Glossary
Cash vs Accrual Accounting
Cash accounting records revenue when money arrives and expenses when money leaves. Accrual accounting records them when they are earned and incurred, regardless of when cash moves. Most owner-managed businesses keep cash-basis books because that is what minimizes tax. At Treewalk we convert those books to accrual constantly, and the gap between the two versions is usually far wider than owners expect.
The difference in one example
You invoice a customer in March for work you finished in March. They pay you in June.
Under cash accounting, that revenue lands in June. Under accrual accounting, it lands in March, when you earned it, and an account receivable sits on the balance sheet until June.
Same business, same work, two very different pictures of when the company made money. Stretch that across a year of invoices, bills, prepayments and deposits, and the two sets of books can tell genuinely different stories about profitability and about which months were good ones.
Why small businesses run on cash basis anyway
It is not carelessness. Cash basis is simpler to maintain, it needs no judgement about when revenue is earned, and critically it lets an owner manage taxable income by timing when invoices go out and when bills get paid.
That is a rational way to run a private business you intend to keep. It becomes a problem the moment somebody outside the business needs to understand it: a lender, an investor, or a buyer.
| Cash basis | Accrual basis | |
|---|---|---|
| Revenue recognized | When payment received | When earned |
| Expenses recognized | When paid | When incurred |
| Shows receivables and payables | No | Yes |
| Shows deferred revenue | No | Yes |
| Reflects true monthly performance | Poorly | Well |
| Good for | Tax planning, very simple operations | Lending, reporting, selling, scaling |
| Required under Canadian and US GAAP | No | Yes |
What the conversion actually surfaces
Converting cash books to accrual is routine on our diligence engagements, and it consistently exposes three things the cash view hid completely.
Receivables, and how long they are stuck
Cash basis shows you collected money. It does not show you how long the money took to arrive. On one engagement the day sales outstanding averaged around 110 days, which is close to four months of revenue sitting in accounts receivable rather than in the bank. That is working capital the business cannot use, and a buyer has to fund it from day one.
Deferred revenue
This is the one cash basis erases entirely. If customers pay upfront for memberships, packages or multi-year terms, cash accounting books all of it as revenue on receipt, even though the obligation to deliver is still outstanding. We have worked on a deal where essentially the whole business was deferred revenue: prepaid packs and one, two and three year memberships. Under cash basis, that reads as a very profitable year. Under accrual, most of it is a liability.
The book-to-tax gap
Where the financial statements are accrual and the tax return is cash, the two will disagree, sometimes dramatically on revenue. That is expected and not a red flag by itself. What matters is whether the difference reconciles.
We see this play out on most owner-managed targets. On a recent engagement the tax return was prepared on a cash basis while the financial statements were accrual, which produced a large apparent gap in revenue. Once we accounted for the increase in accounts receivable over the period, the difference all but disappeared and the two income figures landed almost identically. The remainder traced to movements in inventory and bad debt.
That reconciliation is the test. Two very different revenue figures that resolve to nearly identical income once receivables and inventory movements are accounted for means the books are sound. A gap that does not close is where the real questions start.
When you need to switch
You do not need accrual accounting to run a small owner-managed business well. You do need it when:
- You are selling. A buyer will convert your books whether you do it or not, and finding out what accrual does to your earnings during their diligence is the worst time to learn it.
- You are borrowing. Lenders underwrite on accrual figures and on debt service coverage, both of which the cash view distorts.
- You carry deferred revenue. If customers pay before you deliver, cash basis is actively misleading about what you have actually earned.
- You are growing. A growing business collects later than it spends. Cash basis hides that squeeze until it becomes a cash crisis.
- You need real monthly numbers. Month-to-month comparisons only mean something on accrual, because cash basis moves performance into whichever month the payment cleared.
How we handle it
On diligence work the conversion is part of the standard procedure, feeding the normalized earnings and the net working capital peg. On ongoing accounting engagements we either maintain accrual books directly or run an accrual overlay for reporting while the tax filing stays on whatever basis is appropriate.
The two are not in conflict. Plenty of businesses report internally on accrual and file taxes on cash. What causes damage is having only the cash view and assuming it tells you what the business earns.
Frequently asked questions
Which one does the CRA or IRS require?
It depends on size and structure rather than preference. Many small businesses can file on a cash basis, and corporations above certain thresholds cannot. Your tax preparer should make that call. This page is about which basis tells you the truth about the business, which is a separate question from what you are permitted to file.
Can I use accrual for reporting and cash for taxes?
Yes, and it is common. The two ledgers reconcile through timing differences, mainly receivables, payables and inventory. What matters is that the reconciliation holds.
How hard is the conversion?
It depends almost entirely on record quality. Clean records in cloud accounting software with intact invoice and bill history convert quickly. Where the history is incomplete, the work is reconstruction rather than conversion, and that takes longer.
Will accrual accounting make my business look worse?
Sometimes, at least initially, particularly if you have been collecting slowly or carrying deferred revenue. But it is showing you something that was already true. Buyers and lenders are going to see the accrual picture regardless, so seeing it first is an advantage.
Does this affect my valuation?
Indirectly but significantly. Valuations are built on normalized earnings, and normalization starts from an accrual presentation. It also feeds the working capital target, which determines how much cash has to be left in the business at close.
Where to next
If your books are on cash basis and you are heading toward a sale, a loan or a growth push, converting on your own timetable is far better than having someone else do it to you. Our private company team handles both the ongoing accounting and the conversion. If a transaction is what is driving this, read buy-side due diligence and EBITDA normalization adjustments for what a buyer will test. To talk it through, email Avnit Sekhon at avnit.sekhon@treewalk.com.
