Whether you have been selling online for a while or you are just launching your ecommerce business, there is one important aspect of running an ecommerce store that you simply can't ignore. The success or failure of your business to a large extent depends on your understanding of accounting for ecommerce businesses.
Business accounting is very critical as it allows you to properly manage your finances and stay in business. Accounting provides you with vital information regarding your costs and earnings, profits and losses, liabilities, and assets; all needed to evaluate the financial performance of your business.
In this guide, we would cover the key things you need to know about accounting for ecommerce businesses. This guide would contain everything from registering your ecommerce business to choosing the right accounting software.
Let's get started:
What is Business Accounting?
Business accounting is the systematic recording, analyzing, interpreting, and presentation of financial information. The information gotten from accounting shows in detail the financial health of a business. Accounting allows business owners to keep track of their business finances so they can make better decisions.
While accounting is a very broad topic, it can be summarized into three main parts:
- Bookkeeping (recording of financial transactions)
- Creating financial reports
- Filing tax returns
Registering Your Business
All you need to start operating a business is to provide a product or service. While registering your business with your state or locally is not required by law, you need it to make certain important business transactions.
For example, you need proof that your business is properly registered to open a business bank account (which is vital for accounting) or apply for small business loans. You would also look more professional when you give clients a business name. It legitimizes your business.
When it comes to registering a business, there are many options you can choose from. Look at the options:
This is the simplest and most common way to start a business. It is an unincorporated business where there is no difference between the owner and the business. The owner of the business is entitled to all its profits, losses, and liabilities. This also means that you are held liable for any business debts by the IRS. The IRS can seize your bank account or close your home to pay off your debts.
As long as you are the only owner of the business, then you are already a sole proprietor. Like all businesses, you need to obtain certain licenses and permits to run the business. Regulations for licenses and permits differ by industry, state, federally, and locally.
You can choose a business name different from your own. But before you do that, make adequate research to ensure that there are no other businesses trading with that name. Using your original name is far easier as it cannot already be claimed by another business.
A partnership is the best structure when two or more people want to own a business together. The two common kinds of partnerships are limited partnerships (LP) and limited liability partnership (LLP).
In limited partnerships (LP), there is one general partner with unlimited liability and another partner with limited liability. The general partner is in charge of running the business while the limited partner does not partake in running the business. The general partner is also liable for any business loss while the limited partners are liable up to the amount of their investment.
In limited liability partnerships (LLP), every owner has limited liability. The LLP protects every partner against debts or losses incurred by the business. Each partner is also protected from the actions of other partners.
Limited Liability Company (LLC)
An LLC is the best structure for medium or high risks businesses. It protects the business owners from personal liability so they won't be at risk of losing their personal assets when the LLC faces bankruptcy. In the case of lawsuits, it is the business that is taken to court and not you.
An LLC can choose not to pay federal taxes as profits and losses can be listed on the personal tax returns of the owner. The main disadvantage to LLC is that upon the death or bankruptcy of a member, most states' law would dissolve the LLC. It is not the best option if you plan on becoming a publicly-traded company in the future.
Apart from the standard corporation (C Corp), there are other variations like the S corp and B corp.
C corp is a legal entity that is separate from its owners. It can be taxed, make a profit, and is also held legally liable. While it offers its owners the best protection against personal liability, it is the most expensive business structure to set up. It would require a ton of record keeping, reporting, and involves a lot of operational processes.
Depending on state laws, most corporations are taxed twice; when the company makes a profit and after shareholders collect their dividends, they pay personal taxes.
The biggest advantages of C corp are that the business can raise capital by selling stocks and that the business would continue to run if a shareholder leaves the business or sells their stocks.
S corp is designed to avoid the double taxation drawback that C corp faces. It allows some of the business profits, and losses to pass to the business owners' personal income without being subject to corporate tax rates.
There are certain limits to S corp. The business cannot have more than 100 shareholders and all of them must be US citizens. You are also required to follow the same strict operation process of a C corp. A shareholder leaving the company does not affect the business also.
B corp also known as benefit corporations are driven by mission and profit. Shareholders require the company to produce some sort of public benefit as well as financial profits. Some states would even require that B corps submit an annual benefits report to show their contribution to the public good. Note that B corps are taxed the same way as C corps.
A cooperative is a business owned by and for the benefits of those using its services. To be part of a cooperative, you must purchase the business shares. The higher your shares, the higher your voting power. A board of directors or executives run the business, while regular members have voting power to decide the direction of the business. Profits and earnings are also distributed among the members.
Understanding Business Account Types
Every registered business type apart from a sole proprietorship is legally required to open a business bank account. Even though you operate as a sole proprietorship, we recommended you open a bank account so that you can keep your personal and business finances separate.
When opening a bank account, you need to consider the different account types. These are the different bank account types you'll most likely need.
A checking account allows you day-to-day access to the money you deposit in them. There are usually no minimum account balances required. All you need is enough money to cover your purchases. They often have low-interest rates and might also place a limit on the number of cash deposits you can make monthly.
With a savings account, you earn interest on the money you deposit. The account is designed for savings and they are usually restrictions on the number of withdrawals or transfers you can make monthly. It also usually has a daily minimum balance requirement. Note that any interest on the account is regarded as income so it is taxable.
Money Market Account
A money market account is a combination of both savings and checking accounts. They offer limited check-writing privileges but have higher interest rates than checking or savings accounts. They are best for people who hold high balances in their accounts and want to interest at a higher rate. The main drawbacks are that they have a higher minimum balance requirement and you are permitted six withdrawals monthly.
Certificate of Deposits (CDs)
CDs are like a savings account that holds your money for a fixed term. This can be as short as 3 months or as long as 5 years. You usually earn higher interest, but you have to leave your money in the CD till the maturity date to avoid a penalty.
Types of Financial Statements
As an ecommerce business owner, it is important that you always have an up to date view of your finances. A clear picture of your business expenses would help you make better financial decisions. Regular auditing of your financial books would ensure that you mitigate losses and improve your profit margins.
There are three main financial statements that you would use in your business regardless of the size of the business or the industry:
- Balance sheets
- Income statement
- Cash flow statement
A balance sheet is a financial statement that gives a detailed report on a company's assets, liabilities, and shareholder's equity at a specific point in time. The report gives an overview of what a company owns, what they owe, and the investments from shareholders.
The balance sheet is made up of two columns where assets are on one side and liabilities plus shareholder's equity is on the other side. Both columns must balance each other for the company to be in the clear. It follows the accounting equation -
Assets = Liabilities + Shareholders equity
Assets are divided into four main types. Current, fixed, tangible, and intangible assets.
- Current assets:They have a short lifespan and are easily transferable into cash. They include cash/cash equivalents, inventory, deposit accounts, money orders, cheques, bank drafts, marketable securities, investments (short term), stock, prepaid expenses, and AR (money that clients owe your business and you expect to receive within a year).
- Fixed assets:They are intended for long term use and not easily transferable into cash. They include property, plant, equipment, tools and machinery, furniture, and investments (long-term).
- Tangible assets:The physical and material financial resources of your business. They include cash, stock, buildings, land, office equipment, machinery, and vehicles.
- Intangible assets: They are the resources without material substance. They include intellectual property, trade secrets, licenses, franchises, reputation, brand, goodwill.
Note that intangible assets might not be necessary for your balance sheets except they have a measurable monetary value. While it is good to monitor your reputation amongst customers, it should not be a part of your balance sheet. Only assets that have monetary value should be added to the balance sheet.
Because most ecommerce businesses tend to have less physical space and equipment, your main assets would be cash and cash equivalents, marketable securities, account receivable, and inventory.
Liabilities are the debts and money that your business owes. This would include money owed to outside parties, bills that would be paid to suppliers, interest on bonds issued to creditors, rent, utilities, and salaries. Liabilities are divided into current liabilities (liabilities that are due within one year) and long term liabilities that are due after a year.
Shareholder equity is the money that is attributed to the owners of the business (it's shareholders). It is calculated as the total assets minus the company's liabilities.
An income statement focuses on a company's expenses and revenue during a particular period of time. It can also be called the statement of revenue and expense or a profit and loss statement. While a balance sheet shows an overview of a company's financials, the income statements report the income of a company through a particular period of time.
The main focus of income statements is revenue, expenses, gains, and losses.
Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
Revenue and gains
The revenue and gains of your business would depend on local regulatory guidelines, the scope of your business, and associated operating activities:
Operating revenue is defined as the revenue gotten from the sales of primary activities. For an ecommerce business that sells products from an online store, revenue from primary activities refers to the revenue from inventory sales.
These are revenue gotten from non-core business activities. They can also be called non-operating recurring revenue. The revenue is obtained from earnings outside the products or services offered by the business. An example is an income gotten from advertisements displayed on business property.
Gains refer to the revenue obtained from other activities, like the sale of long term assets. An example is selling a subsidiary company or unused land. For ecommerce businesses, a good example of gains is selling an old delivery van.
This is an example of an income statement:
Cash Flow Statements
As an ecommerce entrepreneur, your cash flow statement is very important to you. It gives you a summary of the cash and cash equivalents entering and leaving your business. Cash flow statements measure how much cash a business generates to pay off its debts and funds its operating services.
Cash flow statements do the following:
- They help the business owners understand how the company's operation is running
- Where the money is coming from
- And how the money is being spent
The main components of a cash flow statement include:
- Cash from operating activities
- Cash from investing activities
- Cash from financing activities
Cash flow from operating activities
Operating activities reflect how much cash is generated from a company's products and uses of cash from business activities.
They include receipts gotten from the sales of products and services, payments to suppliers of the goods and services used during production, interest payments, income tax payments, rent payments, and salaries/wages to employees. For ecommerce businesses, it is important to track the sales of products from your store. There are several sales tools that would help you keep track of these figures.
Cash flow from investing activities
This is a section of the cash flow statement that shows cash generated or spent related to investment activities. It includes purchases of current or long term assets and investments or sale of securities.
Cash flow from financing activities
This section of the cash flow statement shows the net cash flow used in the funding of business operations.
Important Expenses to Track
It is important that you track the business expenses that you make on a daily basis. Tracking your business expenses help you to monitor the growth of your business, create your financial statements, and prepare your tax returns.
To simplify the process and help you keep track of expenses, make use of the same bank account or business credit card for your purchases.
These are some of the important business expenses to track:
- Proof of payments
- Bank and credit card statements
- Canceled checks
- Financial statements from your bookkeeper
- W2 and 1099 forms
- Previous tax returns
- Any document that supports an item of income, deduction, or credit shown on your tax return
- Tax-deductible expenses: These are ordinary, necessary, and reasonable expenses that help to earn business income. Here is a list of small business tax deductions.
Keeping Track of Inventory Cash Flow
It is essential that you keep track of your inventory cash flow. In an inventory cash flow report, you would keep track of the price of purchasing your inventory as well as the manufacturing and production costs.
If you create all the products that you sell in your ecommerce store in-house, you can also add the cost of raw materials, equipment acquisition, and maintenance to inventory cash flow reports.
As well as inventory sales, you should keep track of inventory losses. These losses can include spoilage, theft, or other factors that would make an inventory unsellable. You have to keep track of the overall cost of your inventory (including losses) so you can know the net profit you get from sales.
Shopify offers a free template you can use in tracking your cash flows. With this spreadsheet, you can track what you spend each week and how much you expect to come in next week. Your business would be in trouble if the amount you spend is more than how much you make each week.
Inventory Tracking Methods
To accurately keep track of your inventory cost, you need a complete picture of how many units of inventory you have at any given point in time. There are two primary methods you can use in keeping track of your inventory - periodic and perpetual tracking methods.
Periodic tracking method
Periodic inventory tracking method involves physically counting every inventory you have in stock and recording the cost/sale value of each item. So each time you recount, you update your cash flow sheet to reflect how much your company spent and gained on inventory for that specific period.
The size of your business and inventory would determine how often you use this method. If you are just starting out with your ecommerce store, you can use this method monthly. As your business grows larger you can track inventory quarterly or annually.
Perpetual inventory tracking
In this tracking method, you will use automated accounting software to continuously keep track of your inventory. The software would automatically update your inventory count, purchase account, and overall cash figures whenever an item is scanned for purchase or enters your inventory storage. This method is the easiest way to keep track of your inventory cost.
Calculating Break Even Sales
Break even sales is the amount of revenue at which a business earns a profit of zero.
It is the sales amount that is needed to cover the expenses of running a business. Knowing your break even sales allows you to determine the minimum amount of sales that you must make during a particular reporting period to avoid incurring losses.
The formula for calculating break even sales:
Break even sales = fixed expenses ÷ contribution margin
Where contribution margin is sales minus all variable expenses.
So if your ecommerce store incurs $5,000 in fixed expenses each month and the contribution margin is 50%, the break even sales for your store would be $10,000 per month.
Note that your variable contribution margin might vary with each month. If you sell a different product in your store each month, the product would have different margins. What this means is that your break even sales level will also change.
Best Accounting Software
To effectively run your ecommerce business, you need the right accounting software to help you automate your accounting processes. These are some of the ideal options you can check out.
QuickBooks is an advanced online cloud-based accounting solution for small and large businesses. It is an easy to use platform that allows you to manage income, tracking expenses, bills, and due dates all in one place.
It comes with a ton of accounting features to support your ecommerce business. Some of these features include tracking income and expenses, invoice and payment acceptance, running reports, tracking sales and sales tax, tracking inventory, paying employees, sending estimates, managing bills, and much more. The app also integrates with other tools like PayPal and Shopify.
Price starts at $12/month.
2. Free Agent
Free Agent is a cloud-based accounting software that helps small business owners handle accounting tasks. Some of its features include estimates and invoicing; expense, income, and profitability reporting; time tracking; reporting dashboard for taxes, and bank connection for import tracking. The app is easy to use and comes with excellent tax reporting features.
Price starts at $12/month
3. Wave Accounting
Wave is a web-based accounting solution designed for small businesses. The app has a reconciliation feature that allows businesses to link their bank accounts, PayPal, and other sources of data in real-time. Some of its features include invoicing, billing, payroll management, payment tracking, receipts, and finance management.
Wave is free to use.
NetSuite is a financial and accounting software designed for large businesses. This platform combines both finance and accounting functions with a strong compliance management system. If you are running a large ecommerce business, then you should check out NetSuite.
Some of its features include billing and management, planning and budgeting, revenue recognition, sales order management, inbound and outbound logistics, and global management.
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Important Accounting for Ecommerce Terms to Note
These are important terms you should take into account when performing accounting for your ecommerce business:
Ecommerce sales tax
A sales tax also known as a consumption tax is imposed by the government on the sale of goods and services. A sales tax is levied at the point of sale, collected by the retailer, and passed on to the government.
Ecommerce sales tax is a small percentage of sales tacked onto that sale by an online retailer.
As an online retailer, it is your duty to charge your customers the right amount of sales tax and remit that sales tax back to the government. Different states have their own requirement for which items are taxable and which items aren't. Check with your state to find out.
The formula for calculating the sales tax on a good or service is:
Sales tax = selling price x sales tax rate
The formula for calculating the total cost of a purchase:
Total sale amount = selling price + sales tax
A sales order is a commercial document prepared by the seller and issued to the customers to confirm the sales of a good or service. The document would contain the details of the sale, the number of goods or services sold, the quality, and the price of the goods or services.
It would also cover vital information such as payment method, delivery address, and delivery date. A sales order is an internal document that allows the business to keep track of the orders they fulfill.
A purchase order is an official confirmation from a buyer that they want to purchase goods or services from a seller. It would include details such as pricing and requested quantities. It is with the purchase order document that the seller would create the sales order.
After the seller has received the purchase order and has written the sales order, they send the buyer an invoice. The invoice would tell the buyer the specific amount of money they would pay the seller for the agreed goods or service.
The difference between the sales order and invoice is that the sales order remains with the seller while the invoice is sent to the buyer.
A receipt is a written acknowledgment that something of value has been transferred from one party to another. In the case of your ecommerce business, it confirms that payment has been made by the customer for a particular product. Customers use it as proof of payment.
The Fair and Accurate Credit Transaction Act makes it compulsory for every business to give customers sales receipts.
You do not need to be an accounting expert before you can effectively run the financial processes of your business and meet your business goals. All you need to do is invest in the right accounting software and follow the steps in this guide and you are good to go.
For further reading, you can check our list of free resources for businesses in the time of corona.