DEFINITION of Modified Cash Basis
The modified cash basis is an accounting method that combines elements of the two major accounting methods: the cash method and the accrual method. The cash method recognizes income when it is received and expenses when they are paid for. The accrual method recognizes income when it is earned (for example, when the terms of a contract are fulfilled) and expenses when they are incurred. The modified cash basis method uses accruals for long-term balance sheet elements and the cash basis for short-term ones.
BREAKING DOWN Modified Cash Basis
Because both accounting methods have limitations, a business may use a modified cash method to develop what it feels is a more accurate picture of its finances. The modified cash method may be used for internal purposes because it does not comply with the Generally Accepted Accounting Principles (GAAP), which outline what companies must follow when preparing their officially reported financial statements. As a compromise between cash and accrual base methods, modified cash basis accounting methods are a middle ground.
By borrowing elements from both techniques, the modified cash basis method can better balance short-term and long-term accounting items. Short-term items, like a regular monthly utility expense (a bill), are recorded according to the cash basis (as there is a related inflow or outflow of cash), which results in an income statement largely populated with items based on the cash basis. Long-term items which do not change within a given financial year, such as a long-term investment property, plant and equipment, are recorded using the accrual basis.
When Might the Modified Cash Basis Be Used?
To avoid the expense and effort in swapping from the cash basis to an accrual basis, the modified cash basis method has the advantage of accrual basis methods which produce a clearer picture of business performance, which may be practical for a small or private business. However, if financial statements are subject to formal reviews, such as analysis performed by auditors, investors or a bank, the modified cash basis method will prove inadequate. Deeper financial analysis methods will require transactions recorded by a cash basis to be converted to accruals methods, as the modified approach is not GAAP or International Financial Reporting Standards (IFRS) compliant.