In this video, we walk through 5 FAR practice questions teaching about preparing cash basis or modified cash basis financial statements. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Preparing Cash Basis or Modified Cash Basis Financial Statements
When preparing financial statements, businesses can choose between several accounting methods, with cash basis and modified cash basis being two popular options, particularly for small and medium-sized businesses. Understanding the differences between these methods is crucial, as they significantly impact how a company’s financial position and performance are reported. Here, we’ll explore cash basis and modified cash basis accounting, focusing on how they differ in handling property, plant, and equipment (PP&E), liabilities, cost of goods sold (COGS), and interest and income tax payables.
Cash Basis Accounting
Cash basis accounting is a simple and straightforward method that records transactions only when cash changes hands. Revenue is recognized when cash is received, and expenses are recognized when they are paid. This approach makes it easy to track cash flow but may not provide the most accurate picture of a company’s financial health.
- Pros:
- Simplicity: Easy to implement and understand.
- Immediate Cash Flow Insight: Provides a clear picture of cash inflows and outflows.
- Cons:
- Limited Financial Insight: Does not match revenues with expenses accurately.
- Excludes Accruals: Ignores accounts receivable, accounts payable, and other non-cash transactions.
Modified Cash Basis Accounting
Modified cash basis accounting is a hybrid approach that combines elements of both cash basis and accrual basis accounting. While it may recognize revenue and expenses when cash is received or paid (like cash basis), it also includes certain accruals, such as depreciation of long-term assets and accounts payable.
- Pros:
- Greater Detail: Incorporates key accruals for a more comprehensive financial picture.
- Flexibility: Offers a middle ground between cash basis and full accrual accounting.
- Cons:
- More Complex: Requires additional tracking of accruals.
- Not Fully GAAP Compliant: Modified cash basis is not acceptable for all financial reporting purposes.
Key Differences in Accounting Treatment
Property, Plant, and Equipment (PP&E):
- Cash Basis:
- PP&E is expensed entirely in the period it is purchased. There is no capitalization or depreciation, meaning large purchases can significantly affect net income in the year of purchase.
- Modified Cash Basis:
- PP&E is capitalized and depreciated over its useful life. This means the expense is spread out over several years, providing a more accurate reflection of asset usage and helping to smooth out net income over time.
Liabilities:
- Cash Basis:
- Liabilities such as loans or accounts payable are not recorded on the balance sheet. Expenses are recognized only when cash is paid, including payments on liabilities.
- Modified Cash Basis:
- Certain liabilities, like loans payable, are recognized. Interest expenses are accrued as they are incurred, even if they haven’t been paid. This provides a clearer picture of the company’s obligations.
Cost of Goods Sold (COGS):
- Cash Basis:
- COGS includes all cash paid for inventory during the year, regardless of when the inventory is sold. This method does not consider beginning or ending inventory levels, which can lead to mismatches between costs and related revenues.
- Modified Cash Basis:
- COGS is calculated by adding beginning inventory to purchases and subtracting ending inventory. This method matches the cost of inventory more closely with the revenue it generates, offering a more accurate measurement of profitability.
Interest and Income Tax Payables:
- Cash Basis:
- Interest and income tax expenses are recognized only when cash is paid. If interest accrues but is not paid by year-end, it is not recognized as an expense in the current period. Similarly, income taxes payable at year-end are not recognized as an expense until they are paid.
- Modified Cash Basis:
- Accrued interest is recognized as an expense in the period it is incurred, even if not yet paid. Income taxes payable are also recognized as an expense in the period they are incurred, reflecting the company’s current obligations.
Conclusion
Choosing between cash basis and modified cash basis accounting depends on a business’s needs and the level of financial detail required. Cash basis accounting offers simplicity and a clear view of cash flow but may not provide an accurate long-term financial picture. Modified cash basis, while more complex, offers a more detailed financial representation by incorporating key accruals such as depreciation, accounts payable, and accrued expenses.
Understanding these differences is essential for preparing accurate financial statements and making informed business decisions. For businesses that need more insight than cash basis accounting provides but aren’t ready to adopt full accrual accounting, modified cash basis offers a flexible alternative.
