The Cash vs. Hybrid vs. Accrual Conundrum
What to Ask for and Use?
Most small businesses use the cash basis of accounting. Despite that practice, prospective clients will prepare their books in a variety of different ways that do not conform with the accounting cash basis. There are hybrid and accrual cash basis and the business valuation practitioner needs to recognize the differences between these forms of accounting. In this article, the author shares the importance of understanding each and what to do and ask for from the client to better understand the financial disclosures.
Which should I ask for?
Does it really matter?
Isn’t each one “easy” to work with?
Won’t either provide the same conclusion of value?
Should I just let the client tell me what he/she is going to send to me?
The attorney seems to be “pushing” whatever the client is willing to provide?
Software:
QuickBooks® and other “similar” software programs are able to print either the cash and/or the accrual financial statements; the Balance Sheet and the Profit and Loss.
Each should be evaluated (scrutinized) for its reasonableness!!! Each account should be evaluated for its reasonableness!!!
If you have a question about a particular account and/or it just “doesn’t look right” or “doesn’t make sense”, then you must ask for qualitative assurance for the historical amount.
As business valuation professionals, we are trained to request the past five year’s financials mainly for visual and mathematical testing for reasonableness, trending, proper and improper recording of assets and liabilities; for example, a credit amount entered as a current asset and/or a debit amount appearing in the current liabilities.
Are the accounts appropriate? Do they convey the proper disclosure of what the account is supposed to mean? Stated otherwise, are commissions that are listed as an expense when it is really something else or the outside services are a disguise for cash paid “under the table” without any invoicing for proof or a suspicious amount is a disguised owner’s withdrawal. Or a note payable is “too low” a number because it was reduced by both the principal and interest payment.
Do not forget to review the Adjusting Journal Entries. These may be the most revealing in how the balance sheet and/or the income statement was manipulated particularly in small businesses.
Basic Definitions:
Cash Basis of Accounting
Amounts expended are recorded only at that time when cash has been paid and receipts are recorded only when they are explicitly received.
Basically, business owners do not want to pay income taxes on revenue it has not received. Expenses work in reverse in that they want to capture all the expenses they can to reduce the operating income and therefore reduce the income taxes for both federal and state.
Hybrid Basis of Accounting
This basically means that the accounts reflect the particular type of business practice and/or particularly what the owner wants to maintain on a daily basis.
For instance, the owner may want to know on a daily basis the current balance in accounts receivable. Accounts payable may not be an issue because the owner has good credit with various vendors and different dating when payables are due.
Another owner may only find it necessary to know the current “real-time” balance in inventory. For instance, when would be the critical point in real-time to purchase the specific product to receive replenishment relative to minimum order points? In this manner management would make sure that at no time they would be out of products to sell.
Generally Accepted Principles of Accounting
Financial statements should be presented to us in accordance with the American Institute of Certified Public Accountant’s principals. This means the statements would be presented on the accrual basis of accounting.
Amounts recorded as debits (both for assets and expenses) are recorded when incurred and credits (both for liabilities and income) are recorded when acquired. It does not matter if the assets or liability has been received or paid for, it only matters that a transaction has occurred. Accrual accounting means that an event must be recorded on the financial statements.
In accounting we refer to the accrual method of accounting as a methodology wherein we view a suitable matching of revenues and expenses relative to the particular time period; this is either a calendar or fiscal year period.
Is Accrual Basis of Accounting Always Necessary?
There are very few “always” conditions in our lives. Most small businesses are on a cash basis of accounting because it is easy for them to understand. Also, in the whole scheme of things, it may not make very much difference even if they were on an accrual basis of accounting. Just be understanding and recognize if the financial statements represent just what the business is doing (its heartbeat) and if it reflects an operating income that you may convert to an equity net cash flow to capitalize.
Problem Areas:
Cash Basis of Accounting
Routinely, especially businesses that deal with a lot of cash receipts such as physicians, checks received in December are held and not deposited until January. This really makes the income statement look worse than it should. Make sure you review the previous January deposits to make some adjustments so at least the latest and most recent year reflects the “real” receipts.
Prepaid expenses, buying additional inventory, and increasing accounts payable are areas that require the same scrutiny as the receipts. These expenses will tend to decrease the net income and therefore total income taxes.
The above largely occurs when the in-spouse has been planning to divorce for obvious reasons. Or a majority holder wishes to buy-out the minority interest. Just keep your wits about you and recognize what is going on with the records.
Hybrid Basis of Accounting
Since we discussed hereinbefore what occurs within the hybrid books, this methodology will require the same scrutiny as the cash basis of accounting. It is just that simple!
Accrual Basis of Accounting
I find that large companies (for the most part) which have more than a small management group run the business without wholesale deceit. However, misspostings, overpayments of expenses, double billings, and bad accounting do occur.
On at least three occasions that I remember (that is particular to a small accounting office) the office manager (1) set up her own business with the same three letters (acronym) as the name of the business in which she worked. When checks came in with just the three letters instead of the business name spelled out, she deposited the checks into her business account and began a kitting process in the accounts at work; (2) delicately erased the cleared amount of a check she wrote to herself from the bank statement and then marked the check void in the manual ledger. I had to perform a bank reconciliation to determine why the cash balance was out-of-balance; (3) over a period of years shorted small amounts credited to receivable accounts. She then created adjusted journal entries to cover the differences by crediting returns and allowances and discounts allowed. She was prosecuted having absconded with over $300,000.
Obviously, internal controls set-up by management are at fault and we are not relied upon to discover a defalcation. The above points out to be aware that sometimes bad things do happen and that you may discover a wrongful act.
I have a client who “thinks” he can do it all and “creates” entries that he believes are correct. The trial balance demonstrates a series of mistakes which routinely must be corrected. I am not saying you will have to look for mistakes, the fact remains we will all come across account postings that will have us scratching our heads.
The above demonstrates why it is important to compare the company’s financials to industry metrics such as RMA, Bizminer, Integra, etc. A particular account may jump out at you and cause you to inquire why there is a material difference when compared to the industry. It will most assuredly put the client on notice that you are a professional who is not just going through the process blindly. This is a very good thing to remember.
Conversion from Cash to Accrual
Obviously, if the “normal” prepaids, accounts receivable and payable, inventory, deferred income, etc., are not on the books, we must ask if management can provide us the factual reference amounts to change the financial statements (particularly dealing with small companies; remember to charge for this assistance).
I had an occasion to ask the client to provide me with the inventory amount at the valuation date. It then occurred to me that I required to know the ending inventories for all five historic years and the sixth oldest year. Why? I had to properly account for the beginning and ending inventories in the income statement to assure the cost of goods sold was stated with assurance.
Remember, this all relies on your ability to reflect a particular cash flow amount to capitalize. It also relies on your ability to reflect a particular account (revenue, gross profit, EBIT, EBITDA, SDE, etc.) that you would use in the market approach. The accounts must reflect reasonableness.
Do not make this an overly difficult process. If the client is only able to provide you with some details but not all for them to provide an accrual trial balance, then just use what was provided to you. More times than not you will be able to proceed.
If you need to, make sure you explain in detail what you observed in your report and that you were still able to complete the engagement. I strongly suggest for you to protect yourself and explain the process in the Statement of Assumptions and Limiting Conditions of your report.
Conclusion:
Do not make the engagement harder than it needs to be. Enough will be presented that will surprise you and cause you angst in the valuation process. Stay the course and your “guns.” Meaning, if you recognize that more detail is or will be required and you price the engagement accordingly, then do not back down!!
Also, do not cheapen the engagement. This will always ruin your self-respect and in the eyes of future referral business; future business will come to you because you are willing to charge less for this highly specialized service. If the client will not pay what the valuation is worth, walk away!!!
We have enough work to perform in the engagement process without making it more difficult for us and the client. Just be diligent and mindful that even if you agree on a fee for the engagement, you will probably spend a little more time on some issues then you thought you would. The product is what is important, and it is the final report that will also be respected and be the strength of your reputation.
What is most important is our independence and credibility, these are paramount, above all else. When you have completed the engagement, you need to make sure that the calculation or conclusion of value is reasonably correct (in your head, heart, and stomach) rather than horribly wrong.
Mr. Rudich, CPA, MS, MCBA, CVA, ABAR, MAFF, CMEA, CM&AA, BCA, is the founder of the business valuation and litigation support services company, Business Valuation Group, LLC. His responsibilities include valuations of closely held and publicly traded companies, machinery and equipment appraisals, strategic business planning, budget and forecasting services, business consulting, business loss computations, depositions, and court testimony.
Mr. Rudich was named a “Business Valuation and Financial Forensic Master”, as part of the National Association of Certified Valuators and Analyst’s Industry Titans awards at their June 2016 Conference. He was selected into the Founders Circle of the of the Alliance of Merger & Acquisition Advisors in January 2013, elected to the Advisory Board in 2004, and received the 2008 Chair of the Year award in January 2009. He was admitted to the Westlaw Round Table Group, Washington, DC expert network as a Round Table Scholar in January 2009 and recognized by SmartCEO as one of the Top CPAs in the Baltimore/Washington, DC area in their September 2008 issue.
Mr. Rudich can be contacted at (410) 581-1888 or by e-mail to Ron.Rudich@bvgllc.com.
