Advantages and Disadvantages of GAAP vs Tax-Basis Accounting

Q: 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.

Q: 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.

Q: Is the tax basis of accounting accrual?

Tax-basis accounting can be cash basis (when you record income and expenses after the company exchanges money with a consumer or pays off an expense) or accrual (when you record revenues and expenses when they occur, rather than when the money exchange occurs).

GAAP vs Tax-Basis Reporting - A Comparison

Lauren WardUpdated June 17, 2022

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

If you own your own business, you may be wondering whether you’re better off going with GAAP or tax-based accounting. The answer depends on the size of your business, as well as your plans for financing and future growth. Generally speaking, GAAP is a good fit for larger companies with complicated revenue streams (it also happens to be mandatory for public companies), while the simpler tax-basis accounting can be advantageous for smaller companies. However, there are exceptions to this rule. Here’s what you need to know about the differences between tax vs GAAP accounting and why one method may be a better fit for your business than another.

What Is GAAP?

GAAP stands for Generally Accepted Accounting Principles, and is a set of accounting procedures public companies must follow to remain compliant with the U.S. Securities and Exchange Commission (SEC). 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 in order 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.Public companies are required to follow GAAP because investors, lenders, and the overall market need to be able to trust the data that companies provide. GAAP makes this possible. With GAAP, all financial statements are produced with the same methodology, so it’s not only easier to trust a company’s reports, but it’s also possible to compare one company to another, 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. Recommended: Differences and Similarities Between GAAP vs Non-GAAP

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 used by certified public accountants (CPAs). To be 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 is focused 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 not as difficult to prepare as GAAP, and can be done in a fraction of the time. Choosing this method of accounting also helps simplify tax filing, since the majority of the work has already been done. However, if you are choosing between GAAP basis vs tax basis accounting, be aware that many lenders prefer borrowers to use the GAAP method, so you could potentially find it more challenging to get a small business loan if your business records use tax-basis reporting.Recommended: EBITDA vs. Gross Profit: Examining the Differences and Similarities

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 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 show as much loss as possible, maximizing deductions and deferring income in order to reduce taxable income (and the taxes that will be due). Thus, those are the aims of tax-based accounting.

GAAP vs Tax-Basis Reporting

	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	Can use cash, accrual, or modified basis accounting
Depreciation of Fixed Assets	Tangible assets are depreciated using a method that equally distributes the expense with the period of time in which it was used (often the straight line method)	Tangible assets are often depreciated using the accelerated method, which allows for higher depreciation write-off during an asset’s first years

Pros and Cons of Tax-Basis Accounting

Pros of Tax-Basis Accounting	Cons of Tax-Basis Accounting
Simpler and less costly than GAAP	Investors and lenders prefer businesses to use GAAP
Allows you to track your taxable income throughout the year	Does not reliably report all liabilities and assetsIs
Simplifies tax filing	If you grow and need to switch to GAAP, the transition may be difficult

How to Know Which Is Best for Your Business

When deciding whether to use GAAP vs tax-basis accounting, there are a few things to consider. If your business needs to issue financial statements to investors, you may want to go with GAAP, since it is guided by industry standards, provides greater consistency in the reporting, and is not subject to changes in tax rules. Using GAAP can also be helpful If you are newly in business, since it can give you a clear view of how money is being used in different areas of your business. 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.

The Takeaway

Tax-based accounting has fewer rules than GAAP. It also makes it easier to see where you stand at any given point of the year with taxable income, and simplifies tax filing. However, if you are looking to attract an investor, now or at some point in the future, it may be worthwhile to go with GAAP accounting, which offers a more accurate picture of your company’s assets and liabilities. Going with GAAP can also serve you well if you are in the market for a small business loan, as lenders typically prefer to look at GAAP-compliant financial statements.

3 Small Business Loan Tips

Online lenders generally offer fast application reviews and quick access to cash. Conveniently, you can compare small business loans by filling out one application on Lantern by SoFi.
If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.

Frequently Asked Questions

What does tax basis mean in accounting?

Do tax accountants use GAAP?

Is the tax basis of accounting accrual?

Photo credit: iStock/Ridofranz

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About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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