Cash vs. Accrual: The Importance of Revenue Recognition

Chris Barrett

Through the use of technology and strategic thinking, Chris brings executive-level financial support into your business.

What Is Cash vs Accrual Accounting?

When it comes to accounting methods, cash basis accounting is often favored by small business owners for its simplicity. Under this approach, revenue is only recognized when cash is received, and expenses are recorded when cash is actually paid. While easy to manage, this method can distort the financial picture by failing to align revenue and expenses with the periods they relate to, resulting in inconsistent, “lumpy” financials.

In contrast, accrual basis accounting provides a more accurate and consistent view of a company’s operations. Here, revenue is recognized when it is earned (typically when a product is delivered or a service is rendered) regardless of when payment is received. Similarly, expenses are recorded when they are incurred, not when the money leaves the account. This method aligns with GAAP standards and is preferred by investors, lenders, and acquirers alike for its reliability. Ultimately, the key difference between these two methods is timing—and in business acquisitions, that timing can significantly impact valuation and risk assessment.

Why Improper Revenue Recognition Hurts Acquisitions

Relying solely on cash basis accounting can seriously distort a company’s financial profile during an acquisition. When revenue is recognized only when cash is received, profits can appear inflated during strong collection periods, even if the underlying performance doesn’t justify it. This often leads to overstated earnings, which misguides valuation and creates false confidence in the deal. At the same time, critical liabilities such as unearned revenue or unpaid expenses may go unrecognized, giving a misleading sense of financial health.

These distortions also cause inconsistencies in key metrics like gross margin and EBITDA, making it difficult to spot true operational trends or evaluate profitability accurately. Without proper accrual adjustments, growth may look stronger than it really is, and working capital calculations may be skewed, putting the buyer at risk of inheriting financial obligations they weren’t prepared for. Ultimately, improper revenue recognition introduces unnecessary risk and uncertainty, opening the door to unpleasant surprises after the deal closes.

Red Flags That Revenue Is Being Mis-Recognized

Not sure if a business is using cash basis improperly? Here are common indicators:

1. Gross Margin Volatility

Large swings in gross margin month to month typically indicate revenue is being recognized based on cash flow, not actual service delivery.

2. Inconsistent Revenue Timing

If income aligns with bank deposits—not contracts or delivery dates—that’s a classic cash-basis symptom.

3. Minimal Accounts Receivable or Payable

Little to no AR/AP activity often signals a lack of accrual processes.

4. Prepayments Counted as Revenue

Customer deposits or retainers booked as revenue before the work is done? Big red flag.

5. Absence of Adjusting Entries

No monthly adjusting entries for deferred revenue, accrued expenses, or prepaids means accrual accounting isn’t being followed.

The Cost of Getting Revenue Regcognition Wrong

Misunderstanding or overlooking cash vs accrual accounting during a small business acquisition can have significant financial consequences. Imagine acquiring a business that reports $500,000 in annual revenue, only to discover later that half of it was from prepaid retainers for services that haven’t been delivered. Without making proper accrual-based adjustments, you could easily overpay for revenue that hasn’t been earned, assuming profitability that doesn’t actually exist. Worse, after closing, you’d still be responsible for fulfilling those services, meaning essentially taking on additional work without any new revenue to support it. That misalignment not only inflates profit metrics but could also severely impact post-acquisition cash flow and resource planning.

Consider another example: A digital marketing agency shows high earnings on paper due to upfront payments for 12-month service contracts, but their team is overloaded and already behind on deliverables. If revenue is recognized on a cash basis, it looks like the business is thriving. But once acquired, the new owner is burdened with months of unfinished work, potentially strained client relationships, and unexpected staffing costs. What looked like a profitable opportunity turns into an operational and financial headache. In today’s fast-moving, high-stakes M&A environment, these missteps can lead to value erosion, buyer’s remorse, and in extreme cases, a failed acquisition.

Choose Accrual Accounting for Smarter Financial Decisions

Cash vs accrual accounting may sound technical, but in a business acquisition, it can mean the difference between profit and peril. As a buyer, don’t rely on the seller’s simple cash-basis reports. As a potential seller, make sure your financials are accurate to avoid lost deals.
Whether you need help changing your revenue recognition from cash to accrual as your business grows, or you want to better understand the financial picture of a business you are hoping to buy, reach out to us here at Midwest CPA. We’d love to work with you.

Disclaimer

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.