Cash vs. Accrual Accounting: What Sellers Need to Know

When selling your website, your financial statements are usually the most important piece of information you have that can be offered to any prospective buyers. These financial statements allow a buyer to see how the unique selling points of your business translate into a bottom line. Additionally, your financial statements are tools that buyers can use to measure the risks and opportunities of getting a solid return on the investment you are asking them to make.

Because these documents are so important, it is necessary that you have your financial information organized properly. Oftentimes, this means changing the approach you have taken to your accounting– switching from cash basis accounting to accrual basis accounting, or vice versa.

Cash Basis vs. Accrual Basis – What’s the Difference?

The difference between cash and accrual-based accounting is quite simple. In cash-basis accounting, revenues and expenses are recorded as they are received or spent. In accrual-basis accounting, revenues and expenses are recorded as they are incurred. The differences between the two types of accounting show up most clearly for firms carrying inventory, and for companies that pay or receive their payments on terms. Take the following examples:

Example 1. You buy advertising on net 45 day terms that run on March 1st. With these terms, you will not have to pay the bill until April 15th (45 days after the ad ran). In accrual-based accounting, you would record the expense on March 1st– when the responsibility to pay the bill was incurred. In cash-based accounting, you would record the expense when the money actually left your bank account (presumably April 15th).

Example 2.You run an Ecommerce store and receive a large purchase order on March 15th from a customer who asks to pay on terms of net 30. In accrual-based accounting, the revenue would be recorded when the purchase order is received. In cash basis accounting the revenue would be recorded when the customer makes their payment.

For most small businesses, either method is sufficient. However, there are a few notable examples of when you should lean towards one method of accounting over the other.

E-Commerce Business That Carries Inventory: Use Accrual

The most common mistake we see in financial statements from prospective sellers comes from Ecommerce businesses that stock their own inventory.  If your business does not fit this, feel free to skip to the next section.

Using cash basis accounting for an inventoried business can significantly hurt your business value. The reason for this is that it artificially lowers your profit by approximately the cost value of the inventory you have on hand.

Let’s use an example to illustrate the point. Let’s assume you have an ecommerce store in which you typically get a 50% profit margin. Your inventory completely turns over every 5 months. Under an accrual basis accounting, a 3-month snapshot will look as follows.

Accrual Basis P&L

Now let’s assume a cash basis accounting method is used. In this example, your inventory has turned over, or is close to doing so, at the end of February. So in March, you buy the equivalent of 5 months of inventory (~$25,000). 

A 3-month snapshot would look as follows.

Cash Basis P&L

Why Accrual Basis is More Accurate

Over time, both cash basis and accrual basis accounting will arrive at the same, or very similar, profit numbers. However, when a snapshot in time is taken, the picture can be quite deceptive. More importantly, cash basis accounting without a regular turnover rate of inventory makes it nearly impossible for a buyer to gauge any trends in your gross profits.

The problem with cash basis accounting is that it improperly records an expense before it is actually an expense to record. Cash basis accounting does not recognize the receipt of inventory. In reality, when a business owner buys inventory, they are not reducing their assets, just converting one asset (cash) for another (inventory).

When Cash Basis is Better

Generally speaking, accrual basis accounting better captures the finances of any business. However, for very simple businesses, cash basis may be preferred when it comes to selling.  Examples of businesses that would use cash basis accounting effectively would be:

• Sites that earn 100% of their money through affiliate earnings and have no payables or receivables.
• Subscription sites such as directories without open accounts receivables
• Web hosting businesses
• Any business whose balance sheet does not have significant assets in any category other than cash

Why Cash Basis Can Be Better

Although accrual accounting can offer more insights into businesses with various levels of complexity, some businesses simply don’t have that level of complexity. In these cases, cash basis accounting is sufficient. Even more so, cash basis accounting can be easier to verify transactions from a buyer’s perspective, as they can simply match up transactions from a bank account with a ‘money in/money out’ formula.

Should I Recast My Books?

You may be wondering if taking the time and effort to recast your books into an accrual-based accounting system would be worth the effort for the value gained from an eventual sale. The answer to this depends largely upon the size and complexity of your business.

For any business owner who carries inventory and plans to exit within the next few years, taking the time to recast the books into an accrual basis accounting system would be recommended. This is especially true if your revenues are significant. Much of the decision to recast your books will depend on just how much value you potentially add to your business by doing so.

If at any time you would like more insight into whether you should recast, or make any changes to your books, we would invite you to contact us and receive a no-cost valuation and consultation.