GAAP Vs. Tax Basis
Many different ways exist to report a company’s financial information. GAAP, or Generally Accepted Accounting Principles, is an accounting method required by the Securities and Exchange Commission. The SEC established GAAP so that companies can present a uniform and accurate picture of their financial position to company stakeholders. However, income tax laws have different rules and mandates that can run contrary to GAAP. As a result, companies also need to use a tax method to report financial information to the Internal Revenue Service.
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Different Accounting Methodologies
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In order to meet the standards of Generally Accepted Accounting Principles, companies must create financial reports using accrual accounting. Accrual accounting is a system based on a number of frameworks and rules that instruct a company when it must record revenues and expenses. For example, a company does not record revenue until it has earned that revenue or record expenses until it incurs the expenses. This is not necessarily the same as when the company receives or pays out money. Tax accounting allows for either accrual accounting or cash accounting. In cash accounting, a company recognizes revenue when it receives cash and recognizes expenses when it pays out cash.
Allowance for Doubtful Accounts
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Under Generally Accepted Accounting Principles, companies must present their accounts receivable balance at net realizable value. This means that companies must establish an allowance for doubtful accounts to estimate the amount of receivables that will be uncollectable and reduce the balance in accounts receivable. In tax accounting, the tax law allows for bad debt deductions when companies determine receivables to be uncollectable.
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Inventory Valuation
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Since costs of inventory purchases are always fluctuating, it can be difficult for companies to value inventory. Generally Accepted Accounting Principles requires that companies record inventories at the lower of cost or market. Tax basis allows companies to use either methodology. A company can also decide to use different cost methods for different accounting basis in the same year. For example, a company could use first in, first out when filling under Generally Accepted Accounting Principles, but use last in, first out for tax purposes.
Depreciation
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Depreciation methods can vary between Generally Accepted Accounting Principles and tax basis. Under tax basis, a company can use depreciation rules to encourage certain purchases. For example, companies can write off to a set maximum the depreciation limit for equipment under tax rules. However, Generally Accepted Accounting Principles requires depreciation to be spread out over an asset's useful life.
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References
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