Modified Cash Basis

It is a term used to describe an accounting approach that combines elements of both accrual and cash basis

Author: Himanshu Singh
Himanshu Singh
Himanshu Singh
Investment Banking | Private Equity

Prior to joining UBS as an Investment Banker, Himanshu worked as an Investment Associate for Exin Capital Partners Limited, participating in all aspects of the investment process, including identifying new investment opportunities, detailed due diligence, financial modeling & LBO valuation and presenting investment recommendations internally.

Himanshu holds an MBA in Finance from the Indian Institute of Management and a Bachelor of Engineering from Netaji Subhas Institute of Technology.

Reviewed By: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Last Updated:October 25, 2023

What Is Modified Cash Basis?

This accounting method, commonly referred to as hybrid accounting, aims to combine the advantages of accrual and cash basis accounting.

  • Cash basis accounting: A type of bookkeeping in which a company only records cash transactions for the duration of an accounting period. Cash receipts are documented as revenue, and cash disbursements are recorded as expenses.

  • Accrual basis accounting: recording transactions regardless of when cash is received or dispersed.

Revenues are reported when earned, and expenses are recorded when they are incurred.

  • Modified cash basis accounting: a type of bookkeeping that is based on the cash basis method but also incorporates the accrual basis of accounting. Hence, it combines the cash basis of accounting and the accrual basis.

A quick review of the accrual basis and cash basis methods:

  • Only when cash is received or paid are revenues and expenses recorded under the cash basis of accounting. For instance, until they receive a check and it clears the bank, a freelancer wouldn't record revenue.

  • Revenue is recorded as it is earned (i.e., when goods or services are delivered), and expenses are recorded in the same period as they are incurred in accrual basis accounting. 

Even though the check is still in the mail, or hasn't even been sent yet, a freelancer using the accrual basis method would record income after finishing an assignment.

  • A modified cash basis takes elements from both systems.

Modified versus pure cash basis:

Only cash accounts are used in cash basis accounting. When it's necessary to record things like received revenues, cost of goods sold, financing from equity, and paid expenses, it works well. 

It falls short when it comes to accrual accounts for some key line items, including fixed assets, loans, other debt, or inventory. It also can't always be used to perfectly match revenues to expenses.

On the other hand, accrual accounts and cash accounts can both be recorded using this accounting method.

However, because there are more accounts and more transactions that need to be recorded, it's more complex than cash basis accounting.

Understanding Modified Cash Basis

It is a term used to describe an accounting approach that combines elements of both accrual and cash basis. The preparation of reports using the cash basis of accounting and the incorporation of accrual adjustments is known as hybrid accounting.

Rules governing GAAP and IFRS are not followed by this type of accounting. As a result, small and/or private enterprises typically use it for internal accounting needs.

Private small enterprises, manufacturers, some construction firms, and merchants typically use this system for internal accounting purposes. Every time there is a cash component, a transaction is recorded using cash basis rules. 

As a result, a revenue entry will be made whenever cash is received, and an expense entry will be made whenever cash is paid. 

However, according to accrual accounting concepts, revenue is recognized when it is earned, and expenses are recorded whenever they are incurred. 

This approach balances the specifics of short-term and long-term accounting items by utilizing both the cash and accrual basis methods. 

By recognizing revenues and expenses for long-term assets on an accrual basis and those for short-term assets on a cash basis, it tries to be the best of both worlds. 

It is intended to act as a cost-effective alternative to a pure accrual accounting system.

Another way this method combines aspects of accrual and cash basis of accounting is by adding accrual adjustments to internal cash basis reports.

Why use these accrual adjustments? Businesses frequently desire more information than cash basis accounting alone can offer, but they may not have the money or labor capacity required to keep a set of accrual books.

With the use of double-entry accounting, a full set of financial statements can be created from the transactions that arise. Using only the single entry method is not compatible with modified cash basis accounting.

This accounting system tracks revenue as it is received and recognizes expenses as they are paid. 

Because this approach does not use the accrual basis for short-term items, revenues and costs that have been incurred but have not yet been paid or received are not included in the financial statements. 

Small enterprises and charitable organizations often employ this accounting because it is less expensive and complex than the accrual basis but more insightful and flexible than the cash basis.

Modified Cash Basis: Basics

First, it is crucial to analyze how this hybrid model affects conventional bookkeeping techniques to understand how this system works.

When using the cash basis accounting method, revenue is recorded as it is received, and expenses are recognized as incurred. Its simplicity is by far its greatest benefit. 

On the other hand, accrual accounting tracks expenses regardless of cash flow and records income when a sale is fulfilled instead of when it is paid for. 

Accrual accounting is a little more difficult. However, the ability for a company to match its revenues and associated costs, as well as comprehend what it costs to run the organization each month and how much it makes, is quite beneficial.

Depending on the type of asset, this incorporates aspects of both cash and accrual accounting. It has the following characteristics:

  • Like cash-based accounting, it records short-term assets such as accounts receivable (AR) on a cash basis on the income statement.

  • The balance sheet includes longer-term assets, including fixed assets and long-term debt. Depreciation and amortization are on the income statement, just like in accrual accounting.

Converting to a hybrid basis:

You can convert transactions compiled on a pure cash basis accounting system to a hybrid system using two basic principles. 

Note that there are no established guidelines that you must adhere to, and you decide where and when to make the changes. If you’re using the modified cash basis for tax or internal accounting purposes, be sure to be consistent.

The transactions are often broken down into two categories and documented as follows:

  1. A cash basis of accounting is used to record all short-term items, such as monthly expenses that are incurred during the fiscal year. These consist of expenses for rent, utilities, inputs, etc. 

  2. Long-term items, on the other hand, are recorded and reported on the balance sheet using the accrual method, even if they do not change throughout an accounting period. This includes long-term investments, fixed assets, or debt. 

Similarly, the income statement also includes information about depreciation and amortization.

1. Double-entry accounting is used with the modified cash basis. It necessitates the creation of an equivalent and opposing entry in a different account for each entry. 

A single-entry accounting system cannot produce an accounting record in this system because it maintains a bare minimum cash account system and doesn’t account for some needed line items.

2. It records short-term items using the cash account. Almost all components of the income statement are recorded using a cash basis. 

This means that certain short-term line items typically found on the balance sheet aren’t on it. 

3. On the balance sheet, long-term items are recorded using the accrual basis method. 

The balance sheet contains long-term obligations and fixed assets, and the income statement shows the depreciation and amortization related to those fixed assets.

4. It is prohibited by both International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). 

While this method is closer to the GAAP-approved accrual-basis method than the pure cash basis method, an external auditor won’t approve financial statements prepared using the modified cash basis. 

Of course, it’s easier to change hybrid transactions to the accrual basis system than for transactions recorded using a pure cash basis. 

They’ll have to convert transactions recorded using the cash basis to make them accrual-based and make sure line items are in their proper place - e.g., inventory on the balance sheet.

When GAAP or IFRS compliance is not required, it can be quite useful. Privately held companies may use it if it creates financial statements for internal use.

5. This approach provides financial data that is more pertinent than the data that can be gathered using the cash basis method, without the high costs of the accrual method.

As a result, this method might be considered a good middle ground between the two methods.

If it is employed, transactions should be handled consistently to ensure that the resulting financial statements are comparable over time.

Advantages of Modified Cash Basis

Some of the advantages are:

By combining aspects of both accounting methods, this approach can better balance the importance of short-term and long-term accounting items. 

An income statement is primarily filled with items based on a cash basis since short-term items, like a regular monthly rent, are best recorded according to the cash basis.

The cash basis works well for these short-term items because there's an associated receipt or outflow of cash. Hence, using the cash basis for these items can also help businesses track their cash flows more closely.

The accrual basis is used to report long-term assets, like fixed assets that don't change over a fiscal year.

While using cash basis records for other expenses helps keep accounting costs low, the accrual basis procedures provide a clearer picture of the business performance and the state of fixed assets. 

Maintaining a set of complete accrual accounting records takes much more work and isn't ideal for all firms.

Disadvantages of Modified Cash Basis

The disadvantages are:

This method will be insufficient for producing financial statements used for external purposes, such as an examination by auditors, consideration by potential investors, or securing a bank loan.

Because it does not adhere to the GAAP or IFRS financial statement preparation guidelines, the modified cash method is only permitted for internal use.

It’s also important to remember that there is no major standardization of the modified cash basis - this is part of the reason it’s not suitable for preparing financial statements or filings. 

This is part of why using this method prevents publicly traded corporations from having auditors certify their financial statements.

This accounting method is therefore common among private or small enterprises. 

Transactions recorded on a cash basis must be converted to accrual transactions to maintain consistency, which can be time-consuming. This also means that firms who use the modified cash basis may be partially duplicating their efforts. 

IFRS and GAAP require the use of the matching principle, where expenses are recognized in the same period as the associated revenues, not when they are paid.

Companies that had an average yearly total revenue of less than $25 million over the last three years may opt to use the accrual or cash accounting method for tax reporting purposes.

Modified Cash Basis illustrations

How does this affect your financial situation or business operations? Depending on the circumstances around you or your business, that could vary. 

The distinction between short-term and long-term items is one characteristic of a modified cash basis.

Any short-term item is recorded on the income statement using a cash basis, such as recurring monthly costs (rent, facilities, internet). The income statement, like in the accrual method, still contains depreciation and amortization. 

The accrual method is used to record long-term items on the balance sheet that don't change considerably over the fiscal year, such as fixed assets or property, plant, and equipment.

Why do some businesses use a hybrid system?

This accounting system provides various benefits for a small or newly established business. In comparison to the accrual basis of accounting, it is straightforward, easy, and affordable. It also provides a lot more insight than the pure cash basis model.

Given that you can change it as you see fit, it is very flexible and can be easily changed to best fit your business needs. 

You can make accrual adjustments while using cash basis accounting if you wish to maintain a close eye on a specific item that is excluded from cash basis accounting. 

You can, for instance, continue to use the cash basis of accounting in your company and still maintain accounts for long-term obligations like loan repayments. 

Unlike the accrual basis of accounting, this hybrid system doesn’t involve complex estimates of specific items like warranties and bad debt provisions. This accounting system is less difficult.

This accounting system is based on a double-entry system as opposed to a cash basis accounting system. Consequently, it accurately portrays your company’s short- and long-term status.

Making use of modified cash basis accounting

With this method of accounting, long-lived assets and inventory are recorded using accrual basis accounting, while revenue and the majority of expenses are recorded using cash basis accounting. 

This means that this accounting method also requires adjusting entries through accrual accounts. 

Although there are no hard and fast accounting rules for this basis of accounting, we can describe how some line items are generally treated. This is shown below:

Line Item Recognition Method
Assets with a long lifespan Use accrual accounting.
Revenue Recognize after receiving cash payment.
Current assets Cash and inventory accounts are often recognized on a cash basis. When pre-paid costs are significant, such as rent, some entries will recognize them on an accrual basis.
Cost of goods sold Calculated using a periodic inventory system. Changes in inventory levels are processed using the cash basis.
Long-term liabilities Loans are valued at cost.
Operating expenses Payments made to suppliers and employees are acknowledged when cash goes out to pay them.
Current liabilities Not always acknowledged. Some organizations could accrue costs.
Depreciation costs and gains/losses from asset sales Calculated and recognized using accrual accounting.
Equity Recognized on a cash basis.

Modified Cash Basis FAQs

Researched and authored by Deeksha Pachauri | LinkedIn

Reviewed and Edited by Sara De Meyer | LinkedIn

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