Many early stage companies and small businesses use elementary cash-basis accounting, a simple method by which income is recorded when cash is received and expenses are recorded when cash is paid out. Often, there can be a significant time gap between recording the action (sale or purchase) and its result (payment or receipt of money).
While a small business may prefer cash-basis accounting, Trilogy Partners recommends using accrual accounting if it ever seeks additional investors, bank loans, or contemplates a sale, merger or acquisition. In this case, the company will need historical financial statements, prepared on an accrual basis, in compliance with Generally Accepted Accounting Principles (GAAP). Typically, these financial statements are required for the three preceding years and are also necessary if the company is required to be audited by a public accounting firm.
The complexity of recreating historical financial statements in compliance with GAAP can be both costly and time consuming especially when combined with a public audit. Any delay can prevent a timely closing of a strategic transaction and can exacerbate a cashflow problem. It is more prudent to initiate accounting methods and prepare GAAP compliant financial statements from the very beginning. Thereby, the company will always be ready for any future financing or strategic transaction. Financial statements prepared for tax return purposes typically are not prepared on an accrual basis and will not suffice.
Consider ABC Company whose accounting records were being maintained for tax purposes only. They acquired two companies in two years and never recorded the purchase accounting. In addition, they utilized office space and other properties owned by the CEO and did not record the liabilities. Subsequently, there was a downturn in the industry resulting in a liquidity crisis and ABC decided to sell the business. They found a buyer who required, among other due diligence, audited financial statements. ABC Company attempted to engage an audit firm, however there were no financial statements prepared in accordance with GAAP. After defaulting on bank loans and paying high fees for accountants to create GAAP financial statements reflecting proper accounting for the two acquisitions, an audit was successfully completed. During that period, the prospective buyer provided a bridge loan at punitive rates. After four months of attorneys, outsourced accountants and auditors, ABC successfully closed a deal however, the sale was at a significantly lower purchase price all because they did not maintain financial statements that could be audited in a timely manner.
At Trilogy Partners, we believe it is better to plan for the future and BE PREPARED for opportunities when they arise. If you’d like to learn more about accrual basis accounting and GAAP, contact me at email@example.com or (609) 688-0428.