Cash vs Accrual Accounting: How to Know When to Switch to Accrual

In this video I'm going to address four main stops along your path to maturing as an ecommerce business. I'll discuss pain points and company needs within each stop, so you'll have a very clear picture of how the path will look for you as your business matures. We'll also follow a fictional company, Bath Time Ducky Co, along the spectrum. Make sure to watch to the end of the video so you can see how the company's accounting changes as it grows from the startup phase to being a publicly traded company.

For the sake of clarity, I'll say cash based accounting to mean recording revenue when cash hits the bank account, and expenses when cash leaves the bank account. I'll say accrual based accounting to mean recording revenue and expenses when a transaction actually occurs, rather than when the money is exchanged.

1:09 Stop one, cash is king

Your first stop along the spectrum is, cash is king.

Companies in the startup phase almost always choose to track their finances on a cash basis. They may have little or no revenue at all. They're mostly concerned with making sure they have enough cash in the bank to pay those bills as they come in. Thus, the number that most startups pay attention to is their bank account balance.

At this stop the biggest pain point is the fact that the bank account balance is everything. Questions you might be asking in this phase are, am I still going to be in business in a month? Am I going to have enough cash in the bank to pay all those bills when they start coming in?

The pros to this approach are that it's really easy to use and implement and maintain, and it's also really easy to see how much cash you have on hand. But I would argue that the disadvantage to this approach is that it's very restrictive. It really doesn't give you the full picture of your sales or your profitability.

2:04

For example, our brand new startup Bath Time Ducky Co launched its first few products in March of 2021. The company hoped its product would gain popularity before the Christmas selling season, but soon found out that their first months of sales just barely covered advertising costs.

While Bath Time Ducky Co owners wanted to spend time each month reviewing their profit and loss statement, they instead had to focus all of their efforts on increasing sales so that they'd even still survive until Christmas. So the owners settled on just keeping an eye on the bank account balance, and sometimes even contributing personal funds to the company so they could stay afloat.

2:41 Stop two, timing differences

Stop number two along the spectrum, timing differences for revenue and cost of goods sold.

So what happens to a company that has uneven sales throughout the year due to seasonality, or when the company pays for supplies in one month though the products or supplies don't get used for several months?

If this is you, some of your pain points at this stop along the spectrum could include customers that sell on ecommerce platforms and want to show gross revenue, not just revenue net of fees. Customers who pre-order and pay for new products but don't receive the products for several months. Customers who receive the product and then don't pay for it for several weeks. Or inventory orders that come in all at once, though the inventory sells for several months afterwards.

Companies experiencing these pain points might start choosing to record the revenue on an accrual basis, and then simultaneously or afterwards the cost of goods sold, even if they record everything else on a cash basis. When companies begin feeling that cash-based accounting isn't showing them the full picture of their sales, the most natural first step of better accounting is recording sales on an accrual basis. The next step of better accounting is recording cost of goods sold on an accrual basis.

3:57

Back to our case study. Bath Time Ducky Co gets to 2022 and has increased its sales enough to break even, then it may decide to start recording gross sales and gross expenses for ecommerce. The company may also start selling wholesale, which means needing to collect cash payments from clients who get credit and payment terms as well.

Recording revenue on an accrual basis will help Bath Time Ducky Co have a better feel for the periods where their sales are actually happening, regardless of when the cash payments are coming in.

In 2023 they may decide to begin tracking their cost of goods sold on an accrual basis too, so then they will have an even more accurate picture of how much their sales are actually costing to produce, regardless of when the cash for inventory exits the company's bank account.

4:43 Stop three, uneven admin expenses

Stop number three, uneven administrative expenses.

Once a company begins tracking revenue and cost of goods sold on an accrual basis, the company may still struggle to track its profitability accurately. This would most likely be due to administrative expenses still being recorded on a cash basis. Things like annual software renewals or other prepaid expenses may get paid out in large amounts one month, and then have no comparable expense for several more months.

Pain points along this stop could include, getting financial information that's comparable from month to month will be very difficult in this phase. Also, from a cash planning perspective, management will have a lot of difficulty deciding on sales targets, since there really doesn't seem to be a clear picture on how much the monthly expenses will end up being.

The question you might ask yourself is, am I relying on my financials on a month-to-month basis to know if there are things that are out of the ordinary? If so, then the company's next move would be to move further along the spectrum from cash to accrual by recording prepaid expenses and accrued expenses. This would involve recording expenses in the period they're being enjoyed, regardless of whether or not they were paid for upfront.

For Bath Time Ducky Co, they're able to continue growing their business in 2024. Management feels that its revenue and cost of goods sold are being recorded in the proper period, and wants to now record its software subscription expenses on a monthly basis, to spread them over the length of the subscription rather than recording a cash amount once an item is delivered.

6:16 Stop four, full GAAP compliance

Stop number four, the home stretch, full GAAP compliance.

Once a company is recording revenue, cost of goods sold, and most or all of their administrative expenses on an accrual basis, the company may find that it has investors or debt holders who now want financial statements, or who require the company to comply fully with GAAP, or generally accepted accounting principles. Also, if your company makes 25 million in sales over a three-year period, or it's publicly traded, you must use full accrual based accounting.

Things to consider would be, do you have a hard month end close and you don't want anyone to be able to make changes? Then it's time to start doing accrual based accounting. Or are you reporting numbers to outside entities such as investors or debt holders? If so, then you must have accurate accounting. Books can't stay open all year, and you likely have to issue monthly or quarterly financial statements to investors or debt holders.

Bath Time Ducky Co on the stock exchange. If after rapid growth and expansion Bath Time Ducky Co finds itself preparing for an initial public offering of stock, it will have likely worked to prepare for GAAP accounting in its fullness, and will then focus on improving the presentation of the financial statements to be at the level that is needed.

7:33 The spectrum in a nutshell

So here's the cash to accrual spectrum in a nutshell.

Number one, am I going to have cash in the bank? Number two, I have cash in the bank, but sales aren't happening at the same time the cash comes in. Number three, I've got plenty of cash in the bank, but I need to know if I'm going to have cash in the bank in the future, or if my expenses are getting out of whack. And number four, cash is in the bank, expenses are handled, no one is touching my records because they are done correctly and I don't want them messed up.

Some companies only want cash and some companies want all the details. We customize our services to what you need. If your ecommerce business is over 2 million in annual revenue and you need some help moving to accrual based accounting, or if you want an ecommerce specialized accountant, let us know at the link in the description. We are happy to help.