Starting your business decades ago was about finding and filling a niche that wasn’t fulfilled. Doing it better or faster may have motivated you in the beginning. As the years pass, growing revenue, building sustainability and incremental YOY profits are what continue to drive you. At some point, considering an exit enters your orbit, and approaching an exit requires preparation. Images of the Fram Oil Filter commercial from the 70’s, ‘you can pay me now, or pay me later’ are recalled. For others, having conversations with your CPA is the dreaded quarterly or yearly activity. Getting your businesses financially in order begins with your accounting system.
Cash vs. accrual accounting
Most of the 30-some million are operating out of a cigar box. Your cigar box is cash-based accounting similar to balancing your personal checkbook. Most businesses typically choose cash-based accounting because of its simplicity requiring limited accounting expertise. You record transactions only when money physically enters or leaves your bank account. According to SBA, small businesses in the U.S. with less than $10 million in revenue account for 34.7 million of the roughly 36.2 million are represented in this category.
These businesses record transactions when cash is paid or received. However, a business may need to convert to accrual-basis accounting to prepare for an audit, sale, public offering, or loan application. Accrual-basis accounting offers a more comprehensive view of your finances. With this method, you record revenue when you earn it and expenses when you incur them, regardless of when the cash changes hands.
“Your business isn’t a piggybank; stop treating it like one!” – David Reed
There are several reasons why businesses switch from the cash basis to the accrual basis. If one of the businesses goals is to surpass the $10MM threshold becoming part of the 2% of SMBs to scale beyond. If securing a premium exit when the time comes to do so. If providing generational wealth is important to you, then putting the disciplines in place to do so is required. Doing so puts accounting records in compliance with Generally Accepted Accounting Principles (GAAP) which promotes transparency and accuracy in financial reporting.
Any investor, lender or potential buyer will want to see financial statements formulated under GAAP before they invest or lend into a business. It also facilitates better budgeting and forecasting as businesses, like yours, can anticipate future cash flows based on receivables and payables. Making the transition enables more informed decision-making regarding investments and resource allocation.
When you record your income and expenses has a huge impact on how you understand your company’s financial health. One method gives you a snapshot of your cash on hand, while the other provides a more complete picture of your profitability over time. Let’s break down how each one works. The accrual method is not restricted to by revenue size if the business is under $10MM. Your CPA may be for or against your transition; that’s for y’all to discuss, strategically.
Another reason to switch is accrual based financial statements provide a more accurate representation of how well a business has performed during each reporting period. Under the cash basis, variabilities in the timing of cash inflows and outflows interfere with the results posted on the financial statements, leading to some variability in results from period to period.
The fundamental difference between cash and accrual accounting boils down to one thing: timing
Cash accounting is reactive, recording transactions only when money moves. Accrual accounting is proactive and predictive recording transactions as they happen. For example, your HVAC business finishes a project for a client on December 15th. The invoice is sent on that day also, but the client doesn’t pay until January 10th. Cash accounting is straightforward, which is why many new businesses start there. But as your company grows, that simplicity can become a liability. Relying on cash-basis books is like trying to drive using only your rearview mirror looking where you’ve been, but not the road ahead. Accrual accounting provides a comprehensive map of your financial performance. It gives you the insights needed to make strategic moves, stay compliant, and truly understand your company’s health.
How to Transition
Before you can switch accounting methods, it’s important to have a solid grasp of what makes them different. At first glance, cash and accrual accounting might seem like two sides of the same coin—they both track your money. But the real distinction lies in timing. It’s advisable to make this switch at the end of a fiscal year or reporting period for a clean transition. Transitioning to accrual accounting can enhance your financial management and reporting, making it easier to track your business’s performance over time. When you record your income and expenses has a huge impact on how you understand your company’s financial health. One method gives you a snapshot of your cash on hand, while the other provides a more complete picture of your profitability over time.
Difficulty of Converting Basis
The conversion of cash basis to accrual basis accounting can be a difficult one if the businesses disciplines are lacking. Is it more work for your accountant? Yeah, it is; ONE TIME. We’re coming from a POV to help our clients earn the exit they’ve dreamed of creating generational wealth. What can go wrong in transitioning? It’s possible for some transactions to be missed during the conversion. Unfortunately, the only way to be certain of a complete and accurate conversion is to examine all accounting transactions during the year being converted, as well as in the final quarter prior to the transition. Accounting platforms used to struggle with what would appear to be a simple switch. Today, that’s not the case as the major players have ironed out the issues minimizing the time and costs of transitioning.
A successful transition requires specific steps. You’ll need to set up accounts for receivables and payables, calculate a one-time financial adjustment, and file Form 3115 with the IRS to make the change official.
Whose business is it anyways – yours or the CPAs? Understand, we’re not bashing CPAs here, but once you sell your business, your CPA loses a client. If you’re a strategic thinker, you understand the message. If not, then stop reading here and best of luck to you! If you decide to move beyond self-imposed ceilings and grow over the next several years to achieve a premium exit then here’s a transition checklist.
The Core Transition Checklist
• Step 1: Establish the Cutoff Date.
Select the first day of the new fiscal year to prevent mid-year P&L distortion.
• Step 2: Record Accounts Receivable.
Identify and post all uncollected invoices for services already delivered prior to the cutoff.
• Step 3: Record Accounts Payable.
Identify and post all unpaid vendor bills for goods or services received prior to the cutoff.
• Step 4: Calculate and Post Accrued Expenses.
Record liabilities for payroll, interest, and taxes incurred but not yet paid.
• Step 5: Adjust Prepaid Expenses.
Move cash paid for future services (e.g., annual insurance) from the P&L to the balance sheet as an asset.
• Step 6: Record Deferred Revenue.
Move cash received for future services from the P&L to the balance sheet as a liability.
• Step 7: Reconcile Inventory and COGS.
Count physical inventory and adjust the balance sheet to reflect actual stock on hand.
• Step 8: Post the Retained Earnings Adjustment.
Offset all transition journal entries against a dedicated equity account to balance the books.
Only Transition If You Want:
A true picture of your financial health. Accrual accounting provides an accurate view of your profitability by recording revenue when you earn it, not just when you’re paid. This clarity is essential for making smart business decisions and securing funding.
A premium exit. The reality once your business goes in-market is you’ll receive LOIs ranging from 40-50% below and above your business’s valuation. Your true value is what a potential buyer is willing to pay.
Make the change stick with internal process disciplines: The switch is just the first step. Part of being fully prepared financially is the businesses reports reflect accurate data according to GAAP which reflects accurate financial process disciplines. To maintain these accurate records, establishing consistent monthly routines is paramount. Train up your team on the new workflows and maintain document integrity.
