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How Accrual Accounting Helped Jim Reveal a Hidden $1.2M Profit

Cash basis accounting is simple and affordable, but it misses crucial details needed for informed business decisions. Discover why accrual accounting provides a clearer picture and helps you make smarter financial choices for your business.

Where did all the profits go? 

When Jim approached us, he faced a familiar challenge we see with many eCommerce sellers: strong sales but an unclear financial picture.

Despite growing his Amazon and Shopify revenue by 300% in one year, he wasn’t seeing the profits he expected. He even had to put in $300,000 of his own money to cover expenses and purchase inventory. Frustrated and feeling like he was missing something, Jim was ready to quit, believing his business was failing. He couldn’t afford to inject more personal funds and didn’t want to borrow for what he thought was a losing venture.

Jim’s previous bookkeeper set him up on a cash basis accounting system for small businesses. He was told that this was a simpler and cheaper method that records revenue and expenses when cash changes hands.

While this seemed to work well in the beginning, it soon became clear that the cash basis method was not providing him with useful information to analyze his business performance.

    Cash basis vs Accrual. Simplified example:

    Here is a simplified example of some of the differences between the two types of accounting. In this example, Jim sells high-end hammers on Amazon and Shopify. This is how the transaction would look under each type of accounting:

    • Jim buys 1000 hammers for $10 each ($10 000) in October and pays cash for it
    • He sells it in November for $30 each ($30 000)  with a net 30 days payment terms
    • The customer pays $30 000 in December for the product they purchased

    The Problem: Misleading Financials Due to Cash Basis Accounting

    Cash-basis accounting is simple.  Revenue is recognized when cash is received, and expenses are recorded when cash is paid.

    Jim’s situation highlighted a common problem many eCommerce sellers face, especially when managing inventory and the cost of goods sold (COGS).

    Under cash-based accounting, Jim’s inventory purchases were expensed as soon as payments were made, which meant his income statement showed large, sporadic expenses depending on when he bought inventory. Meanwhile, his revenue was recorded when cash came in from sales. What made things worse was that the value of the inventory he had on hand was not being tracked at all.

    This mismatch caused several issues:

    • COGS didn’t match revenue: Jim couldn’t clearly see which sales were driving profits because his COGS were all over the place, not tied to the periods when he actually sold the goods.
    • Inventory wasn’t tracked properly: His balance sheet didn’t reflect the inventory he had in stock, making it difficult to understand the true value of his business.
    • Bank balance misled him: Like many cash basis users, Jim was relying on his bank balance to gauge the health of his business. But with large upfront inventory payments, his cash flow looked worse than it was, and he wasn’t seeing profits in real-time.

    As a result, Jim thought he was doing well based on revenue, but his business felt cash-strapped. He couldn’t understand why he wasn’t seeing more money in his own pocket despite the growth.

    In Jim’s case, he was constantly placing large inventory orders to keep up with his booming sales.  These orders required significant upfront payments to suppliers. Under cash-basis accounting, these payments were immediately expensed, making his profit margins appear razor-thin (or even negative) even though the inventory hadn’t yet been sold.

    Our Solution: Switching to Accrual Basis Accounting

    When Jim partnered with us, we immediately recognized the need to switch him to accrual accounting.

    Why Accrual Accounting is better

    Accrual accounting provides a much clearer picture of profitability by matching revenues and expenses to the period in which they are earned or incurred, regardless of when cash changes hands.

    Accrual accounting allows businesses to record revenue when it is earned (not just when the cash is received) and expenses when they are incurred (not just when payments are made). This change had a dramatic impact on how Jim viewed his business:

    • Revenue Recognition: Instead of recognizing revenue only when Amazon settlements or Shopify payouts were paid, we recognized it when the orders were created, providing a more accurate view of sales performance. 
    • Sales-related fees recorded: We also recorded the revenue from sales separately from the Amazon and Shopify fees. Compared to previously only the net receipt into the bank being recorded as revenue.
    • Cost of Goods Sold (COGS): We calculated COGS based on the inventory sold during the period, accurately matching expenses to the corresponding revenue. This gave him an accurate picture of profitability for each month with COGS “matched” to revenue.
    • Inventory on the balance sheet: Instead of expensing inventory purchases immediately, we recorded his inventory and any inventory deposits as an asset on the balance sheet. This helped Jim understand how much product he had available for future sales and how much he had already paid for it.
    • Clear financial performance: Jim could now see not just his top-line revenue separately from selling fees, but his gross profit and net profit, as well as the value of his inventory in stock.

    The Results: Turning a Loss into a Profit

    Once we made the switch to accrual accounting, Jim’s financials completely transformed. 

    After transitioning to accrual accounting:

    • Jim’s revenue increased from $5.7 million to $7.3 million with selling fees shown separately and $150,000 “receivable” for funds held by Amazon and Shopify
    • His net loss of $300,000 transformed into a net profit of $1.2 million.
    • His balance sheet now accurately reflected $1.5 million in inventory assets and deposits for future inventory orders.

    Jim now had a much clearer view of his business. He could see that his company was profitable and that he had not “lost” another $300,000 but that he had in fact invested that into inventory assets to keep up with a healthy growing business needs.

    The adjustments allowed him to make more informed decisions about growth, inventory purchases, and cash flow.

    The Power of Accurate Accounting

    This dramatic shift in Jim’s financial picture wasn’t due to any magical increase in sales. It was simply the result of using the right accounting method to reflect the true performance of his business.

    Accrual accounting gave Jim the insights he needed to:

    • Understand his true profitability: He could now see how much money his business was actually making.
    • Make informed decisions: With accurate data, he could confidently invest in growth initiatives, knowing his business could support them.
    • Secure funding: Accrual-based financials are essential for obtaining loans or attracting investors.
    • Reduce stress: Understanding his financial position gave Jim peace of mind and allowed him to focus on growing his business.

    Jim now understood that he had a profitable and healthy business. He used the newly discovered high-quality accounting and growth projections to get a 2-year loan with a low APR% and monthly repayments so that he could afford to fund the growing inventory needs and felt comfortable doing so while starting to pay himself a reasonable salary.

    Key Takeaways

    If you’re an e-commerce entrepreneur relying on cash-basis accounting, it’s time to consider making the switch to accrual accounting.This is especially crucial if your business is:

    • Experiencing rapid growth
    • Carrying significant inventory
    • Seeking funding
    • Struggling to understand your true profitability

    Don’t let your accounting method hold you back.  Partner with an experienced e-commerce accounting firm to ensure your financial data is accurate, insightful, and empowers you to make the best decisions for your business.

    Are you on cash basis or accrual basis accounting now? Most e-com sellers are not accounting experts, and are not 100% sure if they are using cash basis or accrual basis bookkeeping. An easy way to tell. Look at your balance sheet, is there a line item for inventory?

    If not, and your cost of goods sold appear only to be aligned with the payments you have made to your suppliers, then you are on cash basis!

    Remember that not all accrual basis accounting is of a high quality, but any accrual basis attempt is better than cash basis only.