Cash vs. Accrual: What a Seller's Books Show You, and What They Hide

A seller hands you three years of financials and the top line climbs every year. Revenue up, up, up. Looks like a business with momentum, the kind you want to own.

Then you notice the books are kept on a cash basis. And some of that climb isn't more business. It's the same business collecting its money faster.

That distinction (whether revenue actually grew or whether cash just showed up sooner) is the kind of thing a buyer has to know before signing anything. The accounting method the seller uses decides whether you can see it at all.

So before you read another line of a seller's P&L, figure out which method built it. Cash or accrual. The answer changes what the numbers are telling you, and more to the point, what they're leaving out.

Two methods, one business

Cash accounting is simple. You record revenue when the money lands in the account and an expense when the money leaves it. A customer pays in March, that's March revenue. You pay a vendor in June, that's a June expense. Money in, money out, nothing more.

Accrual accounting records revenue when it's earned and an expense when it's incurred, regardless of when cash actually moves. You did the work in March, so it's March revenue, even if the customer pays in May. The vendor delivered in June, so it's a June expense, even if you don't cut the check until August.

The reason accrual exists is the matching principle. It lines up the cost of doing something with the revenue that something produced, in the same period. Sell a product one month and pay for the materials the next, and accrual puts both in the month of the sale, so the margin on that sale is visible. Cash basis scatters them across whatever months the money happened to move.

Accrual also creates accounts that cash basis simply doesn't have:

• Accounts receivable: Money customers owe you for work already done.
• Accounts payable: Money you owe vendors for things you've already received.
• Deferred revenue: Money you've collected for work you haven't done yet.
• Prepaid expenses: Money you've paid for things you haven't used yet.

Hold onto those four. They're most of what a buyer loses when the books are cash basis, and I'll come back to them.

Same transactions, same business. The method alone decides which period looks strong.

Why most lower middle market sellers run cash basis

Most small businesses you'll look at keep their books on a cash basis, and they have reasons that have nothing to do with hiding anything.

Start with cost. Cash basis is something a part-time bookkeeper can run. Accrual takes more skill to maintain, often a controller or an outside accountant doing real monthly work, and that's an expense a $4M revenue business doesn't always want to carry.

Then tax. On a cash basis you don't owe tax on a receivable until you collect it. A business sitting on $200K of unpaid invoices at year end pays nothing on that money until it arrives. Push collections into January and the tax bill moves a year out. For an owner running the business for their own account, that's rational.

And the code allows it. Below a gross receipts threshold that most lower middle market businesses fall under, a business can keep its books and file its taxes on a cash basis without anyone raising an eyebrow.

So the takeaway for a buyer isn't that cash basis is suspicious. It's that cash basis is the default you should expect to walk into. Treat it as normal, then do the work it requires.

What cash basis hides

This is the part that matters, so I'll spend some time here. Cash basis isn't wrong. It's incomplete in specific ways, and each gap is something a buyer needs and doesn't get.

Receivables and payables are invisible.

Remember those four accounts accrual creates? On cash basis they don't sit on the books at all. Which means you can't see what the business is owed or what it owes.

No accounts receivable means you can't see how much money is tied up in unpaid invoices, or how fast the business actually collects. A company could be booking sales it's terrible at collecting on, and the cash basis books would never show you the backlog.

Payables work the same way in reverse. Without them on the books, you can't see what the business owes its vendors. A seller could be stretching payables, sitting on bills for 90 days to keep cash in the account, and the books would look healthy right up until you take over and those bills come due.

Growth can be an illusion.

Here's the one from the top of this article. Rising cash receipts can mean two very different things. Either the business is selling more, or it's collecting faster on sales it already made. Cash basis can't tell you which.

Picture a business that tightened up its collections in the year before going to market. The prior year it collected slowly. This year it leaned on customers to pay on time, maybe pulled in a chunk of old receivables that had been sitting around. Cash receipts jump. On the books it looks like a growth year. The underlying business didn't grow at all ... it just emptied the receivables drawer.

You're buying future earnings. Knowing whether last year was real growth or a one-time collection bump is the difference between a fair price and an overpay.

Timing can be managed.

This one follows directly from the method. Because cash basis keys on when money moves, the timing of money movement changes how a period looks. Collect early and revenue rises. Delay payments and expenses fall. Neither requires anything improper. It's what the method does. A period can look stronger than the steady-state business simply because of when the cash happened to cross the line.

Working capital is unreadable.

Without receivables, payables, and the rest, you can't see the cash the business needs just to operate day to day. That's working capital, and it's one of the most expensive things for a buyer to get wrong. It deserves a full piece of its own. For now the point is narrow: Cash basis books don't give you the pieces you'd need to size it.

What converting to accrual shows you

None of this makes cash basis books useless. It makes them a starting point, not a finished picture. The work is converting them to an accrual view.

Restate the financials on an accrual basis and the things cash basis hid come back into focus. Revenue lands in the period it was earned, so you see the real trend instead of the collection pattern. Costs line up with the sales they produced, so the true margin shows up. Receivables and payables get reconstructed, so you can finally see what the business is owed, what it owes, and how much cash it needs to keep running.

This is normal diligence work, not an accusation aimed at the seller. Most owners on cash basis aren't hiding anything. They're running their books the cheap and rational way, and nobody ever asked them to do otherwise. The buyer is the first person who needs the accrual version, so the buyer is the one who has to build it.

It takes some skill to do well. Reconstructing receivables and payables from incomplete records, separating what's earned from what's collected, sorting out the timing ... that's hands-on financial work. It's also the work that turns a seller's bank statement into something you can actually underwrite.

Where a QoE fits

Converting cash basis books to an accrual view, then reading the real earnings and working capital picture underneath, is a good share of what a Quality of Earnings analysis does on a lower middle market deal, where cash basis books are the norm rather than the exception. Whether the report is commissioned by a buyer sizing up a target or a seller getting ahead of diligence before going to market, the conversion work is the same.

One honest boundary: A QoE is earnings quality analysis, not a tax compliance review and not an audit. It tells you whether the earnings are real, recurring, and representative of what changes hands. It doesn't certify the seller's tax filings or attest to the books under accounting standards. Different questions, different tools.