With a small to medium size business, you are likely to find the company has chosen the cash basis of accounting. While this choice actually gives you a better sense of cash flow, it can be misleading in understanding how profitable the company really was.
First, some background:
- Record income when received
- Record expenses when paid
- Advantage…the borrower defers taxes if the company receives the funds after they are earned and it overlaps the year-end.
- Advantage…this type of accounting is easy to do (checkbook and throw in some depreciation) so a very small business without an outside CPA can easily do their accounting themselves.
- Advantage…the borrower has some ability to impact the tax level by year-end acceleration of expenses or deferral of revenue.
- Disadvantage…the borrower pays taxes early if the company receives the funds before they are earned (a deposit) and it overlaps the year-end.
- Disadvantage…the tax return can be very misleading when their lender is using it to determine credit-worthiness.
- Income is recorded when earned. (Earned but not received shows up on the Balance Sheet as an asset: Accounts Receivable. Received but not earned shows up on the Balance Sheet as a liability: Deferred Revenue.)
- Expenses are recorded when incurred. (Incurred but not paid shows up on the Balance Sheet as a liability: Accounts Payable. Paid but not incurred shows up on the Balance Sheet as an asset: Prepaid Expenses.)
- Advantages and disadvantages when it comes to tax returns? Just reverse the ones noted in the cash basis section above.
What is a lender to do?
- You do not get to choose whether your borrower provides cash basis or accrual basis tax returns. And with a small- to medium-size business, you may not have influence on whether the financial statements they provide are on cash basis versus accrual basis.
- In the overview stage of analyzing the borrower’s tax return (see my business tax manuals, page one of each type of return for the overview list) note whether the return is cash-basis or accrual-basis before you compare the years.
- If your software calculates accrual adjustments (most of my Ag Lending clients do) leave them in if cash-basis but zero them out if the tax return is already accrual basis.
- If you have the tax return for anything other than a sole proprietor or one owner LLC you may have the balance sheets per books in the tax return. (There is an exception of the company is small enough.) If the tax return is on the cash basis and the books are on accrual basis you’ll spot the accounts receivable and/or accounts payable. And if you know how, you can then convert the income statement (front page of the tax return) from cash to accrual.
So to answer the question, no…cash-basis on a tax return is not a red flag.
For a full explanation of cash vs accrual basis and the formula for conversion see Pages 2-5 through 2-7 in the self-study manual: Understanding the Business Scorecard: Financial Statement Analysis.
For the overview list (including the tip to check on cash or accrual basis) for the 1065, 1120 and 1120S returns see Pages 2-9, 3-13 and 4-13 in the self-study manual: Beyond the 1040: Corporation, Partnership and LLC Tax Return Analysis.