Prepayments and Accruals for E-commerce Startups: Practical Examples and Month-End Checklist

Prepayments and Accruals: Practical Examples for E-commerce Startups

For many e-commerce founders, the numbers can be confusing. Your Shopify dashboard shows a profitable month, but your bank balance tells a different story. This disconnect often stems from how and when you record large, infrequent payments. Paying for a year of software upfront or buying a large batch of inventory can distort your financial picture, making it difficult to manage cash flow and report accurately to investors.

Learning how to record prepayments and accruals in ecommerce accounting is not just an academic exercise; it’s a core skill for understanding your true profitability month-to-month. By correctly timing your expenses, you can avoid overestimating your cash runway and present a clear, consistent view of your startup’s financial health. This guide provides practical examples and a simple process for managing these essential bookkeeping for online stores.

The Matching Principle: A Foundation for Accurate E-commerce Accounting

At the heart of this topic is a simple idea called the matching principle. It states that you should record expenses in the same period as the revenue they helped generate. If you sell a product in May, the cost of that specific product and the ads that drove the sale should also be recorded in May, even if you paid for the inventory in March or the ad bill in June.

This principle is the foundation of accrual-basis accounting, which is the standard under both US GAAP and the UK’s FRS 102. It provides a more accurate view of profitability than the cash-basis method, which simply records transactions when money changes hands.

Focus on Materiality: When This Matters (and When It Does Not)

Before creating complex workflows, it is important to focus on what is material to your business. You do not need to spread a $20 monthly software bill over 30 days. The reality for most e-commerce startups is more pragmatic: apply these principles to the big items that can significantly swing your monthly profit and loss (P&L).

As a rule of thumb, a single prepaid or accrued item deserves attention if it is more than 5-10% of your total monthly expenses. For everything else, the simpler cash-basis approach of recording it when paid is often sufficient at the early stage. UK-based businesses should also be aware that VAT timing rules can affect prepayments; GOV.UK guidance explains the tax points for advance payments.

Recording Prepaid Expenses: Common Scenarios for Online Stores

A prepaid expense is a cost you pay upfront for a product or service that you will receive or use over time. Recording these correctly is crucial for accurate expense recognition timing. Here are two common examples in e-commerce.

Example 1: The Annual Software Subscription

Many e-commerce tools offer a discount for an annual payment. Let’s say you pay $2,388 for a Shopify Advanced annual plan. If you record this as a single expense in the month you pay, that month will show an artificial loss, while the next 11 months will appear more profitable than they really are.

Here’s how to handle it correctly using accrual accounting:

1. Initial Payment: When you pay the $2,388, it does not hit your P&L. Instead, you record it on your Balance Sheet as a “Prepaid Expense” asset. Your cash decreases by $2,388, and your prepaid asset increases by the same amount. Your net position is unchanged.
2. Monthly Expense Recognition: Each month, you will make a journal entry to “use up” one month’s worth of the service. You will move $199 ($2,388 / 12) from the Prepaid Expense asset on your Balance Sheet to a “Software Expense” on your P&L. In software like QuickBooks or Xero, this can be set up as a recurring journal, automating the process.

Example 2: Inventory Purchases

Inventory is one of the most significant prepaid expenses for any online store and a common source of accounting errors. A scenario we repeatedly see is a founder treating a large inventory purchase as an immediate expense, which severely understates profitability until the goods are sold. Managing this correctly is fundamental to e-commerce accounting basics.

Imagine your startup makes an inventory purchase of $50,000.

1. The Purchase: Just like the software plan, this $50,000 payment is not an immediate expense. It is an exchange of one asset (cash) for another (inventory). On your Balance Sheet, cash goes down by $50,000, and your “Inventory” asset goes up by $50,000. Your P&L remains untouched.
2. The Sale: In the following month, you sell products that represent 40% of that inventory batch. When you recognize the revenue from those sales, you must also recognize the cost of the goods sold (COGS). You will make an entry to move $20,000 (40% of $50,000) from your Inventory asset on the Balance Sheet to the COGS expense account on your P&L. This perfectly matches the cost with the revenue, giving you an accurate gross margin for the period.

For US businesses, tax guidance on the timing of prepaid expenses can be found in IRS Publication 538.

Accrued Expenses Examples for E-commerce

Accrued expenses are the opposite of prepayments. You have incurred an expense and received the benefit, but you have not paid for it yet. This is very common for e-commerce businesses that rely on third-party services billed in arrears.

Example: The Monthly Ad Spend Lag

Advertising platforms like Meta or Google are a perfect example. You run ads in one month and get billed in the next. For instance, you spend $10,000 on ads in May, and the platform invoices you on June 5th. If you wait until you pay the bill in June to record the cost, your May P&L will be artificially inflated, and your June P&L will be unfairly penalized. This masks the true return on ad spend for each month.

Here’s the correct process for recording accrued expenses:

1. At the End of May: On May 31st, you create a journal entry to recognize the expense. You will debit (increase) “Advertising Expense” on your P&L by $10,000 and credit (increase) a liability account on your Balance Sheet called “Accrued Expenses” by $10,000. This ensures the cost is matched to May’s sales.
2. When the Bill is Paid: On June 5th, when you pay the invoice, the transaction does not touch your P&L. You simply debit “Accrued Expenses” to reduce the liability to zero and credit your cash account. Most accounting software allows for the creation of a 'reversing journal' to simplify this process, automatically reversing the accrual on the first day of the new month.

Other common e-commerce accruals include 3PL/fulfillment fees (e.g., ShipBob), shipping costs (e.g., FedEx), and sales commissions.

A Lean Month-End Process for Managing Cash Flow for Startups

Implementing this does not require a full-time finance team. What founders find actually works is a simple, repeatable process that builds reliable startup financial processes. Your lean month-end routine should be performed on the first or second business day of the new month.

The goal isn't perfect accounting for every penny; it's about getting the big items right. A lean process focuses on your top 3-5 biggest recurring prepayments and accruals, like inventory, software, and advertising. For tracking, a simple two-tab Google Sheet listing your key items is often enough to start. This consistent process ensures your financial reports are reliable, giving you and your investors a clear and accurate understanding of your business’s performance. For more details on when to make the switch, see the Cash vs. Accruals hub.

Frequently Asked Questions

Q: What is the main difference between prepayments and accruals?
A: The difference is timing. A prepayment is when you pay cash now for an expense you will benefit from in the future (like annual software). An accrual is when you benefit from an expense now but will pay cash for it later (like monthly ad spend billed after the month ends).

Q: At what stage should my startup start using accrual accounting?
A: Most startups can begin with cash-basis accounting. You should consider switching to accrual-basis when you start managing inventory, have significant prepaid or accrued expenses, or need to provide formal financial reports to investors or lenders, as it gives a truer picture of your financial health.

Q: How do these adjustments affect my company's cash flow?
A: These adjustments do not directly change your cash flow; the cash has already been spent (prepayments) or has not yet been spent (accruals). However, they are essential for managing cash flow for startups because they provide an accurate P&L, helping you understand your true burn rate and forecast future cash needs more effectively.

Q: Can accounting software automate recording prepaid expenses?
A: Yes, modern accounting software like QuickBooks and Xero can help automate this. You can set up recurring journal entries to automatically expense a portion of a prepayment each month. This saves time and reduces the risk of manual error in your month-end bookkeeping process.