There are two choices when selecting an accounting method for your business: GAAP, which stands for Generally Accepted Accounting Principles, and Tax Accounting. Having a clear understanding of how these two methods compare will help you make your decision. Each has benefits that may be ideally suited to the needs of your business financial reporting, and each method has drawbacks that may make it an unsuitable choice.
GAAP accounting records all financial transactions: cash, accrual, investment, expenses, tax and deductions that may or may not have to be reported on your yearly tax form. This form of accounting is governed by strict standards and rules and may show actual income that is different from taxable income. GAAP accounting is a set of standards provided by policy boards and commonly accepted methods of recording financial information that gives consistency to any type of financial reporting.
Tax-based accounting is used by most CPAs, and the majority of certified financial statements come from tax-based accounting. The focus of this type of accounting is on tracking your taxable income as it builds throughout the year. Tax accounting is a method of producing financial statements that uses the same methods that will apply to your tax return.
GAAP accounting provides a means for a business to have a complete overview of the reality of its operations by tracking all monetary relationships, investments and expenditure. Tax accounting provides a focus on business or personal expenses that pertain to tax records only.
GAAP accounting is more involved then tax accounting and provides more details about the monetary reality of daily operations that may or may not pertain to your tax needs; it also provides an accurate statement of your liabilities and assets. Tax based accounting has less rules and makes it easier to see where you stand at any given point of the year with taxable income. It does not, however, reliably report all liabilities and assets.
When choosing which form of accounting to use for your personal or business needs there are several points to consider. If your business must issue financial statements to investors, GAAP provides greater consistency in the reporting, as it is guided by industry standards and not subject to the many changes that occur in tax requirements on a yearly basis. If you are newly in business or if you are just beginning to use an accounting method in your personal life, you may want to utilize GAAP standards; it will allow you to begin to see how money is used in all areas of your life and business. If you are established in your business and do not need to issue financial statements or your personal budget is adequate and realistic to your living needs, the simpler tax accounting methods may be better for you; your focus will remain on what is needed to successfully file taxes at the end of each year and you do not need the masses of data associated with tracking every financial transaction that occurs during the year.
Tax accounting, also known as Other Comprehensive Basis of Accounting, also includes a method of accounting known as cash basis. It is rare that any business can succeed basing its accounting on cash. The intricacies of financial transactions and the necessity of looking for non-cash based deductions come tax time make cash based tax accounting impractical. Note that all standards for accounting are set by the International Accounting Standards Commission.