Oftentimes, accounting methods are overlooked when preparing your business for an exit. There are so many moving parts going on inside and outside the business during a sale, that it happens. But that can be to the seller’s detriment, with many buyers walking away before making an offer for your business.
When preparing your business for a sale and working on your business exit strategy, it is important to have your accounting and financials as organized as possible. The better your business’s financials are, the more attractive your business becomes. Buyers want to look at your business to understand what the financials are showing them, and they’ll usually compare your financial statements with other companies they are exploring or to an industry benchmark. They will expect your financials to be presented in a standard way, usually in accordance with Generally Accepted Accounting Principles (GAAP).
There are two main accounting methods that we are going to discuss and compare: the Cash Basis vs Accrual Basis. It is worthwhile explaining these two methods because an attractive component that buyers are looking for in a business is clean and organized financials that represent the most accurate representation of the financial condition of your company.
Cash Basis
Cash basis is an accounting method that records income and expenses as cash is received or paid out, respectively, versus when income is earned, or expenses are incurred. This method of recording is less accurate than accrual accounting in the short-term. If your business’s sales are under $25 million, then the cash basis accounting method is allowed but not necessarily recommended. You are also free to use the accrual basis under $25 million as well. Because using the cash basis is more straightforward, many small business owners choose to use it as their primary method of accounting. It is important to note that cash basis accounting is not accepted by GAAP. The Tax Reform Act of 1986 prohibits the cash basis accounting method from being used for C Corporations, tax shelters, certain types of trusts, and partnerships that have C Corporation partners.
A construction company is a good example of some of the shortcomings of using the cash basis accounting method. For example, a construction company secures a contract but will only be paid upon completion of the project. With the cash basis method, the company is only able to recognize the revenue when the cash is received. The downside is the expenses will be incurred during the completion of the project and are recognized as they are paid during the project. If the project’s timespan is greater than one year, the company’s income statements will appear misleading as they will only show the losses from expenses from the project. Then the following year, the income statement will show a large gain followed by a few expenses.
Also read: Defining Key Financial Terms – Avoiding Confusion
There are of course benefits to using the cash basis accounting method. For small business owners who carry no inventory, it works great. Using this method also allows a small business owner to avoid employing accountants or spending money on a complex accounting system. Most importantly, it also gives the business owner an accurate picture of how much cash is on hand.
There is a downside to using the cash basis accounting method, too. Like the example above, it can paint an inaccurate picture of a business’s health and growth. It can make projecting a company’s future growth more difficult with the way the revenue and expenses are recorded. Just like it is difficult to project future growth, using the cash basis method also makes it more difficult to acquire financing due to the high probability of inaccuracies.
Here are a few more examples that we see working with business owners across the country. We’ll see bi-weekly payrolls recorded in one month, since the cash was paid out, versus allocating the payroll across months through an adjusting journal entry. That makes one month’s payroll too high, and the other month too low. This can happen with rent double-counted because you paid early, or business insurance recognized up-front for a given policy because you paid 50% down. The down payment for your business insurance overstates the expense in the month you paid, and understates the remaining months insurance expense, since you recorded too much in that first month.
You can see why buyers prefer the accrual basis of accounting, which will talk about next, because the cash basis can distort your financial statements and make decision making inconsistent for your company, and tough for buyers to get a handle on your financial performance.
Accrual Basis
Accrual basis is an accounting method that records income and expenses when they are billed and earned, regardless of when the money is actually received. Any business that is either publicly traded or over $25 million in revenue must use the accrual accounting method. The accrual accounting method generally provides a clearer picture of a company’s overall finances and therefore is accepted and stipulated by GAAP.
The general concept of how accrual accounting works is that economic events are recognized by matching revenues to expenses at the time the transaction occurs rather than when payment is made or received. This allows your business’s cash inflows to be matched with the cash outflows and vice versa. Ultimately, this gives a much more accurate picture of your business’s financial position.
The benefits of using the accrual accounting method outweigh the disadvantages. The accrual method can capture more complex business transactions such as selling on credit. It also captures projects that provide revenue streams over a long time more accurately as well.
An example of the accrual accounting method can be shown with a consulting firm. Suppose a consulting firm provides a service for $10,000 on July 30th. The client received the bill for services rendered and made a cash payment on August 25th. The accrual method recognizes the consulting company’s $10,000 in revenue when the client’s services have been concluded even though the cash payment has yet to be received from the client. As a result, the $10,000 in revenue is recognized as earned on July 30th. The sale is then recorded as accounts receivable, under current assets on the balance sheet.
When a company incurs an expense on credit, the company will report that expense as an account payable under the current liabilities on the balance sheet and an expense on the income statement. When the expense is paid, the accounts payable will be debited and the cash account is credited.
There is another form of accrual basis accounting that is called modified accrual accounting. This is a method that combines cash basis accounting and accrual accounting. This method is widely accepted, and we see that buyers like this method of accounting as well.
Cash Basis vs Accrual Basis – What Buyers Prefer
Clean and organized finances are what buyers are looking for today when buying a business. Financial and strategic buyers will both be looking at many businesses when they are trying to acquire a business that fits their investment criteria or synergies. What will make your business more attractive to buyers is presenting your financial records using the accrual method or a modified accrual method. Why?
First, buyers will want to know what kind of return they will get on buying your business, especially financial buyers. If you are using the cash basis accounting method, it will make it much more difficult to create financial models and to project future revenues and earnings. The more uncertainty there is around your business, the more risk there is. If your business has more risk than an identical company, your business will end up being worthless. With the accrual accounting method, the buyers can accurately project revenue and earnings with a fair amount of certainty. This helps reduce the risk on the buyers’ side and they will be willing to pay more.
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Second, as mentioned earlier, buyers will be comparing similar businesses to yours. If all the businesses are not using the same accounting methods, it will make it much more difficult to compare your business to the others.
In the end, you want to showcase your financial performance, much like putting your best foot forward when applying for a job. You would not submit your resume to a prospective employer with typos and grammatical errors, right? You’d never get the job, no matter how qualified you are for the position. In the same vein, your financials are like your resume. Leveraging accrual-based accounting methods, or the modified accrual method, will allow your business to shine and to accurately reflect your financial performance. Buyers will be much happier evaluating your business because they can trust your financials much more than the alternative.