Tax Basis Financial Statements May Be Right for Your Business
James Boissonneault, Audit Senior Manager
Most financial statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP). However, with the issuance of additional Accounting Standard Updates (ASUs), most notably Revenue from Contracts with Customers (ASU 2014-09) and Leases (ASU 2016-02), preparing GAAP-basis financial statements is becoming more difficult and time consuming than ever before. One alternative is to forgo GAAP, and instead prepare financial statements on a tax basis.
Differences exist between GAAP income and taxable income. GAAP requires a number of estimates, the purpose of which is to match potential or likely items of income and expense with the period that set those possibilities or likelihoods in motion. This often accelerates recognition of transactions and events under GAAP relative to taxable income, because for tax purposes, those items of income and expense are delayed until they come to fruition.
The greatest potential benefit of preparing financial statements on a tax basis is time savings for company management, primarily because it eliminates the need to make several GAAP-specific estimates. Examples of efforts that are not needed include establishing an allowance for overdue accounts receivable balances, evaluating long-term assets for potential impairment, and accruing for contingent liabilities. Management can forgo preparation of a cash flows statement, although many companies reporting on the tax basis find this to be a meaningful statement, and therefore include it even though not required. Not-for-profit companies who report on the tax basis are not required to record donated service revenue. Management can avoid classifying net assets as unrestricted, temporarily restricted, or permanently restricted, as required by GAAP; and a statement of functional expenses is not required.
When deciding if tax basis financial statements are suitable for your business, be sure to evaluate the needs of the users of the financial statements. Users can include owners, investors, regulators, and lenders. Management should consider how adopting tax basis accounting policies could change the results reported in their financial statements. For example, use of accelerated tax depreciation could result in lower income, thus arguably allowing the company’s choice of accounting methods, rather than its operations, to cause it to fail its lender’s financial covenants.
Management should not prepare financial statements on a tax basis if those financial statements would prove misleading. For example, because contingent liabilities (and related estimated expenses) are excluded, companies commonly subject to environmental fines, penalties, or litigation may find that omitting provisions for these liabilities (when they are probable and estimable) is misleading to the users of the financial statements. The same could be true for companies holding large receivable balances with uncertainty regarding whether the cash will be collected. Under GAAP rules, an allowance for doubtful accounts and related expense are recorded, reducing the net receivables down to an amount deemed to be truly collectible. Because that allowance is not allowed for tax purposes, use of tax basis financial statements potentially has the effect of inflating a company’s receivables.
If tax basis financial statements are prepared, management will need to disclose the following items in the financial statements:
- The financial statements should be appropriately titled to avoid a reader’s assumption that the statements were prepared in accordance with GAAP. Common examples include “Statement of Assets, Liabilities, and Equity—Tax Basis” and “Statement of Revenues and Expenses—Tax Basis.”
- The notes accompanying the financial statements should include a summary of significant accounting policies.
- The notes of the financial statements should disclose the differences in preparing the financial statements on a tax basis as opposed to GAAP. Common examples include the timing of recording revenue, depreciation expense, and evaluation of assets for impairment.
- The notes of the financial statements should include the same disclosures for financial statement line items as are used in GAAP basis statements. For example, the notes should continue to disclose important terms in a debt agreement, the composition of inventory (raw materials, work-in-process, and finished goods), and details related to outstanding equity instruments (number of shares authorized, issued, and outstanding).
Tax basis financial statements offer the potential benefit of time savings and less complexity, and represent a great alternative to GAAP basis reporting in the right situations. However, due to the unique differences between GAAP and tax rules, management should weigh the potential for confusing readers of those reports when considering whether tax basis reports are appropriate for their business.
If you have any questions about tax basis financial statements, please contact James Boissonneault or your BNN advisor at 1-800-244-7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.