Financial Statements for Lawyers: Cash and Accrual

Two sets of financial statements for a company that cover the same time period can both be technically correct yet display dramatically different values. The key to effective financial discovery means knowing what to request.

By Jeff Compton and Jeff Davidson
May 05, 2014
Originally published in Texas Lawyer.

Two sets of financial statements for a company that cover the same time period can both be technically correct yet display dramatically different values. The key to effective financial discovery means knowing what to request.

To understand these differing results, lawyers need to know a little bit about the two common methods used to prepare financial statements: cash basis and accrual basis.

All of us experience the cash method of accounting regularly; our bank accounts show only cash in and cash out of our accounts. However, United States accounting guidelines, called Generally Accepted Accounting Principles (GAAP), recognize economic events regardless of when cash comes in; this is known as accrual accounting.

In contrast, accountants record transactions on the company’s books when rights and obligations arise—say, when the company issues or receives an invoice, regardless of when the cash is received or paid. Accrual accounting uses double entries to record transactions, meaning each entry on the books has an equivalent entry in an opposing account; e.g. completion of a sale generates both revenue and an account receivable before the cash comes in. This is what we mean in saying that the books “balance.”

Understanding the resulting financial statements depends upon understanding their method of preparation. Asking the right questions produces valuable information. Consider the following hypothetical situation:

Allen Attorney obtained judgment on behalf of his client against ABC Manufacturing. The balance sheet that ABC provided in response to Allen’s post-judgment discovery showed a little cash, some equipment of questionable value and bank debt greater than the assets. In other words, ABC appeared insolvent with little promise of satisfying Allen’s judgment.

Frustrated, Allen rang Carol CPA to talk. Carol had helped Allen before by using her skills to explain the facts of financial statements to Allen. With Carol on the phone, Allen read the figures from the balance sheet. When he finished, Carol had two questions: Did Allen have an operating statement showing profitability? Did he see a label in the upper left corner of the balance sheet saying “cash” or “accrual”?

In response to the first question, Allen explained he did not know the profitability because he did not have the operating statement. With regard to the second question, the word “cash” appeared in the upper left.

Carol began by exploring what they did have: the balance sheet showing liabilities were greater than assets on its face. She said this was technically a “modified cash basis” balance sheet because assets other than cash appeared. But she and Allen needed to see the accrual basis balance sheet showing all the assets.

Fortunately, she said, this was likely just asking the debtor to click a different box in the software to print the accrual version so all the assets could be viewed. With regard to the operating statement and its reflection of profitability, she likewise described how it should already exist and simply requires a software command to see it on both an accrual and a cash or modified cash basis.

Allen went back to the debtor’s counsel and obtained the accrual basis balance sheet along with the operating (income) statement. He got the latter in the two forms, representing cash and accrual. At Carol’s request he had obtained the electronic data files for the accounting software as well as the printed reports. He got this information to Carol and asked her to call him after reading it.

When Carol called, they discussed the accrual basis balance sheet first. Even without her analysis, Allen had seen a big change on the printed form. In addition to the cash, equipment and bank debt, two new accounts showed up, accounts receivable and accounts payable. The former represents an asset and the latter a liability. Importantly, the account receivable asset was far greater than the account payable. Now, in Allen’s mind, ABC appeared to be solvent and had substantial accounts receivable to potentially satisfy the judgment.

Why would the two operating statements, one cash basis and the other accrual basis, differ so much? The accrual version showed a larger profit.

Carol had, of course, noticed the difference as well. She explored the electronic detail to determine why the accrual version operating statement was more profitable than the cash version.

She offered Allen two valuable insights.

  1. The cash version showed money the company was collecting and spending versus earning or accruing. She explained that, as she had delved further, she found ABC had accelerated its collections of amounts due from customers during the period just before trial. Moreover, ABC had accelerated payments to certain creditors which appeared to be insiders.
  2. $20 of those cash collections had been distributed to the owner of ABC also just before trial. This occurred through neither the asset nor liability accounts but rather through the equity account. Carol said this explained the small amount of cash appearing on both the cash and accrual balance sheets. Allen realized that, in addition to the accounts receivable, he also had a potential claim against the owner for distributions made shortly before trial.

Jeff Compton is a shareholder in and Jeff Davidson is a consultant with Houston CPA firm Compton & Wendler. Compton regularly investigates suspected fraud. He is also accredited in business valuation by the American Institute of CPAs and is a certified fraud examiner.