Whether you’re running a small business with a team or doing your own solo freelance work, at a certain point you’re going to need to sit down and settle on an accounting method to keep track of your income and expenses in an organized, consistent way. As you may already be aware, the two basic methods of keeping track of your accounting are the cash basis and the accrual basis. What you may not know is that there’s actually a middle ground between these two methods that can apply in certain situations: introducing the modified cash basis of accounting.
Cash Basis vs Accrual Basis
Before we dive into the modified cash basis of accounting, let’s make sure we’re up to speed on the basics of the cash basis and accrual basis. After all, the modified cash basis is a hybrid of these two methods, so you’ll need to be familiar with the key elements of both if you’re going to apply the modified cash basis in your bookkeeping.
Under the cash basis, all of your transactions, whether they’re related to income or expenses, are recorded on the books when cash is actually received on a sale or paid out for an expense. In other words, transactions are recognized at the moment when there is an inflow or outflow of cash. This method is a bit simpler to manage, so it’s generally used by freelancers or small business owners who are just getting started.
The accrual method is much more commonly used in accounting. With this method, income is recorded when a sale is made, not when the payment itself (the cash) is received. Likewise with expenses, they are recorded when you receive the goods or services that constitute the expense and not when you pay the supplier/vendor for them. While it requires a bit more complex record keeping than the cash method, the accrual method offers a much clearer “big picture” of your company’s financial situation and can help you plan for your monetary needs down the line.
Short-term vs Long-term Items
The modified cash basis borrows elements from both the cash basis and accrual basis, which becomes clear in the way it handles short-term vs long-term items.
Short-term items – a regular monthly expense like a utility bill, for example – are recorded following the cash basis, i.e. when there is a related inflow or outflow of cash. This means that most of your income statement will be generated according to the cash basis.
When it comes to long-term items (i.e. those that will not change within a single financial year, such as a long-term investment in a property or a long-term debt), these are recorded on the accrual basis. In terms of your financial statements, this means that fixed assets and long-term debt are recorded on your balance sheet. The accrual basis is also followed in that both depreciation and amortization [link on “amortization” to amortization article if posted before this article] will be shown on your income statement.
When is the Modified Cash Basis Used?
You’re probably wondering why you would choose to apply the modified cash basis to your bookkeeping, rather than simply going with either the cash basis or switching to the more commonly used accrual basis.
Generally speaking, you might use the modified cash basis to get the advantages of the accrual basis in terms of having a clearer financial picture of your business, without actually having to deal with the cost and effort of switching from cash basis to accrual basis accounting entirely. If your business is privately held and your financial statements are only used internally, then the modified cash basis could be a viable option.
Be aware, though, that if your financial statements are going to be looked at by an outside party – whether it’s a bank where you’re trying to get financing, or by an auditor – the modified cash basis isn’t going to cut it, and you’ll have to convert the transactions that were recorded on the cash basis over to accrual. The modified cash basis is also not GAAP– or IFRS-compliant, so if you’re following those accounting standards, then the modified cash basis is off the table.
Not sure which accounting method is right for you? Reaching out to an accounting pro is always a good idea (especially since this article is intended for informational purposes, not legal or financial advice!). And if you need a helping hand switching from the cash basis to accrual within Kashoo, give us a shout anytime at email@example.com.