Cash Accounting vs. Accrual Accounting for Ecommerce
Estimated reading time: 8 minutes.
Accounting is an ongoing process, one that most people take years to master.
Whilst some aspects of accounting are regulated and need to look a certain way, like balance sheets, for example, this isn’t the case for everything.
When it comes to bookkeeping, business owners have some choice in the methods they use.
Timing is everything, and the method an ecommerce seller uses will dictate a number of important things for their business. And ultimately, whether the company survives, thrives, or dies.
In this article, we will focus on the two most common bookkeeping methods: Accrual accounting and cash accounting.
We will explore what they mean, how they work, and the rationale for why accrual accounting is hands-down the favorite for ecommerce.
We’ll also show how books can be set up to do this automatically, so sellers get all of the accrual accounting benefits and none of the headaches!
In this guide, part of our ecommerce fundamentals series:
Table of Contents
Let’s get stuck in.
An Overview of Accounting and Why It Matters
Before we dive straight into bookkeeping methods, let’s take a step back.
Why should we spend time and money on accounting and bookkeeping in the first place?
Accounting is fundamental to your business.
It is the process of summarizing, analyzing, and reporting on the financial transactions within a business.
It’s about managing the money, and understanding its movements. And since your money is the blood flow of your business, powering its essential organs, its proper management is essential.
Accounting gives businesses:
- Insight into their costs and revenue, so that they can calculate profit margins.
- Information about their business performance and health, so that they can prepare for cash flow peaks and troughs.
- Information about new or sudden changes to cash flow, to diagnose potential problems or unexpected charges.
- The tools to become compliant with legal obligations, like sales tax collection.
- A way to track what the business owns, owes and is owed by others.
- A system for detecting single points of failure, and diagnosing why unexpected cash flow problems may have arisen at any given time.
- The means to apply for a business loan if required, or a business credit card.
- A value which can be shared with potential stakeholders or buyers, and lend credibility to the business.
Businesses are fuelled by money. Without accounting, running a compliant, profitable and scalable business is practically impossible.
So, how does it work?
How Accounting Works Today
Before we dive into the mechanics of accounting, let’s cover a couple of definitions and the statements businesses use to understand their finances.
The terms bookkeeping and accounting are sometimes used interchangeably, but they are different things.
- Bookkeeping refers to the daily organization and reconciliation of accounts. It’s about efficient records and tidy books.
- Accounting is the next level. Using records compiled by bookkeepers, accountants analyze, summarize and report on that information, and help business owners make informed decisions about their investments and claims.
The standard documentation that businesses need like income statements, cash flow statements and balance sheets rely on both detailed bookkeeping and accurate accounting.
We’ll talk more about what these are below.
Cash flow statements
These statements are usually split into three sections: operating, investing, and financing activities.
They help you track how much money is moving into and out of your business, and where it’s coming from or going to.
The key concern in your cash flow statement is that your operating activities total is positive. This indicates that your business is generating enough cash to stay in the black.
If you want to invest, you’ll need this operating activity to be enough to cover that too.
If it’s not, you may be propping up your business in unsustainable ways, like using credit cards or loans. And that’s not something you want to rely on in the long term.
Opening cash + cash received (or forecasted to be received) - cash spent (or forecasted to be spent) = closing balance.
Income statements (or P&Ls)
The income statement, sometimes referred to as a “P&L”, “PNL”, or profit and loss statement, lays out your sales, costs of goods sold, and expenses, to give you your profit.
It is a record of your past income, up to the present day.
You can track your sales patterns and trends, and you want to ensure that these rise in parallel with your net income.
If your sales rise but your income doesn’t, you can use the statement to figure out where your money is going.
Profit = income (or revenue) - expenses.
This is a bird’s eye view of everything your business owns or owes. In a snapshot, it tells you whether your business has value or not today.
Where cash flow statements and P&L are your business’ road maps, your balance sheet is the globe.
It consists of assets (what your business owns), liabilities (what your business owes) and equity (the value of your company: assets - liabilities).
The balance sheet provides an opportunity to look for errors and patterns in financial activity. By comparing these snapshots, you can see an overview of your business’ monthly performance, and check that all your numbers make sense and are recorded accurately.
If your equity is trending up over time, that’s a good sign that your business is healthy and on the right track.
Assets - liabilities = owner’s equity (or capital value)
Real-world examples of these statements
In this video, Catching Clouds founder Patti Scharf shows you examples of these financial statements and explains what ecommerce sellers should be looking for within them.
Skip to 9m:30s for cash flow statements, 5m:50s for income statements and 0:40s for balance sheets.
If you use a good accounting software partner for your ecommerce business, these statements should be generated automatically for you.
Ask your bookkeeper or accountant to help you interpret them and look for weak areas.
Now that you know how we use financial information and diagnose issues with it, let’s take a step back and look at how this information is recorded in the first place.
The foundations of accounting today originated in 16th century Europe, to help rationalize growing trade and commerce.
These foundations took the shape of the double-entry bookkeeping system. And it’s understanding this system that will help in our debate about using cash vs. accrual accounting later on.
Double-entry bookkeeping refers to a method of entering accounting records. It works on the basis that every credit entry to a business’ books should have a corresponding debit entry, and vice versa.
This keeps books balanced, hence the name, “balance sheet”.
It is used to satisfy the accounting equation we also mentioned above:
Assets = liability + equity
As credits and debits are offset, they should always be equal. If they are not, this indicates an error in the process and helps accountants diagnose problems.
It’s worth noting at this point that “credits” don’t always mean increases and “debits”, decreases. For example, debits to an expense account increase its balance, and debits to a revenue account decrease its balance.
“Essentially, the representation equates all uses of capital (assets) to all sources of capital (where debt capital leads to liabilities and equity capital leads to shareholders' equity). For a company keeping accurate accounts, every single business transaction will be represented in at least [two] of its accounts.”
The accrual method of bookkeeping gives businesses a clearer understanding of the relationship between their revenues and expenses.
This, in turn, helps provide a more accurate picture of assets and liabilities for a business’s balance sheet, because both are recorded at the time they are accrued.
Let’s look into accrual accounting vs. cash accounting a little more deeply now, to see how the former makes most sense to ecommerce businesses in particular.
Cash And Accrual Accounting Basics
The cash and accrual accounting methods are ways to manage business bookkeeping.
“Bookkeeping involves the recording, on a regular basis, of a company’s financial transactions. With proper bookkeeping, companies are able to track all information on its books to make key operating, investing, and financing decisions.”
The key difference between the cash and accrual accounting system comes down to timing.
Cash accounting definition
Cash accounting involves recording income and expenses when money changes hands. Income is recorded when money is received and expenses when bills are paid.
Cash accounting is used because it is simple (sellers can pretty much go off of bank statements, and they know exactly how much money their business currently has).
Cash accounting example
For ecommerce sellers, sales are counted when the settlements come in from the platform. So if you sell on Amazon, you only record sales once the money has come into your bank account.
Which types of businesses typically use cash accounting?
Cash accounting can be effective for businesses that have little to no time delay between when transactions occur, and when money changes hands.
Cash accounting may suit restaurants, for example. There isn’t much of a delay in when they get paid and when their bills are due:
“With most restaurants if they’re paying bills on time, everything is within 30 days. They’re getting paid when the customer comes in with cash or credit card, then receiving the credit card payments in a couple of days. It doesn’t make a lot of difference in how they manage the business whether they use cash or accrual.”
Accrual accounting definition
The accrual accounting method involves recording transactions at the time sales are made or orders raised, even if the money hasn’t changed hands yet. It focuses on the movement of value as opposed to immediate cash handling within a business.
Income or expenses can be recorded if either:
- Liability is agreed and can be determined with “reasonable accuracy”, or
- When a service or property has been provided or used.
Accrual accounting is used because businesses often 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.
The accrual accounting method is required by the GAAP (generally accepted accounting principles) for larger businesses:
“All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP). If you’re reading a corporation’s financial reports, what you see is based on accrual accounting.”
Accrual accounting example
If a transaction took place on Amazon on 5th June, accrual accounting would record that date against that transaction, even if the settlement from Amazon didn’t actually arrive until 10th June. Cash accounting would record it on 10th June, when the money arrived.
Which types of businesses typically use accrual accounting?
Larger businesses or those with a greater time difference between when they receive money and need to pay their bills should use the accrual accounting method.
“So a consultant would record revenue as billable hours are completed. A building contractor would record revenue when a remodeling job is finished. A manufacturer would record revenue when a product has shipped.”
Pros and cons of accrual accounting and cash accounting
It might seem like only counting cash when it’s in the bank is the smartest way forward, but that’s not necessarily true.
Check out what the methods mean for bookkeeping below:
See those “cons” next to accrual-based accounting?
Well, keep reading to see how A2X removes those from the picture, making all those benefits accessible to ecommerce sellers with none of the hassle.
Why Is Accrual Accounting Better For Ecommerce Sellers?
There are many different advantages of accrual accounting for ecommerce sellers.
Aside from the fact that the GAAP requires this method from businesses that reach a certain size, even smaller sellers should consider it from the beginning too.
Unlike the restaurant example we discussed under the cash accounting section, selling online doesn’t typically involve immediate payments both to or by a seller.
Certain transactions might be made in anticipation of a need to settle up later on. An example of this might be using a credit card to cover fees or inventory purchases before paying it off later, when the cash is available to do so.
Sellers need to forecast cash flow in order to do this successfully, and to avoid deficits that could incur extra fees and eventually put them in debt.
An additional benefit of accrual accounting is to enable sellers to estimate whether they need funding to grow and how much to request. If they are considering a loan, this will help to ensure they only take out as much as they need.
SellersFunding is one example of a service for ecommerce sellers to raise their capital this way.
What the accrual accounting method gives sellers
- A more accurate insight into the health of a business.
- The ability to compare financials across different sales channels over time.
- A clearer picture of profitability and financial resilience.
How To Do Accrual Accounting Using Smart Automation
It probably sounds by now like accrual accounting is a bit of work. While this is true, it doesn’t mean everything has to be done by the business owner themselves.
There are plenty of resources specially designed to help ecommerce sellers manage industry-standard, accurate books in less time - zero existing expertise required.
Number crunching is a time-consuming, easy-to-delegate task. By automating it, that redundant vegetable is gone from the sellers’ plate, making room for something far more exciting. Perhaps a new revenue stream, product or client?
For optimized, industry-standard ecommerce books, you need:
Cloud accounting software
The crucial first step for any ecommerce seller: Cloud-based accounting software. Sellers of any size should think about investing in this before any other automation technology.
Cloud accounting software gives ecommerce sellers:
- A visual snapshot of their business financials.
- Instant reports and insights.
- Access to their books anytime, anywhere.
- Automatic data transfer from their ecommerce platform.
- Books protected by secure encryption technology.
- Control over access levels to share with others.
Plus, there’s nothing to install or download. Everything is based in the digital stratosphere for easy but protected access.
Connector app A2X to integrate your platform and accounts, using the accrual method
A2X integrates with cloud accounting software and ecommerce platforms Amazon, eBay, Shopify, Etsy or Walmart.
It captures settlement data from the platforms and calculates each line item for each bank deposit, organizing them into accrual accounting journal entries.
A2X gives ecommerce sellers:
- Summarized journal entries which break down every income and expense line that went into a bank deposit.
- Accounts organized according to the accrual accounting principles, allowing cash flow to span months and show a more accurate financial picture.
- Payouts matched automatically with bank deposits, so that reconciliation consists of a few checks and confirmations.
- Accounts and taxes mapped automatically based on a blueprint that sellers create when they get set up. This can be changed and updated anytime.
- Accurate, seamless accounts with nothing missed and in a fraction of the time.
Check out how A2X works here:
Start a free trial for A2X anytime via the dedicated platform links below:
Psst: A2X also supports multi-channel sellers. For those interested in expanding, other platforms can be integrated into one A2X account later on.
Accrual Accounting = Greater Understanding = Growth
Accrual accounting helps sellers get to know their business on the kind of level required to make the big decisions. Decisions that could be the difference between sink and soar.
Sellers should start with cloud accounting software. Once that is set up, wherever they are in their journey, A2X can go in and organize books via the accrual method - backdated if need be.
No more assumptions, no more guesstimates - steer your business on accurate, reliable numbers from now on.
Next in the Series…
This blog is the third part of the A2X ecommerce accounting fundamentals series.
So far we have covered the core concepts of ecommerce accounting and what makes it different. Now that we’ve looked at bookkeeping methods above, let’s explore a great way to manage your cash flow: Profit First for ecommerce sellers.