If you buy and operate small businesses, you will face one accounting fork in the road sooner or later: cash vs accrual accounting. Sellers often keep books on a cash basis for simplicity or tax reasons. Buyers, lenders, and diligence providers typically need accrual numbers to understand how the business really performs across periods.
Treat this as more than a technicality. The accounting basis can change how you view profitability, working capital, seasonality, and even valuation. Get it wrong and you risk overpaying or inheriting avoidable cash flow headaches. Get it right and you will negotiate cleaner terms and step into ownership with eyes open.
Below is a practical guide to what the two methods mean, why it matters in buyer due diligence, and how to handle the accrual adjustments that affect your LOI, QoE, and closing mechanics.
The short version: cash vs accrual accounting
Cash accounting records revenue when cash hits the bank and expenses when cash leaves. It is simple, but it distorts timing. A December project paid in January shows up as January revenue.
Accrual accounting records revenue when earned and expenses when incurred, regardless of when cash moves. It is more work, but it matches activity to periods and produces more reliable trends.
A seller’s financials might look healthy on cash basis because they delayed vendor payments in December and collected a few large prepayments in the same month. On accrual, those moves would settle into accounts payable, deferred revenue, and prepaids. EBITDA and working capital would look very different.
Why the accounting basis matters in an acquisition
Pricing and valuation. Accrual numbers help you understand normalized EBITDA. Cash timing quirks can inflate or deflate earnings in any single month or year.
Trend analysis. Accrual removes noise from collections and payment timing so you can see seasonality, margin drift, and customer behavior more clearly.
Working capital. Your peg and true-up at close depend on balance sheet accuracy. That requires accrual entries for accounts receivable, accounts payable, inventory, prepaids, and deferred revenue.
Covenants and lender underwriting. Banks and SBA lenders evaluate debt service on accrual results. They also care about AR aging quality, inventory valuation, and accrued liabilities.
Post-close management. You will operate on accrual if you want accurate forecasting. Starting clean avoids month one surprises.
How to tell which basis you are looking at
- Income statement shows big revenue spikes tied to cash receipts, not delivery dates.
- No AR or AP on the balance sheet, or the balances never change.
- Large annual expenses booked in a single month, like insurance or software, with no prepaid schedule.
- Deposits from customers flowing straight to revenue rather than deferred revenue.
- Inventory is missing or carried as a flat number with no cost of goods reconciliation.
If you see these signs, assume cash basis until proven otherwise. Plan to convert key periods to accrual in buyer due diligence.
Core accrual adjustments every buyer should understand
A good Quality of Earnings will do this work. Even so, it helps to know what to expect and how each item affects value and structure.
Accounts receivable and revenue cutoff
- What to test: Revenue recorded in a period without delivery, or delivered in-period but not billed or collected until the next period.
- Why it matters: Accrual revenue must reflect delivery or earning, not cash timing. AR aging also measures collection risk you inherit.
- Buyer move: Tie invoices, delivery notes, and bank deposits to a cutoff date. Adjust revenue and AR accordingly. Consider a specific reserve for old AR in your model.
Accounts payable and expense cutoff
- What to test: Expenses incurred before period end but paid later.
- Why it matters: Understated AP inflates profit and understates the cash you need for payables after close.
- Buyer move: Rebuild an AP schedule from vendor statements and receiving logs. Adjust COGS and operating expenses, then reflect AP on the balance sheet.
Deferred revenue and customer deposits
- What to test: Prepayments and retainers booked as revenue when cash arrives. Common in services, maintenance plans, sponsorships, and e-commerce preorders.
- Why it matters: Revenue should be recognized over service periods. Deferred revenue is a liability you take on at close.
- Buyer move: Identify prepayments, recognize revenue ratably, and book the remainder as deferred revenue. Negotiate how deferred revenue influences the working capital peg.
Prepaid expenses
- What to test: Annual policies, licenses, or subscriptions booked fully in the payment month.
- Why it matters: Expenses should be amortized over the coverage term.
- Buyer move: Create a prepaid rollforward. Amortize to expense monthly. This improves period-by-period margin accuracy.
Inventory and COGS
- What to test: Inventory not tracked or valued improperly. COGS booked on cash receipt rather than matching to sales.
- Why it matters: Misstated inventory distorts gross margin. It also drives the cash you will need for replenishment after closing.
- Buyer move: Confirm valuation method, count reliability, and shrinkage assumptions. Align COGS recognition to sales. If needed, build a landed cost adjustment.
Accrued liabilities and payroll
- What to test: Bonuses, commissions, PTO, taxes, and utilities incurred but unpaid.
- Why it matters: Omissions inflate EBITDA and leave you with unexpected cash needs.
- Buyer move: Accrue these items and ensure the APA addresses pre-close obligations clearly.
Revenue recognition traps that show up in small businesses
- Milestone or project work: Revenue booked at contract signature rather than delivery.
- Subscriptions and memberships: Cash collected up front with little or no deferral.
- Chargebacks and returns in e-commerce: Inadequate reserves that overstate net revenue.
- Channel or platform fees: Recognized inconsistently, which distorts contribution margin.
- Owner-performed services: Revenue tied to the owner’s personal efforts without trained backups.
Your QoE and buyer due diligence should review contracts, SOWs, refund policies, and platform dashboards to confirm how revenue is earned and when it should be recognized.
What lenders expect to see
- Accrual income statements and balance sheets for at least two to three years.
- AR and AP aging reports with concentrations and delinquency trends.
- Inventory valuation method and turnover.
- Deferred revenue detail and service obligations.
- Normalized EBITDA after accrual adjustments, with a clear bridge from seller-provided numbers.
Delivering this cleanly builds confidence and can shorten underwriting timelines.
How accrual adjustments influence valuation and terms
Price. If accrual adjustments reduce EBITDA, your valuation should reflect the lower, normalized earning power.
Working capital peg. Accrual balance sheet items define “target” working capital. Be explicit about definitions, inclusions, and seasonality so your post-close true-up is fair.
Holdbacks and escrows. Uncertain accruals, like tax exposure or customer refunds, can justify a holdback.
Reps and warranties. Ask for specific reps around proper revenue recognition, completeness of liabilities, and the absence of undisclosed side agreements.
Close mechanics. Align the closing statement with accrual definitions to avoid arguments when cash hits the account.
Red flags that warrant deeper digging
- Large swings in profit around year-end that disappear on accrual.
- Little or no AR and AP on the balance sheet despite credit terms.
- Negative inventory movements with no explanation.
- Large customer deposits booked entirely as current-period revenue.
- Material expenses consistently booked late or in odd accounts.
- Tax returns that do not reconcile to management financials.
Any one of these does not end the deal. Several together suggest you should slow down and expand scope.
A simple cash-to-accrual walk-through
Assume a service firm shows the following for December on cash basis:
- Reported revenue: $300,000
- Reported expenses: $210,000
- Reported EBITDA: $90,000
Your testing reveals:
- $40,000 collected in December relates to services delivered in January. Defer it.
- $55,000 of December work was delivered but not yet collected. Accrue it to AR.
- $18,000 of vendor services were received in December but paid in January. Accrue to AP.
- $24,000 of annual insurance was paid in December. Only $2,000 belongs to December; the rest is prepaid.
Accrual adjustments:
- Revenue: 300,000 minus 40,000 plus 55,000 = 315,000
- Expenses: 210,000 plus 18,000 minus 22,000 prepaid benefit = 206,000
- Accrual EBITDA: 109,000
On accrual, December looks stronger than cash. In other months the reverse will be true. The point is not “higher” or “lower.” The point is truer to economic activity. Your price, peg, and lender case should rely on this view.
Diligence requests that make conversion faster
- Trial balances and general ledgers by month for at least 24–36 months.
- AR and AP agings at month end and after period close.
- Customer and vendor master files with terms.
- Contract lists, SOWs, renewals, and refund policies.
- Inventory listings, valuation method, and cycle count procedures.
- Prepaid and deferred revenue schedules with rollforwards.
- Bank statements and merchant processor statements tied to sales.
Providing this list early saves time and reduces surprises.
Practical tips for buyers
- Ask the seller early which method they use and why. Do not assume.
- Model both views. Build a bridge from cash to accrual so you can see the impact on EBITDA and working capital.
- Use your QoE provider as a thinking partner. They will spot patterns in revenue recognition, cutoff errors, and liability omissions.
- Align your LOI with the need for accrual-based diligence and a clear working capital definition.
- Educate the seller on the process. Many owners have never built a deferred revenue schedule or prepaid rollforward. A calm explanation goes a long way.
Final thoughts
You do not need to be a CPA to buy a great business, but you do need to understand cash vs accrual accounting and how accrual adjustments change the story the numbers tell. Accurate accrual financials reveal real earning power, real obligations, and the real cash you will need after closing. That is the foundation of smart buyer due diligence.
If you convert the right periods, test cutoff carefully, and tie your LOI and working capital peg to accrual definitions, you will negotiate with confidence and operate with fewer surprises. That is how you protect your downside without slowing your deal to a crawl.
Contact us today or book a free consultation and learn how we can be a trusted partner on your next deal!
