One of the first decisions that eCommerce businesses will need to make is their accounting method. Two popular choices for eCommerce sellers are accrual and cash accounting. Each method results in different financial statement requirements and taxation, making it important to choose the right one for your business.
Understanding the Different Methods of Accounting
The fundamental difference between the accrual basis of accounting and the cash basis of accounting is the timing of transactions. The cash basis of accounting only recognizes transactions when cash is received or paid. On the other hand, the accrual basis of accounting recognizes transactions when the contractual obligation is satisfied.
For example, let’s say you pay a supplier on December 31, but the cash doesn’t leave the bank until January 1. Under the cash basis of accounting, the expense wouldn’t be recognized until the following year since cash didn’t leave the bank until January 1. However, under the accrual basis of accounting, the expense would be reported as the amount was incurred.
The Specific Differences Between Profits and Cashflows
The adjustments between the cash basis of accounting and accrual are made to the balance sheet, which then flows through to the profit and loss statement and the statement of cash flows. Here are a few of the specific accounts that are adjusted:
Receivables
Since receivables represent an amount due but not yet paid from customers, they get reversed out for the cash basis of accounting. For example, if you have $10,000 in receivables, you would create an adjusting entry to zero out that account and reduce sales by $10,000. Under the accrual basis of accounting, there is no adjustment.
Prepaids
Prepaids hold amounts paid to third parties, like vendors and suppliers, without goods or services being received yet. Under the cash basis of accounting, the prepaid will be reversed to pick up the expenses since cash left the bank account. However, under the accrual basis of accounting, the amounts are not recognized since the performance obligation was not satisfied.
Inventory
When you purchase inventory for your eCommerce business, the amount does not go directly to the income statement. Instead, inventory sits on the balance sheet until the units are sold. Using the cash basis of accounting, your eCommerce business could be reporting costs for units not sold yet or vice versa, creating financial statements that don’t truly depict the financial positions of your eCommerce business.
Payables
Accounts payables work the opposite of accounts receivable. Cash basis taxpayers will reverse out accounts payable, removing expenses that didn’t flow through the bank account yet. On the contrary, accrual basis taxpayers may need to accrue for additional expenses, such as accrued vacation, real estate taxes, and payroll.
Factors to Base Your Decision On
There are a few different factors that you can utilize to make your decision on which method of accounting is right for your business. The first consideration is the size of your eCommerce business. Growing businesses can benefit from using the accrual basis of accounting because it presents a clearer picture of your financial health by recording all transactions that the company is subject to receive or pay. On the contrary, small eCommerce businesses that don’t have as many transactions can use the cash basis method of accounting for simplicity in reporting.
Some businesses are required to use the accrual basis of accounting. According to GAAP, businesses that have over $25 million in annual revenue or are in the manufacturing industries must report on the accrual basis of accounting. In addition, public companies or private companies considering going public should also utilize the accrual basis of accounting because it presents the company’s financial position more accurately.
The good news is that you can change your accounting method. Many eCommerce sellers decide to start by using the cash basis of accounting because it remains simple, especially when all income or loss is reported on Schedule C of the individual tax return. Once the business begins to scale and generate more revenue, eCommerce sellers will then transition to the accrual basis of accounting for more transparency and compliance with GAAP.
Summary
Determining the accounting method of your eCommerce business can be a tricky decision, especially as both the accrual basis and cash basis of accounting retain advantages. Working with an eCommerce CPA that can walk you through the impacts of each accounting method on your business can help you make the most informed decision. Reach out to one of our team members today for more information.
