Welcome to everybody's favorite subject, accounting and bookkeeping. Well, not really, but we at Finaloop understand that, and always aim to simply and help our customers understand some of the more difficult, but highly crucial concepts that can make or break any business.
Any new or growing business, especially an eCommerce business, which usually maintains inventory, needs to know how to properly keep and maintain the books, and to prepare and understand financial statements such as the balance sheet, profit and loss statement and cash flow statement if they hope to grow their business, and especially if they intend to raise capital or borrow money.
One of the questions we get asked often is about the differences between cash and accrual based accounting.
Give Me The Basics
Every company needs to keep accurate records of its activities to know what is going on with the company, determine areas of improvement, understand financial growth and solvency, and of course, calculate taxes.
There are many ways to measure the results of a company, and some of it is reflected in our chosen method of ecommerce accounting and bookkeeping.
The primary difference between cash and accrual based accounting comes down to _when_ a transaction is recorded.
When keeping records on a cash basis, revenue and expenses are recorded only when cash actually changes hands. Credit card transactions are considered cash transactions, even though the credit card processor may not have transferred the funds to you yet. Where in the accrual method, revenues and expenses are recorded when they are actually incurred.
The accrual method tends to work better for the purpose of showing a company's long term financial health, because it takes into account the revenues and expenses that have already been incurred and are expected to result in a future cash inflow or outflow.
How Do I Choose What's Best For My Company?
That's a decision that each new business founder will have to make for themselves based upon what they are most comfortable with. Let's break it down for you a bit further.
Cash Basis Accounting
Simply put, cash basis accounting recognizes transactions when cash is paid or received. The cash basis does not account for accounts payable or receivable. Most small businesses, such as small eCommerce businesses tend to use the cash basis because it is simpler and easier to track, and provides a good fit for a small company.
However, the cash basis method isn't very useful for long term planning and growth, as the numbers may be skewed. The cash basis shows only when cash was exchanged, making it difficult to determine when an event actually occurred.
For example, in December you agree to sell 1,000 shirts to a retail clothing store for $10,000. You ship the shirts in December, but your invoice is not paid until January. In this case, your accounting records would only be updated to show the $10,000 in revenues in January.
Further, if you ordered $5,000 worth of fabric in December to make your shirts, but did not pay your supplier until January, you would not record the expense in your records until January, despite having already incurred the expense in December.
Accrual Basis Accounting
Unlike the cash basis, accrual basis accounting recognizes revenues and expenses at the time they are incurred, without regard for when the cash actually changes hands. For this reason, the accrual method tends to require more work from an accounting and bookkeeping perspective, but ultimately it gives a better big picture of the company's financial status.
The accrual method gives a more accurate picture of when events occurred, which allows managers to assess important factors, such as when is busy season so you can hire additional seasonal or temporary workers to cover the additional work.
However, the accrual method does not give information on cash flow, and if the accounts are not closely followed, even the most profitable of companies can suddenly find itself with insufficient cash on hand to pay its bills.
Most growth-stage companies use the accrual method of accounting. Small companies will usually use the accrual method of accounting if they expect to apply for loans or to raise money through investors such as venture capital firms, or if they see the business significantly growing in the future.
Using our examples above, if in December you agree to sell 1,000 shirts to a retail clothing store for $10,000, but your invoice is not paid until January, in this case, your accounting records would be updated in December when the transaction occurred, despite the fact that you won't be paid for another month. The $10,000 would be recorded as an account receivable.
Further, if you ordered $5,000 worth of fabric in December to make your shirts, but did not pay your supplier until January, you would record the expense in your accounting records in December, despite the fact that you wont pay the supplier for another month. The $5,000 owed would be recorded in your records as an account payable.
Will My Choice of Accounting Method Affect My Tax Liabilities?
Absolutely, and this is where things can get a bit more complicated. It is important to note, that how you manage your internal accounting records does not have to be the same method by which you record transactions for tax purposes.
Simply, you can choose to manage your internal bookkeeping according to the cash basis, but come tax time, file and pay your taxes according to the accrual method, or vice versa. However, this would require additional work on your part, or that of your accountant. Prior to the Tax Cuts and Jobs Act of 2017, the IRS required all companies with over $5 million in revenues to file their taxes according to the accrual method of accounting. Following the passage of the TCJA in 2017, the IRS has raised the requirement threshold for taxes to be filed according to the accrual method by companies (not including S Corporations) with over $25 million in annual gross revenues.
There are certain additional exceptions mentioned below.
Cash Basis Accounting Tax Consequences
The IRS allows certain taxpayers to report their taxes on a cash basis, where taxes are only paid on cash actually received, and deductions only incurred on expenses actually paid.
Using our example above of the cash basis accounting, if you sell $1,000 shirts in December 2019, but don't get paid the $10,000 for them until January 2020, you would not include the $10,000 profit in your 2019 tax return, but rather in your 2020 tax return.
Further, if you ordered $5,000 worth of fabric in December 2019 to make your shirts, but did not pay your supplier until January 2020, you would not take the deduction in 2019, but rather account for the expense and deduction in your 2020 tax return.
However, the ability to report on a cash basis for tax purposes has some exceptions that result in a hybrid of cash and accrual based reporting. For instance, the IRS requires companies holding inventory or other fixed assets to report these items on their tax returns on an accrual basis, without regard to how much you earned in revenues. This means that even a cash basis business cannot take tax deductions on unsold inventory, even if the purchases were made in cash. This hybrid accounting is very often seen in eCommerce businesses, which typically hold inventory. To simplify the accounting process, we see many of our eCommerce customers choose the accrual method of accounting from the start, or quickly choose to switch over to the accrual method.
Accrual Basis Accounting Tax Consequences
In many cases, reporting on an accrual basis will usually have tax benefits which are beneficial to a taxpayer. For example eCommerce sales are usually all in cash, including credit card transactions, and reporting on an accrual basis allows these businesses to take a tax deduction for employee salaries and expenses incurred in that year, but which may not be paid out until the following year. In this case, the revenue side is not affected, but the company is still able to claim a deduction which lowers its tax liability.
To illustrate this, your eCommerce business sold 1,000 shirts on your online store for $10,000 in December 2019. As a credit card transaction, you immediately record the revenue as you would on a cash basis, even if you don't receive the proceeds from the credit card processor until January 2020.
However, if you hire a web programmer for $3,000 in December 2019 to fix and make changes to your website and online store, but you don't pay him until January 2020, under the accrual method you can record the expense and claim a tax deduction in 2019.
Changing Accounting Methods
If your company already exists and has previously filed taxes, and now you want to change your accounting method for tax purposes, it is important to be sure to follow all relevant IRS guidelines. If you believe that a different tax method will work best for your company, and you want to file taxes this year using a new method, you can file IRS Form 3115. Please consult with your tax professional prior to changing your accounting methods, as there may be additional tax implications for your specific circumstances.
Your company's choice of accounting method can have a large impact on the business and its record keeping and tax reporting. Most companies use an accounting software such as Quickbooks or bookkeeping software such as Xero to maintain their financial records, and then may hire a bookkeeper to manage their books, and a tax accountant at tax time. For a simple and easy choice, you can choose Finaloop to do it all for you for one affordable flat rate.