Your financial statements are usually the most important piece of information you have to offer prospective buyers when selling your website. Your financial statements allow a buyer to see how all of the unique selling points of your business translate into a bottom line. Additionally, your financial statements are tools buyers use to measure their risk and opportunities in obtaining 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 books put together properly. Often times this means changing the approach you have taken to your accounting and switching from cash basis accounting to accrual basis, or vice versa.
Cash Basis vs. Accrual Basis – What’s the Difference?
The difference between these two types of accounting are thankfully 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 is 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 leaves your bank account (presumably April 15th).
Example 2. You run an e-commerce 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 will be sufficient, however, there are a few notable examples when you should lean towards one method of accounting over another.
E-Commerce Business That Carries Inventory: Use Accrual
The most common mistake we see in financial statements from prospective sellers come from an e-commerce 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 e-commerce store in which you typically get a 50% profit margin. Your inventory turns over completely every 5 months. Under an accrual basis accounting, a 3 month snapshot will look like this:
Accrual Basis P&L
|Cost of Goods Sold|
Now let’s assume a cash basis accounting. In this example, your inventory has turned over (or is close) at the end of February, so in March you buy the equivalent of 5 months of inventory (~$25,000). A 3 month snapshot looks like this:
Cash Basis P&L
|Cost of Goods Sold|
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, but 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. 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
- In general, 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 to be understood. In these cases, cash basis accounting is sufficient. Even more so, cash basis accounting can be easier to verify from a buyer’s perspective as they can simply match up transactions from a bank account in a ‘money in/money out’ fashion.
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 value gained from an eventual sale. The answer to this depends largely upon the size of your business and the complexity of your business.
For any business owner who carries inventory and who is planning to exit within the next few years, taking the time to recast the books into an accrual basis accounting system would be recommended, especially 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 anytime you would like more insight into whether you should recast your books, or make any change for that matter, we would invite you to contact us and receive a no-cost valuation and consultation.