Why we use accrual accounting
The key difference between cash and accrual accounting lies in the timing of when revenue and expenses are recorded. In accrual based accounting, the revenue and expenses are recorded when the occur. However, in cash based accounting, revenue and expenses are recorded on the day the cash exchanges hands.
Accrual Accounting is the most commonly used method of accounting. Revenue is recorded when it is earned, rather than when it is paid. In the context of an Amazon business, this means that sales are recorded on the day of purchase by the customer, rather than the day that Amazon deposits money into your account. Likewise, expenses are recorded on the date that they occur, for example, the storage fees for July are counted as a July expense, even if you don’t pay for them until September!
Cash Based Accounting is far simpler, however it is not as accurate – it could show that you’re in profit, simply because you have outstanding invoices. As the name implies, sales are recorded on the day money is deposited into your account. Therefore, with cash accounting for an Amazon business, one day, every fortnight it would show two weeks’ worth of sales on a single day. Likewise, any expenses due would be counted on the day that they’re paid.
Think about cash accounting for an inventory business… You would incur huge ‘expenses’ in the months which you buy stock, putting huge ‘dips’ in your profitability.
Consider the following example:
Sue has a product which costs $6 (landed), sells for $30, and she buys 1000 units at a time. In January she purchases her first order, and is selling soon after. In March she sells 50 units, April 100 and May 150, slowly building.
She orders stock every 3 months.
In a cash accounting method her books look like this:
Which graphically can be represented as:
Yes, the cash on her Xero file exactly matches her bank statements, but she has no real visibility as to her profitability. If she buys a heap of stock, suddenly her ‘profits’ nosedive.
Using the same example, when Sue does her books using the accrual method, her books look like this:
Graphically represented as:
Obviously, Sue’s books have been simplified for the sake of illustration. What it allows you to see is that her profitability is directly related to her sales and expenses incurred within that month. The main difference is that stock is counted as an expense only when it is sold.
As it accounts for things on the date that they occur (not the date they are paid), when accounting with the accrual method, the balances in Xero may often not match exactly with the physical amounts that are in your bank accounts. However, it does show a much more accurate picture of your business performance and financial position. It allows you to make financial decisions with far more confidence.
Also, it is VERY important to note, if you’re considering an exit… any business broker will need your accounts in the accrual method.