Many small companies use cash basis accounting, for the simple fact that it can more easily be manipulated for tax purposes. You probably know the drill – you can pay bills or purchase items for cash at the end of the year to lessen your taxes. Although you are not suppose to, some business owners also hold checks into the new year so the revenue doesn’t fall into the current year.
However, for the same reasons, cash accounting is not a good method to base valuations on. It often doesn’t measure the true revenue and earnings power of the business and instead measures how creative or aggressive the owner was in minimizing their taxes.
Accrual accounting, on the other hand, does more accurately measure the true activity of a business. Revenue is recognized and is shown on the profit and loss statement after the work is completed (a service is performed or a product is delivered). Not when the money comes in. Similarly cost is recognized when you buy something, not when you pay the bill.
For these reasons business appraisers are taught to use accrual based accounting for valuations, and to convert from cash to accrual when possible. Many business brokers, however, are somewhat perplexed on the differences between cash and accrual or don’t want to spend the time to make the adjustments. Much of the time there isn’t a significant difference. For a mature, stable business without a lot of tax manipulations they can be very close.
However for some businesses there is a HUGE difference. For example, a growing business usually has a growing amount of account receivables. Sometimes a dramatic amount since a high growth period also can be a chaotic and challenging time with not a focus placed on collections. Cash basis accounting doesn’t capture all of this growth, and a broker can cost a business owner a lot of money by not accounting for this in his valuation.
Just in the last year I’ve seen three businesses that had significantly more revenue when adjusted from cash to accrual basis. Growth in payables (expenses) is typically less than growth in AR (income), and in all these cases that was true, so earnings in all three cases were much higher. These companies were valued at between 3.5 and 4.5 time earnings, so the net affect can be large – in one case over $1 million dollars!
This business would have been valued at $3 million if the tax returns were used on face value. However we were able to adjust the financials for accrual basis, and add hundreds of thousands of dollars in revenue, most of which fell to the bottom line to boost earnings.