Accounting Standards

Cash vs Accrual Books in Small-Business Deals

Cash-basis books record revenue when cash is received and expenses when paid; accrual books record them when earned and incurred. Many small businesses keep cash or modified cash books, which can misstate profit, especially when the business is growing or seasonal. Converting to accrual requires adjusting for changes in receivables, deferred revenue, payables, accrued expenses and prepaid items.

What is the difference between cash and accrual accounting?

Under cash-basis accounting, revenue is recorded when a customer pays and expenses are recorded when the business pays a bill. Under accrual accounting, revenue is recorded when it is earned, typically when goods or services are delivered, and expenses are recorded when incurred, regardless of when cash moves. Accrual accounting matches revenue with the costs of generating it in the same period, which is why it is required under GAAP and IFRS and why it provides a better view of operating performance.

Many small businesses use cash or modified cash accounting because it is simpler and, for eligible taxpayers, may be permitted for tax purposes. Modified cash basis typically records some accrual items, such as fixed assets and depreciation or long-term debt, while leaving revenue and most expenses on a cash basis. The result can be a hybrid that is internally consistent for tax filing but difficult to compare with accrual financial statements prepared by other businesses or used in valuation work.

Why do cash-basis books mislead in a transaction?

Cash-basis profit reflects the timing of collections and payments as much as operating performance. A growing business that bills more each month than it collects will understate revenue on a cash basis, while one that is shrinking and collecting old receivables will overstate it. A business that delays paying suppliers at year end will show higher profit than one that pays promptly. Because purchase prices and loan amounts are multiples of earnings, these timing effects translate into real value differences.

Cash-basis books also hide the balance sheet. Without recorded receivables, payables and accruals, a buyer cannot set a working capital peg, measure the cash conversion cycle or identify liabilities that will need to be paid after closing. Customer deposits and prepayments may have been recorded as revenue when received even though the work has not been done, which leaves the buyer obligated to deliver services for which the seller has already collected cash. Each of these gaps creates risk for both buyer and lender.

• Growing business: cash basis usually understates revenue and receivables
• Declining business: cash basis can overstate revenue as old receivables are collected
• Customer prepayments: recorded as revenue on receipt, hiding a service obligation
• Delayed payables: inflate cash-basis profit and hide liabilities the buyer inherits

How do you convert cash-basis financials to accrual?

Conversion uses the balance sheet accounts that a cash-basis system omits. For revenue, start with cash collected, add the increase in accounts receivable during the period, and subtract the increase in deferred revenue or customer deposits. For expenses, start with cash paid, add the increase in accounts payable and accrued liabilities, and subtract the increase in prepaid expenses. Inventory purchases require adjustment for the change in inventory to derive cost of goods sold rather than purchases. The same logic applies in reverse for any balance that falls during the period.

The challenge is building reliable opening and closing balances when the books never recorded them. Receivables can be reconstructed from invoicing systems and subsequent collections, payables from vendor invoices paid after period end, and accruals from payroll registers and recurring bills. Customer deposits can be traced from contracts and deposit records. Each balance should be tested by looking at cash activity in the weeks after the period end, which shows which items were genuinely owed or receivable at the balance sheet date.

What should lenders and buyers request?

When the seller maintains cash-basis books, request monthly bank statements, accounts receivable and payable agings at each period end, invoicing records, payroll registers, and a list of customer deposits and open contracts. Ask for subsequent cash receipts and disbursements for at least the first sixty to ninety days after each period end to test the reconstructed balances. Compare these records to the cash-basis ledger and the tax returns, which may also be prepared on a cash basis. Where records are incomplete, interviews with the bookkeeper and a review of the invoicing software usually fill the gaps.

The deliverable should be accrual-basis monthly income statements and balance sheets for the trailing twelve months and the prior fiscal years, prepared consistently, with a reconciliation from the cash-basis figures. The SDE or EBITDA used for valuation and debt sizing should be calculated from the accrual figures. Where reconstruction is uncertain, the underwriter should apply a conservative view, for example by excluding unsupported receivables or recognizing all identifiable liabilities, and reflect the uncertainty in price, structure or covenants. A short memo describing the reconstruction method helps reviewers judge how much reliance to place on the results.

How does the conversion affect the deal terms?

Once accrual figures exist, the working capital peg can be set on a meaningful basis, and the purchase agreement can define closing working capital using the same accrual methodology. Debt-like items such as customer deposits for undelivered work, accrued payroll and unpaid taxes can be identified and deducted from the price. Without this work, a buyer may inherit obligations funded by cash the seller has already taken, or pay a multiple on profit that was simply a timing difference. The definitions in the agreement should match the conversion method used in diligence, so that the peg and the closing balance are measured the same way.

Lenders may also require that the borrower move to accrual accounting after closing, with monthly reporting prepared on that basis, so that covenants are measured consistently and early warning signs such as rising receivable days are visible. For businesses below the scale that justifies a full accounting team, outsourced bookkeeping with accrual closes is often a practical condition of financing. The initial investment in better reporting typically pays for itself in clearer covenant monitoring and fewer post-closing disputes. It also gives the new owner a clearer view of margins by month.

Converting a year of cash-basis results to accrual

1. Cash-basis revenue (collections) = $2,400,000. Accounts receivable rose from $150,000 to $230,000; customer deposits rose from $60,000 to $90,000.
2. Accrual revenue = 2,400,000 + (230,000 - 150,000) - (90,000 - 60,000) = 2,400,000 + 80,000 - 30,000 = $2,450,000.
3. Cash-basis expenses (payments) = $1,900,000. Accounts payable rose from $80,000 to $110,000; prepaid expenses rose from $20,000 to $35,000; accrued payroll rose from $40,000 to $55,000.
4. Accrual expenses = 1,900,000 + 30,000 - 15,000 + 15,000 = $1,930,000.
5. Cash-basis profit = 2,400,000 - 1,900,000 = $500,000. Accrual profit = 2,450,000 - 1,930,000 = $520,000.
6. Balance sheet effect: the buyer inherits $90,000 of customer deposits for undelivered work and $165,000 of payables and accrued payroll, none of which appeared in the cash-basis books.

How underwriters apply this

• Never size debt or price a deal on cash-basis earnings without converting to accrual.
• Rebuild receivables, payables, accruals and deposits from source records and test them with subsequent cash activity.
• Treat customer deposits for undelivered work as debt-like items in the purchase price.
• Set the working capital peg only after accrual balances exist for each month of the reference period.
• Require accrual-basis monthly reporting after closing as a condition of financing.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.