Many small clients do not use GAAP. A contractor keeps books on the cash method, a partnership prepares statements on the same basis as its tax return, or a bank accepts statements prepared under a basis it has defined in the loan agreement. These are special purpose frameworks: financial reporting frameworks designed to meet the information needs of specific users, which AU-C 800 lists as the cash basis, the tax basis, the regulatory basis, the contractual basis and other bases with substantial support.
This guide covers when a special purpose framework is appropriate, how the statements and notes should be prepared, what the report says in an audit, review or compilation, and a worked reconciliation from GAAP to tax basis. For the cash versus accrual choice itself, including the tax rules, see cash vs accrual accounting.
When is a special purpose framework appropriate?
The framework has to be suitable for the intended users. Common cases:
- Owner-managed entities whose users are owners and a bank that accepts cash-basis or tax-basis statements.
- Pass-through entities (partnerships and S corporations) that already keep tax-basis records. See business tax returns 1065, 1120 and 1120S.
- Entities with contract-defined reporting, such as a franchise or loan agreement that specifies revenue and cost definitions.
- Regulated entities reporting to a regulator, such as some insurance companies.
A special purpose framework does not shorten the work to the user's benefit unless the user accepts it. If a lender or investor requires GAAP, a cash-basis statement will not satisfy the requirement. The firm should confirm acceptance with the users before the engagement. The AICPA also publishes its own Financial Reporting Framework for Small- and Medium-Sized Entities as an alternative special purpose framework.
What each basis includes
Cash basis. Revenue is recorded when cash is received and expenses when paid. Receivables, payables, accruals and deferred revenue are not recorded. A modified cash basis adds selected accrual items, such as capitalizing and depreciating fixed assets or recording long-term debt, where the modifications have substantial support and are disclosed.
Income tax basis. The statements apply the entity's tax return rules to recognize and measure assets, liabilities, income and expenses. They do not include deferred income taxes. Method elections matter: if the entity expenses equipment under section 179, the statements should do the same. See income tax basis of accounting.
Regulatory and contractual bases. The framework is defined by a regulator or an agreement. The firm reads the source and tests compliance with its definitions. See special purpose framework.
Titles and notes
The statements should be titled to show the basis, such as "Statement of Assets, Liabilities and Equity, Income Tax Basis" or "Statement of Revenues Collected and Expenses Paid, Cash Basis". Calling a cash-basis statement a "balance sheet and income statement" without the basis in the title can mislead readers.
The notes describe the basis of accounting and the significant accounting policies. For the income tax basis, the notes should explain the principal differences from GAAP, and for the cash basis, that revenue and expenses are recorded when received and paid, with the items not recorded. Omitting notes is not a way to simplify; only a compilation allows omission of substantially all disclosures, and that is subject to conditions. See omission of substantially all disclosures.
What the report says
Audit under AU-C 800. The report identifies the framework in the title of the statements and in the opinion, and includes a paragraph that draws attention to the note describing the basis of accounting, stating that it is a basis other than GAAP. That paragraph is an emphasis of matter and does not modify the opinion. Management's responsibility paragraph refers to the framework. A contractual basis requires a use restriction in the report. See types of audit opinions and independent auditor's report example.
Review under AR-C 90. The report states that the statements were prepared on the special purpose framework and refers to the note that describes it. Reviewed statements include the disclosures required by the framework. See review engagements.
Compilation under AR-C 80. The report refers to the framework and the note. Where management elects to omit substantially all disclosures, the report says so and states that if the disclosures were included, they might influence users' conclusions. See compilation engagements and compilation report.
Templates: cash basis financial statements, tax basis financial statements and the special purpose framework audit report.
Worked example: GAAP to income tax basis
Illustrative numbers. A two-owner manufacturing partnership has GAAP net income of $180,000. The partners and the bank agree to income tax basis statements. The accountant identifies the differences between GAAP and the partnership's tax return treatment:
| Item | Effect on income | Reason |
|---|---|---|
| GAAP net income | $180,000 | |
| Allowance for credit losses expense | + $12,000 | GAAP accrues an estimate. Tax allows a deduction only when a receivable is written off |
| Depreciation | - $20,000 | Tax depreciation, including bonus depreciation, exceeds book depreciation by $20,000 |
| Accrued vacation | + $5,000 | GAAP accrues the expense. Tax allows the deduction when paid, in the situations covered by the rules |
| Income tax basis net income | $177,000 |
Check: $180,000 + $12,000 - $20,000 + $5,000 = $177,000.
In the statements, the allowance and accrued vacation are not recorded and equipment is carried at the tax depreciated amount. The notes disclose the basis and explain that the principal differences from GAAP are the allowance method, depreciation methods and accrued compensated absences. The statements record no deferred taxes. The tax-return deduction depends on the facts and the tax rules, so the accountant coordinates with the preparer of the return, and the tax details are a matter for the partnership's tax adviser.
Moving a client to GAAP
Move the client to GAAP when a lender, investor or acquirer requires it, when the entity's growth makes cash or tax basis misleading (for example, large receivables, prepayments or deferred revenue), or when the entity expects to go public or be sold. The first-year conversion involves opening balances for receivables, payables, accruals and deferred revenue, and the disclosures required by GAAP. See first-year audits and opening balances and the GAAP disclosure checklist.
Common mistakes
- Using a GAAP-style title on cash-basis statements.
- Not describing the basis in a note, or missing the differences from GAAP in a tax-basis note.
- Mixing GAAP and tax methods and not disclosing it.
- Recording deferred taxes on tax-basis statements.
- Omitting the basis-of-accounting paragraph in the audit report.
- Accepting a special purpose framework without checking that users accept it.
Frequently asked questions
Can an auditor audit cash-basis financial statements?
Yes, under AU-C 800 if the framework is acceptable for the intended users and the statements describe the basis.
What is the difference between modified cash and tax basis?
Modified cash starts from cash and adds selected accrual items. Tax basis follows the entity's tax return rules for recognition and measurement.
Do tax-basis statements include deferred taxes?
No.
Is a compilation allowed on a cash basis?
Yes. The compilation report refers to the basis.
Do cash-basis statements need notes?
Yes, in an audit or review. A compilation may omit substantially all disclosures if management elects and the conditions in AR-C 80 are met.
Sources
- AICPA, AU-C Section 800, Special Considerations: Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks
- AICPA, AR-C Section 80, Compilation Engagements, and AR-C Section 90, Review of Financial Statements
- AICPA, Financial Reporting Framework for Small- and Medium-Sized Entities
- IRS, Publication 538, Accounting Periods and Methods, irs.gov/publications/p538
Part of CORAA University · Tax and compliance for CPA firms: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error