Methods of Accounting Used When Selling Businesses
In order to properly price and sell a small business, it is critical to use a correct and consistent method of accounting when evaluating and presenting its financials. The difference between the two methods of accounting – the accrual basis and cash basis – has to do with the timing of when revenues and expenses are recognized. A cash basis method of accounting is the simpler and most widely used method of accounting for small businesses. It recognizes revenues and expenses when cash is received or disbursed. The accrual basis method recognizes revenues and expenses when transactions occur and not when cash is received or disbursed. Unlike the cash basis method, the accrual basis method includes accounts receivable (money owed to a business for services rendered or products sold) and accounts payable (money owed by a business for services or products received).
Cash-Basis Tracks Cash Flow
For many service-related, construction-related, and healthcare-related businesses, there is often a significant lag between transacting a sale and when cash is received. In such instances, the distinction between an accrual and cash basis method of accounting has an enormous impact on the reported profits or adjusted owner benefit of the business. The accrual basis method typically results in a higher level of recognized revenue and a higher level of recognized expenses. While the accrual basis provides useful metrics when evaluating such businesses, the cash-basis method of accounting tracks the actual cash flow of a business and as such is used by buyers and lenders when evaluating the vast majority of small businesses.
Consistency Critical When Presenting Financials to Buyers
Whether or not a business uses a cash basis or an accrual basis method of accounting when measuring its financials, it is critical for a business broker to be consistent when presenting the financials to potential buyers. The reconciled financials (using a tax returns or profit and loss statement) should clearly state what type of accounting method is used. Further, the method of accounting used when comparing year over year historical financials should be consistent. In most instances where a business uses the accrual basis method of accounting, it is preferable for the business to also show the cash basis method of accounting for the same corresponding periods. This way, buyers and lenders may still use the cash basis method when evaluating the business.
Include Accounts Receivable and Accounts Payable in Sale?
Accounts receivable and accounts payable should both be included in a business sale when using the accrual-basis method of accounting. This is because both accounts receivable and accounts payable are included when using the accrual method to determine the adjusted owner benefit (which serves as the basis for a business valuation). If they are not included, then it is inconsistent to base a business valuation on the adjusted owner benefit from an accrual basis method. When using the cash basis method, neither accounts receivable nor accounts payable are included when calculating the adjusted owner benefit used to value the business. The inclusion of accounts receivable or accounts payable in a business sale is negotiable when a cash basis method of accounting is used.
Quality of Accounts Receivable
In addition to the problem that the accrual basis method does not track the actual cash flow of a business, the quality of the accounts receivable (A/R) relied upon by the accrual basis method is often highly problematic. Many small businesses in the service-related, construction-related, or healthcare-related industries have problem payors. An A/R ageing report will let a buyer know how old the receivables are and of what overall quality. If a buyer or lender questions whether a company’s A/R will be collected, then the veracity of a company’s adjusted owner benefit based on the accrual basis method (which recognizes uncollected money as revenue) will also be questioned.
Example of Accrual v Cash Basis Method of Accounting
- Jason owns a Durable Medical Equipment (DME) company which bills insurance companies or third party payors for medical supplies delivered to its customers.
- Jason wishes to sell his business due to his pending retirement, and consults a professional business broker who examines his tax returns as a part of the valuation process.
- The business broker discovers that the tax returns are in the accrual basis method of accounting.
- In 2023, the reported revenue is $1.5M (incorporating the amount billed for transactions in 2023) and the reported profit (or owner benefit) is $300K on an accrual basis.
- The business broker then sees that the business has $200K of accounts receivable from third party payors, as well as $50K of accounts payable for supplies from vendors which has been delivered but not yet been paid.
- Note that some of the $200K of A/R may not ever be paid, or may be paid at some distant point in the future.
- It is far better for Jason under such circumstances to revise (with the assistance of his accountant) his financials using the cash-basis method of accounting.
- Using the cash basis method, the 2023 reported revenue is $1.4M (incorporating money received in 2023 even though it was billed in prior years) and the reported profit (or owner benefit) is $250K.
- The owner benefit is also affected by not including accounts payable when using the cash basis method.
- Although $250K of owner benefit (using the cash basis method) is less than $300K of owner benefit (using the accrual basis method), Jason will now be able to keep his A/R as a negotiable deal point.
- He will also be liable for his $50K of accounts payable, but the $200K of A/R more than makes up for this.
- More importantly, buyers and lenders (such as banks using loans backed by the Small Business Administration) trust financials based on the cash basis method.
- They will not need to guess as to whether the A/R will be collected, and can base their decision to buy Jason’s business on the cash flow of the business.
The accrual basis and cash basis methods of accounting both have a role to play when buying or selling businesses. It is almost always preferable to prepare and present financials based on the cash basis method because of its simplicity, the unreliability of including accounts receivable when using the accrual basis method, and so that buyers and lenders may properly value a business based on its cash flow.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.