This month's article, Methods of Accounting, is written by Russ Anderson, a partner in the firm SSA, P.C., Certified Public Accountants & Advisors. My firm has worked with Russ and his team on numerous M&A transactions over a span of twenty plus years. They are a full service accounting and tax firm that understand the nuances of both large and small business transfers.

We believe that Russ' article does a great job in explaining the differences between cash and accrual accounting. As a business grows and becomes more sophisticated, the differences between the two methods of reporting can be substantial, and lead to significant variances in the value of a business, depending on the method that is utilized. As in many situations involving tax and accounting matters, there are numerous traps for the unwary, and you should consult your advisor for specific ramifications to your situation.

We remain bullish on the business transfer market as capital remains available and rates are very competitive. We are also seeing an increase in buyers across most categories (Strategic, Private Equity, Family Offices, and Individuals), but it is critical to have timely, accurate financial information that will withstand third party scrutiny. 

The majority of our business is derived from referrals.  Please consider referring our services if you encounter a situation involving the potential purchase or sale of a business.  

Sincerely,

Ronald V. Chernak

President 

METHODS OF ACCOUNTING by Russ Anderson, SSA, P.C., Certified Public Accountants & Advisors

Generally, most small business can elect either the cash or accrual method for income tax reporting purposes. There are exceptions related to size of business, type of entity that might be a partner, and whether inventory is a material factor in producing income. The decision as to which method to use is often based on the timing of when income is received and expenses are paid.

Under the cash method, income is recorded on the financial statements when it is actually received and expenses are recorded when paid. The accrual method records revenue when earned (even if the cash is received sometime later) and expenses when incurred (even though the payment happens sometime later).

Example - ABC business bills $5,000 to a customer for services. The accrual method requires the $5,000 to be recognized at the time of billing. The cash method requires the income to be recognized when ABC has the unrestricted right to the funds from the customer. The simplest example of this is when a check is received, but not deposited. Because ABC possesses the check, they must record it under the cash method, even if not yet deposited in the bank.   The same business receives an invoice to pay a telephone bill for $800. The accrual method requires recording the expense when the bill is received, but the cash method records the expense when the actual check is written and sent to pay the bill.

Small businesses often choose the cash method because it is simpler. This method can also provide deferral opportunities for tax purposes, which is one of the most common reasons it is elected. We see many businesses report on the accrual method for financial statement purposes, but on the cash method for tax related reasons. This is often accomplished with an adjustment that contemplates the accrual accounts (mainly accounts receivable and accounts payable) at both the beginning and end of the tax reporting year in question.

Generally, a business that has accounts receivable exceeding their accounts payable may benefit from cash reporting for tax, as this defers the recognition of taxable income into the future. This is especially true if a business is in the growth stage of its life cycle and the difference between the receivables and payables continues to grow. Businesses that elect this treatment need to be diligent in future years if the spread between the accrual accounts shrinks, as the cash basis income to be reported for tax may now exceed the accrual basis income, per the financial statements.

A disadvantage of cash over accrual is that it does not generally provide a true economic picture of operating results and realistic equity (from balance sheets). This issue is critical for the purchaser of a business to decide if the business has the ability to generate the financial results necessary to support the purchase price. If the cash basis financial statements are not converted to accrual (and more likely to accrual under Generally Accepted Accounting Principles - GAAP) for all years employed in the due diligence analysis, the buyer may significantly overpay or possibly, but less likely, underpay for the business.

If inventory is a material income producing factor in a business, generally the accrual method must be used for tax purposes for the inventory, while the other items of income and expense can be treated under the cash method. The cash method can be used by partnerships, individuals, and S corporations. A C corporation, or a partnership with a C corporation as a partner, cannot use the cash method of accounting. Exceptions to this rule are farming businesses, personal service corporations, or entities with annual gross receipts of $5 million or less.

Using the cash method for a growing business can defer tax for years and allow profits to be retained for growing the business, but knowing when to convert to accrual is also important for analysis purposes. 

Russ Anderson has been with SSA since 1981 and is an expert in Tax Services, Succession Planning, and Consulting Services.  

Russ can be contacted at: russ@4ways.com 

Phone (719) 574-0100