It is often suggested that preparing financial statements on the income tax basis is a cost-effective means of financial reporting because much of the cost of preparation is absorbed in the preparation of the tax return. In addition many accountants believe the disclosure requirements for income tax basis financial statements are less demanding than those required by "full" GAAP. However, IRS regulations have become so complex that many accountants do not feel comfortable with an SAS 62 report stating that the financial statements are in accordance with the incom etax basis when ultimately only an IRS audit can determine compliance with tax regulations. Other problems associated with income tax basis financial statements relate to choices within the tax law, such as the choice between a cash, accrual, or modified cash basis. Choices made on the tax return are made to affect a company's tax return are made to affect a company's tax liability with little regard for their effect on the usefulness of the financial statements that may result. For example, choices that lower taxable income on the tax returns and net income on the tax basis income statement, may produce a financial picture that leads to higher borrowing costs. Since tax choices may change from year to year a consistency or comparability problem may arise.

Cash Basis of Accounting versus

Modified Cash Basis

To avoid misunderstanding, it is important to distinguish between the cash basis and the modified cash basis. The cash basis recognizes revenues when collected rather than when earned and expenses when paid rather than incurred. Under the cash basis, long-term assets are not capitalized, and, hence, no depreciation or amortization is recorded. Also, no accruals are made for payroll taxes, income taxes, or pension costs, and no prepaid assets are recorded. Thus, the major complexities of GAAP are avoided.

The modified cash basis is a hybrid method such combines features of both the cash basis and the accrual basis. Modifications to the cash basis accounting include such items as the capitalization of assets and the accrual of income taxes. If these modifications are made, the resulting balance sheet would include long-term assets, accumulated depreciation, and a liability for income taxes. The income statement would report depreciation expense and income tax expense. Modified cash basis financial statements are intended to provide more information to users than cash basis statements while continuing to avoid the complexities of GAAP.

A Comparison of Cash and

Modified Cash Basis

Exhibits 1 and 2 compare three financial reporting alternatives. For a cash basis, a statement of assets and liabilities would include only cash and owners' equity, while the statement of revenues, expenses, and retained earnings would include revenue from cash sales and revenue from cash collected from credit sales of prior years reduced by all cash expenditures, including capital expenditures. Ending

EXHIBIT1

ACCOUNTINGMEASUREMENTS(DOLLARSEXCLUDED)

BalanceSheetorStatementofAssetsandLiabilities--Basis

Indicated

ACCOUNTSGAAPModifiedCashBasisCashBasis

Assets

CashYESYESYES

AccountsReceivableYESNONO

InventoryYES(2)NO

PrepaidItemsYES(3)NO

PlantandEquipmentYES(1)NO

Accumulated

DepreciationYES(1)NO

CapitalLeases(net)YES(6)NO

Liabilities

AccountsPayableYES(2)NO

IncomeTaxPayableYES(5)NO

CurrentPortionof

Long-termDebtYES(1)NO

AccruedLiabilitiesYES(4)NO

DeferredTaxesYESNONO

Long-termLiabilitiesYES(1)NO

LeaseObligations--

Long-termportionYES(6)NO

Owners'Equity

CapitalStockYESYESYES

RetainedEarningsYESYESYES

StatementofCashFlows

StatementRequired?YESNONO

Note:Possiblemodificationstothecashbasisareidentified

bynumbersin

parentheses.Thenumbersareusedtoidentifyinterrelated

accounts

TABULAR DATA OMITTED

retained earnings would be calculated by adding net income to beginning retained earnings and subtracting dividends paid during the year.

To avoid cash basis statements being mistaken for GAAP financial statements, SAS 62 requires different titles for them. Statement of Assets and Liabilities--Cash Basis, the Statement of Revenues and Expenses--Cash Basis, and the Statement of Retained Earnings--Cash Basis are descriptive titles. The latter two statements can be combined and titled as a Statement of Revenues, Expenses, and Retained Earnings--Cash Basis. Within cash basis statements, captions can be the same as those found in GAAP statements. Some accountants, however, prefer to use different captions such as "excess of revenue collected over expenses paid" instead of net income. A Statement of Cash Flows is not required for cash basis financial statements. It is assumed that the interested user can estimate the investing and financing activities by examining comparative cash basis balance sheets.

Pure cash basis financial statements may be adequate for certain smaller companies where cash flow is of primary importance to management and a limited number of external users. However, pure cash basis financial statements are relatively rare in practice.

Modified Cash Basis

Some companies believe they are using a cash basis, but they are really using a hybrid of a cash basis and an accrual basis. Technically, this basis is called the modified cash basis. SAS 62 permits modifications having substantial support in the authoritative literature. Since the modified cash basis isn ot formalized in the accounting literature, modifications have evolved through common usage.

The basic concept to guide cash basis modifications is to be logically consistent by treating interrelated accounts, such as sales and purchases, on the same basis in the financial statements. For example, reporting sales on a cash basis and cost of goods sold on the accrual basis would likely result in misleading financial statements and would therefore not be appropriate.

Modified cash basis financial statements include all accounts that result from cash transactions and from those modifications adopted that have substantial support. The cost to include the modifications should be justified by the increased relevance they provide. The cost would include both the incremental cost of preparing the financial statements and the incremental costs of auditing or reviewing them. Exhibits 1 and 2 identify the logical interrelationships among the accounts for possible modification by coding them with the same number. Accounts receivable, deferred income taxes, and capital leases are excluded as possible modifications to the cash basis because they are normally considered as the last level of adjustment to bring statements to the full accrual basis. It is likely that financial statements prepared using a modified cash basis are more useful to owners and creditors than strictly cash basis financial statements.

Modified Cash Basis or Accrual

Basis?

A question arises as to what constitutes the use of the modified cash basis and what would more correctly be referred to as an accrual basis of accounting. The answer is that if modifications are so extensive to the cash basis that the statements more closely resemble accrual basis statements, the accountant should treat them as accrual basis statements and note their departure from GAAP in the audit or review report.

An Example of Financial

Statement Measurements

Exhibits 3 and 4 show financial statements prepared for a hypothetical manufacturing company using GAAP, the modified cash basis, and the cash basis. Realistic dollar values are computed using published financial ratios for a manufacturer of sheet metal stampings. Financial statements of companies in many other industries likely would provide similar differences as reflected in the hypothetical company.

The GAAP balance sheet indicates that the company has assets of about $1 million, of which approximately two-thirds have been contributed by creditors and the balance by owners. Plant and equipment make up approximately fifty percent of the assets, and a capital lease exists. The largest liabilities are accounts payable and long-term debt. Owners equity includes capital shock and retained earnings.

The GAAP income statement illustrated in Exhibit 4 shows revenue of slightly under $2 million, gross profit under $600,000 and net income of approximately $50,000. It is assumed that the hypothetical company is a small, non-public company. As this company is small and closely held, the use of OCBOA statements would be a distinct possibility.

Exhibits 3 and 4 also show financial statements for the hypothetical company prepared on a modified cash basis and a cash basis. These statements use the same data as used for the GAAP statements, except that they have been adjusted to reflect the different bases. The cash basis statements obviously differ the most from GAAP. Reported assets are about one percent of those reported on the GAAP balance sheet, no liabilities are reported, and owners' equity, which reports a deficit, is less than ten percent of that reported in GAAP. When viewed individually, differences in revenue, cost of goods sold, gross profit, and operating expenses do not appear to be materially different from GAAP. However, the combined effect of the differences causes net income to be approximately twenty-five percent of the GAAP net income.

Earlier in the article it was stated that financial statements prepared using a "cash basis" would rarely be appropriate for financial reporting as these statements provide only limited information to financial statement users. It seems highly unlikely that the hypothetical company would be successful in securing a bank loan because of the lack of

TABULAR DATA OMITTED

information on assets available as collateral, the uncertainty about unrecorded liabilities, the reported deficit, and the low net income. The statements probably would have to be accompanied by extensive disclosures in the notes to the financial statements, schedules of accounts receivable and accounts payable, lengthy interviews, and various other sources of information that may be requested by a bank lending officer before approval would be received for a loan. It is quite possible that the bank lending officer would deny a loan request without this additional information.

The modified cash basis financial statements shown in Exhibits 3 and 4 provide a substantial improvement over the cash basis statements. Accounts receivable, prepaid items, and capital leases are still excluded, but modifications are made to recognize inventory paid for in cash, plant and equipment, and accumulated depreciation. Plant and equipment and accumulated depreciation are included at the same value as GAAP, and the portion of the inventory costs that was assumed to be paid in cash is included.

The only liabilities recognized in the financial statements are those associated with the acquisition of the plant and equipment and accrued income tax. If the hypothetical company were to borrow cash, an additional liability would be recorded. Accounts payable are not included, and liabilities arising from capital leases are not recorded. With the

TABULAR DATA OMITTED

exception of income taxes, other accrued liabilities were not recorded. The cost of accruing other liabilities does not seem to be justified in this example as this would only account for approximately seven percent of the GAAP liabilities. For some companies, it may be justifiable to accrue other liabilities. The end result is that the modifications resulted in the recognition of slightly less than forty percent of the GAAP liabilities.

The owners' equity reported in the modified cash basis statements is much improved over that reported using the cash basis. The reported deficit in the cash basis statements is eliminated and owners' equity is now about seventy percent of that reported in GAAP. Creditors would likely be more willing to extend credits as the deficit has been eliminated, thus justifying the costs of the modifications.

An examination of the statement of revenues, expenses, and retained earnings shows little change in the net income that is reported in the cash basis statements. There is no difference in measuring revenue and cost of goods sold except that changes in inventory acquired for cash are reported in the modified cash basis statement. In the operating expense section, neither the cash basis nor modified cash basis deduct amortization, as this cost is associated with the capital lease, but several differences between these two bases are reported. A depreciation deduction replaces the deduction for capital expenditures as reported in the cash basis statement and the income tax deduction is different.

Income tax expense is reported on the modified cash basis statement using the flow-through method where income tax expense is reported for the amount of tax as computed on the current year's tax return. The cash basis statement reported income tax expense for the amount of tax paid during the year which is likely the balance due from the prior year's tax return. Neither the cash basis nor modified cash basis statements report the deferred income taxes shown on the GAAP income statement. The resulting net income is still far removed from GAAP.

Disclosure Guidelines for

Modified Cash Basis Financial

Statements

Notes to financial statements provide additional information and more details than can be presented within the body of financial statements. The auditor must determine if the financial statements, including the notes, are informative of matters that may affect the use, understanding, and interpretation of financial statement users. Modified cash basis financial statements that are audited or reviewed would generally be expected to have the same basic disclosures that would be included with GAAP financial statements to the extent the same items are included in the financial statements. For example the modified cash basis statements in Exhibit 2 would have note disclosure on plant and equipment and depreciation the same as GAAP basis statements, but would not have the same disclosures for leased assets. Compiled OCBOA financial statements may omit substantially all disclosures. SSARS 1 permits this for compiled statements but not for reviewed statements.

Cash basis and modified cash basis financial statements, and the notes to these statements, should disclose that the statements are prepared on the cash basis and modified cash basis of accounting. A description of the cash basis modifications should be provided in the notes to the modified cash basis statements. The notes should also describe in general terms how the basis differs from GAAP.