In the United States, different accounting methods are used for various reasons, such as, to prepare and maintain different reports available for different reasons. Business accounting includes recording the financial transactions of a business, which can be recorded by using the GAAP or tax accounting. GAAP or the Generally Accepted Accounting Principle is a method of recording the financial transactions of public companies, whereas, the tax accounting is similar except that taxpayers can avail more options. Therefore, in order to know which accounting method is suitable for your business, it is important to know what these methods are, and the difference between the two.
History of GAAP and Tax Accounting
Due to the increased complexity of businesses, it was very important to standardize the accounting practices as financial accounting is considered as a backbone of any business. This is the reason why GAAPs were introduced in the United States by a body called the Financial Accounting Standard Board (FASB). FASB is considered as the highest authority in the U.S. to develop and maintain the GAAPs.
On the other hand, tax accounting was founded by ratifying the sixteenth Amendment of the United States constitution, which actually initiated the revenue collection agency formed back in 1894. As time passed, different alterations, name changes, and reorganizations were made, and today, this authority is called the Internal Revenue Service.
Purpose of GAAP and Tax Accounting
The purpose of GAAP is to provide a standard set of guidelines and accounting principles in order to bring uniformity and relevance as it increases the reliability and comparability of financial statements. Whereas, the tax accounting framework is developed and maintained by the Internal Revenue Service or IRS, and the purpose of this framework is to impose tax against taxable income or net earnings of the business.
Taxable income is not the same as revenue (as defined by GAAP). The tax is deducted and collected in the earlier of receipt of cash, or earning.
Basis of Accounting
The basis of accounting actually determines how to report the financial transactions and information should be accounted for. Both GAAP accounting and tax accounting use a different basis of accounting to record and recognize financial transactions. In the GAAP accounting, accrual based accounting is the only acceptable method. On the other hand, tax accounting uses accrual, cash and modified basis of accounting.
The cost of developing, implementing and using the GAAP accounting system is sometimes too much for small scale businesses, therefore, the IRS allows such businesses to record their financial transactions using alternative methods.
As you all know, depreciation is the allocation of the cost of an asset over its estimated useful life. Under the GAAP accounting, different accounting methods are used, such as, reducing or declining balance method, straight line method, the sum of the year digit method, and activity-based depreciation method.
Whereas, in the tax accounting, Modified Accelerated Cost Recovery System or MARCS is used, which calculates the depreciation by using IRS defined declining percentages. In addition to this, according to the section 179, the IRS allows individuals and taxpayers to expense a depreciation on the fixed asset in the year of purchase.
Accounting for Accruals
Under the GAAP accounting system, the expenses, which are due but not yet paid, are considered as accruals in the balance sheet. It is represented as an accrual of the expense, which is a current liability that is due to be paid on the later date.
On the other hand, in a tax accounting, accrual based accounting is not required unless a company report its business tax returns as an accrual based tax payer. Moreover, the IRS enforces certain limitations for cash and modified basis accounting, which includes income and expense reporting limitation, and also includes the revenue limitations.
It is very important to streamline the business processes if a company wish to keep track of its business activities, which can only be done by having a proper accounting system in place. Therefore, an individual or a company should understand the different accounting systems used in the market and must also know their differences in order to successfully account for their transactions and present their financial statements.
You might also like…
Difference Between Cash and Accrual Accounting
Difference between GAAP and Statutory Accounting
Difference Between GAAP and IFRS
Difference Between US GAAP and Canadian GAAP
Difference Between Accounting and Finance
Difference Between Cash Flow and Net Income
Difference Between Accounting and Economic Profit