All businesses required to file a tax return must maintain records. However, the records they keep for tax accounting purposes may differ from the records maintained for business purposes.
If a company is required to or chooses to comply with Generally Accepted Accounting Practices (GAAP), it will typically follow an accrual-basis method for reporting revenue. Its business tax records, on the other hand, must comply with the Internal Revenue Code, which recognizes Cash, Accrual or Hybrid Accounting as valid reporting methods.
If a company uses a different accounting method for both sets of books, the income it reports on its financial statement may not match the income it report on its tax return.
Accrual-basis accounting
The accrual accounting method records anticipated revenue when a product or service is delivered, even if payment for said product has not yet been received. Expenses, too, are reported in the year they are incurred, regardless of when they will be paid.
Some expenses must be paid within a certain time to be deductible under the accrual method, such as pension contributions like 401k matching. Other expenses must meet certain reporting tests to be expensed. For example, health and workers’ compensation claims are incurred but not reported (IBNR).
What is an example of accrual basis?
If you’re trying to understand the difference between cash vs. accrual accounting, here’s how it works: If a company provides a service in December but doesn’t receive payment until January, under accrual accounting, they record the revenue in December when the service was performed rather than in January when the payment is received. The accrual method provides a more accurate picture of a company’s financial health than cash basis accounting typically does.
Cash-basis accounting
The cash-basis method of accounting involves immediate recognition of revenue and expenses. Revenue is reported on the income statement only when money is received, and expenses are only recorded for the tax year when they are actually paid out.
Cash vs accrual accounting similarities and differences
Cash-basis and accrual-basis accounting are two methods for recording financial transactions.
Both tax accounting methods share some similarities:
- Both methods track income and expenses.
- Both cash and accrual accounting use a double-entry system of debits and credits to maintain financial balance.
- Both methods of tax accounting offer insights into the financial performance of a business.
However, there are significant differences between cash vs. accrual accounting:
- Cash-basis accounting records transactions when cash is received or paid out, while accrual-basis accounting records revenue when earned and expenses when incurred, regardless of cash flow.
- Because of this critical difference, accrual-basis accounting is generally considered a more accurate reflection of a company’s financial health.
Tax accounting
Tax accounting is focused on calculating a company’s taxable assets and liabilities with to raise revenue for the United States government. It is regulated by the laws in the Internal Revenue Code (IRC) and accepts either cash, accrual or a hybrid as valid reporting methods to determine how much of the company’s income is taxable.
GAAP accounting
Generally Accepted Accounting Principles (GAAP) are a standard set of accounting rules and procedures for preparing, presenting, and reporting financial statements in the U.S. GAAP accounting ensures that financial information is consistent, comparable, and reliable across different companies.
Understanding GAAP vs. tax accounting
While GAAP accounting and tax accounting are widely accepted and accurate accounting methods, each serves different purposes. GAAP accounting provides a comprehensive and accurate financial picture of a company for external stakeholders like investors and creditors. Meanwhile, tax accounting aims to minimize tax liability by following specific tax laws and regulations. If a company were to employ both methods, each would likely show differences in revenue recognition, expense deductions, and asset valuation.
Book income vs. tax income
Book income describes a company’s financial income before accounting for taxes. It is the amount a corporation reports to its investors or shareholders, which gives an idea of how well a company performed during a certain time period . Tax income is the amount of taxable income a company reports on its return.
Note: The difference between book income loss and tax income loss is reported on the tax return for larger entities that meet certain revenue and asset requirements. This reconciliation is contained on Schedule M-1 on 1065, 1120 and 1120S returns.
Understanding temporary vs. permanent tax differences
Temporary and permanent tax differences arise when income recorded through financial accounting diverges from taxable income. Here’s how it works:
Temporary differences in book income vs. tax income
Certain transactions will eventually be reflected in both a company’s book income and tax income, but if the company uses different tax accounting methods for each set of records, those transactions may simply be recognized at different times.
For example, if a company receives advance payment for a service, it isrequired to report it as taxable income on itstax return. But for its book accounting, that advance payment will not be reported as income until the day the money is due, or “earned.” Once this occurs, the temporary difference in book and tax income that was a result of this transaction will be resolved.
One common temporary difference between book income and tax income results when they take bonus depreciation and Section 179. In such cases, the entity accelerates the tax deduction before the actual expense occurs. This overstates deductions on the tax return in the early years of the asset’s useful life and understates deductions later.
Permanent differences in book income vs tax income
Certain differences in book and tax income will never be reversed. Some common permanent differences include:
- Penalties and fines – These may be deducted from book income but are not deductible for tax purposes.
- Meals and entertainment – Meals and entertainment costs can be completely expensed for book accounting. For tax accounting purposes, a company can only deduct 50% of meals and 0% of entertainment expenses.
- Municipal bond interest – This is considered net income for book accounting but is not included in taxable income.
Unlike temporary differences, permanent tax differences only impact the specific period it occurs, so they do not create deferred tax assets or liabilities.
As a tax preparer, you’ll be helping businesses minimize tax liabilities, making it critical to understand the different types of accounting for taxes.
Interested in learning more about GAAP vs. tax accounting or cash vs. accrual accounting? Check out our library of online resources for tax preparers.
