Key Insight
Most small businesses file taxes on a cash basis. This means their financials may not match economic reality — large invoices, deferred revenue, and accrued expenses are invisible until cash moves. Buyers need to understand the method before trusting any number.
The Core Difference
Cash basis: Revenue recorded when cash received; expense recorded when cash paid. Simple, intuitive, and the dominant method for small businesses under $25M revenue (IRS generally requires accrual above this threshold).
Accrual basis: Revenue recorded when earned (invoice issued, service delivered); expense recorded when incurred (vendor invoice received), regardless of when cash changes hands. Required under GAAP; produces financials that more accurately reflect economic performance.
Why the Method Matters for Buyers
A cash-basis business can look better or worse than its economic reality depending on timing:
- Revenue timing: A cash-basis business that invoiced $200K in December but collected in January looks like it had a bad December and a great January. Economically, both months were the same.
- Expense timing: Large annual bills (insurance, equipment servicing) create expense spikes in cash-basis financials that accrual would smooth over 12 months.
- Working capital: Cash-basis financial statements often don't show accounts receivable or accounts payable — making working capital assessment impossible without additional data requests.
Conversion for Due Diligence
For deals where precision matters, buyers sometimes request that the seller's accountant provide a conversion from cash to accrual basis for the trailing 3 years. This ensures the financial analysis is based on economic performance rather than cash timing.
At minimum, buyers should request AR aging and AP aging reports to supplement cash-basis statements.
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