Which Special Purpose Reporting Framework Should I Use?

Choosing between cash, modified cash, and tax basis accounting

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.

Special Purpose Reporting Frameworks

Picture is from AdobeStock.com

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.

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:

ABC Company

Statement of Cash Receipts and Disbursements

For the Year Ended December 31, 2016

Receipts

Rent                                                                                                                      $XX

Sales                                                                                                                        XX

Other                                                                                                                       XX

Total Receipts                                                                                                       XX

Disbursements

Supplies                                                                                                                  XX

Wages                                                                                                                      XX

Utilities                                                                                                                   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:

                                                  Dr.      Cr.

Loans Receivable                  XX

Cash                                                    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:

                                                 Dr.     Cr.

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.

Tax Basis

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
  • LLC
  • Partnerships
  • 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)

Reference Books

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.

FRF for SME – The Lowdown

Well the public brouhaha between NASBA and the AICPA seems to have settled down since the AICPA issued the Financial Reporting Framework for Small- to Medium-Sized Entities (FRF for SME). I won’t say they’re holding hands now, but at least the discussion has simmered.

Here’s a Q&A to help you digest some of the salient points of FRF for SME.

What is FRF for SMEs?

It’s an other comprehensive basis of accounting (OCBOA) that can be used as an alternative to generally accepted accounting principles (GAAP) as issued by the Financial Accounting Standards Board.

When can FRF for SME be used?

Immediately.

Who created FRF for SME?

The AICPA.

What is the size of FRF for SME?

A little over 200 pages.

What is the size of GAAP?

Thousands of pages. (I have heard more than 20,000 pages. Correct me if I’m wrong.)

How often will FRF for SME change?

About once every three to four years. (That’s one of the beauties of it.) Stability? Yes.

Why was FRF for SME created?

GAAP had become too complex for small- to medium-sized private businesses, driving up the costs of creating GAAP-compliant financial statements. Existing OCBOA (e.g., modified-cash basis) lacked standardization.

Does FRF for SME define a small- to medium-sized entity? Is there a dollar threshold?

No. It’s subjective. There is no dollar threshold.

Is “FRF for SME” GAAP?

No. (It is not little GAAP. It is not GAAP at all – not intended to be.)

Can entities with debt covenants requiring GAAP use FRF for SMEs?

No. But they can see if the lender will amend the agreement.

Can financial statements created using FRF for SME be audited, reviewed or compiled?

Yes. Yes. Yes.

What are some of the characteristics of companies that might use FRF for SME?

  • For-profit
  • Closely-held
  • Not a public company
  • No regulatory requirements for GAAP
  • Individuals with controlling ownership also manage the company

What entities should not use FRF for SME?

  • Nonprofits
  • Those with complex transactions
  • Governments

Is FRF for SME principles-based?

Yes. Use the flexibility and disclose the policies used.

Do the FRF for SME financial statements look like GAAP statements?

Yes. This is a downside (at least to me). I do think a user might mistakenly believe the financial statements are GAAP. You will need to clearly disclose that FRF for SME is being used. Also your opinion or SSARS report will refer to FRF for SME (rather than GAAP).

What are some key points of FRF for SME?

  • No comprehensive income
  • Investments will be at historical cost (market value used when held-for-sale)
  • Derivatives (think swaps) are not recognized on the balance sheet (only disclosed); no hedge accounting
  • Goodwill amortized over the same period as that used for tax purposes or 15 years
  • Intangibles (all) will be amortized over their economic life
  • Income taxes recognized using taxes payable method (what you owe at period-end) or the deferred income tax method (as GAAP requires)
  • No requirement to accrue uncertain tax positions (no FIN 46)
  • Leases will be recognized as operating or capital leases (FASB’s presently proposed lease standard will require all leases of more than 12 months to be recognized as a liability; expect to see the FASB lease standard approved in early 2014)
  • Policy choice to consolidate subsidiaries or account for them using the equity method (parent-only presentation allowed; use equity method accounting for subsidiaries)
  • Variable interest entities will not be consolidated (disclosure of the relationship); can I get an Amen?
  • No assessment of long-lived assets for impairment
  • Going concern assessment required by management (this assessment is not required by GAAP – yet)
  • Revenue recognition is principles-based (disclose how you recognize revenue); percentage-of-completion is allowable for contractors
  • Stock-based compensation not booked as a liability (disclosure only)
  • Defined benefit plan liabilities can be recognized using contribution payable method (record current pension plan payments not made; no projected benefit obligation liability required)
  • Disclosure requirements are greatly simplified

Can’t I just continue issuing tax-basis financial statements?

Yes. But tax-basis statements do not incorporate some of the more traditional accounting concepts that FRF for SME does.

How will the use of FRF for SME change the peer review process?

No change; FRF for SME is just another OCBOA – like tax-basis or modified-cash basis.

Does the AICPA offer any implementation tools?

Yes. Click here for toolkits.

How About You? 

Will you and your firm use FRF for SME? Do you like it (or dislike it)?

Compiled Income Tax Basis Financial Statements and a Provision for Income Taxes

If you are compiling financial statements for a C corporation, would the lack of a “provision for income taxes” be considered a departure from the income tax basis of accounting?

Yes (if material).

Would the CPA need to report the OCBOA (income tax basis) departure in his or her compilation report?

Yes (if material).

Accountants who become aware of material departures from an OCBOA (e.g., income tax basis of accounting) have three options:

  1. Refer to the departure in the compilation report
  2. Persuade the client to revise the statements to conform with the OCBOA requirements or
  3. Withdraw from the engagement

If option 1 is followed, the accountant should add language to his or her compilation report such as:

During our compilation, we did become aware of a departure from the income tax basis of accounting that is described in the following paragraph.

The income tax basis of accounting requires that the Company record a federal income tax provision. Management has informed us that the Company has not recorded such a provision. The effect of this departure on the financial statements has not been determined.

Interestingly, the same lack of a provision for income taxes in compiled financial statements of S corporations, LLCs or partnerships (commonly referred to as pass-throughs) is not considered a departure from the tax basis of accounting. Since pass-through entities have no tax payment requirement (the tax being passed through to the owner), there is no provision for income taxes; consequently, there is no departure from the income tax basis of accounting – and no need to add OCBOA departure language in the compilation report.

If you are compiling financial statements with substantially all disclosures omitted, consider parenthetically stating the type of entity in the first sentence of the compilation report; for example:

We have compiled the accompanying statement of assets, liabilities, and equity – income tax basis of Winston Company (an S Corporation) as of…

This clarification will assist the reader in understanding why a “provision for income taxes” is included or not included in the financial statements.

OCBOA Governmental Financial Statements

The AICPA recently provided a webcast titled: The New AICPA OCBOA Publications: What They Are and How They Apply to Governments and Not-for-Profits Using Cash, Modified Cash, and Regulatory Frameworks.

I was surprised to see the number of governments that present financial statements in accordance with an other comprehensive basis of accounting (OCBOA). The webcast did not provide an exact percentage of governments using OCBOA, but it looks like you can easily conclude that over 33% of governments use OCBOA. 

Why Issue OCBOA Financial Statements?

As I said in my prior OCBOA post, the short answer is: Cost. If you’ve created GAAP basis governmental financial statements, you know how complicated these statements are. OCBOA statements – whether cash basis, modified cash basis or tax basis – are simpler to create. 

Many governments require GAAP basis statements so make sure, before making any changes, that OCBOA statements are permissible in your locale.

Modified Cash Basis of Accounting

The modified cash basis is the pure cash basis with modifications having substantial support. (A pure cash basis of accounting would reflect only cash inflows and outflows with beginning and ending cash.)

A common modification to the cash basis is the capitalization of assets purchased and recognition of depreciation over estimated useful lives. Though using the modified cash basis, impaired capital assets may also be written down. In addition, the related long-term debt would normally also be recorded. 

Another common modification is the deferral of revenue recognition for governments receiving cash that will be used in future periods; the deferral would be shown as a liability.

OCBOA Presentation Issues

GAAP basis governmental financial statements reflect government-wide and fund-level presentations. OCBOA statements will normally include the same type of presentation – government-wide and fund-level statements – though you are using different recognition criteria. A general rule for OCBOA statements is: follow GAAP guidelines where you can; this includes disclosures (though the notes are amended in accordance with the framework used).

While not required for OCBOA statements, you may include supplementary information.

Required supplementary information (RSI) is not required under the modified cash basis, but can be provided; if provided, the information is not considered RSI but supplementary information or additional information. RSI can only be “required” by GAAP.

While certain disclosures are not required in OCBOA statements (e.g., fair value of investments or the funded status of a defined benefit plan), such information can be provided in the notes. 

Use of the AICPA Financial Reporting Framework for Small- and Medium-Sized Entities 

Governments should not use the AICPA small- and medium-sized entity framework.

Updated AICPA Guidance

If you are issuing governmental OCBOA statements, I strongly recommend that you purchase the AICPA’s updated book: Applying OCBOA in State and Local Governmental Financial Statements. Mike Crawford and Mike Glynn have done a fine job in preparing this publication.

OCBOA Financial Statements

OCBOA is not a monster, although it does sound like one.

It is actually a kinder, gentler animal when compared to GAAP (generally accepted accounting principles) – also not a monster (though some accountants would beg to differ).

Types of OCBOA

OCBOA – other comprehensive bases of accounting – encompasses the following:

  • Cash basis
  • Modified-cash basis
  • Tax basis
  • Regulatory basis
Why OCBOA?

In a word: Efficiency.

Often OCBOA is used as a simpler substitute for GAAP and is most often used in compiled financial statements. For instance, an accountant may be compiling financial information to complete a tax return, so it may be easier to create financial statements on the tax basis – killing two birds with one stone. (Converting tax-basis financial statements to GAAP can, in many cases, require a great deal of time, and your client’s banker may be just as happy with tax-basis statements.)

Sources of OCBOA

So where does OCBOA come from?

There is no standard setter for OCBOA. The OCBOA reporting options have largely evolved from tax and governmental regulators and from client requests for cash or modified-cash statements.

The lack of a standard setter allows for a great deal of reporting flexibility, however, the down side is that there is little guidance on the application of the various OCBOA options.

Cash and Modified-Cash Bases of Accounting

A pure cash-basis balance sheet has only two accounts: cash and equity.

The modified-cash basis of accounting is the cash basis with selected modifications such as capitalizing property and equipment and recording any related debt (without accruing certain items such as trade receivables, prepaid assets, and deferred taxes). These modifications are selective rather than mandatory; consequently, if note disclosure is provided, the basis of accounting should be fully explained.

The modified-cash basis can involve so many modifications that the statements become GAAP-like; then the CPA needs to decide whether he or she should just present the statements in accordance with GAAP.

Tax-Basis of Accounting

Generally most tax-basis financial statements are prepared in accordance with federal tax guidelines (which include the cash and accrual bases of accounting depending on the business).

Where possible, the CPA should consider preparing tax-basis financial statements without disclosure. This option is appealing because there are no disclosures and no cash flow statement to prepare, and the resulting statements agree with the tax return.

Reporting and Work Paper Considerations

Remember to title your financial statements appropriately (e.g., statement of assets, liabilities and equity – income-tax basis). Accordingly, the engagement letter and representation letter (for review engagements) should incorporate the OCBOA financial statement titles.

Disclosures, if provided, should be prepared using GAAP as a guide and then modify the notes to dovetail with the OCBOA used. (Many notes required by GAAP would not be pertinent to or needed for OCBOA statements.)

AICPA OCBOA Coming

The AICPA is presently working on a new OCBOA that can be used in place of GAAP. At this time, we don’t know what this basis of accounting will entail, but it will allow CPAs to present financial statements on a simplified basis (avoiding thorny issues like variable interest entities).