If you’re looking to sell your Amazon business, the financial statements you provide are typically the most critical information that potential buyers will consider. These statements reveal how your business’s unique selling points translate into actual profits. They also serve as useful tools for buyers to assess the risks and opportunities associated with investing in your business, and the potential return on their investment.
Given the importance of these documents, it is crucial that your financial information is well-organized. This may require changes to your accounting practices, such as switching from cash basis accounting to accrual basis accounting, or vice versa.
Cash Basis vs. Accrual Basis – What’s the Difference?
Cash-basis accounting records revenues and expenses as they are received or spent, while accrual-basis accounting records revenues and expenses as they are incurred. The distinction between the two methods becomes most evident for companies with inventory and those that pay or receive payments on terms. Consider the following examples:
When you purchase advertising with net 45 day terms on March 1st, you are not obligated to pay the bill until April 15th, 45 days after the ad has run. In accrual-based accounting, you would recognize the expense on March 1st, when the obligation to pay the bill was incurred. On the other hand, in cash-based accounting, you would record the expense on the date when the payment was actually made, which is presumably April 15th.
Suppose you operate an Ecommerce store and on March 15th, you receive a substantial purchase order from a customer who requests to pay on terms of net 30. In accrual-based accounting, the revenue would be recognized when the purchase order is received, while in cash basis accounting, it would be recorded when the customer makes their payment. Generally, either approach is suitable for most small businesses. However, there are a few exceptional situations where you may need to favor one accounting method over the other.
E-Commerce Business That Carries Inventory: Use Accrual
Ecommerce businesses that maintain their own inventory make this mistake often. If your business does not fall under this category, feel free to skip ahead to the next section.
If your business keeps inventory & you use cash basis accounting; you could be seriously harming your business value. This is because cash basis accounting artificially reduces the profit by roughly the cost value of the inventory on hand.
To clarify this, let’s consider an example. Suppose you own an ecommerce store that usually generates a profit margin of 50%. The inventory is entirely replenished every 5 months. Under an accrual basis accounting, a 3-month snapshot will look as follows.
Accrual Basis P&L
Now let’s assume a cash basis accounting method is used. In this example, your inventory has turned over, or is close to doing so, at the end of February. So in March, you buy the equivalent of 5 months of inventory (~$25,000).
A 3-month snapshot would look as follows.
Cash Basis P&L
Accrual accounting: $15K in gross profit
Cash account: $5K in gross profit
Why Accrual Basis is More Accurate
Over time, both cash basis and accrual basis accounting will arrive at the same, or very similar, profit numbers. However, when a snapshot in time is taken, the picture can be quite deceptive. More importantly, cash basis accounting without a regular turnover rate of inventory makes it nearly impossible for a buyer to gauge any trends in your gross profits.
The problem with cash basis accounting is that it improperly records an expense before it is actually an expense to record. Cash basis accounting does not recognize the receipt of inventory. In reality, when a business owner buys inventory, they are not reducing their assets, just converting one asset (cash) for another (inventory).
When Cash Basis is Better
Generally speaking, accrual basis accounting better captures the finances of any business. However, for very simple businesses, cash basis may be preferred when it comes to selling. Examples of businesses that would use cash basis accounting effectively would be:
- Sites that earn 100% of their money through affiliate earnings and have no payables or receivables.
- Subscription sites such as directories without open accounts receivables.
- Web hosting businesses
- Any business whose balance sheet does not have significant assets in any category other than cash
Why Cash Basis Can Be Better
Although accrual accounting can offer more insights into businesses with various levels of complexity, some businesses simply don’t have that level of complexity. In these cases, cash basis accounting is sufficient. Even more so, cash basis accounting can be easier to verify transactions from a buyer’s perspective, as they can simply match up transactions from a bank account with a ‘money in/money out’ formula.
Should I Recast My Books?
You may be wondering if taking the time and effort to recast your books into an accrual-based accounting system would be worth the effort for the value gained from an eventual sale. The answer to this depends largely upon the size and complexity of your business.
For any business owner who carries inventory and plans to exit within the next few years, taking the time to recast the books into an accrual basis accounting system would be recommended. This is especially true if your revenues are significant. Much of the decision to recast your books will depend on just how much value you potentially add to your business by doing so.
If at any time you would like more insight into whether you should recast, or make any changes to your books, we have teamed up with CapForge to offer you a 10% discount on your first project. Click here
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