Small business owner should understand the following before they decide to maintain their accounting records on the income tax basis or based on generally accepted accounting principles (“GAAP”).
- GAAP is proscribed by the Financial Accounting Standards Board (“FASB”) and the Securities Exchange Commission (“SEC”) while the Internal Revenue Service is responsible for the establishment of the income tax accounting framework. The primary purpose of the tax basis accounting is the determination of taxable income, whereas GAAP strives for comparability across entities. The income tax method of accounting may be presented on a cash or accrual basis.
- The definition of revenue maybe significantly different under the two accounting frameworks. GAAP recognizes revenue as earned; the IRS basis recognizes income when earned or upon the receipt of cash whichever is earlier. Under GAAP certain advance cash payments such as, rent received in advance, subscription income, and income from 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.
- The handling of fixed assets and depreciation expense represents another area of major differences. Under the income tax basis of accounting, tenants who receive incentives from landlords as a part of lease arrangements are required to reduce the basis of the leasehold improvements made by the extent of the incentives received. Under the GAAP framework 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, 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 recognized 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 written off as an impairment charge. Start-up and organization cost are currently expensable for GAAP purpose while they are capitalized and amortized over 15 years for tax basis accounting 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, inventory valuation allowance is currently expensable for GAAP purpose but can only be deducted for tax purpose when the inventory is actually written off.