Whether you have ever taken an accounting class or not, the concept between cash vs. accrual is pretty simple. For most start-ups, the easiest way to do your accounting is using the cash method. However, it becomes increasingly challenging to obtain accurate books as your business begins to scale. This is when the accrual method becomes the best and most efficient way to go about your bookkeeping.
For starters, the cash method recognizes a sale/expense when the cash is received/spent. Easy, right? The sale/expense will not be recognized until the cash is exchanged by the two parties–even if a service has been performed by either yourself or by someone else .
Accrual, on the other hand, recognizes the sale/expense as soon as it happened–meaning it doesn’t matter when cash was spent. This is when accounting methods like Accounts Receivable are used to accurately track one’s books. With the increase of complexity, also means that there is a higher level of accuracy and trustworthiness in one’s books.
Cash vs. Accrual: E-Commerce Issues
Tax laws and GAAP rules state that a non-publicly traded company can pick the method they so choose. Each method comes with pros and cons. So, which one really is the best one to choose? As seasoned accountants, our default is to say Accrual. We also understand that using the cash method can bring different tax benefits and lower operating costs. When it comes to E-Commerce, that is when we see some distinct accounting issues that arise between the two methods.
Arguably the trickiest accounting for E-Commerce, Inventory becomes a challenge not only for vendors but accountants as well. For small sellers, inventory becomes physical as soon as the check is clears from one’s bank account. This is probably the best option since inventory turnaround is slow and easy enough to track through seller central. However, this method is unadvised when inventory turnaround reaches more than 2 or 3 times a year and storage increases to outside of Amazon FBA.
When it comes to accrual accounting, timing becomes much more difficult when it comes to tracking items like purchase orders and in-transit inventory in one’s books. This creates new issues: when do we recognize the goods as inventory and not a pre-payment? When do they hit FBA vs. in a warehouse/transit? How do I make sure that my inventory is being correctly accounted for on an accrual basis? Do we use F.O.B. Shipping or F.O.B. Location? For these questions to be answered, vendors must invest a heavy amount of time and money to ensure that their books can remain accurate. Accrual based accounting must be able to change on a day by day basis instead a sporadic, variant method like cash.
A few things we recommend to improve accrual based inventory:
- keep accurate records of purchase orders and payments with the supplier(s)
- make sure COGS is updated (at least) monthly
- make sure that your COGS per unit has the correct landed cost
- re-evaluate inventory every quarter
Done properly, accrual basis accounting for inventory will make any vendor more attractive when it comes to selling their business. However, that requires a substantial investment and only recommended when a seller wants to make a push to the next level.
With the trade war in full swing, tariffs only become more of an accounting headache as time goes on. It has been almost a year now since Trump announced that he will impose tariffs on Chinese imports. Since then, the President has increased the tariffs three times and no one knows when the dispute will end. Because of the FIFO method (most common for online vendors), these tariffs have only now really begun affecting one’s books.
When it comes to the two accounting methods, the new political issue has created a new set of accounting questions: where on my reports should the tariffs go? How do I show these macroeconomic effects to accurately reflect my business? Well… it depends! The cash method forces the expense to go straight onto the Profit and Loss report as Cost of Goods Sold. For smaller sellers, this shouldn’t be much of an issue anyways since the tariffs will be infrequent and small. However, this becomes a huge dent in one’s income statement for larger sellers. These company’s should capitalize the expenses to one’s inventory so profits aren’t variant on the timing of the delivery. The problem has only worsened. To accurately expense the goods out of inventory, sellers need to invest in either an inventory system that can apply the inventory cost on a per-unit basis or an accounting system that can effectively reflect the expense on the reports.
Understanding the Cash versus Accrual methods of accounting is relatively simple. However, it becomes challenging when it comes to looking at change, accurate reporting, and more concise accounting problems. It is important to pick the method that can represent your business–not just what you think would be the best. Smaller companies should stick with the cash method and slowly implement a better accounting system as they scale. Larger sellers must choose accrual or they will never be able to make accurate decisions. There are pros and cons of each that need to be considered. If you need help deciding how to go about your books, contact us for a free consultation!