Many small business owners maintain their accounting records on the income tax basis of accounting. However, many small business owners are not clear on (i) the reason the income tax basis was selected, or (ii) how the income tax basis of accounting differs from generally accepted accounting principles (“GAAP”).
The difference between the income tax and GAAP bases of accounting are directly related to the authoritative sources and related objectives of both frameworks. GAAP also loosely referred to as “book basis”, is based on a set of widely accepted standardized accounting principles and practices. These accounting standards are prescribed by the Financial Accounting Standards Board (“FASB”) and the Securities Exchange Commission (“The SEC”). Whereas the rules and regulations pertinent to the income tax accounting framework are prescribed by the Internal Revenue Service (“IRS”). The single purpose of the IRS is the collection of income taxes. Consequently, the objective of the income tax accounting framework is the determination of taxable income. GAAP was designed to provide an accepted method of recording financial information that results in comparable financial statements.
Businesses may prepare income tax returns on a cash or accrual basis, dependent on whether certain IRS thresholds are met. GAAP basis financial statements are always prepared on an accrual basis. The application of the accrual concept to accounting records maintained under the income tax framework may erroneously lead one to think, that the resulting financial statements are GAAP basis financial statements.
A major difference between tax and GAAP accounting relates to revenue recognition. Under the income tax basis of accounting; revenue is recognized as earned, or upon the receipt of cash, whichever is earlier. GAAP recognizes revenue as earned. Therefore, certain advance cash payments such as rent received in advance, subscription income, and income from the sale of gift cards must be deferred until earned. In addition, the timing of deductions may be different under both methods of accounting. For instance, GAAP may require companies to estimate and deduct warranty expenses from gross revenue as revenue is recognized. Under the income tax basis of accounting, warranty expenses cannot be deducted until a cash payment is actually made.
Property Plant and Equipment and the accompanying depreciation expense represent another area of major difference. Under the income tax basis of accounting, tenants who receive qualified improvement incentives from landlords as a part of lease arrangements can exclude the incentive receipts from income and reduce the depreciable basis of the leasehold improvements to the extent of the incentives excluded. Under the GAAP basis of accounting, the basis of leasehold improvements made is measured at the full cost associated with the improvements. Any lease incentives received is recorded as an element of deferred rent; with the deferred rent liability being relieved against rent expense on the straight-line basis over the lease. The issue of depreciation expense highlights numerous differences between the income tax and GAAP bases of accounting including the depreciation methods applied. The 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 section 179 expense and bonus depreciation. Both provisions allow taxpayers to expense certain fixed assets up to a specific amount in the year of purchase.
Other common differences between the income tax and GAAP bases of accounting also include the treatment of goodwill, start-up and organization cost, allowance for bad debt and inventory. The income tax basis of accounting provides for the amortization of goodwill over a period of 15 years. Under the income tax rules, a bad debt expense may only be deducted at the time the debt is actually written off. On the other hand, under the GAAP basis of accounting, business owners may record an expense for allowance for bad debt. GAAP does not allow amortization of goodwill. Instead, goodwill must be reviewed regularly to determine whether the amount at which it is carried is recoverable, and any unrecoverable amounts are written off as an impairment charge. Start-up and organization cost are expensed as incurred for GAAP purposes while they are capitalized and amortized over 15 years for tax purposes. Accounting for inventory is substantially the same under both bases of presentation, however, if certain thresholds are met, certain indirect expenses must be capitalized under section 263A of the income tax regulations. Also, the inventory valuation allowance is currently expensable for GAAP purposes but can only be deducted for tax purposes when the inventory is actually written off.
The accounting records of public companies must be prepared in accordance with GAAP or another comparable framework approved by the SEC (such as International Accounting Standards); however, closely held businesses may have the privilege of choice. Business owners faced with such a choice should carefully consider how the financial statements would be used since the time and money for the preparation of GAAP basis financial statements can be significant.
Circular 230 Disclaimer:
This article represents a general overview of tax developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation. Any tax information contained in the body of this article was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.
Author: Cas Findlay, CPA – Audit & Assurance Services Manager