GAAP vs. tax-basis reporting: Choosing the right model for your business
Virtually every business must file a tax return. Some private companies choose to issue tax-basis financial statements, rather than statements that comply with U.S. Generally Accepted Accounting Principles (GAAP), in order to keep their financial statements in line with their tax return. But the method of reporting has implications beyond the format of the financial statements, impacting specific line items on the financial statements. Here are the key differences between these two financial reporting options.
GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many lenders expect private borrowers to follow suit, because GAAP is familiar and consistent.
In a nutshell, GAAP is based on the principle of conservatism, which generally ensures proper matching of revenue and expenses with a reporting period. The principle also aims to prevent businesses from overstating profits and asset values to mislead investors and lenders.
Compliance with GAAP can also be time-consuming and costly, depending on the level of assurance provided in the financial statements. So some smaller private companies opt to report financial statements using a special reporting framework. The most common type is the tax-basis format.
Tax-basis statements employ the same methods and principles that businesses use to file their federal income tax returns. Contrary to GAAP, tax law tends to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other requirements have been met.
When comparing GAAP and tax-basis statements, one difference relates to terminology used on the income statement: Under GAAP, businesses report revenues, expenses and net income. Tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.
Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. Businesses must assess whether useful lives and asset values remain meaningful over time and they may occasionally incur impairment losses if an asset’s market value falls below its book value.
For tax purposes, fixed assets typically are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 expensing and bonus depreciation are subtracted before computing MACRS deductions.
Other reporting differences exist for inventory, pensions, leases, and accounting for changes and errors. In addition, businesses record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law; instead, they are deducted when transactions take place or conditions are met that make the amount fixed and determinable. Tax law also limits the deduction of certain expenditures such as penalties, fines, meals and entertainment and accrual expenses not paid within 2-1/2 months of year-end.
Pick a winner
Tax-basis reporting is a shortcut that makes sense for certain types of businesses. But for others, tax-basis financial statements may result in missing or even misleading information. Contact Herzl Ginsburg, CPA, Ciuni & Panichi, Inc. Audit and Accounting Services Department senior manager, at firstname.lastname@example.org or 216.831.7171 to discuss which reporting model will work best for your business.
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