Accounting Unit 4: Tax Accounting vs GAAP

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In the 21st century many laws and regulations have been standardized but there are still some standards which are specific to each country.

If you work in accounting in the US you will have heard of and understand tax accounting, but your European counterpart will have no idea what it is. Unlike a lot of countries where the generally accepted accounting principles (GAAP) is the only method for calculating tax, accountants in America have two options; tax accounting and GAAP.

So to clear up the question: ‘What is the difference between GAAP and tax accounting?’

The primary difference between the methods is that under GAAP, all financial transactions must be recorded and accounted for whereas tax accounting focuses on the transactions which have an impact on the tax situation of the company, with other transactions being omitted.

The Generally Accepted Accounting Principles is the compulsory method of accounting for a public company. Tax accounting can be similar, but with far more options available.

Knowing the differences between these two methods of accounting will help you determine the best method to use for your clients and your business.

GAAP exists to provide accounting principles, standards and practices, which as a result of being standardised provides financial statements capable of being compared amongst each other. The Internal Revenue Service (IRS) developed a tax accounting system to levy taxes against net earnings or taxable income. Taxable income differs from revenue as defined by GAAP.

Depreciation, the allocation of cost over the estimated useful life of an asset, also varies between the two methods. Common depreciation methods under U.S. GAAP include straight line and reducing balance depreciation. Tax accounting commonly uses the Modified Accelerated Cost Recovery System, or MACRS, which uses declining percentages defined by the IRS. In addition, the IRS allows taxpayers to expense a fixed asset in the year of the purchase.

The accounting basis used in the production of financial statements determines how to report transactions and what information appears on the finished financial statements. Under GAAP the only option is accrual basis accounting. But the tax accounting system allows for the use of cash, accrual or modified basis accounting. Developing and using the GAAP accounting system can be too expensive for small business, so the IRS lets smaller companies account for their business transactions using alternative methods.

Using GAAP, unpaid due expenses accrue on the balance sheet. This results in an expense accrual, which is a liability to be paid at a later date. Tax accounting does not need an accrual basis unless you report your company tax return as an accrual basis taxpayer.

The IRS imposes limits for both cash and modified basis accounting, which includes income and expense reporting limits as well as revenue limits.

Having highlighted the differences between the two systems, it is clear that the two are not equal and depending on your business one may be better suited for your needs.

There are several reasons why so many small and medium sized enterprises (SME) use the tax accounting system over GAAP.

Tax accounting is significantly simpler than GAAP, as instead of having to record every single transaction, only those which impact on the tax situation are taken into consideration. This makes tax accounting the preferred method for the majority of CPA’s and SME’s.

Many firms use professional accountants to prepare the tax returns and financial statements. When the basis of the taxes differs from the financial statements, more time is spent on the process, resulting in higher fees. Businesses often change to tax accounting basis when changes required by GAAP are too expensive.

Most business owners have a degree of knowledge on income taxes because they usually check their returns and sign them. This knowledge should be consistent with tax accounting principles. Tax regulations use everyday language and easily understandable examples as they are not just meant for experienced accountants but also business owners. GAAP rules are more technical and are designed for professionals with wide financial knowledge who can fully understand and apply them.

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