Deciding which accounting method to use for your online business is an important decision. You can start by knowing that the two most popular methods are the accrual method and the cash method.
Do you know how different cash accounting is from accrual accounting? If not, that's okay—most business owners don't.
But it's important to understand the differences, especially if you're running an online business. In this blog post, we'll explain the differences between cash and accrual accounting and help you decide which is best for your business. So read on to learn more!
A Brief on Cash vs. Accrual Accounting
Cash accounting is when you record income earned, or expenses paid. Meanwhile, accrual accounting is when you record transactions as soon as you earn or owe them.
To give you a better idea, let's bring out a sample transaction from MPOM Pet Supplies' general journal.
|Date2022||Account Title and Remarks||AmountDebit Credit|
|July 30||Cash Sales Revenue(to record cash collected)||$5,000|
|Date2022||Account Title and Remarks||AmountDebit Credit|
|July 1||Accountable receivable Sales Revenue(to record sales)||$5,000|
|July 30||Cash Accounts receivable(to record cash collected)||$5,000|
Do you see the big difference between accrual and cash-based accounting in data entry? It's in the expense and revenue recognition. Let's dive in deeper.
Based on Cash Movement
The simpler accounting method would be cash basis accounting. Why is it the easiest way to manage your income and expenses? Because you input the transaction only when there is cash involved. But cash here also means bank payments, cheque transactions, and the like.
Given the example above, you will notice that the transaction was only recorded on July 30th. That's because that is the only time you receive actual money.
It's important to remember that cash accounting has no such thing as accounts receivable and accounts payable. Because in this accounting method, you don't record the moment you make the transaction. It is only when you receive payment do you record it in your ledger.
What Are the Benefits of Using the Cash Accounting Method?
Most small business owners choose cash-based accounting for three reasons.
Easy to Record
Money goes in, and money goes out. When it does, you record it. It's easy to manage your online business this way, and you don't need to hire a professional accountant to do the job.
You don't need to adjust if a customer doesn't pay or you haven't paid your supplier yet. It's because there's no initial record of it in the first place.
Good sense of short-term finances
With the cash basis accounting method, you get an up front report of how much you actually earned or paid during that period. This is perfect when making cash flow statements since you only record ongoing and outgoing transactions involving cash. Thus, you get the net income or net loss easily.
Advantages During Tax Season
If you are only keeping records of cash transactions, you may have the upper hand when you need to file for your business taxes. It's because you can lower your tax liabilities by slowing down your revenues or speeding up your expenses. Of course, this is all legal.
Are There Drawbacks of Using Cash Basis Accounting?
It's the easiest accounting method to use. But there are disadvantages to using it for your ecommerce business.
Inaccurate Idea of Your Business's Health
MPOM Pet Supplies
Comparative Income Statement
For the Months Ended May, June, July
(in thousands of US dollars)
In this comparative income statement, MPOM received the most income during May, making it look like the online business is doing well. On the other hand, coming June and July, its profits fluctuated. This might suggest that the business was busy in May, but the other two months were stale.
So, what happens if it only gives a rough idea of your business standing in given periods?
The small business owner might make wrong business decisions. Perhaps, they'll cut back on inventory in June and July since no one was buying their products during those months. They could also make more purchase orders for May since it's the busiest, thus adding more billables that month.
Hard to Track Profitability in the Long Run
Whether your online business is slow or not, it's quite impossible to remember every cash transaction coming in and going out of your business. So, if you review your last year's income statement, you won’t even remember why your revenue was low or your expenses were high back then.
Generally accepted accounting principles are accounting standards businesses and the US SEC commonly adopt. In the case of cash basis, it's a non-compliant method. But it doesn't mean using it is illegal. GAAP are not legal rules but rather the level accounting boards like Financial Accounting Standards Board (FASB) wish businesses would follow.
However, if you earn over $25 million in sales over 36 months, you are obligated to use the accrual method of accounting according to the IRS.
Who Can Use Cash Basis Accounting?
Even if it doesn’t conform to the standards of GAAP, many people still use the cash basis method. Because of its simplicity, you can use this method in specific situations like the ones below.
Sole Proprietor of a Starting Online Business
Are you just taking your first step to business success? Perhaps, you have a passion for running a business but don't know how to do accounting. If so, the cash method is for you.
Are you strapped for cash, worrying about how you will pay your taxes this year? With cash basis accounting, you’ll have lesser taxes to pay since your income during this period is low.
Based on the Date Transactions Are Made
Now, with accrual basis accounting, you don't have to wait to record your income or expenses. You record these transactions as soon as they are earned or billed.
Once your customer buys your product on installment, you record the transaction when the order is completed. Meanwhile, expenses, such as raw materials for inventory, are recorded as soon as you receive them. Therefore, line items such as accounts payable and accounts receivable are particulars in your books.
What Are the Benefits of Using Accrual Basis Accounting?
It's not known for ease of use, but there are many advantages to using the accrual method of accounting for your online business.
Accurate Current Assets and Liabilities
Accrual-based accounting doesn't clearly show how much cash you actually have. So how is it more accurate in financial reporting than the cash method? This is because it gives the exact period when you earned or incurred an expense.
Better Projections and Decision-Making in the Long Run
Accrual basis accounting allows you to gauge and plan for peak months of your business operations as you can see your business's profitability and performance clearer.
Did you receive a lot of orders for the month? Or did you make several dealings with the supplier at that time? The accrual method shows you the exact movements of your business operations so you can make better financial decisions in the future.
If you're not hitting the $25 million mark yet, you can still use the accrual method for recording your income and expenses. It's what the board of accounting regards as a standard, after all. Moreover, banks, lenders, and investors prefer this GAAP-compliant accounting method over cash basis accounting.
Grows With Your Business
Your business may just be starting out, but you can triple your revenue in a few years, thus earning over $25 million. So, if you use accrual accounting from the beginning, you do not need to change accounting methods as you already comply with IRS regulations.
Are There Drawbacks of the Accrual Method?
The disadvantages to using accrual accounting are only a few. But it's not without its difficulties.
For some, bookkeeping is already daunting as it is. But when you use the accrual accounting method for your online business? Daily records, end-of-the-month, and end-of-the-year reports might be stressful for you. You need to learn this accounting method well to use it properly.
Uncertain Cash Flow
Using the accrual method, you can see that your income statement (profit and loss) is looking good. However, upon checking your cash flow statement, your cash is almost $0. That's because when you look closely at your P&L statement, your accounts receivable is quite high. After all, your customers haven't fully paid yet.
Following the accrual accounting method keeps track of your profitability but not your actual cash. Thus, it's important to make cash flow statements that go hand-in-hand with your P&L.
Who Can Use Cash Basis Accounting?
Despite its tedious workflow, it's still the standard. Plus, once you earn a huge profit within three years, you must switch to the accrual method anyway.
Aside from these facts, small business owners choose to work with this method because they live in some states in America, like New York, requiring accrual basis tax returns. If you live in one of these states, you need to be tax compliant and pay your dues.
Use Both Accounting Methods with Unloop
Which is better for your online business—accrual vs. cash? The answer is both. Accrual accounting gives clearer snapshots of your business's performance. While cash accounting can help you keep tabs on your cash flow.
Is it a lot of work? Sure, but you get the best of both worlds to make short-term and long-term decisions that would greatly benefit your online business. If you can't handle both methods, you can ask a professional accountant aware of ecommerce businesses and bookkeeping.
Don't waste your time scratching your head in deciding which accounting method to use. Instead, book a call with Unloop today to handle your income and expenses correctly.