GAAP (generally accepted accounting principles) refers to a common set of accounting principles, standards, and procedures that companies use to compile their financial statements. These principles are established by the Financial Accounting Standards Board (FASB) in the United States. GAAP requires companies to use the accrual basis of accounting, where revenues are recognized when earned and expenses are recognized when incurred, regardless of when cash transactions occur. GAAP is generally used for external financial reporting purposes, such as preparing financial statements for shareholders, creditors, regulatory bodies, and other stakeholders interested in a company's financial health. General uses for GAAP accounting are to provide consistency and comparability in financial reporting, provide a true and fair view of the financial position, performance, and cash flows of an entity, and to ensure that financial statements are reliable and transparent for investors, creditors, and other stakeholders.
Tax basis accounting refers to the accounting method used for calculating tax obligations. It follows the rules and guidelines established by the relevant tax authority’s, for example, the IRS. Tax accounting can be based on cash receipts and disbursements or a modified cash basis that includes some accrual accounting principles but still differs from full GAAP accrual basis. Tax basis accounting is primarily used for preparing tax returns and reporting taxable income to government authorities. Its main focus is on calculating taxable income and ensuring compliance with tax laws. General uses for tax basis accounting are comply with tax regulations and laws, minimize tax liability by utilizing allowable deductions, credits, and exemptions as per tax laws, and to ensure accuracy and consistency in tax reporting to avoid penalties and audits from tax authorities.
Differences and When to Use Each Method
Basis of Measurement: GAAP uses the accrual basis, focusing on economic events regardless of cash flow timing. Tax basis accounting often uses cash or a modified cash basis, which may defer recognition of income or expenses until they are received or paid.
Purpose: GAAP is geared towards providing a clear picture of a company's financial health for external stakeholders. Tax basis accounting is focused on calculating taxable income and ensuring compliance with tax laws.
Regulation: GAAP is regulated by the FASB and enforced by the SEC (Securities and Exchange Commission), but tax accounting is regulated by tax authorities such as the IRS.
Timing: GAAP requires more timely recognition of revenues and expenses to reflect economic reality, while tax accounting allows for certain timing differences and specific deductions or credits that GAAP may not recognize.
In summary, companies use GAAP for external financial reporting to stakeholders, while tax basis accounting is used for calculating taxes owed to government authorities. The choice between these methods depends on legal requirements, reporting objectives, and the specific needs of the users of the financial information.
This article was written by Brandon Hackworth. Brandon is an Accounting Specialist II with Baldwin CPAs. For more information on the support Baldwin CPAs can provide you, contact brandon.hackworth@baldwincpas.com.