[Webinar] Which Accounting Method is Best for Ecommerce? Cash vs. Modified Cash vs. Accrual
Choosing an accounting method has a significant impact on how much visibility you have into your business’s finances. It’s crucial to choose a method that is not only an efficient use of your time but gives you the level of insight needed to make decisions that will help your brand grow.
In this webinar, ecommerce accountant Cyndi Thomason talks about the two main methods of accounting: cash basis and accrual basis. She also introduced a third method, the modified cash basis, and explains why this method actually works best for most businesses in the scaling phase.
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Geoff: Cyndi, before we jump in, do you mind providing a little bit of context on yourself and on bookskeep as a practice?
Cyndi: I founded bookskeep in 2014, and we started focusing on ecommerce in 2015. At the same time, we were also diving in with Profit First. We are an accounting firm, we do ecommerce bookkeeping but we also do Profit First advising. Profit First is just a cash flow methodology that works really well to help you manage cash in your business and not give you any surprises. We also do ecommerce advising—things along the lines of inventory, product, profitability, etc. That’s really the suite of services we provide.
Geoff: And what’s fantastic, especially about today’s subject matter, is that a lot of the businesses that come to your practice today, I’m assuming, are using cash basis accounting, or potentially nothing. So, one of the big parts of your role is to help them understand what are the pros and cons of each accounting method, and what’s usually best suited towards their business.
Cyndi: Yeah, that’s right. It’s good to have your accounting done but it’s also good to really understand what it means and what the information is telling you. And to be sure that it’s set up in a way that’s giving you good information.
Geoff: So let’s dive into today’s agenda and what we’re going to try to cover over the next 45 minutes.
- We’ll take a kind of a level above each of the individual accounting methods and talk about why picking the right one is actually more important for your business than folks might realize.
- We’ll then jump into each of the different accounting methods that are available to you today and the pros and cons for each. And then what types of businesses are best suited for cash or modified cash or accrual.
- And then after you kind of get a good picture of which accounting method is likely best for you, based on your business’s characteristics, we’ll talk about the next steps required to help you get from where you are today to where you’d like to go from an accounting perspective.
- And then as mentioned, well, we’ll jump into the Q&A (Amy is monitoring it right now. If anyone has any questions, we will dive into it wherever relevant).
So, I’m just going to bring this up to the group before we even get into accounting. It’s a few key stats here that I think helped shape the narrative on why accounting in general is incredibly important for businesses. Did you know that:
- 32% of ecommerce businesses fail because they run out of cash
- 29% fail because of cost and pricing imbalance
- And many businesses fail because they tried to scale too quickly.
The source of this is Small Business Trends but it’s one that you can kind of see from multiple different sites, it kind of hovers around the same margins in terms of percentages. The key message is: Cashflow is incredibly important to the success of a business, and in a lot of ways is why many fail or succeed.
Cyndi, do you want to provide some additional context here?
Cyndi: Yeah, it’s the biggest challenge. It starts out from day one when people decide to go into an ecommerce business—the first thing they have to do is figure out buying inventory. And very often, they spend all their money buying inventory, not realizing that they’re gonna have to turn around and buy a second round of inventory before they really sell through everything, just the timing of shipping, manufacturing, etc.
So from the very beginning cash is a barrier for a lot of ecommerce businesses when they get started. And it’s true, most businesses fail within the first five years, and it’s because they run out of cash. It’s the number one reason for all businesses for why they have to shut their doors.
Geoff: And knowing our audience, I’m sure that none of these statistics are surprising to them, because they’re in the nitty gritty of it on a day-to-day basis. But even if you know the statistics, many don’t even see it coming, because they don’t know their numbers. And one of the reasons why they don’t know their numbers is because:
- They aren’t accounting at all, which we see from time to time
- They’re using the wrong accounting method for their business
- They’re doing it incorrectly
Cyndi, do you mind for a second taking stock of the ecommerce businesses that come to your door and categorizing what percentage fall within each of these categories?
Cyndi: I think the first point: “they aren’t accounting at all,” it’s a small minority. It used to be more than it is now but I think more people in the ecommerce space are realizing the importance of it. So it’s a small percentage, maybe 3-5%.
I would say the last point: “they’re accounting incorrectly,” that’s a much higher number—somewhere in the 70%. This happens when they’re just not taking stock of Amazon deposits or whatever, in the correct way.
And, as to the middle point, many businesses are using the cash-based method, which is not giving them the best information for managing their business for growth—for understanding profitability. I would say probably 20-25% are in that bucket.
Geoff: Awesome. I’m actually going to pass the question over to the group to get an understanding of where the audience is currently at, and help frame some of the discussions that we’ll have a little bit later in the presentation.
So I’ve just gone ahead and launched a poll, and I’ll give folks a little bit of time to put in their answers. But effectively, it’s asking:
What accounting methods are you using?
- Don’t really do accounting, which falls into the “aren’t accounting at all” category
- Cash basis accounting
- Accrual accounting
- Combination of cash and accrual
- Your accountant or bookkeeper is currently handling it
I’m gonna go ahead and end the poll now and share the results:
- So, that first category that you were talking about, Cyndii, those that aren’t doing accounting at all, kind of falls within the range of what you would see your practice—the minority.
- Many are doing some accounting, which is what we usually see with cash basis accounting. We’ll get into that in a little bit.
- There are a few folks that are doing accrual and a combination of cash or accrual, which are two other accounting methods that we’re going to talk about later in the webinar.
- And last but not least, some are working with an accountant or bookkeeper. Always a great idea, especially if they’re specialized in ecommerce.
Thanks everyone, for filling in that poll, very helpful context—and quite in line with what you were mentioning earlier, Cyndi.
So why is accounting important at a high level? We talked about the high level details of why businesses typically fails—because they don’t have cashflow visibility and cash flow is a big part of the equation. So, how do you get good cash flow visibility? Accounting is a core component of that but there are other really strong benefits to accounting and why picking the appropriate accounting method helps you achieve these:
- Increased confidence in compliance goes without saying
- Helping you pay the right amount of tax
- Helping build more profitable businesses, when you have line of sight into your business, and how it’s actually performing financially, you can make the right decisions for the business and help it become more profitable
- Attractive to buyers. This is a really interesting one and I think it lends itself really well to today’s conversation, because depending on the accounting method that you pick, you will be more or less attractive to buyers.
Cyndi, I know that you have a lot of anecdotal evidence on this based on some of your clients. Do you mind talking about it a little bit?
Cyndi: Sure. From 2021, 2022, there were a lot of sales that went on with our clients. And one of the things that the buyer’s brokers were always doing is the due diligence process. They always wanted to be sure that they could have confidence and that the books they were presented with were a reflection of what’s really going on in the business.
We had many people come to us during that time to get their books set up in a way that they could demonstrate profitability. And what our clients would tell us as they went through this process was that if their books were in order, and they were really confident in their numbers, they got a lot less questions from potential buyers and they were able to be more confident in their answers. And they said that that gave them a better place to negotiate from to receive higher offers.
Unfortunately, we had a client that couldn’t defend their numbers. The inventory information just was not there to back up their information, we worked with them to get it as close as possible but ultimately a buyer walked away, because they perceived that there was risk in buying that business because they couldn’t feel comfortable in the numbers.
Geoff: And that happens across many different industries. I have firsthand experiences of deals falling through in software, because the numbers were a little bit squishy as you mentioned earlier. So, being attractive to buyers is incredibly important, especially when picking the appropriate accounting method for your business and your stage of growth.
- Less risk. You can slice the ‘less risk” pie in a multitude of ways. But knowing what your profitability looks like on a month-to-month basis, helps you better plan for the future, helps you avoid pitfalls. We’ll talk about this a little bit later but Profit First and having more cash on hand, is also incredibly valuable.
Cyndi, you had a client, I remember, that Amazon lost their inventory three times. Other businesses who didn’t have appropriate accounting in place, who weren’t using Profit First methodology could have run out of business. But this particular client was able to weather the storm and eventually actually sold her business, right?
Cyndi: Yeah, she had a really nice exit but early on she ran into that really unbelievable situation of having bought inventory, having it lost three times. Luckily, she had dollars set aside to buy inventory—and to buy inventory a second time. She had profits set aside, so she was able to use that as a rainy day fund to buy inventory again. And then she got her account suspended in the middle of all of this! So it was just like “how much bad luck can one person have?!”. But by really understanding her numbers, by having her cash available, for preparing for a rainy day, she was able to go through what would just be unbelievable circumstances—and would put a lot of people out of business. She was able to weather that storm and be in a position for when her account was restored, to be able to sell through all of that product. And ultimately, she didn’t have anything major like that happen again, she had really strong financials and she had a successful exit this past year. Her financials set her up for being able to not only weather the storm, but then to sell the business and move on to the next thing in her life.
Geoff: Totally. And last but not least, this goes without saying but:
- better performance visibility. Knowing your numbers is all about understanding how your business is actually performing.
What I think is interesting, and how A2X specifically has seen the conversation shift over the last few years, 2020 and 2021 were the years of growth at all costs. Numbers were almost an afterthought because, obviously with lockdowns and with stimulus everyone was purchasing online, so more and more ecommerce businesses were spinning up. It was more like, “how do I attract and acquire as many customers as possible?” Whereas now, as things have gone back to normal, ecommerce is the more realistic percentage of retail, I think businesses have shifted their focus now to better line of sight into their performance and profitability. Profitability is something that keeps coming up time and time again. And I don’t think you get to profitability without solid accounting. So we’re probably beating a dead horse here in terms of why accounting is important but it’s something that folks always overlook, but it’s so critically important to the success of most businesses, specifically in ecommerce, because you’re dealing with so much complexity.
Cyndi: If you don’t have the data to really know if the changes you’re making are impacting your bottom line—or your top line, I mean, we talked earlier about advertising and the ability to understand if your advertising is working, if you don’t have the ability to look at that data and understand how the levers you’re pulling are impacting your financial success, you’re working with a blindfold. So the numbers give you that line of sight.
Geoff: And talking about line of sight: What does that translate into when you’re doing accounting well, and you’re deploying the right accounting method? Usually it’s your financial statements, things like your Profit and Loss and your balance sheet. Cyndi, did you want to talk through these documents a little bit and why it’s important?
Cyndi: Yeah, the Profit and Loss I think is something that most people are familiar with. And for those that aren’t doing accounting with an accounting system, like Xero or QuickBooks Online, or something like that, you may be using some of the other products out there that give you a dashboard, and that would also give you a Profit and Loss.
Those tools are really useful to getting close, if you will, but they’re not necessarily something that you can count on. And it’s one of the things that I see when people come to us, and they’ve got this perception of how their business is performing from these tools. But then we go through and get them started on an accounting system and provide them with a balance sheet, and what they see is that those numbers that they’ve been relying on, don’t always add up.
Those dashboard-type tools recognize revenue a little bit differently and they also are never reconciled back to an outside source, like a bank statement. If you have a full accounting system with a balance sheet, you’re going to get that reconciliation back to the external source. And that lets you know that you can count on what you’re seeing in your financial system.
People get confused about what they’re seeing with the Profit and Loss and ask do they even need a balance sheet? I want to explain that there are two different things, they give you two different windows into your business.
First of all, the Profit and Loss is for a specific period of time. It’s for the year. You see what’s going on in that year’s timeframe. Whereas the balance sheet gives you insight into your business over time. It shows you how the business has performed over the years that you have owned the business. It gives you some insight about whether your business is growing in an appropriate way year over year. You’re investing your time and your effort into it, just like you might invest dollars into the stock market. So, are you getting that return? Your balance sheet helps you see whether you are or not.
Geoff: A question for you on these financial statements that we didn’t dig into a little bit earlier. When you’re dealing with external parties, like a bank for a loan, or an investor, or a potential acquirer. Are either of these documents more important than the other? Do you need both? What’s the mix?
Cyndi: They want to see both. They want to see how you’re performing with profitability, but they also want to see how strong your balance sheet is. This is because you may look really good from a Profit and Loss perspective but you may be reliant on too much debt and whatever debt you’re carrying is a factor. For example, from the bank’s perspective—are they willing to loan you more money for that business?
Geoff: And I would imagine that most people that are coming to your door and looking for accounting services are likely familiar with Profit and Loss but may not have a balance sheet, as of yet?
Cyndi: Yeah, I think the balance sheet is less familiar and they’re less comfortable with it. But it provides such important insight that that’s one of the things we want them to understand. Because as we talk today, we’ll talk about inventory, and inventory being recorded in the correct way to give you insight into your business. Your balance sheet comes into play in that situation.
The Three Accounting Methods
Geoff: Okay, so let’s now dive into the accounting methods. So far we’ve been peeling back the layers of the onion: First and foremost, we’ve been talking about why cash flow and understanding your cash position is so important for businesses. The way that you do that is through accounting, and then why accounting is so important, just beyond that, that cash layer.
Now to do appropriate accounting, what are the accounting methods that are available to us today?
I’m sure that a lot of people here are familiar with the cash and accrual methods. So Cyndi, do you want to just provide a quick high level overview of these? And we’ll dive in a little bit deeper shortly.
Cyndi: Thecash method is simply that when money changes hands, it’s recorded in your accounting system. So if you get a deposit in your bank account, or if you use your debit card, when that activity happens is when it’s recorded in your financial system.
The accrual method is based more when the value changes hands. For example, if someone places an order at Amazon and that order is shipped, that constitutes a sale that can go on your books, even though you may not have received the cash for that item yet. So it’s when the value changes hands as opposed to when the cash changes hands.
Geoff: So when we look back at the poll that we did a little bit earlier, the majority of folks on today’s webinar are doing cash accounting, some are doing accrual accounting. But there was a third option there and it looked like the minority were doing a combination of the two and that’s called modified cash.
Cyndi: To me, modified cash is kind of the best of both worlds, because it allows you to do your accounting for revenue recognition and recording the Cost of Goods Sold based on the accrual methodology. But you don’t worry about accruing everything that’s at the operating expense level. For example, things like insurance and rent, you don’t get so tight about trying to figure out how that might need to be done on an accrual basis. And if you’re not worried about that, that can ease your burden of keeping up with your accounting. It can be less costly for you. It allows you to pay attention to the stuff that’s important without getting into the minutiae of accounting for everything on an accrual basis, which gets to be more complicated and more expensive.
Amy: Hey!We’ve got a question and it might make sense to either answer it now or you might want to touch on it with each of the different methods. The first question is:
Is there an accounting method for scaling, given the amount of cash one has access to?
Cyndi: I think the modified cash method is the one that will allow you to scale with the correct information. So that you can make good decisions without being overly complex and burdensome from an administrative perspective. And that’s really what we’re going to go into a lot of detail about, but to be the spoiler alert here: Modified cash is the thing that, to me, gives you the best of both worlds in terms of good visibility from your accounting data, without all the burden of extra cost to keep up with things.
Geoff: Which is nice, right? We’re about to dive into the topic but instead of just telling people at the end “hey, do modified cash,” we’re going to show why.
And again, your accounting method is dependent on each individual ecommerce business’s circumstance, sometimes different use cases require different methods, and obviously, it’s always great to connect with an accounting expert to help you make those selections. But to Cindy’s point, this presentation is quite biased towards modified cash. And you’ll start to understand why as we dig into each of the methods, their pros and cons, and what types of businesses are best suited for each of the methods.
So just a high level recap on the cash method for ecommerce sellers: Sales are counted when the settlement comes in from the platform. For example, if you sell on Amazon, you only record sales once the money has come into your bank account. And this also applies to expenses.
So that was the example to which Cyndi provided some of the pros as to why the cash method is good. Cyndi, do you want to jump into each of these bullets and then we can do the counter argument and talk about why the cash method might not be the best?
Pros to using the cash method
Cyndi: I honestly love the cash method from the standpoint that it’s really simple and one thing that you can do is look at your financials, and it reflects what’s going on in your bank account. And I always think that’s a good thing to have those things line up.
Cons to using the cash method
But the reality is that while it doesn’t take as much effort to do, there are some limitations as well.
The limitations that we see, include:
- You’re not going to get the level of financial detail that you need to make good decisions about profitability.
- It’s not scalable, as your business grows and gets more complex, the financial method of cash accounting just doesn’t doesn’t meet the level of complexity that’s actually going on in your business.
- The biggest challenge is that the revenue is not necessarily being recognized in the period that it occurred, and it doesn’t match up to the COGS to that same period. So you’re not able to really understand profitability.
- One of the things that we see from clients who haven’t been doing accounting or have been doing cash accounting is that they come to us because they’re ready to do an exit, and their brokers have told them “you have got to get these books on an accrual or modified cash basis because buyers are not going to accept cash method.” So in the long run, the cash method is not going to get you where you want to be if you’ve got an exit in mind, or if you’ve got scaling in mind.
Cash Profit and Loss statement
Geoff: This Profit and Loss statement is probably something that most of those that are doing cash are familiar with. Cyndi, do you mind providing a high-level overview of what we’re looking at here?
Cyndi: Let’s just look here at the income for January, February, and March, you can see there’s $1.8 million in income in January, compared to $1.2 in February and about $1.3 in March. And this is a situation that we see a lot, where a client that has been using cash basis accounting. They’re reporting their revenue correctly when Amazon is doing their payout. But Amazon occasionally does three payouts in a month because they give payouts on an every two week basis.
As you can see here, the way the calendar lines up in January, this particular client got an extra boost in their revenue in January. And if you look right below that for Cost of Goods Sold, you see that there’s none in January. So when you buy your product in cash based accounting, you record the COGS in the month that you pay for the inventory, but then you may sell it through for several months. As you do that, you will have months where maybe you don’t pay for any inventory, and that’s what happened to this client in the month of January, they had a big payout from Amazon, because they probably got some Christmas money in there. And then they had an extra third payment in the month. They had already bought all their inventory in December, so they didn’t buy any more in January, knowing things might be slowing down. And as a result, they had a really great net income for the month of January. But February and March were negative.
What this demonstrates is that if you’re not recognizing the revenue as it happens in the month, it happens, you get these wild swings based on when Amazon might send your deposit to you. And if you’re not recognizing your Cost of Goods Sold at the time in which you’re making the sale, then you have very little data to be able to understand your profitability, and you have these wild swings in your Profit and Loss that show you that you just don’t have data here that you can use to manage your business.
Geoff: You talked about one of the pros of cash basis accounting earlier, which is the lower administrative burden. But let’s say you get to this point, and you see these swings, and you realize you need better visibility, for example, to understand how your advertising costs are cutting into your margins. Then you have to dig into that, and guess what, you’re doing admin on the back end!
So I always find it interesting when I’m seeing this. Sometimes picking the simpler route, you tend to pay for it a little bit later on the back end when when you need to dig in and get the financial visibility. Or you end up like some of the businesses that we talked about earlier, where line of sight into cash flow becomes a core issue and profitability isn’t as big as you thought, and so on and so forth.
So I guess we keep coming back to this theme but visibility is incredibly important. And picking the right county method helps you achieve that level of visibility, without more administrative work on the back end. Also the idea of real time, right? You get the information on a real time basis if you’re planning it out on the frontend versus doing the audit on the backend to see what’s going on.
Cyndi: yeah, if you wait till you file your taxes, it’s a little too late to be making decisions for how things are going to go for you for the year.
What businesses is cash accounting best suited to?
Geoff: Totally. So let’s talk a little bit about who cash accounting is best suited for.
Cyndi, could you provide us with some characteristics of the type of businesses this method is probably the perfect partner to?
Cyndi: Yeah, if you’re just getting started and you’re not sure that this ecommerce thing is for you, and you’re just wanting to see if your product is even gonna flow, or if you’re going to have the time to manage it, then cash based accounting is a good way to go.
But when you see something start to take off in terms of product sales, or you realize “I’m enjoying this, I’m thinking this may be a career path for me, I’m gonna work this up until I can quit my day job.” At that point, it’s good to move over to something a little more sophisticated.
If you’re in a business where there’s very little delay between when you buy the products you’re going to sell, and when you actually sell them and get the cash for them, cash based accounting can work pretty well for them.
Restaurants are a good example, we hope that if they buy food they’re going to turn it into something we can eat quickly. And they don’t need to carry a bunch of inventory for long periods of time.
But if you’re spending a lot of money on products that’s going to have a long time between reorders, then it begins making things more complex in your accounting to see how you’re doing.
Geoff: Can I ask a direct question that I know there’s not always a direct answer to because this tends to be nuanced based on everyone’s circumstance. But can you give us a revenue level, for example, if you’re making $X per year, you should start to think about other methods basides cash basis. Or if you’re making below $X then using the cash method is typically sufficient?
Cyndi: I think if you’re starting to sell at a level where you’re going to be hitting $100,000 in income in a year, then theoretically, from what we see in numbers, that could leave you with $30,000. That’s enough money to start to be serious about.
When it starts in your mind to become less of a gamble and more of a direction you’re headed—for example, investing in inventory—then that’s the place to switch from using the cash method. But certainly, if you’re getting $100,000 in revenue, you’re getting into some real numbers there. And I would want more visibility, if it were my money.
Geoff: Awesome. So accounting method modified cash just to recap, the high level overview that Cindy provided earlier: modified cash uses aspects of both cash and accrual accounting, it allows you to handle your operating expense transactions using the cash basis, which is the one with less administrative burden, and your revenue and COGS using the accrual basis, in order to give you a good comparison of the costs incurred for the revenue generated.
Modified cash is likely the type of method that is going to remove some of those swings that we saw on the Profit and Loss statement with the cash basis. And we’ll provide an example of a modified cash Profit and Loss statement little bit later in the presentation.
Beyond that, Cyndi, can you talk about a little bit more of the pros related to the modified cash method?
Pros to using the modified cash method
Cyndi: Well, the primary thing that you want to understand is profitability. So being able to see how much money you get in in a particular period, and have that leveled out month by month, so that you don’t have these swings with Amazon’s deposit schedule. Instead, you’re able to see how that revenue comes in, and then compare it with what the costs are for providing that product to meet that sale. That’s where you see profitability. And being able to understand profitability is the key thing here—that gives you visibility into your business performance.
With modified cash, you’re not having to keep up with all the aspects of accrual down with the operating expenses—the burden is less for keeping track of those things. And if your business is growing, this is a way you can add a little bit of complexity and get some real data you can use to manage your business without going to the full complexity of an accrual methodology. And, in addition, it can save you some cost as you’re making that transition and growing.
Cons to using the modified cash method
As we’ve talked about before, there are there are specific reasons why you may have to do accrual accounting, and one is that the IRS requires that if you’ve achieved a certain level—$25 million in revenue over a three year period—then you need to be on a completely accrual basis for your accounting.
Geoff: What’s the upper echelon of people that you see transitioning away from modified cash and to accrual? Like what type of annual revenue are they making?
Cyndi: Well, for us, it’s interesting, I’ve had a client go from zero to $33 million and about 18 months— it just kind of blows your mind. But the point where they’re starting to get in the $25-30 million range, they’re ready to start bringing accounting in-house. They’ve got investors etc., so they need more of an in-house function to be able to manage their accounting. And because of the IRS requirements, accrual basis accounting is what they need too.
Geoff: Yeah, this is also the stage where they’re probably upgrading to NetSuite moving away from tools like Xero and QuickBooks.
So it feels like the band in which modified cash is relevant for is quite large, right? You had mentioned that the lower echelon is about $100,000 in revenue and then the upper echelon, because the IRS requirements is about $25 million. So modified cash is well suited to a lot of businesses in that middle range. Again, though, I just want to be clear, sometimes accrual is the right method, it does depends on the circumstance. But, Cyndi, would you say that modified cash can apply to most businesses within that range?
Cyndi: We found that it works well for most of the ones that have come to us. There are situations where if they’ve got an investor, for example, and the investor wants something beyond modified cash, we will go to full accrual accounting but it’s a little more costly. So, if you don’t have that requirement, why pay for something that you’re not going to spend a lot of effort on?
Modified cash Profit and Loss statement
Geoff: Let’s look into a profit and loss statement with modified cash applied. Do you mind talking to us a little bit about what we’re seeing here in this new environment?
Cyndi: Well, the big number in January for revenue is kind of spread out, because, I’m assuming, some of that third payment that the seller got in January was probably related to some December activity. So that got recorded in December. As a result, the activity for the 31 days in January is what’s reflected in January.
But the real big change here is what’s going on with the Cost of Goods Sold. We see that in January, even though this seller did not buy any inventory in January, what they did was, using an accrual treatment for their Cost of Goods Sold, they recorded how much of that revenue that came in in January really related to paying for that product that they sold. That amounts to roughly $700,000 here in the modified cash statement, as it relates to that $1.4 million in income. Whereas in our cash basis statement, they didn’t buy any inventory, so it was $0 before.
This gives us much more understanding of how our business really performed in January, for example, what sales actually took place in January and what it cost us in products to meet that demand. And our net income is spread out a lot more evenly over the three months, because we are looking at truly what it cost us to meet the demand for the product that we sold in those months.
Geoff: Yeah, I love that a) this takes the swings out of the equation and b), we talked about kind of that administrative burden on the back end if you need to dig in. But you can see at face value, advertising costs have stayed relatively constant as compared to our gross profits.
But in a world using the cash basis method where you’re buying a lot of inventory, and you’re looking at negative gross profit on any given month, it’s hard to tell if my advertising costs went up or went haywire. And that’s how that’s happened a lot over the last few years with iOS 14 updates, cookie blockers, so on and so forth—advertising is a really tough nut to crack for a lot of ecommerce businesses—I would easily be able to see what the fluctuations are and the impact that it’s having on my gross margins using the modified cash basis versus in the cash basis, which we’d have to do a little bit more administrative work on the back-end to kind of get that visibility required.
Cyndi: Yeah, if you’re making an investment in advertising, you want to see that revenue number benefit from having advertising. You don’t want to be wondering, “is it because I got a third payout from Amazon?” you want to know it’s because I spent these dollars and they were working for me.
What businesses is modified cash accounting best suited to?
Geoff: So we talked about what businesses are best suited to using the modified cash method, but just to confirm, Cyndi: over $100,000 in annual revenue but under $25 million works for most—with the exception of people who may have external investors, etc.
Cyndi: Yes, exactly.
A2X can help as you transition to modified cash accounting
Speaking of modified cash, one thing that we see quite a bit is that when people are making the transition from cash to modified cash, there are a few areas where they’re not necessarily set up for success:
- They’re not working with an expert ecommerce accountant that can help them with the transition, which is always good to do so—bookskeep is one example but the A2X team has access to a ton of other ecommerce accountants and bookkeepers as well, depending on your region and on your needs available on Ecommerce Accountant Directory.
- And then also tooling
Amy, do you want to talk a little bit about one of the mistakes that we see a lot of businesses make as they make this transition from cash to modified cash or accrual?
Amy: Yeah, definitely. So one of the biggest mistakes we see is seller’s coding their whole deposit as sales. This is applicable regardless of the accounting methodology you’re using.
What we often see is that sellers will receive a payout in the bank account. For example, this Amazon Seller has received a deposit. Amazon pays out their sellers every two weeks. As Cyndi mentioned earlier, it’s highly likely that this deposit might have covered two months, it might have been some December payout and some January payout. If they were to code this whole deposit to just a sales accounts, they wouldn’t be getting this visibility and they wouldn’t be having those accurate numbers going through into the financial statements that Cyndi has been showing.
In this example, you can see that the $52,355 is not the sales amount, on the right hand side, you can see that the deposit is broken down accurately. This gives you a lot more visibility around all of your expenses, all of your income, what were sales, what was advertising, discounts, all those sorts of things. This is the way that you can break down your data to keep that visibility.
Why is it hard to do ecommerce accounting?
One of the reasons that people avoid doing ecommerce accounting is because it’s actually really challenging. So, why is that?
- One of the issues is that settlements/payouts can cover a long period. As we’ve mentioned, if a seller got paid today, the majority of those sales may have occurred in the prior month
- There are a lot of different transactions to account for. In the prior example, you could see that the seller was just coding sales, but that deposits actually also included sales and fees and taxes, and all sorts of things that you need to accurately account for so you can get visibility into how your business is doing.
- Tax. Tax can be complicated for a whole number of reasons, whether you’re selling overseas, or selling in different states, you might have products that have different tax rates. Additionally, if you sell on Amazon or another marketplace, you’ll have marketplace facilitator tax, which is when Amazon collects your tax and remits it on your behalf. Although that might seem really nice and straightforward, you’ve also got to account for that. It’s your responsibility to ensure that is all done correctly.
Geoff: Next, do you want to talk about what makes it easy?
Amy: Absolutely. I mean, I guess it’s not all doom and gloom! And this challenging or difficult ecommerce problem is the whole reason why A2X exists. So A2X can automate a lot of this for you and you can use it on a bunch of different ecommerce platforms. Essentially, it automates the process. It’s really accurate, and it will save you a lot of time. So it lends itself really nicely to particularly modified cash and accrual accounting.
Geoff: Yeah, essentially, that example that Amy showed—the deposit from Amazon—was actually made up of a bunch of individual transactions and A2X will pull that deposit in and break out those transactions for you and then it posts it to your accounting software, which saves a ton of time.
And Cyndi, you were talking earlier that A2X is not just a benefit to modified cash and accrual accounting, it actually also adds value to cash accounting, as well?
Cyndi: Yeah, really, A2X’s tool does put you into a modified cash or an accrual basis. But if you are recording in the way that Amy showed, with the one sales deposit on the left hand side, even if that’s what you’re doing from a cash basis, you’re really misrepresenting what’s going on in your business. And, the big one is if you put this $52,000 deposit in as sales, which is what a lot of folks do, you’re overstating your income by almost $13,000. When you report that to the IRS, you’re going to be paying taxes on $13,000 worth of income that you didn’t actually receive and nobody wants that! Especially when your sales were a good bit less than that.
So, even if you’re doing it yourself and using a cash basis, you want to break it out, so that you’re not misrepresenting what your sales are, because that’s going to hurt in the pocketbook.
What is Profit First and why is it useful?
Geoff: And one of the other cool things about transitioning to modified cash is not only does it give you better line of sight into your money, but it also unlocks opportunities to use other mechanisms or methodologies to help you run more successful businesses.
We talked earlier about the Profit First methodology and how it’s helped businesses. Cyndi, do you want to talk about Profit First and how Profit First gets unlocked in a modified cash world?
Cyndi: Yeah, I’ll be glad to and I’ll try to keep it short because I know we’re running tight on time here.
When you move to modified cash you are getting, you’re giving up the ability to see your P&L and your bank account being in alignment with each other. The way we work with our clients is using a methodology called Profit First, that helps you have that better visibility into your cash situation by using bank accounts for specific purposes.
So your online banking dashboard really kind of becomes another tool for you to manage cash in your business. Profit First is complex—I teach a whole course on it that takes several weeks to go through.
Geoff: You’ve even written a book on it, right?
Cyndi: Yeah, I wrote the book on it specifically for ecommerce businesses. The beauty of it is that it works with our behavior that we have already—logging in and seeing what our bank account tells us—but we get more sophisticated by having multiple bank accounts for specific purposes.
And as we understand how cash is flowing through our business, that online banking dashboard really informs us how things are going in our business even quicker than we can get through financial statements.
As you’re getting more sophisticated in your business, implementing a tool like Profit First will also be a way to stay more in touch with the cash, even though your financials are getting a little bit further away from it.
We’ve talked about the rainy day fund—putting money aside for situations like Amazon losing inventory, etc.—but it also helps you as you’re planning for growth or setting aside money for taxes. All of these are bank accounts that we create. We set money aside much like our grandmother may have done with an envelope but we’re doing it with bank accounts.
The nice thing is, as you’re setting that money aside for specific purposes, it’s putting pressure on your operating expenses, which is a good thing, because operating expenses can get bloated over time. By putting pressure on that, it forces us to be more efficient, to be more frugal, and to be more innovative. And all those things are good drivers in our business.
Geoff: It also lends itself really well to this new Zeitgeist, right? The period 2020-2021 was about growth at all costs. And now in the current period that we’re in, it’s about profitable growth. And Profit First helps you achieve that outcome a lot easier.
If you have any questions about Profit First, Cyndi’s practice bookskeep is one of the top experts on the subject, especially as it relates to ecommerce businesses.
Geoff: So the last accounting method is accrual. Here’s a quick recap on this one as I’m sure that most people are familiar: Records transactions at the time sales were made or orders raised, even if the money hasn’t changed hands yet. It focuses on the movement value as opposed to immediate cash handling within a business. So, in this context, not only are you doing an accrual on the sales and on the inventory and the COGS, but you’re also doing an accrual on all of your operating expenses as well.
Pros to using the accrual method
Cyndi, do you want to talk a little bit about the pros and cons of accrual?
Cyndi: The pros are very similar to what we said with modified cash, you get all those benefits, but it’s also a requirement for some businesses. So be sure you understand if you’re in that area where the IRS would require it.
Accrual also gives you the good data for sale, if you’re selling your business, meaning your valuation will be good, just like with the modified cash. Many of the benefits from modified cash carry over to accrual basis accounting. And if you’re a larger size business, it may be a requirement to do accrual accounting.
Cons to using the accrual method
The reason why you might not want to go full accrual is that it does take more effort and more time. And the administrative effort just may not be necessary for what you look at and how you make decisions.
If you’re using Profit First, using the accrual method is putting pressure on operating expenses already. And you see that much more quickly than you would in your financials.
So, marrying up Profit First and modified cash kind of gives you the best of both worlds without as much bookkeeping headache.
Geoff: I have the profit and loss statement for accrual on its own but I think it looks really good when you put it beside cash and modified cash to start to see the differences between the three.
And one of the things that you mentioned on accrual and modified cash is there’s more of an administrative burden but sometimes it’s like a marginal difference or marginal improvement. And I think this slide really demonstrates that.
Do you want to talk through the differences between cash modified cash and accrual in terms of what we’re seeing on the P&L?
Cyndi: Sure, we’ve looked in detail at the cash basis for income and for modified cash. You can see if you look at the accrual P&L, there’s no change there because we’re doing accrual treatment of income. The same is true for the COGS (cost of goods sold), you see a big difference in the cost of goods sold in cash versus modified cash but in the accrual statement, you’re not seeing that change as it remains the same from modified cash to accrual.
The only change really is if we look down into the operating expenses and to the insurance. Now, there will be changes that you may have unique to your business, but just for point of illustration here, on the insurance line, the full amount of the insurance was paid in January for the whole year—that’s $2300 for for the insurance line—but you’re getting value and benefit of insurance for the whole year. So when using an accrual basis, you would spread that $2300 out over the life of that policy, which typically be about a year. So you would take that $2300, divide it by 12, and then book the amount that relates to that month in that particular month.
The bottom line is if you look there’s just not much difference between what happened in the modified cash net income and what happened in the accrual net income.
Sometimes that visibility is important for you, for example, it may be important because you have investors that want to see it at that level of detail. But if it’s not really something you use for making decisions day to day, then why go to that headache of trying to do full accrual accounting when modified cash is going to give you what you need to be making decisions.
As business owners, we have so much to pay attention to, we need to spend our time on the things that are going to get us the most results. And most of the time, accruing operating expenses is pretty down on the list.
What businesses is modified cash accounting best suited to?
Geoff: So it’s interesting, it keeps coming back to modified cash, and we said it earlier in the presentation when Amy asked that first question: For scaling businesses modified cash is likely going to be the best fit for most businesses.
And I think Cyndi with her expertise and experience covered it really well:
- The cash method doesn’t give you the line of sight and the visibility that you need but it’s super simple.
- The accrual method gives you the visibility that you need, but it’s quite administrative.
- The modified cash method gives you visibility without the administration. The best of both worlds to run a more efficient and scalable business.
And it brings you back to the main point: cash, although sufficient, doesn’t give you the line of sight and when you’re running a business, especially when it comes to cash flow and profitability, close enough really isn’t good enough. And picking the right accounting method for your business in its particular stage is of critical importance.
You want to implement the modified cash method, now what?
Geoff: Now just to kind of like take it all the way home, what are the next steps? How do you go from where you are today to one of these methods (depending on what’s best suited for your business)?
First and foremost, if you have an in-house finance person, speak with them about your accounting methods and let them know how A2X can help accurately automate the reconciliation process and help you transition from cash to modified cash.
A lot of the time people delay this transition process is because they don’t have the appropriate tooling to make it work. And what we showed today, particularly on that slide Amy where talked about “why is that bad” is that it’s not always easy. You have things like settlement periods that cross multiple months, you don’t have the line of sight that you need in each individual transaction and at some layers of complexity on tax.
The second thing: if you don’t have an internal resource, like an accountant or bookkeeper, it’s really important to work with an accountant or financial adviser. bookskeep is an example of the top ecommerce accounting practices that are available on the A2X directory. Definitely jump over there and connect with one of those practices, bookskeep included, and work together to figure out what is the best method for your business and how to move forward to get to that outcome.
➡️Find an accountant or bookkeeper for your ecommerce business now in the A2X Directory
And then last but not least, if you’re still kind of early in your journey and you want to learn a little bit more, the A2X website has a ton of resources available to you to help you continue down this path, so please take a look. All the content is available on our blog or the Ecommerce Accounting Hub.
Question and Answer session
Geoff: Amy, do you mind if I pass the mic over to you to flag some of the questions that have come up
Amy: Yeah, we’ve had a few come through. So one that we answered earlier on, and that was for scaling businesses. The next question that we’ve had—and I think this is possibly relating to the example that you shared, Cyndi, of your client who had all those unfortunate situations. The question is:
Is there insurance available for retailers, i.e., Amazon, for things such as nventory losses, account suspensions, and things like that?
Cyndi: Yes, my understanding is there is. The person that I know that does insurance for Amazon sellers specifically is Ashlin Hadden Insurance. She’s got an ecommerce insurance agency, and she’s where I would start. There may be others out there, she’s just the one that I know several clients are using and have had good results with. So I would touch base with Ashlin Hadden, she got some websites with good information on it as well, so look her up.
Amy: Awesome. When we have these conversations it always really drives home the value of having an ecommerce accountant. I was thinking to myself, “I have absolutely no idea if there’s insurance for things like that,” but these are the things the experts know!
Cyndi: There are lawyers to help you get out of those stickysituations too!
Amy: Hahaha, that’s good to know.
The next question is:
With modified cash, do you run reports as accrual or cash basis? QBO gives you the options to run reports on either.
Cyndi: Well, a lot of it depends on how you’re putting data into the accounting system—if you’re using things like the inventory tracking in your accounting system versus inventory tracking, through A2X or through a 3PL or something like that. The safest answer I can give you is to run them on an accrual basis. But for most applications, it matters how you put the data into QuickBooks, so you might not have to run it on an accrual basis, you may get the same information if you run it on a cash basis. But, not knowing the full details of the situation, I know accrual will get you where you need to go.
Amy: And then we’ve got another question that’s come through and it says:
Is the page we saw which itemized Amazon deposits an example of the A2X reconciliation? It would be helpful to see how A2X is helpful.
I’m happy to take this one!
Yes, the example that we shared earlier is how A2X will split out the data. On the left hand side, it was just a seller that would code the whole deposit to sales. And on the right hand side, that’s the information that you would see if you were using A2X.
So, A2X will split out all of the different transaction types. It will also split it out into the month that it occurred. If you had a deposit that covered two months, you’d get two entries from A2X, so it’s following the accrual methodology and that’s your transactions and accrued period.
But if you are interested, we’re more than happy to give you a specific demo of A2X, we can include that in the follow up if you’re interested in seeing how A2X works. The purpose of today was that we really wanted to dive into that cash vs. accrual vs. modified, but we’re always more than happy to give you more information about A2X as well.
Cyndi: If I could follow along with that just a little bit, Amy. One of the reasons as an accountant we work with A2X is because it is accurate from an accounting standpoint. And one of the challenges that we hear over and over with clients is that we present them their books after we’ve done their cleanup, and they’re disappointed because their sales are not what they thought they were.
This is because they’ve been using another dashboard-type tool, and the challenge with that is that the tool that they’re using is pulling data out of Amazon at an order level as opposed to at a sales level. And that’s not the correct accounting treatment.
This was a little problem until we hit 2020, and then all these people went online and placed orders. But then they didn’t actually take delivery because Amazon had a big backlog. Then at some point, Amazon said, “Hey, do you really want this?” and they got canceled. So it was thousands—tens of thousands of dollars that our clients thought they were getting, because it showed up on the order report in their dashboard—but it was not the correct accounting treatment and then those dollars were washed away, because it truly wasn’t a fulfilled order.
So, for that reason, these dashboards are useful for certain perspectives, but they’re not useful from an accounting perspective. When you’re basing your decisions on what you’re seeing in a dashboard that’s looking at orders, as opposed to true sales, then you’re setting yourself up for possibly having a situation where those numbers aren’t in alignment with what really happens with money that hits your bank.
When we made the decision to use A2X in our practice, it was because we saw the rigor that went into developing a tool that went all the way back to what is being put in the bank, and how it corresponds to what is actually happening at the sales level in Amazon.
That’s the reason we use A2X and find that it’s a tool that can be counted on. But it’s also a red flag if you’re seeing something in a dashboard and then suddenly it’s not matching your accounting system. Or you invest in an accounting system and then realize you’re getting different data—that’s very often the cause. The dashboards are not going to the actual proper place in Amazon to get accounting information, they’re simply pulling out orders, which can change,
Geoff: Do you find that sometimes when people work with you, instead of being disappointed with their numbers, they’re pleasantly surprised?
Cyndi: No! Unfortunately I don’t see it the other way around very often. I see these dashboards typically overstate it and then I’m giving bad news.
Amy: That, I guess, is the downside of those batch deposits, right? They can also include things like tax.
Cyndi: yeah, exactly.
Amy: And I think going back to the theme of the conversation, that’s why cash accounting doesn’t necessarily work that well for ecommerce because you’re often paid far later than the transaction happened. And there are refunds and returns, and all sorts of things that are far more difficult to track.
Cyndi: A lot happens after the fact.
➡️ To find an ecommerce accountant or bookkeeper, check out the A2X Directory.
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