Small businesses have two basic choices regarding the recording of income and expenses for bookkeeping purposes: the cash method or the accrual method. As a business seller, it is important to learn the difference between cash accounting vs. accrual accounting in order to properly represent the company’s financial standings and achieve the optimal purchase price for the business.
The Cash Method
The cash method is a more common mode of accounting among small businesses. It is also what is used for tax reporting in retail businesses. With this method, one records income and expenses on an actual basis; money is not marked as incoming or outgoing until the transaction has been processed and money is physically paid or acquired. This method displays the company’s current cash holdings.
The Accrual Method
With the accrual method, transactions are accounted for as soon as an order is placed. For example, if the company makes a purchase that will not be charged for another three months, it is recorded as soon as the order is placed, rather than when the money is paid. Accounts receivable works the same way, in that the payments that are to be made in the future will be accounted for in the present. The accrual method is most commonly used in companies engaged in manufacturing and other non-retail businesses.
The Modified Cash Method
Because both accounting methods have limitations, a business may use a modified cash method to develop what it feels is a more accurate picture of its finances. While the modified cash method may be used for internal purposes, this method does not comply with the Generally Accepted Accounting Principles (GAAP) that companies must follow when preparing their financial statements.
One may wonder about the relevancy of looking at cash accounting vs. accrual accounting when selling a business. However, the bookkeeping method chosen to represent the business to the buyer can have an impact on the business’s valuation price, and therefore the amount of the purchase price paid to the seller.
In some cases when working capital is critical to the company’s operations, the buyer may prefer to see the actual available cash within the business, in which the cash method may be more appropriate. The only sure way to determine which method is more applicable to one’s situation is to compare the two within one’s specific business. Whichever valuation method produces a more attractive picture of the business, this is one that should be utilized.
It is important to maintain accurate and thorough bookkeeping methods if the business will be sold in the near future. In fact, the buyer will want to look at a minimum of twelve months’ accounting, and more typically three to five years. In order to make it easier for the seller, the desired method should be implemented ahead of time. Converting between cash accounting vs. accrual accounting can prove to be a difficult task if the accounting is not managed correctly.
A business broker can assist in determining cash accounting vs. accrual accounting when it comes to your specific situation. At George & Company in Worcester, MA, we have many years of experience with the appraisal, sale, and financing of small businesses. Contact us today to learn more about how we can assist you in receiving the best price for your small business.