What is “Basis of Accounting?”

Understanding the accounting basis adopted by an organization is necessary for users to accurately interpret the organization’s financial statements. The accounting basis determines how financial transactions are recorded within the financial statements.

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There are multiple accounting bases used to prepare financial statements. A few of the most common are as follows:

1) Cash Basis of Accounting;

2) Accrual Basis of Accounting; and

3) Modified Cash Basis of Accounting.

How do these methods differ? 

The Cash Basis of Accounting recognizes transactions when they occur. Under this method, revenue is recorded when cash is collected, and expenses are recorded when cash is paid. 

The Accrual Basis of Accounting is the only method acceptable under Generally Accepted Accounting Principles (GAAP) under which revenue is recorded when earned and expenses are recorded when incurred, resulting in a proper matching of income and expenses. Fixed assets must be capitalized, and liabilities must be accrued. Public companies are required to use the accrual basis of accounting for financial statement reporting purposes.

The Modified Cash Basis of Accounting stems from both the cash basis and the accrual basis of accounting and combines the features of these two accounting methods. Under the Modified Cash Basis of Accounting, revenue is recorded when cash is collected and expenses are recognized when cash is paid (similar to the cash basis of accounting). However, fixed assets may be capitalized when purchased and debt may be accrued when incurred (similar to the accrual basis of accounting). The Modified Cash Basis of Accounting is, therefore, a hybrid of the cash and accrual basis of accounting.

When is the Modified Cash Basis of Accounting used?

While the Modified Cash Basis of Accounting is a “Non-GAAP” method of accounting, it is an acceptable method of accounting for non-public entities. It is designed to provide users with more information than a pure cash basis financial statement, while avoiding all the intricacies of an accrual basis financial statement required under GAAP.

The Modified Cash Basis of Accounting could be considered under any of the following conditions:

  1. Management uses cash basis financial data during interim periods and does not require complete accrual data on an interim basis for its decision-making process.
  2. Full accrual basis causes an administrative burden on the organization’s resources.
  3. Modified Cash Basis meets the financial statement user’s expectations for financial reporting.

Is the Modified Cash Basis right for your organization?

Which basis is most suitable for your Organization? Accrual basis results in GAAP-compliant financial statements and provides a more complete financial picture of the Organization but creates a more administrative burden. Cash basis is the easiest to produce but excludes fixed assets and long-term payables that could have a material impact on the financial statements. Modified Cash Basis is the hybrid approach.  

There is no one size that fits all when considering which basis best fits your organization. Always consider the users of the financial statements when accurately selecting the basis of accounting for your organization. The correct basis of accounting for your organization is the one that is most beneficial to the users of the financial statements.

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