A cash to accrual adjustment restates a company's earnings from when cash moved to when revenue was earned and costs were incurred. Many small businesses keep their books on the cash basis, so a given year or trailing twelve months can include payments for work done earlier and leave out costs the business has already run up. In a quality of earnings report, the adjustment moves revenue and expenses into the periods they belong to. It can raise earnings or lower them.
On the cash basis, revenue is recorded when the customer's payment lands in the bank, and an expense is recorded when the bill is paid. On the accrual basis, revenue is recorded when the work is done or the product is delivered, and an expense is recorded when the cost is incurred, whether or not cash has changed hands yet.
| Item | Cash basis | Accrual basis |
|---|---|---|
| Revenue | When the customer pays | When the work is done or the goods are delivered |
| Vendor bills | When the bill is paid | When the cost is incurred |
| Wages | On payday | When employees do the work |
| Inventory purchases | Expensed when paid for | Expensed when the goods are sold |
| Customer deposits | Revenue when received | Revenue when the work is delivered |
Many small businesses file their tax returns on the cash basis and keep their books the same way. The timing becomes a diligence question when a buyer and a lender price the business off a single period of earnings.
Small business deals are commonly priced as a multiple of earnings for a specific period, often the most recent full year or the trailing twelve months. On cash-basis books, the earnings in that period depend partly on when customers happened to pay and when the business happened to pay its bills.
A few patterns show up often:
None of these change what the business earns over time, only which period the earnings appear in. When the price is a multiple of one period's earnings, the period matters. The earnings in a Confidential Information Memorandum (CIM) are often built from the same cash-basis books, so the adjustment also affects the comparison between the CIM and the tested figures.
The adjustment comes from the balance sheet accounts that a cash-basis set of books does not track. For these accounts, the QoE measures the balance at the start and the end of the period, and the change between the two moves earnings.
| Account | If the balance rose during the period | Effect on earnings |
|---|---|---|
| Accounts receivable | Work was done that customers had not paid for yet | Increases revenue |
| Customer deposits and deferred revenue | Cash was collected for work not yet delivered | Decreases revenue |
| Accounts payable | Costs were incurred that had not been paid yet | Increases expenses |
| Accrued wages and other accrued expenses | Employees or vendors had earned amounts not yet paid | Increases expenses |
| Inventory | Goods were bought but not yet sold | Decreases cost of goods sold |
| Prepaid expenses | Costs were paid for a future period | Decreases expenses |
When a balance falls, the effect runs the other way. A drop in receivables means the business collected cash during the period for work done before it, and the accrual view takes that revenue back out.
Work in progress matters in businesses that bill by project or milestone. A job half done at period end can have costs on the books with no revenue against them, or billings with half the costs still to come.
An illustration with round numbers. A company's cash-basis books show $400,000 of EBITDA for the trailing twelve months. At the start of the period, customers owed $150,000. At the end, they owed $250,000. Unpaid vendor bills went from $80,000 to $120,000. Wages earned but not yet paid went from $20,000 to $50,000, because the period ended in the middle of a pay cycle.
| Line | Amount |
|---|---|
| EBITDA, cash basis | $400,000 |
| Increase in accounts receivable | 100,000 |
| Increase in accounts payable | (40,000) |
| Increase in accrued wages | (30,000) |
| EBITDA, accrual basis | $430,000 |
In this example the adjustment adds $30,000. Reverse the receivables, so customers owed $250,000 at the start and $150,000 at the end, and the same business shows $230,000 of accrual EBITDA instead. In that case the cash-basis period benefited from collecting the prior year's work. The direction depends on the balances, not on the size of the business.
A company on the cash basis usually does not carry receivables or payables on its balance sheet, so the QoE builds them from source documents:
The bank statements are the anchor. The cash proof ties the company's records to bank activity, so the timing items can be traced to actual deposits and payments. Questions about open invoices, deposits and unfinished jobs go into the management Q&A, and the company's answers are recorded there. If a balance cannot be tied to a source document, the report says so and shows the remaining difference rather than estimating it.
The document request list asks for a monthly P&L on the accrual basis when the company has one. Many only have cash-basis reports, and the adjustment is built from the documents above. When the company has no financial statements at all and they have to be built, an added fee applies, quoted once the documents are in.
A QoE reconciles the company's financials to three years of filed tax returns and IRS transcript data. For a company that files on the cash basis, the cash to accrual adjustment sits between the tax return figures and the adjusted earnings as its own line, so a reader can see how much of the difference comes from timing and how much from add-backs. The adjustment is made in the QoE workbook. It does not change the company's books or its returns.
The same balances that drive the adjustment are the working capital of the business: receivables, inventory, payables and customer deposits. Once they are built, the working capital analysis shows the level the business normally runs on, by month, which matters for how receivables, deposits and payables are handled in the purchase agreement. More on that is in working capital in an SBA acquisition. Talk to your attorney about how your agreement treats them.
The adjusted figure also flows into the recalculated SDE and adjusted EBITDA, which is the number lenders commonly use for debt service coverage. Confirm with your lender which earnings figure it will use. The layout of the tax reconciliation, the earnings recalculation and the working capital tab is on the sample report page, and the ten procedures are on the quality of earnings page.
It goes both ways. It lowers earnings when the period collected cash for earlier work or ran up costs not yet paid, and raises them when customers had not yet paid for work done in the period.
No. A QoE is not an audit and does not express an opinion on the financial statements.
Not for the QoE. The adjustment is built from the company's records and source documents. Any change to how the company keeps its books or files its returns is a question for its tax adviser.
The adjustment is part of the standard scope. Our fee is $7,500 flat for SBA-sized deals, whether or not SBA financing is used, and larger deals are scoped and priced to the work after a call, with the fee quoted before work starts. There is no hourly billing. The work generally takes two to four weeks from receipt of documents. Details are on the pricing page.