The primary focus of GAAP is financial accounting and reporting rather than tax accounting and reporting. There are different accounting methods for financial and tax accounting (i.e., the proverbial “two sets of books”) (Hopwood 58). The use of different accounting methods should be expected, given the contrasting objectives of financial and tax accounting. The primary objective of GAAP is to provide information useful in making rational economic decisions. On the other hand, the objectives of tax accounting are:
- To raise revenues;
- To achieve stated economic objectives (for example, tax credits are granted to stimulate investment in research and development activities);
- To achieve stated social objectives (for example, tax credits are granted for the rehabilitation of certain nonresidential, real property) (Zodrow 110).
From the financial accounting standpoint, taxes are only considered to the extent that they impact published financial information. However, the manner in which the accountant reflects the impact of taxation is usually different from the information presented on the entity’s income tax returns. Regardless of the accountant’s treatment of income taxes, the analyst must be able to utilize the information provided in the annual report to assess the present and potential future cash flow consequences of the firm’s tax information reported in the financial statements (Hopwood 22).
To oversimplify somewhat, it may be said that if a determination of income meets the standards of GAAP, it is likely to be accepted for income tax purposes as well. That obviously gives great significance to GAAP in the process of computing taxable income. It is true, though, that the rules of accounting, as expressed in GAAP, have a different purpose than the rules of taxation and that GAAP does not comprise a fixed set of simple rules. Proper accounting practice may change over time and may also vary from one line of business to another. Hence, it is only natural that one cannot always combine the two sets of rules. The GAAP depreciation methods can be used for most state and local taxes. U.S. GAAP requires deferred tax allocation on all significant timing differences, including the allocations to untaxed reserves (Tanzi 84).
Timing of Recognition
In addition,” timing and recognition differences exist between GAAP and tax accounting: Timing differences are based upon the variety of different methods of asset valuation or liability recognition and the determination as to when to reflect some associated income and/or expenses (such as the selection of different methods of depreciation for GAAP and tax return purposes, or the accumulation of liabilities associated with expenses in different periods for GAAP and tax return purposes. Recognition differences or “permanent” differences are base upon certain income and expense items being recognized under GAAP although not for tax purposes” (Willis 85).
In addition, under GAAP, businesses are required to use the accrual method, reporting income when it is earned and deducting expenses when incurred while tax rules allow businesses use the cash basis method, reporting income only when it is actually received and expenses only when paid.
Furthermore, tax basis financial statements are prepared on a complete basis of accounting based on the Internal Revenue Code regulations for accounting for transactions more willingly than Generally Accepted Accounting Practices (GAAP). Users interested in the tax aspects of their relationship with an individual will find the use of tax basis rather than GAAP for preparing financial statements can decrease the overall financial reporting costs by avoiding the difficulty of GAAP (Willis 82). Using tax basis will as well reduce taxes paid. The income tax basis of accounting is base on the rules and regulations for accounting for transactions under the IRC. Tax basis financial statements are mostly useful and helpful when statement users are mostly interested in the tax aspects of their relationship with the entity (Willis 111).
Normally, profit-oriented entities are required to sustain records of the tax basis of their assets and liabilities. This means that using the tax basis as an alternative of GAAP in preparing financial statements can generally lessen overall financial reporting costs. A number of factors make tax basis financial statements more attractive than ever for small businesses. First is the growing complexity of GAAP.
Hopwood, Anthony. The Economics and Politics of Accounting: International Perspectives on Research Trends, Policy, and Practice. Oxford University Press: Oxford, 2004.
Tanzi, Vito. Taxation in an Integrating World. Brookings Institution: Washington, DC, 1994.
Willis, Hoffman, Maloney, & Rabbe, West’s Federal Taxation: Comprehensive Volume, 2011 Annual Edition. West Publishing Company, 1995.
Zodrow, George R. State Sales and Income Taxes: An Economic Analysis. Texas A&M University Press: College Station, TX, 1999.