Modified Cash Basis: Definition & Overview

KEY TAKEAWAYS

• Modified cash basis accounting is a hybrid accounting method. 
• It takes elements from both cash and accrual accounting methods. 
• Short-term assets are recorded using the cash basis accounting method, while  long-term assets are reported on an accrual basis.
• This method helps to provide more relevant financial information than the cash basis alone. It is also a cheaper method to use when compared to accrual accounting. 
• Modified cash basis is not GAAP or IFRS compliant.

What Is Modified Cash Basis?

Modified cash basis is an accounting method often used by smaller businesses that are not required to provide audited financial statements. It works by combining elements of two of the primary bookkeeping methods: cash and accrual accounting. 

The aim of this system is to take the best elements from each method. Income and short-term expenses are recorded using the cash basis and long term debt and expenses for long term assets are recorded using the accrual basis. It seeks to provide a clearer, more defined financial picture without having to deal with the costs of switching to a full-blown accrual method of accounting. 

Advantages Of Modified Cash Basis

The modified cash basis method of accounting can better balance both long-term and short-term accounting items. This is because it borrows separate elements from both techniques. 

Short-term items such as monthly bills and cash collected for sales are recorded according to the cash basis. Long-term items that do not change within a financial year, such as a long-term investment, are recorded using the accrual method. 

By using the accrual basis method for some transactions, you end up with a clearer financial picture of your business performance. The cash basis elements help to record other, short-term items, and keep down costs where possible. Doing your books  according to the accrual method would take far more time and resources. 

Disadvantages Of Modified Cash Basis

The modified cash basis has its downfalls. If your business is subject to a formal review by an auditor, investors, or a bank, then this method will fall short of their requirements. The business will have to adjust their financial statements to the accrual basis. 

The modified cash basis can only be used for internal purposes. This is because it doesn’t comply with the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS). These sets of rules outline what procedures companies have to follow when they prepare their official financial statements. 

Modified Cash Basis Features

To properly understand how a modified cash basis operates, you first need to break down how traditional bookkeeping practices are influenced by function. 

Accrual accounting recognizes income when a sale is fulfilled. This is opposed to recognizing it when it is paid for. It records expenses incurred, regardless of cash movement. Accrual accounting is the more complicated of the two methods; however, it allows a company to match its revenue and its associated expenses, understand the cost of running the business each month, as well as how profitable the company is.

In contrast to this, cash basis accounting recognizes and records income when cash is received. It also recognizes expenses at the point at which they are paid for. Cash accounting measures a company’s net operating cash flow. This makes it a completely straightforward and easy-to-understand method of accounting. 

The best of both worlds is the modified cash basis accounting, which borrows elements from both accrual and cash accounting. The elements used from each of the accounting methods  depend on the nature of the asset. The features of this method are as follows:

Short-term assets

Short-term assets such as accounts receivable (AR) and inventory are recorded on a cash basis on the income statement. This is similar to cash basis accounting.

Long-term assets

Long-term assets such as long-term debt and fixed assets are recorded on the balance sheet. In a similar way to accrual accounting, amortization and depreciation also appear on the business’s income statement.

Uses Of Modified Cash Basis

The modified cash basis method of accounting is popular with private companies. This is because publicly traded companies are required to follow GAAP when preparing their financial statements.  

For tax reporting purposes, a business with average annual gross receipts of less than $25 million over the last 3 years can choose either the cash or accrual accounting method. Businesses can also use the modified cash basis to record short-term items such as monthly bills and long-term items such as property. 

Businesses can also use the modified cash basis to record short-term items such as bills and long-term items such as property. 

It also works when a business has to deal with double-entry accounting and bookkeeping. For every entry to an account, you can create both opposite and corresponding entries to a different account. 

Summary

The modified cash basis method of accounting is a useful and well-designed system. However, as it doesn’t align with the standards of both IFRS and GAAP, it cannot be used officially by public companies, and therefore can only be used internally. This makes it impractical for a number of businesses that trade publicly, or are required to provide audited financial statements.