For prospective buyers, analyzing a company’s financial reports is essential. Knowing which accounting method a business uses enables buyers to better interpret and understand the target’s financial statements.
Accrual accounting and cash accounting are the two most common accounting methods. This article explores how they differ, their pros and cons, and explains what each method can reveal to buyers about the business they are evaluating.
Cash basis accounting method
Cash basis accounting records income and expenses when cash is received or paid, rather than when income is earned or expenses are incurred. While this method is simpler, it is generally less accurate than accrual accounting in the short term.
Cash basis accounting is most often used by small businesses with less than $25 million in annual revenue. However, it is not accepted under GAAP (Generally Accepted Accounting Principles), which means C Corporations, tax shelters, certain trusts, and partnerships with C-Corp partners are prohibited from using this method.
For small business owners without inventory, cash-basis accounting can be a practical option. It eliminates the need to hire outside accountants or invest in complex accounting systems, and it provides a clear view of the business’s cash on hand.
However, cash basis accounting can provide an incomplete picture of a business’s health and prospects with a higher likelihood of inaccuracies.
For example, consider a landscaping company that secures a new contract to be paid upon project completion. Using cash-basis accounting, revenue is not recognized until payment is received, while expenses are recorded as they occur. If the project spans two different reporting years, the financial statements may be misleading: the first year could show significant expenses with little revenue, and the following year could show high revenue with fewer expenses. This makes forecasting growth and future performance challenging.
Accrual basis accounting method
Accrual basis accounting records income and expenses when they are earned or incurred, regardless of when the payment is received or made. Publicly traded companies and businesses with more than $25 million in annual revenue are required to use the accrual accounting method.
Let’s say an accounting firm provides tax preparation services to a client on March 31, and the client pays the firm on April 20. The accrual method means the revenue is recorded when the services are completed, not when the payment is received.
In other words, the accrual accounting method provides a more precise representation of complex business activities and extended projects that generate revenue over time. This enhanced accuracy is why investors and lenders often favor accrual accounting, as it offers greater financial clarity.
Hybrid accounting method
Some businesses use a hybrid accounting method, which combines elements of both accrual and cash basis accounting. This method incorporates the simplicity of cash basis accounting (recording income and expenses when cash is received or paid) with the detailed recordkeeping of accrual accounting (recording income and expenses when they are earned or incurred).
Businesses that maintain inventory often opt for a hybrid approach. While they are legally required to use accrual accounting for inventory and the cost of goods sold, they may use the simpler cash method for other types of income and expenses. This allows them to fulfill regulatory requirements while also simplifying their overall accounting processes.
It can be challenging to parse exactly where a company is using accrual or cash basis accounting within a hybrid accounting model. For example, a company may be accruing for payroll but not year-end bonuses or commissions.
Accrual accounting vs. cash accounting: What’s best for buyers
Buyers need a clear understanding of the potential return on investment when acquiring a business. The cash basis accounting method makes it more challenging to build financial models and forecast future revenues, leading to increased uncertainty and risk. In contrast, the accrual accounting method allows companies to project revenue and earnings more accurately, reducing risk and providing greater confidence in financial projections.
That said, the rules for accrual accounting can lead to different interpretations, which ultimately may not provide financial clarity or align to GAAP.
When evaluating a business for acquisition, it is essential for buyers to understand the differences between accrual and cash accounting methods — and to have an experienced consulting firm partner to help them break down complicated accounting structures. This knowledge enables a more accurate assessment of the target company's financial health and future prospects.
We’re here to help
Mowery & Schoenfeld’s transaction advisory services experts can provide both buy-side and sell-side transaction support, helping make sense of financial reporting and uncovering insights. Contact us