17 Sep Cash vs. Accrual Accounting: How Financial Methods Affect Business Valuation
Written by: Gabriel Duque
(5 – 7 minute read)
The two main types of accounting bases by which a business may prepare its financial statements are cash basis and accrual basis. The appropriate accounting method for a business depends on the type of business and that business’ need to track accounts receivable and accounts payable. Ultimately, this also plays a role in accurately determining the business’ value in a valuation.
Cash basis accounting records both revenue and expenses only when payments are made and cash flows into or out of the business, whereas accrual basis accounting records both revenue and expenses when they are incurred, regardless of whether payments have been made. Therefore, balance sheets prepared on a cash basis will not account for an accounts receivable or accounts payable balance whereas most balance sheets prepared on an accrual basis will. Although cash basis accounting can have advantages for a small business, namely by way of its simplicity and certain tax advantages, accrual basis accounting can be essential to painting a more accurate financial picture of a business.
Cash basis accounting will typically be used by businesses that exchange cash for goods at the time of sale, such as retail stores, restaurants, and personal service businesses (i.e. salons, childcare services, delivery services, etc.). Accrual basis accounting will typically be used by businesses that bill customers for goods and/or services to be paid later, such as medical businesses, contractors, and project-based businesses (construction, manufacturing, etc.). These lists are not exhaustive but are rather used for reference purposes.
In a business valuation, it is important that the utilized financial statements are prepared using the same accounting method across the analyzed period. Because of the difference in how revenues and expenses are recorded (or not) between cash basis and accrual basis financials, comparing these items from one year to another no longer provides an accurate or sensible comparison if the accounting bases do not match. This is because the timing of payments into and out of the business can, on cash basis financials, impact whether revenues and expenses related to work done in one specific year will be reported in that one year, across two years, or entirely in a future year. Conversely, accrual basis financials will always report revenues and expenses when they are incurred.
For example, if a contractor completes a job in December of 2023, but does not receive payment until January 2024, cash basis financials would record the revenues and expenses in 2024, while accrual financials would record revenues and expenses in 2023. Therefore, mixing cash basis financials with accrual basis financials can paint an inconsistent picture of operations, including gaps in revenues and expenses, or the double counting of certain revenues and expenses, stemming from payment timing differences.
The following is a quick analysis of a sample Company using cash basis financials vs. accrual basis financials:
As can be seen above, on the cash basis financials, the company’s net income, as well as its total current assets, fluctuates significantly from year to year. On the accrual basis financials, the company’s net income, as well as its total current assets, stabilizes in 2022 and 2023. While the Company records its highest net income on cash basis in 2022, its relatively low net income in 2023 will significantly impact value as, in a business valuation, a business appraiser tends to rely more heavily on the most recent years of financials. Furthermore, the cash basis financials do not record accounts receivable, meaning that currents assets are significantly less than on the accrual basis financials.
Taking the above example into account, it is reasonable for an Appraiser to request, and rely on, accrual basis financials for a business that would typically generate accounts receivable and/or accounts payable, even if the Federal Tax Returns are compiled on a cash basis of accounting. While lenders tend to rely on Federal Tax Returns for underwriting, they too should note the difference in cash vs. accrual accounting and how it impacts the subject business for debt service coverage ratios.
Depending on the structure of the sale of a business, regardless of the type of business, it can be necessary to utilize accrual basis financials (or at least utilize aging accounts receivable and aging accounts payable reports) in a business valuation because of the differences in preparation of the balance sheet. In a sale in which accounts receivable and/or accounts payable are transferring to a borrower, an Appraiser must be able to include an accurate balance in the Final Value or the Final Value may be overstated or understated.
Although cash basis financials may be appropriate for certain businesses, it could be necessary to rely on accrual basis financials to accurately analyze revenues, expenses, receivables, and payables. Therefore, accrual basis financials tend to yield the most accurate value in a business valuation. Regardless of whether the financials are reported on cash or accrual basis, and regardless of the structure of the sale of a business, the basis must match for all analyzed years to enable an accurate comparison of revenues, expenses, assets, and liabilities.