Is accrual really that much better than cash basis? In this economy in particular, with companies going bankrupt left and right, how is accrual better than cash?
With cash, it at least shows the money has been received, and is in the hand of the business owner. With accrual, as the lender, am I supposed to cross my fingers and hope they get that cash?
Great points, Zac, and lenders often like cash basis for just the reasons you stated. And even with cash-basis tax returns, if you sit down with each borrower and get a feel for what is going on, I am guessing you are often ‘thinking’ in the accrual basis.
Example: Your borrower says ‘You know, we did a big project at year-end for one of our strongest customers and that really improved our year’s earnings’. If you take that into account in your thinking, you have mentally switched to accrual basis.
The clues in the accrual basis that all is not well in their world are two:
1) Require the Accounts Receivable and Accounts Payable aging so you can see if their receivables and payables are current.
2) Look at the Bad Debt expense line on the return. When they give up on collecting, they will write the uncollectible receivable off as a bad debt.
Final note: as a business owner I almost exclusively think in the accrual basis. And I always create my own internal financial statements in accrual basis. It does a much better job of telling me what the activity for the year has created in revenues and what that cost the company.
Oh…and one more thought. It is scarier during tough times to count on accrual basis because even your strongest borrowers may encounter difficulties. If you are using accrual basis, getting the aging reports, watching the bad debts and having continuing communication with your borrower is more critical in challenging times than in abundant times.