Tax Vs GAAP: What Small Business Owners Need To Know
A small business owner should understand the following before deciding to maintain their accounting records on an income tax basis or on the basis of generally accepted accounting principles (“GAAP”).
- GAAP is prohibited by the Financial Accounting Standards Board (“FASB”) and the Securities and Exchange Commission (“SEC”), while the Internal Revenue Service is responsible for establishing the accounting framework for income tax. The primary purpose of tax base accounting is the determination of taxable income, while GAAP strives for comparability between entities. The accounting method of income tax can be presented in cash or in accruals.
- The definition of income can be significantly different in the two accounting frameworks. GAAP recognizes income as accrual; The IRS basis recognizes income when it is earned or when cash is received, whichever comes first. Under GAAP, certain up-front cash payments, such as rent received in advance, subscription income, and income from gift card sales, must be deferred until earned. Also, the timing of deductions may be different in both accounting methods. For example, GAAP may require companies to estimate and deduct warranty expenses from gross income as income is recognized. Based on the income tax basis of the bookkeeping collateral, expenses cannot be deducted until a cash payment is made.
- The management of fixed assets and depreciation expenses represents another area of great difference. Under the income tax accounting basis, tenants who receive landlord incentives as part of the lease agreements are required to reduce the basis of the lease improvements made by the scope of the incentives received. Under the GAAP framework, the basis for improvements made in the lease is measured by the total cost associated with the improvements. Any rental incentive received is recorded as a deferred rental item; with the deferred rental liability that is released against the straight-line rental expense during the lease. The depreciation expense topic highlights numerous differences between income tax and GAAP accounting bases, including the depreciation methods applied. Straight-line declining balance, sum of digits, and activity-based methods are among the most common methods used to estimate depreciation expense under GAAP. Tax accounting commonly uses the Modified Accelerated Cost Recovery System (“MACRS”). In addition, the IRS also allows depreciation of expenses and section 179 allowances. Both provisions allow taxpayers to spend certain fixed assets up to a specified amount in the year of purchase.
- Other common differences between income tax and GAAP accounting bases also include the treatment of goodwill, the provision for bad debts, and inventory. The accounting basis for income tax provides for the amortization of goodwill over a period of 15 years. Under income tax rules, a bad debt expense can only be recognized when the debt is actually paid off. On the other hand, under the GAAP basis of accounting, business owners can record an expense for the provision for bad debts. GAAP does not allow the amortization of goodwill. Instead, goodwill should be reviewed periodically to determine whether the amount for which it is accounted for is recoverable and any unrecoverable amount is written off as an impairment charge. Start-up and organization costs are currently accountable for GAAP purposes, while they are capitalized and amortized over 15 years for tax-based accounting purposes. Inventory accounting is substantially the same under both reporting bases, however, if certain thresholds are met, certain indirect expenses must be capitalized under section 263A of the income tax regulations. It will only be deducted for tax purposes when the inventory is effectively amortized.