Cash Versus Accrual Accounting: Which to Use?

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Cash Vs Accrual Accounting: Which to Use?Unless you actually run an accountancy or bookkeeping business, accounting isn’t usually at the top of a business owner’s mind. But if you don’t understand your books, you don’t understand your business, and the choice between cash and accrual accounting is a choice about how you choose to view your business, so it’s an important difference to know about (and make an informed decision on).

Cash Accounting

This is the type of accounting that is used by many small businesses and for personal finance. It is called “cash” but obviously deals with whatever forms of payment you take.  You enter revenues when you receive revenues and you enter expenses when you pay expenses.  

Pros

  • The process is simpler and easier, both for you and for your accountant
  • You get an excellent short-term, day-to-day glance at your business
  • Your bank balance bears resemblance to your bookkeeping

Cons

  • You cannot make long-term decisions based on this type of accounting
  • These books can sometimes provide an inaccurate picture of the company
    • E.g. you could have a very large amount of cash on hand but have payables that exceed all of that amount and then some

Accrual Accounting

This is the opposite of cash accounting. You book revenues when you have an agreement in place (even if you have not been paid) and you book expenses when they are incurred (not when you have paid them). 

Examples:

  1. A client signs up for one of your products and services in March, but they will take delivery in April, hence they may not pay you until then or later. But in accrual accounting you book that revenue in March, not April.
  2. A vendor sends you an invoice in June. It is due in July. In accrual accounting you book the expense in June.

Pros

  • This is the type of accounting that investors want to see because it gives a better sense of the long-term performance of the company
  • It’s more accurate (and GAAP recommended), because you have a better view of the profitability of the company over an entire year

Cons

  • Because you have to record revenue before actually receiving it, cash flow is tracked separately
  • This type of accounting is significantly more expensive in time and money
  • You don’t have a short-term picture of your business

The Choice

Many businesses can choose which type of accounting to use, but some can’t.  

  1. If you stock items to sell to the public and do more than $1M/year in revenue, you have to use accrual accounting
  2. If you do more than $25M/year in revenue, the IRS requires you to use accrual accounting 

If you do want to switch over from cash to accrual you can’t just decide to do it, you have to ask permission of the IRS via Form 3115, and if they approve you, you have to stick to that choice for the whole year. No changing mid-stream.

Small businesses without a lot of cash on hand and are primarily B2C will often choose cash accounting, simply for the ease of it. Businesses that keep a large inventory or don’t get paid quickly will often choose accrual accounting, simply because it makes more sense.

This is ultimately a decision you should make with the advice (and consent?) of your accountant. He/she knows your business, knows its cash flows, but most importantly, knows you, how you deal with different financial statements, and what your long term goals with the business are. Armed with that information, it’s easy to figure out whether your business should be using cash or accrual accounting.

If you want us to take a look at your books to see whether you’re in a good position to sell, we’re always happy to not just look, but offer suggestions on what you can improve and clean up to get ready for a future sale. Give us a call today.

Buying Distressed Businesses During the Covid Crisis

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Buying Distressed Businesses During the Covid CrisisWe’ve seen a lot this year. We’ve seen businesses thrive and have some of their best years ever. We’ve also seen businesses go under and deals fall apart. But, we’ve also had deals move on just as usual, albeit a bit more slowly due to extra diligence from the banks. But as the year comes to a close there might be some owners who are feeling particular pressure to sell now and some buyers in the market looking for a particularly good opportunity. In this article we’ll discuss a few things for buyers to keep in mind.

What’s the Distress?

All businesses faced a new landscape in March 2020, even if they were a company that could continue doing business. Their vendors and customers may not have been in the same position. Some businesses may have already been in some distress prior to the lockdowns, and the changed landscape simply made things worse. So, a drop in sales is not the only thing you want to examine as you’re exploring a purchase of a distressed business. 

You’ll also want to see if there are:

  • Any ongoing debt issues. Does the company need cycles of financing that has put it into a poor financial position pre-Covid?
  • Any legal issues. Does the company have any liens or cases pending?
  • Payroll problems. Did the company receive an EIDL or PPP loan? Will it be forgiven? Are there payroll issues that PPP did not solve or were systemic prior to March 2020?
  • Any staff issues. Some key management and personnel may have had to leave in the last eight months. Are the right people in place to keep the business functional?

What Can You Do?

You need to have a strategy in place. It’s not enough to simply covet “a good deal” on a business during this time period. You need to think about what you bring to the situation.

Examples include:

  • Can you do better than the current ownership?  
  • Do you want to strip it down to essentials and possibly run that form of the business? 
  • Do you want to simply buy the assets and add them to your current business?  

You should think about a distressed business the same way you might when buying anything that you weren’t particularly in the market for, say a piece of clothing that’s on sale:

  • It’s not the color or fabric you want (this isn’t necessarily the business or industry you were considering). But, it has a brand and employees.
  • It has a nick or two (things aren’t exactly as you would like them to be). But, the business has customers and some cash flow.
  • It’s not the time of year for this item (you were maybe thinking of buying later next year). But, there’s an opportunity right now.  

Bring in your accountant and other members of your inner circle to look at the books and the opportunity to make sure you stay level headed and take on something that really makes sense, not just something financially attractive. The more coherent a plan you have that clearly states what you are going to do with the business, the better chances you have that such a plan would actually work.   

Financing

Unfortunately this is not going to be something you can get SBA funding for.

You’ve got three options if you don’t have the cash on hand to make the purchase outright:

  1. Talk to the seller’s lender (if they have one). Find out if they are willing to work with you. You’re going to need to tell them what your strategy is.
  2. Talk to your lender. Explain the situation and see if they are willing to give you a loan; they may be willing to put a lien on hard assets as collateral. This is yet another situation in which a quality banking relationship can come in handy.
  3. Explore asset-based lending. This is the most expensive type of financing you’ll find, similar to some of the fintech solutions we’ve discussed in the past, but these types of lenders do deals all the time and might offer you something that works into your plan.

We’ve got all sorts of businesses available at the moment.  Whatever you are looking for, give us a call and let us help you find it.

Case Study #44: Doubling the Deal at the Last Moment

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Hand Sign - OkayDavid Jondreau grew up watching his father teach Sign Language classes in their family living room. No one in the Jondreau household was deaf, but David’s father had befriended members of that community and became passionate about teaching ASL. Before too long a legitimate small business sprang up that was part of the highly fragmented industry that was (and is) language interpretation services. If you needed sign language services for government meetings and speeches, or hospitals, or education, the Jondreaus’ American Sign Language was there to help.

A couple decades ago, when most people had no idea what “remote work” was, David began helping his father two time zones away. The business was in NYC but David lived in New Mexico. He helped with administrative tasks and booking classes. But one day David’s father passed away suddenly, and he and his sister inherited the business.

Start With Systems

While David was grieving, he also knew his father would want the business to keep going, so he started to put together the pieces of a real, sustainable business. His father was a selling dynamo and also ran the business completely out of his head. David had to learn sales as well as create written processes where none had previously existed.

Determine Ownership

In a nod to keeping the business in the family, David asked his mom to join as a 2% owner. With David and his sister at 49% each, it meant any big decision where there was disagreement needed to involve his mom. But this also meant the business qualified as “female owned” which really helped with some government contracts that listed that attribute as preferential.

Losing a Contract

All small businesses are challenging in their own way, but of particular stress to David over the years was the renewal of contracts. Not getting a contract renewed could massively affect the outlook for the coming fiscal year, and when David lost a game-changing sized bid for a large New York City school system, he had decided that it might be time to investigate a sale.

Thankfully, he had always beyond clean books: they were audited. He had taken the time to put key people in place, and he had refined the systems he first started putting in place when he read The E-Myth in the early years of the business. He started poking around at large regional conferences of language providers for possible buyers before deciding to hire a broker.

One of the possible buyers the broker introduced was building a conglomerate for a family office. David’s business would add a sign language component to a few other small businesses that would roll up into one entity. David was enjoying 10% margin on $2M of revenue and was looking for 3.5 times seller discretionary earnings (SDE).

When David chatted with the buyer he felt instant rapport and connection and felt comfortable moving forward once the price had been agreed to. Due diligence began and they were roughly two weeks away from closing on the sale.

Curveball

The contract that David thought he had lost? Hard to believe, but the government had messed up the paperwork and David had actually won that five-year, multi-million dollar contract! Worse, the client demanded that the services start being delivered within a few days, which was when the school year was scheduled to begin. David leaned on that good relationship he had with the buyer and let him know about the development and asked for two weeks to completely focus on fulfilling the contract, after which time he would come back to work on the deal. That good relationship turned out to be rock solid and David was given that time to put everything in place.

But that meant that two weeks later, the value of the business had effectively doubled. What had originally been an 85% cash/15% paid in a one-year note couldn’t work anymore, especially since David would need to help babysit and optimize delivery in the early years of the contract. An earnout was put into place to account for the new revenue.

Unsurprisingly, the school system couldn’t seem to get their act together on paperwork and it was seven months before the first payment on the contract arrived. In the meantime, David maxed out all his personal and business credit and had even gotten some bridge financing from the buyer (again, see the power of openness and transparency in a transaction?). But as the payments started to be made regularly, the deal closed, and David stayed on for a period of transition, then as a consultant for the large contract.

Lessons

David’s story is filled with key lessons for those who want to sell their business, even if they don’t work with family:

  • Have systems and manuals in place. You never know when something catastrophic might happen (like a worldwide pandemic). Hope is not a strategy.
  • Use a broker. You might predict this, coming from us, but in all seriousness, running a business is a full-time endeavor, and selling a business is at minimum a part-time project, but the stakes are possibly the largest financial transaction of your life. Do you want to be juggling that many balls?
  • Be transparent with the buyer. By developing a relationship early on and communicating at each step of the process, not only did David not lose a sale when he very well could have, but he ended up doubling his take.
  • Don’t give up. Oftentimes the selling process will have obstacles that come out of nowhere, like the late payment that put severe financial strain on David.  Those who accept the obstacles calmly and work through them will get to the finish line.  Those who panic, don’t.

All we do all day is help buyers and sellers come together and get to a mutually satisfactory outcome.  Let us help you!

PPP Forgiveness: An Update

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United States CurrencyA lot has happened since we first wrote about the Paycheck Protection Program (PPP) earlier this year. Some of those loans have actually started to be forgiven, and we wanted to make sure our Apex clients and readers have the most up to date information.

Timeline

Unbelievably, $134 billion of congressionally approved funds went unspent when the program stopped taking applications in early August. It was around the same time that the government began accepting applications for loan forgiveness and in late October we began to see the first positive decisions.

The deferment on loan payments was ten months after the last day of your “covered period.” The covered period is usually defined as the period between the disbursement of the loan and the subsequent 24 weeks. If you want to avoid making any loan payments whatsoever, you need to put the application in during this deferment period.

Your application will go to the lender who originated your loan. They have 60 days to review it and then it is forwarded on to the SBA, who has 90 days. But given the timelines we’ve already seen above, those are worst-case scenarios. Some lenders, like JPMorgan Chase, which has the most PPP loans by dollar amount, have been sending emails to customers inviting them to apply for forgiveness based on when they received their loan.

How to Apply

The latest (and simplest) form is the 3508S, aimed at loans of $50,000 and less. Nearly 3.6 million of the over 5 million PPP loans were for amounts of $50,000 and less, and accounted for about $60 billion in loans.

Form 3508S focuses more on certification than on calculation. The calculation usually revolves around your payroll. To qualify for forgiveness, at least 60% of the loan must have been spent on payroll. The remainder could have been used for other eligible costs like mortgage interest, rent, and utilities. But rather than get the paperwork necessary to back up those other eligible costs, take a look first to see if you hit the amount just on payroll alone: many do. Furthermore, the earlier murmurs about forgiveness being somewhat mitigated because of employees that were let go or pay cuts in general seems to be resolved in the 3508S, which penalizes you for neither.

If your loan amount was more than $50,000, you may need to use the 3508 or the 3508EZ. The EZ form has generally been aimed at those who are self-employed with no employees or who maintained salaries and head count at certain levels. But check with your banker and accountant to be sure.

Talk to Your Bank and Be Proactive

What we’ve learned this year is that those who have kept an open line of communication with their banker and those who have acted with speed have had good things happen when it comes to government aid. This isn’t a situation any of us would have wished for, but we’ve seen that some of the deals we have in process are being held up precisely because of questions about the forgiveness of loans that are on the balance sheet. If this is something that is holding up a sale in process, this is just the thing to break that logjam, and for those who have been holding off on listing a business because of uncertainty regarding PPP, no need to wait any longer. You can list your business while pursuing PPP forgiveness. While we often like to say that we’ve “seen it all” we can also say that we’ve been unafraid of doing deals during this time period, despite never having lived and worked through a worldwide pandemic, as have many of our buyers and sellers.

If you’ve got questions about PPP and a business transaction, give us a call!