A small business owner should understand the following before deciding to keep their accounting records on an income tax basis or on a generally accepted accounting principles (“GAAP”) basis.
- 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 income tax accounting framework. The main objective of tax-based accounting is the determination of taxable income, while GAAP strives for comparability between entities. The income tax accounting method can be presented on a cash or accrual basis.
- The definition of income can be significantly different in the two accounting frameworks. GAAP recognizes revenue as it is earned; The IRS basis recognizes income when it is earned or when cash is received, whichever comes first. Under GAAP, certain advance cash payments, such as rent received in advance, subscription revenue, and revenue from the sale of gift cards, 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 revenue is recognized. Under the accounting collateral income tax basis, expenses cannot be deducted until a cash payment is made.
- Fixed asset management and depreciation expense represents another area of major differences. Under the income tax basis of accounting, tenants who receive incentives from landlords as part of their lease agreements are required to reduce the basis for improvements made to the lease by the extent of the incentives received. Under the GAAP framework, the basis for improvements made to leased properties is measured at the full cost associated with the improvements. Any lease incentive received is recorded as a deferred rental item; with the deferred rental liability being relieved against straight-line rental expense over the lease. The depreciation expense issue highlights numerous differences between 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 allowance and expense depreciation. Both provisions allow taxpayers to expense 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, 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 at the time the debt is written off. On the other hand, under the GAAP basis of accounting, business owners may record an expense for provision for bad debts. GAAP does not allow amortization of goodwill. Instead, goodwill should be reviewed periodically to determine whether the carrying amount is recoverable and whether any unrecoverable amount is written off as an impairment charge. Start-up and organization costs are currently expensed for GAAP purposes, while they are capitalized and amortized over 15 years for tax accounting purposes. The accounting for inventory is substantially the same under both bases of presentation, however, if certain thresholds are reached, 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 written off.
