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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 income tax 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 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 which 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...