What is Modified Cash Basis? And Why Use Modified Cash Basis Accounting?

Introduction:

A modified cash basis of accounting, also known as the hybrid basis of accounting is the accounting policy that certain accounting items are recognized in the entity’s financial statements under the accrual principle and certain items are recognized at the cash principle.

The modified basis is not followed any financial reporting standards including IFRS, US GAAP, as well as local GAAP.

  • Cash basis accounting: A bookkeeping method in which a business records only cash transactions during an accounting period. Income or revenue is recorded when cash is received, while expense is recorded when cash is disbursed.
  • Accrual basis accounting: A bookkeeping method in which transactions are booked per the matching accounting concept. Income is recorded when it is earned and expense is recorded when it is incurred, irrespective of when cash is received or disbursed. 
  • Modified cash basis accounting: A bookkeeping method that is based on a cash basis however, modifications are made to incorporate the accrual basis of accounting as well. It is a hybrid of cash basis and accrual basis of accounting.

Explanation:

The modified cash basis system allows you to modify the pure cash basis accounting system. In fact, there is no definite set of rules for you to follow and it is up to you where and when you want to make the modifications.

The transactions are usually divided into two categories and are recorded in the following manner:

  1. Short-term items: All the short-term items like monthly expenses, which occur throughout the financial year, are booked on a cash basis of accounting. These include utility bills, rent, raw materials, etc. This also implies that no accounts receivable and inventory are being reported on the balance sheet as they are reported on a cash basis on the income statement.
  2. Long-term items: On the other hand, long-term items that do not change within an accounting period, are booked and reported on the balance sheet as per accrual basis. This includes fixed assets, long-term investments, or long-term debt. Similarly, depreciation and amortization are reported on the income statement as well.
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A modified cash basis accounting system is used when the firm wants to represent its financial statements more accurately and precisely than cash basis accounting but does not want to invest the money and time in an accrual basis accounting system. 

It is the middle ground used to better evaluate your financial performance by maintaining accounts like inventory and purchases, which is impossible in a cash basis accounting system.

Why use modified cash basis accounting?

A modified cash basis accounting system has several advantages for a small or start-up firm.

  • It is easy, simple, and inexpensive as compared to the accrual basis of accounting. 
  • It is flexible to use since it allows you to make your own modifications. While using cash basis accounting, you can make accrual adjustments if you want to keep a good check on a particular item that is not included in the cash basis accounting. For example, if you want, you can maintain an inventory and cost of goods sold account even when using the cash basis of accounting for your business.
  • The modified cash basis of accounting isn’t complex like the accrual basis of accounting; it does not involve management’s judgment for estimating particular items like warranty or provision for bad debts. 
  • As compared to a cash basis accounting system, a modified cash-basis accounting is based on a double-entry system. Hence, it is a comprehensive representation of your business except it is in contradiction to the Generally Accepted Accounting Principles (GAAP).

Conclusion:

If you’re a firm that is not obliged to prepare financial statements as per the International Financial Reporting Standards (IFRS) and GAAP by the Financial Accounting Standards Board (FASB), then a modified cash basis accounting system can be one of the best options for you to maintain your business’s books.

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