s say the product cost was $35) during the SAME period.  You would see a net sale amount of $64 for the same date.  If someone did the books on a cash basis, they would record the sale of inventory as an expense and you would see that expense hit on the date of the purchase, regardless of if they all sold or not. 

For a small business in eCommerce retail, carefully consider your needs and goals.  If you want a more accurate assessment of your business's overall financial health and performance, accrual accounting can provide you with more valuable insights. 

To find out more, please schedule a call and we’ll be happy to help.