Cash Vs. Accrual & What You Need To Know

In most businesses, books are kept on one of two typical bases: cash or accrual. Some business owners choose one or the other for a specific reason. Others work under the guidance of their CFO, bookkeeper, controller, tax advisor, accountant, or other financial specialists of choice and review the resulting reports to measure operations. However, the two bases of accounting have major differences and can significantly impact the perceived performance of a business. For example, if you've been grappling with the potential sale of a business, most acquirers prefer books on an accrual basis. There are many reasons for this, but the primary reasoning is that accrual basis financial statements follow Generally Accepted Accounting Principles (GAAP), whereas the cash basis financial statements do not. However, both bases have their merits depending on the type and function of the business.

CASH BASIS

Cash basis is the simplest base and is the default for many new and starting businesses and businesses that do not accrue bills over time. On a cash basis, money is recognized upon receipt, and expenses are recognized when the bill is paid, and money is deducted from the business’ account. This is very easy to track as you can measure and record transactions directly from the company’s bank account and credit card statements. This will provide a good view of businesses whose services are typically paid for in cash or are otherwise due immediately, particularly when most of the business expenses are also paid immediately. However, cash basis does pose disadvantages in that expenses are almost always accrued over time at some level. Take, for example, a lemonade stand using QuickBooks to track its expenses. The owner will need to pay a yearly subscription to track its expenses, resulting in a much larger than typical cost when the time to pay for the software comes due. This is why many financial professionals prefer to accrue long-term expenses like this on a monthly basis.

ACCRUAL BASIS

Accrual basis accounting takes both revenues and expenses, which can be measured over a period, and spreads them out, making payments, both incoming and outgoing, more regular. This is a large boon for clients with long-term projects paid upon completion, as there may be revenue recorded for months if you recognize that revenue by how far along the project is. Recognizing the amount of work completed and money due which has not yet been received creates an account receivable – allowing you to recognize money you can reasonably expect to collect for work already performed. The other side is an account payable: money you can reasonably expect to pay out over a period for services received. Referring to our earlier QuickBooks subscription, on an accrual basis, we can recognize our yearly payment as an account payable and pay in twelve monthly installments toward reducing this payable, recognizing a regular monthly expense to account for our bills each month properly. This full monthly picture of revenues receivable and bills payable creates a more accurate picture of how the business is truly performing month to month, which is why an accrual basis is often preferable for short-term or general financial views.

In most financial transactions, true GAAP accrual basis financials is preferred, as it provides the most accurate picture of a business month-to-month, which can be extremely helpful for viewing profits and measuring net working capital and overall financial positions accurately. However, private businesses rarely practice true GAAP accrual accounting practices, even on an accrual basis. There is typically some level of annual subscriptions, prepaid expenses, or other billings which should be accrued properly and are simply paid in cash because ownership or the finance team are typically pulled in several directions and rarely have the time to accrue each individual expense properly on a weekly to monthly basis. It is for this reason that for smaller businesses, a Quality of Earnings (QoE) report is often performed to ensure that both cash and accrual basis business match up closely to true GAAP accounting. During the QoE process, a third-party accounting firm typically works to reconcile a business’ internal bookkeeping to GAAP methodologies, though the process is not always completely accurate. During this period, it is helpful to have an expert in M&A transactions to review and confirm the methodology utilized by the firm is accurate and makes sense.

Author
Christopher Davidson
Transaction Support Associate
Benchmark International

T: +1 615 924 8950
E: cdavidson@benchmarkintl.com

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Benchmark International is a global M&A firm that provides business owners with creative, value-maximizing solutions for growing and exiting their businesses. Benchmark International has handled over $9.4 billion in transaction value across various industries from offices across the world. With decades of M&A experience, Benchmark International’s transaction teams have assisted business owners with achieving their objectives and ensuring the continued growth of their businesses. The firm has also been named the Investment Banking Firm of the Year by The M&A Advisor and the Global M&A Network as well as the #1 Sell-side Exclusive M&A Advisor in the World by Pitchbook’s Global League Tables.

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