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If you own your own business, you may be wondering whether you’re better off using Generally Accepted Accounting Principles (GAAP) or tax-basis accounting. The answer depends on the size of your business and your plans for financing and future growth.
Generally speaking, GAAP is a good fit for larger companies with complicated revenue streams (and it’s mandatory for public companies), while the simpler tax-basis accounting can be advantageous for smaller businesses. However, there are some exceptions to this rule.
Here’s what you need to know about the differences between tax-basis vs. GAAP accounting and why one method may be a better fit for your business.
Key Points
• GAAP records all of a company’s financial transactions, giving investors a more accurate picture of its financial health.
• Tax-basis accounting is simpler and less costly than GAAP accounting, making it a good choice for many small businesses.
• Many lenders prefer that borrowers use GAAP, as it shows earnings in the period earned rather than when cash is earned or spent.
• Tax-basis accounting helps companies maximize deductions and defer income, reducing taxable income.
• Choosing between tax-basis vs. GAAP accounting depends on whether a business needs more consistent reporting or wants to focus on filing taxes.
What Is GAAP?
GAAP, which stands for Generally Accepted Accounting Principles, is a set of accounting procedures that public companies must follow to remain compliant with the U.S. Securities and Exchange Commission. Private companies aren’t required to follow GAAP, but doing so can make applying for small business loans easier because it can speed up the underwriting process.
Essentially, GAAP is based on the principle of conservatism, which aims to correctly match revenue and expenses with a reporting period. It also seeks to prevent businesses from overstating profits and asset values to mislead investors and lenders. To that end, GAAP records all financial transactions, including cash, accrual, investment, expenses, taxes, and deductions, even if they do not need to be reported on your yearly tax forms. As a result, GAAP may show actual income that is different from taxable income. Unlike tax-basis, GAAP also makes business cash flow visible through a standardized cash flow statement.
Public companies are required to follow GAAP because investors, lenders, and the overall market must be able to trust the data that these companies provide. GAAP makes this possible because all financial statements are produced with the same methodology, and companies can be compared, which is useful for investors.
No matter what type of business loan a small business owner may apply for, lenders tend to prefer GAAP over other accounting methods because it shows all assets and liabilities, allowing a more complete picture of a company’s financial health.
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What Is Tax-Basis Accounting?
Tax-basis accounting can, in some ways, be thought of as small business accounting since it is the method most commonly used by certified public accountants. Being GAAP-compliant can be costly, so many small businesses in the U.S. opt for tax-basis reporting instead.
Tax accounting follows the same methods and principles that businesses use to file their federal income tax returns and focuses on tracking your taxable income as it builds throughout the year. Unlike GAAP, tax-basis accounting (and tax law) recognizes accelerated gross income and doesn’t allow taxpayers to deduct expenses until the amounts are known and other requirements have been met.
Tax-basis accounting is easier to prepare than GAAP and can be done in a fraction of the time. Choosing this method of accounting also helps simplify tax filing since most of the work has already been done.
However, if you are choosing between GAAP vs. tax-basis accounting, be aware that many lenders prefer that borrowers use the GAAP method, so you may find it more challenging to get a small business loan if your business records use tax-basis reporting.
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Comparing Tax Basis vs GAAP
To determine which accounting method is the right fit for your business, it helps to understand the similarities and differences between tax-basis and GAAP reporting.
Similarities
Both tax-basis and GAAP accounting are ways to record the financial transactions of a business. Both provide a standardized presentation of a business’s financial performance and positioning, such as income statements and balance sheets, and can help with decision-making and financial planning. In addition, both allow accrual-basis accounting (though tax basis also allows other options).
Differences
GAAP and tax-basis reporting also have some fundamental differences. One of the biggest is that GAAP is designed to show earnings in the period earned rather than when cash is received or expended. This is often what investors and lenders want to see and what owners want to show.
From a tax perspective, however, business owners generally want to demonstrate as much loss as possible, maximizing deductions and deferring income to reduce taxable income (and the taxes that will be due). These are the aims of tax-basis accounting.
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GAAP vs Tax-Basis Reporting
When you’re considering GAAP vs. tax-basis financial statements, there’s a lot to look at. This table lays out some of the major differences.
| GAAP | Tax Basis | |
|---|---|---|
| Income statement | Companies list expenses, revenue(s), and net income. | Companies list income, taxable income, and deductions (non-taxable items are disclosed via footnotes). |
| Basis | Accrual-basis accounting is the only option. | Cash-, accrual-, or modified-basis accounting can be used. |
| Depreciation of fixed assets | Tangible assets are depreciated using a method that equally distributes the expense within the period of time in which they were used (often the straight-line method). | Tangible assets are often depreciated using the accelerated method, which allows for higher depreciation write-offs during an asset’s first years. |
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Pros and Cons of Tax-Basis Accounting
Tax-basis accounting comes with both advantages and drawbacks. Here’s a quick rundown of both.
| Pros of Tax-Basis Accounting | Cons of Tax-Basis Accounting |
|---|---|
| Simpler and less costly than GAAP | Investors and lenders prefer that businesses use GAAP |
| Allows you to track your taxable income throughout the year | Does not reliably report all liabilities and assets |
| Simplifies tax filing | Potentially difficult transition if you grow and need to switch to GAAP |
Pros and Cons of GAAP Accounting
GAAP accounting also has pluses and minuses. Here are a few to consider.
| Pros of GAAP Accounting | Cons of GAAP Accounting |
|---|---|
| Because it requires accrual accounting, can provide a more accurate view of long-term operational performance | Maintaining and auditing can take up significant time and resources |
| Required for public companies | Complicated compliance may be difficult for small companies |
| Preferred by lenders and/or investors | May be less useful for daily internal management of company |
How to Know Which Is Best for Your Business
When you’re considering using GAAP vs. tax-basis financial statements, there are a few things to think about. If your business needs to issue financial statements to investors, for instance, you may want to use GAAP, as it is guided by industry standards, provides greater consistency in reporting, and is not subject to changes in tax rules.
Using GAAP can also be helpful if you are new in business since it can give you a clear view of how money is being used in different areas of your company. GAAP accounting can also be an asset if you are in the market for a small business loan.
If, on the other hand, you run a small, fairly established business and have no need to issue financial statements, you may be better off with the simpler tax-basis accounting method. You likely don’t need an accounting of every single financial transaction that your business makes during the year and would be better off focusing on what is needed to successfully file taxes at the end of each year.
When to Use GAAP-Based Financial Statements
Times when it may make sense to use GAAP-based financial statements may include:
• When your company is public or you are planning on taking it public
• If you want to be able to show your financial statements to potential lenders and/or investors
• When you need a clear view of long-term operational performance
• If you want a uniform framework so you can compare your metrics against those of other companies
When to Use Tax-Basis Financial Statements
The following are times when you might want to consider using tax-basis financial statements:
• When your company is private and you are not planning to take it public
• If you don’t intend to issue financial statements to lenders or investors
• If you want to keep your accounting focused on what you’ll need to optimize your year’s tax filing
• If your company doesn’t have the time or resources to expend on GAAP compliance
The Takeaway
Tax-basis accounting has fewer rules than GAAP, making it easier to see where your business stands at any given point of the year with taxable income and simplifying tax filing.
However, if you are looking to attract an investor, now or at some point in the future, it may be worthwhile to choose GAAP accounting, which offers a more accurate picture of your company’s assets and liabilities. GAAP can also serve you well if you are in the market for any type of small business loan, as lenders typically prefer to look at GAAP-compliant financial statements.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What does tax basis mean in accounting?
Tax-basis accounting means a company’s financial statements are prepared in the same manner as is required for federal tax documents.
Do tax accountants use GAAP?
Not typically. Tax accountants usually help businesses with tax-basis financial statements and tax filing. Their expertise typically lies in how a business (or individual) can take advantage of all the deductions and tax breaks for which they qualify.
Is the tax basis of accounting accrual?
Tax-basis accounting can be cash basis (when you record income and expenses after the company actually exchanges money with a consumer or pays off an expense) or accrual basis (when you record revenues and expenses when they’re earned or incurred rather than when the money exchange occurs).
What is the main difference between GAAP and tax-basis financial statements?
A major difference between GAAP vs. tax-basis financial statements is their primary purpose. GAAP financing is geared toward giving external parties a clear view of a company’s financial well-being and tax-basis accounting is intended to ensure that the company is in compliance with tax rules and to figure out taxable income.
Can a small business use GAAP accounting?
Yes, a small business can use GAAP accounting. Although GAAP accounting can take more time, effort, and funds to set up and maintain, small businesses that are interested in getting loans, attracting investors, and/or going public may benefit from using GAAP accounting.
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