Cash-basis books record revenue when customers pay and expenses when bills are paid; accrual books record them when earned and incurred. Cash accounting can shift revenue and profit between years, hide receivables, payables and inventory from the balance sheet, and make margins swing with the timing of payments. Lenders reconcile cash-basis statements to tax returns and bank statements, and can underwrite some term and SBA loans that way. A line of credit, a borrowing base or a covenant package needs accrual numbers. Converting the books properly beforehand avoids surprises in underwriting.
- Cash basis
- Revenue when collected, expenses when paid
- Accrual basis
- Revenue when earned, expenses when incurred
- What cash books hide
- Receivables, payables, accrued costs, often inventory
- Where cash basis can work
- Smaller term and SBA loans underwritten on tax returns
- Where accrual is needed
- Lines of credit, borrowing bases, covenants, acquisitions
What the difference actually is
Under the cash basis, a sale is recorded when the customer's money arrives and an expense when the business pays it. Under the accrual basis, the sale is recorded when the work is done or the goods delivered, whether or not the customer has paid, and the expense when it is incurred, whether or not the bill has been paid. GAAP requires accrual. Many private companies keep cash or modified cash books anyway, because the tax rules allow smaller businesses to file on the cash basis and it is simpler to run the books the way the return is filed. See the glossary entry on accrual vs cash basis.
Over a long enough period the two methods arrive at the same total profit. The problem for a lender is that it does not lend over a long enough period. It lends against the last year or two, the trailing twelve months and the balance sheet today, and those are exactly where the two methods can disagree.
How cash-basis books distort the picture
| What the lender looks at | Effect of cash-basis books | Why it matters |
|---|---|---|
| Revenue | Lags sales in a growing business; can run ahead in a shrinking one | Growth or decline is misstated in the year the loan is sized on |
| Margins and EBITDA | Swing with when bills are paid; year-end prepayments cut profit | The earnings a loan is sized on may be understated or overstated |
| Receivables | Absent from the balance sheet | Nothing to build a borrowing base on; collection problems invisible |
| Payables and accrued costs | Absent | Liabilities the business owes do not appear; working capital overstated or unknown |
| Inventory | Often expensed when bought | Cost of goods sold jumps in purchase months; collateral value unknown |
| Deferred revenue | Customer deposits counted as revenue when received | Profit recognized before the work is done |
| Trends month to month | Driven by payment timing, not the business | Interim statements cannot be compared reliably |
The most common distortion is deliberate and perfectly legal. Near year-end, a cash-basis business pays suppliers early, prepays expenses and delays invoicing to lower taxable income. It works for taxes. It also lowers the earnings the lender sees, sometimes by enough to change the loan amount. The reverse happens too: a business that collected a large receivable or a customer deposit just before year-end looks more profitable that year than it was.
A worked conversion
Consider a distributor whose cash-basis P&L shows revenue of 4,000,000 and profit of 300,000 for the year. Over the year its receivables grew from 300,000 to 600,000, its unpaid supplier bills grew from 150,000 to 250,000, and in December it prepaid 120,000 of next year's expenses to reduce its tax.
| Step | Adjustment | Profit after the step |
|---|---|---|
| Cash-basis profit | 300,000 | |
| Add growth in receivables (revenue earned, not yet collected) | +300,000 | 600,000 |
| Deduct growth in unpaid bills (costs incurred, not yet paid) | −100,000 | 500,000 |
| Add back next year's expenses prepaid in December | +120,000 | 620,000 |
On an accrual basis this business earned roughly twice what its cash books show, and it had 600,000 of receivables that could support a line of credit and 250,000 of payables the lender needs to know about. Neither the earnings nor the collateral is visible on the cash statements. For a shrinking business, or one that collected unusually well at year-end, the conversion can go the other way and reduce earnings. Either way, the lender will find the difference; the question is whether the borrower has already explained it.
How lenders reconcile cash books to tax returns
Lenders start from the tax returns, because those are verified with the IRS, and work outward. The checks are consistent across lenders:
- Revenue on the P&L against revenue on the return. They should match if both are cash basis; any difference needs an explanation.
- Revenue against bank deposits. Deposits, less transfers, loan proceeds and owner contributions, should tie to cash-basis revenue. See seller financials vs tax returns.
- An aging of receivables and payables at year-end and today. This lets the lender estimate the accrual picture even when the books do not show it.
- Owner and one-time items. Prepayments and timing moves around year-end are treated like other adjustments: accepted if documented, discounted if not.
For an SBA 7(a) loan or a smaller conventional term loan, this reconciliation is often enough. The lender sizes the loan on cash flow from the returns, tests debt service coverage against it, and accepts cash-basis statements that tie. What it will not do is lend against earnings it cannot find in either the returns or the bank.
Why lines of credit and covenants need accrual
A borrowing base is built from receivables and inventory. Asset-based lenders typically advance 80% to 90% of eligible receivables, exclude invoices more than 90 days past invoice date, and commonly cap any single customer at 20% to 25% of eligible receivables. None of that can be calculated from books that do not record receivables. The lender needs an AR aging by customer with days outstanding, an AP aging and, if inventory is in the base, an inventory report, all of which assume accrual-basis records. See how a borrowing base works.
Covenants have the same need. A fixed charge coverage or leverage covenant is tested quarterly on EBITDA defined in the loan agreement, which assumes accrual accounting. On cash books, a covenant test can fail because a large customer paid a week late, and pass because the owner held back supplier payments, neither of which tells the lender anything about the business. Lenders are reluctant to set covenants on numbers that move like that.
Acquisitions push the same way. A buyer's lender sizes on adjusted EBITDA and sets a working capital peg, both accrual concepts; a quality of earnings report on a cash-basis target starts by converting it.
Converting before the financing, not during it
The conversion is routine accounting work, but it is better done by the company's own accountant before lenders see the file than by a lender's analyst during underwriting. A lender that discovers the accrual picture itself has to decide which version to believe, and the answer is usually the more conservative one.
- Restate the last two or three fiscal years and the year to date on an accrual basis, with a bridge from the cash-basis figures showing each adjustment.
- Ask the tax accountant whether the return can stay on the cash basis. Many businesses give lenders accrual statements and file on the cash basis where the tax rules allow, with a reconciliation between the two.
- Close the books monthly on an accrual basis from now on, so interim statements and the year-to-date P&L through last month-end are comparable.
- Produce AR and AP agings that tie to the balance sheet.
- Decide on a statement level with the accountant; see audited vs reviewed vs compiled.
Hand the lender the bridge from cash to accrual yourself. An explained difference is an adjustment; an unexplained one is a question mark on the earnings.
Where a business keeps cash books, its lender file should carry both views: the tax-return figures a lender verifies, the accrual figures a line or covenant is set on, and the bridge between them. Transparent's underwriting memo shows that arithmetic, so every lender reads the same reconciliation rather than building its own. See how we underwrite and sizing a working capital line.
Common questions
- Can I get a business loan with cash-basis financial statements?
- Often, yes, for term loans and SBA loans underwritten on tax returns, provided the statements reconcile to the returns and bank deposits. A line of credit, an asset-based loan or a loan with financial covenants will need accrual-basis numbers.
- Do I have to change how I file my taxes?
- Not necessarily, but it is a question for your tax accountant. Many businesses give lenders accrual-basis statements and file on the cash basis where the tax rules allow it. What the lender needs is a clear reconciliation between the two.
- What is modified cash basis?
- A hybrid in which most items are recorded on a cash basis but some, such as fixed assets and depreciation, and sometimes inventory or loans, are recorded as under accrual. It narrows the gap but still leaves out receivables and payables in most cases.
- Will converting to accrual raise or lower my earnings?
- It depends on the direction of the business. A growing company with rising receivables usually shows higher accrual earnings; a shrinking one or one that collected unusually well at year-end may show lower. Year-end prepayments made for tax reasons are added back either way.
- Why can't the lender just use my bank statements?
- Bank statements confirm that cash came in, and lenders use them for that. They do not show what customers still owe, what the business owes suppliers, or what inventory it holds, which is what a line of credit and its covenants are built on.