Acuity Blog

GAAP vs. tax-basis reporting: Choosing the right model for your business

Virtually every business must file a tax return. So, some private companies issue tax-basis financial statements, rather than statements that comply with U.S. Generally Accepted Accounting Principles (GAAP). But doing so could result in significant differences in financial results. Here are the key differences between these two financial reporting options.

GAAP

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many lenders expect private borrowers to follow suit, because GAAP is familiar and consistent.

In a nutshell, GAAP is based on the principle of conservatism, which generally ensures proper matching of revenue and expenses with a reporting period. The principle also aims to prevent businesses from overstating profits and asset values to mislead investors and lenders.

Tax-basis reporting

Compliance with GAAP can also be time-consuming and costly, depending on the level of assurance provided in the financial statements. So some smaller private companies opt to report financial statements using a special reporting framework. The most common type is the income-tax-basis format.

Tax-basis statements employ the same methods and principles that businesses use to file their federal income tax returns. Contrary to GAAP, tax law tends to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other requirements have been met.

Key differences

When comparing GAAP and tax-basis statements, one difference relates to terminology used on the income statement: Under GAAP, businesses report revenues, expenses and net income. Tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.

Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. Businesses must assess whether useful lives and asset values remain meaningful over time and they may occasionally incur impairment losses if an asset’s market value falls below its book value.

For tax purposes, fixed assets typically are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 expensing and bonus depreciation are subtracted before computing MACRS deductions.

Other reporting differences exist for inventory, pensions, leases, and accounting for changes and errors. In addition, businesses record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law; instead, they’re deducted when transactions take place or conditions are met that make the amount fixed and determinable. Tax law also prohibits the deduction of penalties, fines, start-up costs and accrued vacations (unless they’re taken within 2½ months after the end of the taxable year).

Pick a winner

Tax-basis reporting is a shortcut that makes sense for certain types of businesses. But for others, tax-basis financial statements may result in missing or even misleading information. Contact us to discuss which reporting model will work the best for your business.

© 2017

 


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Tax planning critical when buying a business

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If you acquire a company, your to-do list will be long, which means you can’t devote all of your time to the deal’s potential tax implications. However, if you neglect tax issues during the negotiation process, the negative consequences can be serious. To improve the odds of a successful acquisition, it’s important to devote resources to tax planning before your deal closes.

Complacency can be costly

During deal negotiations, you and the seller should discuss such issues as whether and how much each party can deduct their transaction costs and how much in local, state and federal tax obligations the parties will owe upon signing the deal. Often, deal structures (such as asset sales) that typically benefit buyers have negative tax consequences for sellers and vice versa. So it’s common for the parties to wrangle over taxes at this stage.

Just because you seem to have successfully resolved tax issues at the negotiation stage doesn’t mean you can become complacent. With adequate planning, you can spare your company from costly tax-related surprises after the transaction closes and you begin to integrate the acquired business. Tax management during integration can also help your company capture synergies more quickly and efficiently.

You may, for example, have based your purchase price on the assumption that you’ll achieve a certain percentage of cost reductions via postmerger synergies. However, if your taxation projections are flawed or you fail to follow through on earlier tax assumptions, you may not realize such synergies.

Merging accounting functions

One of the most important tax-related tasks is the integration of your seller’s and your own company’s accounting departments. There’s no time to waste: You generally must file federal and state income tax returns — either as a combined entity or as two separate sets — after the first full quarter following your transaction’s close. You also must account for any short-term tax obligations arising from your acquisition.

To ensure the two departments integrate quickly and are ready to prepare the required tax documents, decide well in advance of closing which accounting personnel you’ll retain. If you and your seller use different tax processing software or follow different accounting methods, choose between them as soon as feasible. Understand that, if your acquisition has been using a different accounting method, you’ll need to revise the company’s previous tax filings to align them with your own accounting system.

The tax consequences of M&A decisions may be costly and could haunt your company for years. We can help you ensure you plan properly and minimize any potentially negative tax consequences.

© 2017

 


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Larger deduction might be available to businesses providing meals to their employees

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When businesses provide meals to their employees, generally their deduction is limited to 50%. But there are exceptions. One is if the meal qualifies as a de minimis fringe benefit under the Internal Revenue Code.

A recent U.S. Tax Court ruling could ultimately mean that more employer-provided meals will be 100% deductible under this exception. The court found that the Boston Bruins hockey team’s pregame meals to players and personnel at out-of-town hotels qualified as a de minimis fringe benefit.

Qualifying requirements

For meals to qualify as a de minimis fringe benefit, generally they must be occasional and have so little value that accounting for them would be unreasonable or administratively impracticable. But meals provided at an employer-operated eating facility for employees can also qualify.

For meals at an employer-operated facility, one requirement is that they be provided in a nondiscriminatory manner: Access to the eating facility must be available “on substantially the same terms to each member of a group of employees, which is defined under a reasonable classification set up by the employer that doesn’t discriminate in favor of highly compensated employees.”

Assuming that definition is met, employee meals generally constitute a de minimis fringe benefit if the following conditions also are met:

  1. The eating facility is owned or leased by the employer.
  2. The facility is operated by the employer.
  3. The facility is located on or near the business premises of the employer.
  4. The meals furnished at the facility are provided during, or immediately before or after, the employee’s workday.

The meals generally also must be furnished for the convenience of the employer rather than primarily as a form of additional compensation.

On the road

What’s significant about the Bruins case is that the meals were provided at hotels while the team was on the road. The Tax Court determined that the Bruins met all of the de minimis tests related to an employer-operated facility for their away-game team meals. The court’s reasoning included the following:

  • Pregame meals were made available to all Bruins traveling hockey employees (highly compensated, non-highly compensated, players and nonplayers) on substantially the same terms.
  • The Bruins agreements with the hotels were substantively leases.
  • By engaging in its process with away-city hotels, the Bruins were “contract[ing] with another to operate an eating facility for its employees.”
  • Away-city hotels were part of the Bruins’ business premises, because staying at out-of-town hotels was necessary for the teams to prepare for games, maintain a successful hockey operation and navigate the rigors of an NHL-mandated schedule.
  • For every breakfast and lunch, traveling hockey employees were required to be present in the meal rooms.
  • The meals were furnished for the convenience of the Bruins.

If your business provides meals under similar circumstances, it’s possible you might also be eligible for a 100% deduction. But be aware that the facts of this case are specific and restrictive. Also the IRS could appeal, and an appeals court could rule differently.

Questions about deducting meals you’re providing to employees? Contact us.

© 2017

 


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Supplement your financial statements with timely flash reports

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Most companies prepare financial statements on a monthly or quarterly basis. Unfortunately, it usually takes between two and six weeks for management to finalize reports that comply with U.S. Generally Accepted Accounting Principles (GAAP). The process takes even longer if an outside accountant reviews or audits your financial statements. Decision-making based solely on this stale information is reactive, not proactive. To help bridge the timing gap between daily operations and receipt of monthly or quarterly financial statements, consider using “flash reports.”

Reap the benefits

Flash reports typically provide a snapshot of key financial figures, such as cash balances, receivables aging, collections and payroll. Some metrics might be tracked daily — including sales, shipments and deposits. This is especially critical during seasonal peaks or among distressed borrowers.

Effective flash reports are simple and comparative. Those that take longer than an hour to prepare or use more than one sheet of paper are too complex to maintain. Comparative flash reports identify patterns from week to week — or deviations from the budget that may need corrective action.

Beware of limitations

Flash reports can help management proactively identify and respond to problems and weaknesses. But they have limitations that management should recognize to avoid misuse.

Most important, flash reports provide a rough measure of performance and are seldom 100% accurate. It’s also common for items such as cash balances and collections to ebb and flow throughout the month, depending on billing cycles.

Companies generally use flash reports only internally. They’re rarely shared with creditors and franchisors, unless required in bankruptcy or by the franchise agreement. A lender also may ask for flash reports if a borrower fails to meet liquidity, profitability and leverage covenants.

If shared flash reports deviate from what’s subsequently reported on GAAP financial statements, stakeholders may wonder if management exaggerated results on the flash report or is simply untrained in financial reporting matters. If you need to share flash reports, consider adding a disclaimer that the results are preliminary, may contain errors or omissions, and haven’t been prepared in accordance with GAAP.

Customize your flash reports

Each company’s flash report should contain different information. For instance, billable hours might be more relevant to a law firm, and machine utilization rates more relevant to a manufacturer. We can help you figure out what items matter most in your industry and how to create an effective flash report for your business.

© 2017

 


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Could captive insurance reduce health care costs and save your business taxes?

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If your business offers health insurance benefits to employees, there’s a good chance you’ve seen a climb in premium costs in recent years — perhaps a dramatic one. To meet the challenge of rising costs, some employers are opting for a creative alternative to traditional health insurance known as “captive insurance.” A captive insurance company generally is wholly owned and controlled by the employer. So it’s essentially like forming your own insurance company. And it provides tax advantages, too.

Benefits abound

Potential benefits of forming a captive insurance company include:

  • Stabilized or lower premiums,
  • More control over claims,
  • Lower administrative costs, and
  • Access to certain types of coverage that are unavailable or too expensive on the commercial health insurance market.

You can customize your coverage package and charge premiums that more accurately reflect your business’s true loss exposure.

Another big benefit is that you can participate in the captive’s underwriting profits and investment income. When you pay commercial health insurance premiums, a big chunk of your payment goes toward the insurer’s underwriting profit. But when you form a captive, you retain this profit through the captive.

Also, your business can enjoy investment and cash flow benefits by investing premiums yourself instead of paying them to a commercial insurer.

Tax impact

A captive insurance company may also save you tax dollars. For example, premiums paid to a captive are tax-deductible and the captive can deduct most of its loss reserves. To qualify for federal income tax purposes, a captive must meet several criteria. These include properly priced premiums based on actuarial and underwriting considerations and a sufficient level of risk distribution as determined by the IRS.

Recent U.S. Tax Court rulings have determined that risk distribution exists if there’s a large enough pool of unrelated risks — or, in other words, if risk is spread over a sufficient number of employees. This is true regardless of how many entities are involved.

Additional tax benefits may be available if your captive qualifies as a “microcaptive” (a captive with $2.2 million or less in premiums that meets certain additional tests): You may elect to exclude premiums from income and pay taxes only on net investment income. Be aware, however, that you’ll lose certain deductions with this election.

Also keep in mind that there are some potential drawbacks to forming a captive insurance company. Contact us to learn more about the tax treatment and other pros and cons of captive insurance. We can help you determine whether this alternative may be right for your business.

© 2017

 


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