Should You Use Cash or Accrual Basis Accounting When Valuing a Business?

When determining the value of a business, it is important to know on what basis the income statement was prepared to ensure that you come up with an accurate appraisal. Many small businesses use cash basis accounting, where sales are recognized when the money for those sales is received and expenses are recognized when they are paid. Others use accrual basis accounting, where revenue is recognized when services are performed and expenses are recognized when the expense becomes an obligation (not when the expense is paid). Accrual basis accounting gives a more accurate picture of the financial performance of a company because it is not affected by a late payment from a customer or to suppliers.
For many businesses whether you use cash or accrual basis financial statements when performing a business valuation. When valuing a well established, relatively stable business, the distortions caused by cash basis accounting tend to be balanced so the net effect is zero. In December, the company you are valuing may do work that will not be paid for until January, but in January there were revenues recognized from the previous December that would approximately equal those unpaid bills. Similarly on the expense side, you might not pay the current year's phone bill until January of next year, but you probably paid last year's December phone bill this year, which would offset that.
However, there are situations in which using cash basis accounting significantly impacts the valuation. If there are significant changes in working capital over the course of the course of a year the profit figures can differ significantly based on the accounting method that you choose to use. If profit figures are significantly different between accounting methods, you should perform the valuation based on the accrual basis.
Here's an extreme, hypothetical example of how different a cash and accrual basis accounting can be. Joe decides to open a widget factory on January 1. He pays all expenses as incurred, in cash. For the first three months, he incurs expenses of $250,000 but makes no sales, in the second quarter he begins making sales. Each quarter, expenses grow by 40% and he can makes sales of 125% of the quarter's expenses. On an accrual basis the company would show a profit of over $250,000 and on a cash basis a loss of $658,800 as shown in the table below:
Expenses By Quarter:
250,000350,000490,000686,000
Total: 1,776,000
Sales By Quarter
0465,500651,700912,380
Total: 2,029,580
Collections by Quarter:
00465,500651,700
Total 1,117,200
Cash basis profits: -658,800 (Collections - Expenses)
Accrual Basis profit: 253,580 (Sales - Expenses)
Any time that there are significant changes in current assets from the beginning to the end of the year you should either use accrual basis income statements when performing a valuation or use an online calculator that will make adjustments to offset changes in the balance sheet automatically.