The e-commerce store is a popular business model due to its low barriers to entry and high potential upside. However, owning one presents unique accounting challenges, and you need to understand them to keep your business running smoothly.
Here’s everything e-commerce business owners should know about e-commerce accounting to keep your finances in order, including what makes it different, the primary tasks involved, and what steps to take before opening your store.
Why is e-commerce accounting different?
E-commerce accounting follows the same general principles that apply to every other type of business, but the nature of the industry creates several additional accounting issues.
First, e-commerce is an inventory-based business. Managing an inventory is complicated enough with a traditional store-front, but it’s usually even more challenging in e-commerce.
You may have to keep track of your inventory while it’s in production at a foreign factory, en route to your warehouse, in remote storage, and being distributed via multiple channels, not to mention the items in customer carts and return shipments.
Tracking an e-commerce company’s transactions is also more challenging than usual, if for no other reason than the sheer volume being much higher than it is in most business models.
In addition, you can’t rely on your bank statements to capture activities since e-commerce platforms like Amazon, Shopify, and eBay pay out your income net of things like shipping costs, returns, and sales taxes.
Speaking of sales taxes, managing them is another significant accounting task for e-commerce businesses. While brick-and-mortar stores only have to worry about sales taxes in one area, e-commerce stores must often pay sales tax and file returns in many.
Types of accounting for e-commerce.
Contrary to what you might expect, the Internal Revenue Service (IRS) usually lets you account for your e-commerce business in one of two ways. Your financial records and eventual tax liabilities will vary significantly depending on your choice.
Here’s what you should know about the two acceptable accounting methods, including what they are, how they work, and their pros and cons.
Cash basis of accounting.
If you follow the cash basis of accounting, you must recognize revenues when you receive payments and deduct expenses when you pay for them.
For example, say you run an e-commerce store that sells custom furniture pieces. In June, you sell a $5,000 table, but you only collect $3,500 for a project done in May.
In addition, you incur $1,500 of material expenses to build the latest table, but you pay $3,000 for materials you intend to use in July.
If you were using the cash basis of accounting, your net income for January would equal the $3,500 of cash receipts minus the $3,000 cash outlay for a total of $500.
The primary advantage of the cash basis of accounting is that it’s intuitive and easy to implement. There’s no question of when to recognize revenues or expenses. You can simply document everything as it happens.
In addition, using the cash basis means you don’t have to keep a separate eye on your cash flows. You can tell how much money you have coming in and out by looking at your income statement.
Unfortunately, the cash basis of accounting doesn’t do a great job of representing an e-commerce business’s actual profitability. Taking the example above, your profit for June had nothing to do with the work completed during the month.
Accrual accounting method.
Under the accrual accounting basis, you must recognize revenues when you earn them and deduct expenses when you incur them, regardless of when the funds enter and leave your accounts.
Let’s use the same numbers from the example in the previous section where you own an e-commerce store selling custom furniture pieces.
To calculate your net income for June using the accrual basis, you’d subtract the $1,500 in expenses incurred from your $5,000 in sales. As a result, your profit for June would be $3,500.
As you can see, the difference between the two is significant, with your June income being $3,000 higher under the accrual basis than cash basis. Shifting earnings from one month to another can affect your tax liability if it changes the year you report them.
The primary advantage of the accrual method is that it does a better job of reflecting your business’s profitability by matching the timing of your financial records to your activities.
However, maintaining your books according to the accrual basis can be much more work. After all, you must determine when you’ve earned revenues and incurred expenses instead of simply tracking your cash.
You’ll also need to include accounts receivable and payable in your financial statements and pay extra attention to your cash flows. Your income statement may say your last month was profitable when in reality you’re close to running out of working capital.
Note that you must use the accrual basis of accounting if your e-commerce business grows large enough that your average gross receipts in the last three tax years exceed $26 million. The threshold is indexed to inflation and will change in future years.
Basic accounting tasks.
Once you’ve decided which accounting basis you plan to use to organize your financial records, it’s time to get into the weeds of e-commerce accounting. Here are the primary accounting tasks you’ll need to manage or outsource to an expert.
Track your business transactions.
Keeping track of your business’s transactions lays the foundation for all your accounting. One of the best ways to make the bookkeeping process more efficient is to open up a separate bank account and credit card for your company.
Having separate accounts for your personal and business activities saves you from having to go back later and determine which of your previous transactions belong in which category.
Next, you should connect your business accounts to accounting software that can track your transactions automatically. That way, all that’s left for you is to go into the software and recategorize expenses when necessary.
While these steps are usually sufficient to track your business transactions in other industries, that’s not necessarily the case with e-commerce stores. Remember, the deposits that enter your bank account are often net of taxes, fees, and returns.
As a result, you’ll also need to use the information found in the back-end of each sales channel to split those deposits into their correct components, then tie the final numbers back to the totals in your bank statement.
Store supporting documents.
Every small business owner needs to hold onto supporting documents that prove the legitimacy of their financial records. For example, that includes expense receipts, bank and credit card statements, and invoices.
For every business expense, you should have documentation that verifies the amount, date, vendor, and business purpose. The IRS recommends holding onto these records for at least three years since that’s how long they usually go back for audits.
Fortunately, you don’t have to keep paper copies of these documents anymore. You can use record management software to take pictures of any hard copies, upload them to the cloud, then organize and store them for future reference.
Not only are digital copies less susceptible to being lost or damaged, but they’re also much easier to share with others. If you hire a Certified Public Accountant (CPA) to help with your accounting, they’ll appreciate not having to sift through a shoebox of receipts.
Manage your inventory.
Properly tracking your inventory can be one of the most significant accounting challenges for e-commerce businesses, especially if you’re selling your products through multiple channels.
It becomes even more complex as your business grows in scale, starts selling additional products, and enters new markets. Trying to keep track of everything manually often becomes unsustainable surprisingly quickly.
Fortunately, the right inventory tracking software can make the process much easier. Modern solutions can keep track of your inventory at every stage, from acquiring raw materials to the final sale.
In addition, your inventory software should be able to integrate seamlessly with your accounting system and will save you from needing to update financial statements due to inventory changes.
Keep in mind that the complexity of your inventory will change dramatically over the life of your e-commerce business. Because solutions can vary significantly in price, it’s often worth getting less sophisticated software and upgrading only when necessary.
That said, you should make sure to prioritize reliability at all levels. If you use a cloud-based solution that stops working for even a day, it could be quite costly for your business.
Create financial statements.
Your company’s financial statements are the ultimate result of your e-commerce accounting efforts. You’ll need them to get business financing, inform your business decisions, and file an accurate tax return.
The two most important financial statements to create are the following:
- Balance sheet: Also known as the statement of financial position, this documents your business’s assets, liabilities, and equity at a fixed point in time, such as the last day of a tax year.
- Income statement: Also known as the profit and loss statement, this tracks your business’s revenues, cost of goods sold, operating expenses, and net income over an extended period, such as an entire tax year.
The cash flow statement is also beneficial, especially if you’re using the accrual basis of accounting. It does pretty much what you’d expect it to, calculating your business’s cash flows over time from your operating, financing, and investing activities.
While you can probably create an initial draft of these financial reports without help, you can’t afford to make any mistakes. If you haven’t hired a CPA for any tasks previously, it’s a good idea to get one’s assistance at this stage.
Typically, your best option is to outsource this aspect of your accounting to a CPA firm specializing in e-commerce accounting services. You can get the help you need without the cost of a full-time accountant.
Analyze financial trends.
Once you have a set of accurate financial statements, analyzing them will help you find ways to improve the efficiency of your e-commerce business. For example, here are some areas you might want to investigate regularly:
- Cash flow trends: Running out of cash is one of the most common reasons businesses fail. As a result, you must understand your cash inflows and outflows. Being profitable on paper and having impressive revenues mean nothing if you don’t have the cash on hand to meet your obligations.
- Budget variances: Every e-commerce business owner should understand how much it costs to run their operation. Comparing that budget to your actual numbers can reveal areas of overspending and help you refine your future expectations.
- Sales trends: Understanding your e-commerce business’s sales patterns and seasonality helps you determine the right level of inventory to have on hand. That can minimize your carrying costs, avoid backup orders, and smooth out your company’s cash flows.
Regularly analyzing your financial statements for improvement opportunities can be surprisingly lucrative. However, it’s another accounting function you may be better off outsourcing to a CPA that offers advisory services.
Stay on top of your tax obligations.
Your e-commerce business will probably struggle if you neglect your financial analysis, but it can still survive. However, it won’t last very long if you ignore your tax obligations. Getting on the wrong side of the IRS is something you want to avoid at all costs.
First, make sure that you set aside enough funds to complete your estimated tax payments throughout the year. These go toward your federal and state tax liabilities, including income taxes and self-employment taxes, and they’re due quarterly.
If you miss one or more payment deadlines, then you may be subject to penalties and interest. The IRS may also penalize you if you don’t pay at least 90% of your eventual tax liability for the year.
As a result, using your financial data to project your net income for each coming year is essential for figuring out the proper quarterly tax payment amounts.
Alternatively, you can use your prior year’s income to ensure you meet the other IRS safe harbor rule, which states that they won’t penalize you if you pay 100% of your previous year’s tax liability.
In addition to making estimated tax payments, e-commerce business owners must manage their sales tax compliance duties. First, you need to figure out the states in which you have economic nexus in addition to the state where you’re business resides.
Economic nexus is a term that refers to a certain level of involvement between a business and a state. Each state sets dollar value and transaction volume thresholds for sales that determine whether you have nexus.
If you find out that you meet the threshold in any given state, you must collect sales taxes on sales to customers there, then remit the amounts and file sales tax returns quarterly.
Once again, it’s usually worth paying for tax services from an expert e-commerce accountant. They can confirm that you’re meeting all your obligations and help you develop a plan to minimize your annual tax liabilities.
What to get before you start accounting for your e-commerce store.
When it comes to accounting, you’re always better off preventing problems from developing than trying to fix them later. You never want to go back and decipher disorganized records or scramble to meet your tax deadlines.
Here are some things you should acquire before going into business to make it easier to handle your online store’s accounting from the beginning.
Business tax ID.
A business tax identification number, known as an Employer Identification Number (EIN) in the United States, is a nine-digit numerical code unique to your business. Think of it as your company’s Social Security Number (SSN).
If you’re doing business as a sole proprietor, you’re not required to have one, but you can still request one from the IRS. However, if you form a partnership, limited liability company (LLC), or corporation, the IRS forces you to get one.
Whatever legal entity you choose, having an EIN in place before making your first sale is beneficial because you may need it for the following:
- Building credit for your business
- Opening a business checking account
- Filing business tax returns, including sales taxes
- Entering into contracts with vendors and suppliers
If nothing else, having an EIN can help you avoid sharing your SSN with third parties and minimize the risk of identity theft.
Business bank account.
As discussed in previous sections, a business bank account is essential for organizing your e-commerce accounting records. Opening it before making your first sale lets you avoid revisiting your personal account to break out your store’s earliest transactions.
If you’re doing business as a sole proprietor, you can get away with using a separate personal checking account for your business activities. These are usually easier to get than business accounts and have lower fees that are easier to waive.
However, running an e-commerce platform through a sole proprietorship usually isn’t ideal since it offers no liability protection, and the online business exposes you to a surprisingly high risk of lawsuits.
As a result, it’s usually a good idea to choose a legal entity structure that limits your personal liability and protects your assets, such as an LLC or a corporation. If you decide to go that route, you’ll need to open up a legitimate business bank account.
E-commerce accounting software.
Last but not least, make sure to get your e-commerce accounting software in place before you start doing business. Remember, you want your accounting system to be running smoothly from the beginning to avoid having to go back later and fix things.
Make sure you choose an accounting solution that integrates smoothly with any other tools you plan to use, especially your inventory management and invoicing software.
*The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.
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