Why is this even a discussion since one method is correct and one isn’t correct? We are also evolving towards a cashless environment. That will tell you how outdated the cash basis is.
The reason it still exists is because of taxes. Almost all individuals and small businesses file on a cash basis. The IRS prefers this because everything can be proofed against bank activity.
It is often stated that the cash method is factual and easily proved. That is true. However, it does not make the reported financial performance correct. In fact, the tax expense model incentivizes people to take expenses as soon as possible and to defer revenues as long as possible.
I had a client that had 500,000 of cost that was recorded in year one and an invoice was issued to the client for the services performed of 1,200,000 in year one. The client encouraged the customer to not pay the invoice until the following year for “tax purposes”.
Here is how the cash basis and tax methods reported these transactions even though all of the work was completed in year one.
Year One
- Revenue 0
- Costs 500,000
- Tax Loss -500,000
Year Two
- Revenue 1,200,000
- Costs 0
- Tax Gain 1,200,000
What is a buyer supposed to do with this mess?
The correct accrual accounting outcome would have been:
- Year One Tax Gain 700,000
- Year Two Tax Effect N/A
Yes, accrual accounting method requires a lot more effort and it includes various estimates. The accounting estimates are developed to correctly match revenues and expenses by month based upon the economic impact of business transactions and physical activities within the operating month.
This is an example of where the zebra cannot change its stripes (cash basis) to spots (accrual basis) just for a sales transaction.
Buyers dislike cash-based financials but they will navigate through an offering if they like the company enough.
Once again, it is critical to have a strong financially knowledgeable M&A advisor who can bridge the financial performance of your company from cash to accrual for the buyer.
If it is not properly bridged the seller will definitely lose purchase price.
Even cash-based financials are wrong many times due to tax manipulation between “good years” and “bad years”. I have seen many companies pull back on reporting expenses in Q 4 of bad years due to “already having enough expenses to offset revenue for the year”. It is deemed better to “save tax deductions for the following year in hopes that year will be more profitable”
This results in disparities such as 11 months of rent expense in one year and 13 months of rent expense in the next year.
This doesn’t just aggravate buyers. It gives them an opportunity to make their own adjustments and those adjustments will NEVER be in your favor.
You need to work with a quality advisor to determine all proposed adjustments/corrections to be made internally to your financials before you commence your offering. Then you can share one consistent correct portrayal of your company’s financial performance.