Book Versus Taxable Accounting Differences
Tax Accounting Basis
Cash Basis
Similarly, in cash basis accounting, your business expenses are recorded as you pay them. Cash basis accounting can work well for startup businesses, sole proprietorships and small businesses that only accept cash, rather than sending out invoices.
Accrual Basis
In accrual basis accounting, your company’s income is recorded in the books when it is earned, as indicated by an invoice. Your company’s expenses are recorded when you are billed. Bookkeeping will also show dates and record payments when received (for income) or paid (for expenses).
Accrual basis accounting is used by almost all small businesses past the startup stage because it gives a more accurate record of your financial status over time. It’s also necessary if you work with accounts receivable (money your business is owed for goods and services) and accounts payable (money your business owes to suppliers, vendors, or creditors) or have inventory.
If your business is a publicly traded C or S Corp, or you have a goal of becoming publicly traded in the future, accrual basis accounting is a prudent choice, because it follows Generally Accepted Accounting Principles (GAAP), which the U.S. Securities and Exchange Commission (SEC) requires of publicly traded companies. Cash basis accounting does not use GAAP. GAAP is also advisable if you want to apply for financing in the future since lenders may require it.
Once you make the determination of which to use, you generally have to use it year over year so that your records are comparable year to year. You need approval from the IRS to change the method.
The choice between cash basis and accrual basis can affect your taxes because it affects the time at which you receive and book income and when you pay expenses. If you have tax-deductible expenses, for example, and use cash basis accounting, you could choose to pay those expenses by the end of the year to lower your taxable income. That may not be available to you with accrual basis accounting because you may not have received the invoice by the end of the year.
Book Income Versus Tax Income
Taxable income, on the other hand, is the income you report on your tax return as the foundation for the amount of tax you’ll pay as well as your tax bracket.
Book income and tax income can vary considerably. Book income reflects your income as earned, while tax income may reflect the total earned after reductions from tax deductions, tax credits and other methods. It can also be affected by changing laws and regulations. Small businesses strive for tax efficiency, which is generally defined as paying the least amount of tax allowable by the tax code and law.
Book Expenses Versus Tax Expenses
Book expenses and tax expenses can also vary. A book expense is an expenditure showing in your business’s bookkeeping and accounting system and recorded on its financial statements. Tax expenses, though, may reflect deductions and tax rules that make the tax expense different than the book expense. An example is a business expense such as meals and entertainment. This category is generally only 50 percent tax deductible. If you had a $100 meal with a client, therefore, the book expense would be $100, but the tax expense (as given on your tax return) would only show $50.
Differences between book expenses and tax expenses can also be occasioned by depreciation (methods for book depreciation and tax depreciation can differ) and tax credits.
The differences between book expenses and tax expenses are known as “book-tax difference.” The difference between the books and the tax return is typically reported on schedule M-1.
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