Here’s something that’s a surprise to many non-businesspeople: There are actually two different accounting methods, and most successful businesses will compile reports and similar using both.
The two accounting methods are:
Book Accounting (which could simply be called “accounting”) utilizes Generally Accepted Accounting Principles (GAAP), whose rules are set by the Financial Accounting Standards Board (FASB).
Tax Accounting relies on the Internal Revenue Code (IRC), and, as you may have guessed, is used by the Internal Revenue Service (IRS).
So what’s the difference between book accounting and tax accounting?
Book Accounting provides business owners and other interested parties (such as lenders) with accurate and detailed financial data, giving them a clear picture as to how the business is actually doing.
Tax Accounting provides the IRS and other taxing authorities (such as States and municipalities) with taxable income and deductible expenses, which of course determines how much tax the business owes.
To be honest, the differences between the two are fairly small. But one key difference has a LOT to do with equipment and equipment financing (and leasing, which is what prompted this series in the first place).
This difference is in how equipment and assets are viewed and depreciated.
Under Book Accounting, the cost of any Equipment is depreciated/expensed over a period of time matching the Equipment’s useful life. This ‘Straight-Line’ method is the most common method used to calculate depreciation expense under GAAP.
So basically, you buy equipment, and depreciate it a little each year depending on how long the equipment is supposed to reasonably last.
Under Tax Accounting, the cost of Equipment is depreciated/expensed much quicker, which minimizes the immediate tax liability. Tax Accounting uses what’s called the Modified Accelerated Cost Recovery System (MACRS) method, which allows larger amounts expensed in the initial years.
In recent years, Section 179 and bonus depreciation are subtracted before computing MACRS deductions, allowing businesses to fully write-off the cost of equipment in the year it is obtained. Currently, the bonus depreciation is 100% thanks to 2017’s Tax Cut and Jobs Act, with no upper limit, so almost all equipment will fall under this.
Real Quick: WHY?
People have asked “why are there two accounting methods”? The answer can be very intricate, but it can also be simple. Imagine you wanted to loan a business money. You want to make sure they are stable, with solid income.
The following is general, but illustrate why both exist:
If you look at the business through a tax accounting lens, the business may seem to have low income, because of all the short-term high depreciation to save on taxes. Based on only that, you may not loan them money.
But a look at them through book accounting shows the company’s true worth… you may have a fine loan candidate there.
The finance guy in me knows it’s useful to understand the fundamental differences between the two accounting methods, which I hope I’ve accomplished for you in this post.