Which Accounting Method Is Right For My E-Commerce Business?
Every business owner needs to track their transactions, not just because it is an IRS requirement, but in order to know how healthy your business is, and to be able to make informed decisions and plans for your enterprise’s future. Per the Corporate Finance Institute: “Bookkeeping involves the recording, on a regular basis, of a company’s financial transactions. With proper bookkeeping, a company is able to track all information on its books to make key operating, investing, and financing decisions.”
There are three methods of accounting you can use for your e-commerce business, and which one is right for you depends on a number of considerations, including cost and what stage of growth your business is at.
The first, and simplest, method is the Cash Basis. Using this method, your transactions follow your cashflow and largely reflect what is going on with your bank account. Sales, cost of sales and expenses are all recorded in your books when money changes hands.
The most complex method is the Accrual Basis. Under this method, sales transactions are recorded at the time they take place, cost of sales matched to the sales they belong to, and expenses allocated to the period to which they belong. Time of payment is not a factor in when transactions are recorded on the income statement. This form of accounting evolved because most businesses operate on credit and settle debts a while after a transaction might have taken place. Staying on top of what is owed both to a business and by that business is crucial to stay afloat.
A third method is the Modified Cash Basis which, is a hybrid system combining the first two methods. The IRS approve a hybrid system of accounting, which uses elements of the cash and accrual method, accurately records your income and is applied consistently.
So, what are the pros and cons of each method, and which is most suited to your business model and where it is right now?
CASH BASIS
The Cash Basis of accounting is best suited for early-stage businesses, where volume is low and cost more important, and businesses which are mainly cash based, like restaurants, coffee shops, lawn services, etc. This basis is not suitable if your business model requires you to keep track of inventory.
As your business grows, you are likely to find this method does not give you the information you need to have a clear picture of where your business is and make good decisions.
Pros:
- Simple to use.
- Minimal admin time needed.
- Business owners can see exactly how much money they have at a given time.
Cons:
- Lacks financial detail.
- Not scalable (meaning that, as your business grows and the volume of transactions increase, this method will not give you the meaningful information you need).
- Your revenue and cost of sales will not match, as payment will often be made/received in different months.
- You are not tracking how much the business owes or is owed, so it is more difficult to predict cash requirements and can result in unwelcome surprises.
MODIFIED CASH BASIS
This method is best suited to early-stage businesses and small to medium-sized private companies.
It gives you the benefit of being able to track your business performance more accurately than the cash basis, but without the admin complexity and cost of full-blown accrual accounting. As there are no formal IRS rules regarding the modified cash basis, to a major extent companies able to use it can “mix and match” elements from the two main bases to formulate an accounting system which best suits their business model, as long as the methods chosen are used consistently, from year-to-year.
Pros:
- Better visibility into your business’s performance.
- Ability to match cost of sales to the sales they belong to, enabling you to accurately track your gross profit margin and compare it to your competitors.
- Benefits of the accrual basis, without the administrative burden.
- Provides a solid transition between cash and accrual basis.
Cons:
- Not accepted by the IRS for some businesses – Corporations other than S-Corps are required to use accrual basis (GAAP Accounting) if they have averaged over $25M in annual revenue, over a three-year period.
ACCRUALS BASIS
The accruals method is for larger concerns (as mentioned, an IRS requirement for certain businesses) or those with a greater time difference between their transactions and when they receive money or pay their bills.
This method helps owners get to know their businesses on the kind of level needed to help them make important decisions by enabling them to not only gauge the health of the company now and in the near future, but also make projections which could be the difference between sink or fly.
If the intention is to grow the business from the start, it is a good idea to use this method from the outset so there is no need to transition at a later date.
Pros:
- A greater level of detail and better visibility of the health of the business.
- Easier, more accurate profit and cashflow forecasting.
- IRS/GAAP requirement for certain businesses.
- More readily accepted by bankers and investors.
Cons:
- The most complex method, requiring more resources (software, accounting staff, etc.).
- Need to be able to forecast liabilities for such things as taxes (income and employment/property) and set these aside.
IS ACCRUAL ACCOUNTING BETTER FOR E-COMMERCE SELLERS?
Accrual accounting brings various advantages to e-commerce sellers, such that even smaller sellers should consider using it from the outset.
Unlike cash-based sellers, such as restaurants, almost all e-commerce traders experience a time lag between selling their goods and receiving payment. Whether you sell through an online marketplace like Amazon or Etsy, or direct from your own site using an e-commerce platform like Shopify, the likelihood is that payment for sales made in one month will often be received the next month. Using the accrual basis, you record the sales and their associated costs in the month the transaction took place. Only by doing this will you get an accurate picture of how your business is doing and be prepared for your financial obligations.
As your business grows and the number of transactions increase, the cash basis of accounting will not give you the information you need. The accruals method gives the clearest picture of your business, by not only matching sales and their direct costs, but also spreading annually incurred costs across the period they cover. The key benefit here is accuracy, providing the necessary data to allow you to plan and forecast such things as growth and cash requirements.
Simply put, if you do not intend to grow too much (for instance, if your business is a side-hustle) and see your annual revenue remaining under, say, $100k then you should probably stick with simple cash accounting, which will cost you less and your bank balance gives you all the information you need. If, on the other hand, growth is more important, the accrual basis and its potential for forecasting should be your choice. Most growth plans require funds from outside the business, either in the form of bank loans or money from investors, both of whom will expect to see accurate, well prepared financial statements, prepared on an accrual basis.
WHAT’S NEXT?
Accounting for e-commerce comes with its own set of challenges – transactions are not as straightforward as normal payments received directly from a customer. Now you receive batch payments from your service provider, and they deduct fees and charges so that the amount you receive does not reflect what you sold. Reconciling these payments on a weekly or monthly basis back to the sales they represent, after taking account for adjustments for fees, credits, sales taxes etc. can be a minefield and not a job many business owners are prepared for.
Don’t plough ahead and get yourself in a pickle – these situations can quickly spiral out of control. At Safe Hands Bookkeeping, we have the experience, know-how and tools to make light work of what could easily become your nightmare.
Let us take your potential headache off your hands by doing what we do best, so that you can concentrate on what you do best – making money!
Click below to make an appointment to discuss how we can make your bookkeeping hassle-free!