Tax Vs GAAP – What Small Business Owners Should Know

Written by Peter Tran

June 10, 2017

business owner should understand the following before they decide to maintain their accounting records on the income tax bs or based on generally accepted accounting principles (“GAAP”).

  • GAAP is proscribed by the Accounting Standards Board (“FASB”) and the Securities Exchange Commission (“SEC”) while the Internal Revenue Service is responsible for the establisht of the framework. The primary purpose of the tax bs 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 bs.
  • The definition of revenue maybe significantly different under the two accounting frameworks. GAAP recognizes revenue as earned; the IRS bs recognizes income when earned or upon the receipt of cash whichever is earlier. Under GAAP certain advance cash payts such as, rent received in advance, subscription income, and income from sale of ft 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 bs of accounting warranty expenses cannot be deducted until a cash payt is actually made.
  • The handling of fixed assets and depreciation expense represents another area of major differences. Under the income tax bs of accounting, tenants who receive incentives from landlords as a part of lease arrangets are required to reduce the bs of the leasehold improvets made by the extent of the incentives received. Under the GAAP framework the bs of leasehold improvets made is measured at the full cost associated with the improvets. Any lease incentives received is recorded as an elet of deferred rent; with the deferred rent liability bg relieved against rent expense on the straight line bs over the lease. The issue of depreciation expense highlights numerous differences between the income tax and GAAP bases of accounting including the depreciation methods . The straight-line, declining balance, sum of dits 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 treatt of goodwill, allowance for bad debt and inventory. The income tax bs of accounting provides for the amortization of goodwill over a period of 1 years. Under the income tax rules a bad debt expense may only be recognized at the the debt is actually written off. On the other hand under the GAAP bs 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 impairt charge. Start-up and organization cost are currently expensable for GAAP purpose while they are capitalized and amortized over 1 years for tax bs 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.

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