Accounting and Auditing ,
Preparation, Compilation & Review
You’ve been contacted by your client to prepare their financial statements and issue a compilation report. At first, you think, “I’ll create the financials in accordance with GAAP,” but then you remember there are special purpose reporting framework options. Maybe the cash basis or tax basis is better for your client.
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Special Purpose Reporting Frameworks
What is a special purpose reporting framework? It is a reporting framework other than generally accepted accounting principles (GAAP) that is one of the following:
- Cash basis
- Tax basis
- Regulatory basis
- Contractual basis
- Other basis (as long as the basis uses reasonable, logical criteria that are applied to all material items)
Let’s begin our exploration of special purpose reporting frameworks by examining the simplest basis: the cash basis.
While a pure cash basis financial statement is the easiest to create, it may be too simple. After all, you only create one financial statement. For example:
Statement of Cash Receipts and Disbursements
For the Year Ended December 31, 2016
Total Receipts XX
Total Disbursements XX
Increase in Cash XX
Beginning Cash XX
Ending Cash $XX
Notice there are no accruals and no balance sheet. When the company spends and receives cash, the transaction is recorded; otherwise, there is no entry. So who might benefit from the pure cash basis? The cash basis might be useful for a small nonprofit, a trust, or a student activity fund.
If the cash basis is not an appropriate solution, then consider another special purpose reporting framework: the modified cash basis.
Modified Cash Basis
Using the modified cash basis, you can present a balance sheet, an income statement, and a cash flow statement. It is, however, permissible to create just one statement–such as the income statement–and issue a compilation report. If you present a balance sheet and an income statement, the cash flow statement is optional.
What Modifications to Cash are Permissible?
SSARS 21 defines cash basis as a basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support (for example, recording depreciation on fixed assets). So we see that modifications to the cash basis are permissible under SSARS 21.
A modification to the cash basis is considered to have substantial support if it is equivalent to GAAP and is not illogical. What is an example of an illogical modification? The balance sheet includes accrued receivables but no payables are recorded. If such a presentation were allowed, the company’s financial health would appear stronger than it is.
Difference in Cash Basis and Modified Cash Basis
So how does the modified cash basis differ from the cash basis? Using the modified cash basis, you can record an item on a balance sheet when the transaction involves cash. So if a company loans cash to an outside party, a loan receivable could be recorded on the balance sheet. (If the cash basis is used, the loan is reflected as a disbursement.) The accounting entry for the loan is as follows:
Loans Receivable XX
Since cash is a part of the entry, it is okay to record the loan on the balance sheet using the modified cash basis.
But if a company sells inventory on credit it would not record the transaction–no cash is involved in the transaction. The same is true of payables–they are not booked since cash is not a part of the entry. To accrue a payable (amount owed to vendors), the entry is as follows:
Supplies Expense XX
Accounts Payable XX
We do not record the payables on the balance sheet. Why? Because cash is not a part of the entry.
So when a company pays cash for inventory or plant, property, and equipment, then those assets can be reflected on the balance sheet. (Also, plant, property, and equipment can be depreciated.) The same is true when the company obtains a loan–cash is received, so the debt can be recorded on the balance sheet.
Transactions that Should Not be Recorded
What are some examples of transactions that should not be recorded using the modified cash basis? Here are a few:
- Purchase of assets with a capital lease
- The receipt of donated equipment
- The receipt of donated investments
- Receivables when cash is not loaned (e.g. accounts receivable)
- Payables when cash is not received (e.g., accounts payable)
- Accrued interest
Ill-Defined Recognition Criteria
The modifications of the cash basis are not defined in auditing or SSARS guidance. In other words, there is judgment in selecting the modifications. Does this make you uneasy? Is the modified cash basis too ill-defined for you? If yes, you may find the tax basis of accounting a better option.
In using the tax-basis, the transaction recognition criteria is simpler than that of the modified cash basis of accounting. Just ask, “Is this transaction recognized on the tax return?”
What financial statements can be presented using the tax basis? You can present just one financial statement (e.g., balance sheet), or you can present the balance sheet (referred to as the statement of assets, liabilities, and equity-tax basis) and the income statement–with or without the cash flow statement.
What entities can use the tax basis of accounting? Any entity that files a return with the IRS–either an income tax return or an information return. So a nonprofit that pays no taxes can use the tax basis, but a government that files no return could not. Those entities that can use the income tax basis include:
- C corporation
- S corporation
- Nonprofit corporations
- Sole proprietors
As we have seen in an earlier post, if you prepare a tax return for a client, then tax basis is the most efficient way to deliver financials.
Advantages of Special Purpose Frameworks
Special purpose reporting frameworks provide certain advantages including:
- If the tax basis is used and you prepare the tax return, there is no conversion to GAAP
- No cash flow statement is required
- Special purpose frameworks are often easier to prepare (e.g., no accruals for the cash basis)
Are there reference guides for special purpose reporting frameworks? Yes. The two I use are:
Cash, Tax and Other Bases of Accounting — Thomson Reuters
Accounting and Financial Reporting Guidelines for Cash- and Tax-Basis Financial Statements–AICPA
While both publications provide sample financial statements, the Thomson Reuters guide has several sample statements and checklists.