If you want to establish or change your accounting system, you may have heard of or used two basic accounting methods: the cash and accrual accounting methods. These are the textbook methods that every business can choose from.
But there's another method that some entities use. It's called modified accrual accounting, and it can be an excellent record keeping method if you want to see your business's numbers more clearly.
Let Unloop explain the modified accrual method to you. But before we do, we'll also go over the two primary accounting methods to give you a more thorough understanding.
Cash Basis Accounting
Most starting businesses adopt a cash basis method of accounting. This way of financial recordkeeping recognizes transactions only when the money comes in or goes out, making bookkeeping easy.
What's Great About Cash Basis Accounting?
Here are some reasons why cash basis accounting is fantastic for both traditional and ecommerce businesses.
Accountants and bookkeepers use the double-entry method when recording transactions. But what makes it straightforward is they only use cash as a debit or credit account in each transaction.
Since transactions are only recorded when the business spends or receives cash, managers, and small business owners have an accurate view of the movement of cash assets within the business.
Bookkeeping and accounting using the cash basis make financial statement reporting simple. In a given period, there will only be a few accounts presented, making it easier to analyze. Reading the simple reports generated from a cash basis accounting method helps in quick decision-making.
Limitations of Cash Basis Accounting
Despite the ease and simplicity of cash basis accounting, it has certain drawbacks.
Challenging for Complex Transactions
When transactions become more complex in real-world events, the cash basis method may have difficulty keeping up. For example, when a business purchases a significant asset on an installment basis, this could affect multiple accounts for an extended period, and official recording may only take place after a long period.
A Narrow View of the Business
Cash basis accounting only sees transactions as they come and go. This limits the view of a manager or a business owner because, in the real world, transactions are incurred or earned earlier or later than usual.
Accrual Basis Accounting
The accrual basis method allows revenue recognition even if it has yet to be received. and recognizes expenses before anything is paid or incurred. As long as the economic event happened, accrual basis accounting will record it. That’s why large businesses with expanded activity and high annual income adopt accrual accounting rather than cash accounting.
What’s Great About the Accrual Accounting Method?
Here's why big businesses use accrual accounting when recording business transactions.
Can Handle Complex Transactions
Accrual accounting lets accountants and bookkeepers record transactions involving multiple accounts. For example, if they are a software company that sold $100 of a single product on the current date and the buyer pays $10 initially while the rest is payable in 90 days, they can record everything on the current date and not after 90 days when the payment is completed.
Using the accrual method is business accurate because it allows accountants and bookkeepers to record transactions as they happen. This gives managers and owners an accurate view of what's happening in the business in real-time.
Generally Accepted Accounting Principles (GAAP) approves the use of accrual accounting. It is also the type of accounting method that banks and tax authorities require for any business with substantial profit earnings or loan requests.
Limitations of Accrual Basis Accounting Method
As great as the accrual method is, it also has several drawbacks.
It Is Complex
Recording transactions using the accrual method can be complex. Putting them together in a financial statement can be more challenging than with cash basis accounting, as there can be many accounts to balance.
Prone to Fraud and Errors
Unlike the cash basis method, where you can have one debit and credit account in a double-entry transaction, accrual accounting can have multiple and the amounts in each account may vary—which is where errors occur and fraudulent transactions can sneak in.
What Is Modified Accrual Accounting?
The modified accrual accounting is a hybrid of the two methods. It uses the best features of cash and accrual basis and adapts depending on the transaction's nature. This is also known as the modified cash basis or hybrid accounting method.
When recording economic events in the short term, primarily if it affects the entity's cash balance, the modified accrual basis adapts the cash method.
These transactions are the ones incurred monthly or daily. Regular business expenses such as utilities and suppliers adopt a cash-based accounting method.
If an economic event affects the business long-term, such as in years, the accrual method is used to record the transaction.
Acquisitions of property or big-ticket equipment are recorded using the accrual method. The transaction is recognized at the date the transaction is made for more accurate recording purposes.
Advantages of Modified Accrual Accounting
A critical advantage of the modified accrual method is balanced reporting. The financial statements of entities using this method will show little shortage or surplus as the more significant expenses are distributed throughout the business's life, and the more minor expenses are justified.
Limitations of Modified Accrual Accounting
It can be the most complex of methods because it uses a combination of cash and accrual basis. Switching between two methods when recording transactions will test any bookkeeper or accountant.
Can Ecommerce Businesses Use Modified Accrual Accounting?
No, they can't. GAAP and International Financial Reporting Standards (IFRS) don't allow modified accrual accounting.
Government entities generally use the modified accrual method. But private, for-profit entities such as ecommerce marketplace sellers can also use it for internal purposes to improve their vision.
What Can Ecommerce Businesses Do Instead?
You can get experts to decide which method is best for your business, given its current situation. On the other hand, if you started with either a cash or accrual basis, you can let experts continue to use those methods effectively.
Unloop can help you decide what can be done for your business. Book a call or check out our bookkeeping services to find out more.