Tax Basis vs Book Basis Accounting Explained
Understanding the differences between tax basis vs book basis accounting is essential for small business owners as they start their business journeys. Many will be familiar with the Generally Accepted Accounting Principles (GAAP), which is the most prominent financial accounting framework in the United States. However, some business owners may not be aware that it's not the only commonly used accounting method.
The tax-basis and book-basis accounting methods reflect different aspects of a business’s finances, so some businesses have two different sets of books. However, small businesses may find one method more favorable than the other depending on the nature of their business and their aims going forward.
What Is Tax Basis Accounting?
Tax-basis accounting is based upon the Internal Revenue Code (IRC) and other pertinent revenue rulings and precedents that are in vigor. Businesses use the IRC to determine their taxable income and the tax-deductible expenses to which they're entitled.
Tax-basis accounting is generally considered a simpler method of reporting than book-basis accounting. However, it is nuanced and requires constantly evolving and up-to-date knowledge of the system. For that reason, many small business owners turn to experts in accounting services to help them keep their books correct and compliant and to maximize their tax breaks.
What Is Book-Basis Accounting?
Book-based accounting is an accounting method based on GAAP. GAAP obliges companies to follow accrual accounting. This means that revenue and expenses are recorded whenever they're earned or incurred, regardless of when the cash is received or paid out.
The main aim of financial reporting is to provide all of the interested parties—business owners, investors, and other stakeholders—with accurate and comparable financial information. GAAP is a conservative accounting method that generally ensures the correct matching of revenue and expenses in any given reporting period. The principle also largely prevents businesses from overstating their profits and asset values.
What Are the Differences between Tax Basis and Book Basis Accounting?
Book and tax accounting offer different ways for a company to present its profits and liabilities. There can be some discrepancy between what's presented to a company's shareholders via financial statements and what's reported to the IRS on the company’s tax return.
Reporting Revenue and Expenses
With GAAP, revenues and expenses must be reported when they're earned or incurred. With tax-basis accounting, they're reported when cash is received or paid out. This can result in differences when companies use both accounting methods. Financial statements often include "deferred tax asset" or "deferred tax liability" accounts to help them track temporary book-to-tax differences.
Terminology on the Income Statement
The most important terminology under GAAP includes “revenues,” “expenses,” and “net income.” Tax-basis entities report their gross income, any deductions, and their taxable income. Nontaxable items appear either as separate items or are disclosed in a footnote.
Capitalization and Depreciation of Assets
How companies depreciate their assets is one of the biggest differences between tax-basis and book-basis accounting.
Depreciation Under GAAP
Under GAAP, an asset's cost (minus its salvage value) is capitalized and depreciated over the course of its useful life. Businesses can sometimes incur impairment losses if an asset's market value falls below its book value.
Depreciation with Tax-Basis Accounting
Assets are usually depreciated under the Modified Accelerated Cost Recovery System (MACRS). This typically results in shorter useful lives than under GAAP. Many companies choose accelerated depreciation as a means to calculate business depreciation expense as it allows them to recover the cost of depreciated assets sooner. Because these amounts are tax-deductible, many companies prefer to present depreciated assets on a tax-adjusted basis.
Please note: Salvage value is subtracted when calculating depreciation using the straight-line or units of production methods. However, it is not used when using MACRS. Section 179 expensing and bonus depreciation are subtracted before calculating MACRS deductions. An accounting professional can help you apply your chosen depreciation method(s) correctly.
Implications for Small Business Owners
Choosing one accounting method over another for reporting may be beneficial for your small business. Consult an accounting professional about how each applies to your unique situation. The following are among the implications to take into account:
Book-Basis Accounting Implications for Small Businesses
Publicly traded companies or companies seeking to raise capital must follow GAAP reporting. This is because it provides investors with a true picture of a company's financial prospects.
GAAP reporting can be complex and requires significant resources to prepare and audit.
Tax-Basis Accounting Implications for Small Businesses
Smaller businesses or non-publicly traded businesses may find tax-basis reporting more favorable. It may also be easier for business owners to understand as it's based on cash transactions.
Tax-basis accounting is necessary for certain deductions and credits that can help reduce your company's tax liability.
Make Tax Basis or Book-Basis Accounting Work for Your Small Business
Small business owners must consider their present and future aims when choosing an accounting method. Tax-basis accounting is essential for all businesses. GAAP is more relevant to larger companies that are seeking investors.
Ultimately, each business is different and you must make the different accounting methods work for you. Working with accounting professionals is the best way to maximize your tax benefits and put your business on the front foot for growth.
