Income Tax Basis of Accounting vs. GAAP Method- Which is better approach for your Restaurant Business?

gaap-vs-tax-basis-accountingFor all New York City restaurant brands, franchise chains and fine dining businesses, we are certain you’re thrilled that it’s tax season again. This means your yearly income financial statements need to be compiled, reviewed or audited and presented to be compliant with bank covenants and state and federal provisions.  Investors and banks require a company’s year-end financials to be in compliance with generally accepted accounting principles (GAAP). While GAAP requirements are usually made to best serve investors who will look at a public company’s financial statements, they are also useful to private company owners and bankers (those without public investors). This is because it is always paramount to care about understanding a restaurant’s operations, revenue, cash flow and ability to repay debt.

You may be wondering if it makes more sense to have your restaurant CPA prepare your financials using the GAAP or income tax basis accounting method. In an industry where tax impacts are a significant driving force in decision making, we have seen a rise in recent years in the use of tax basis financial statements. There are a few important differences to consider, as both methods have drawbacks. The basis of accounting can change based on your auditor’s opinion. For the restaurant industry, the differences from using the two accounting approaches are most apparent when you are dealing with:

  • Depreciation
  • Lease accounting
  • Gift card recognition
  • Closed store reserves
  • Tenant improvement allowance
  • Goodwill
  • Purchase accounting

As an example, the income tax basis of accounting, which is used by most accountants, requires the recognition of rent, paid or to be paid. GAAP is the opposite, it recognizes the rent expense on a straight line basis over the term of the lease.  This results in a liability or deferred rent, on the balance, for the difference between rent paid and rent expensed.  As a general rule, the adjustments required under the GAAP method result in non-cash adjustments to the books of record, and a thorough understanding of technical financial statements.

If your restaurant is thinking about using income tax basis of accounting approach, there are a few benefits to think about:

  • A review or audit is cheaper for clients and easier to get prepped for, as less accounting assistance is required from your CPA.
  • The results are often more aligned with earnings before interest, tax, depreciation and amortization (EBITDA), as it excludes non-cash transactions and focuses on cash outflow as well as the ability to meet debt servicing requirements
  • The Profit and Loss Statement results better reflect the operating cash flow of the restaurant by excluding non-cash transactions for continuing operations
  • It has less impact on sales, cost of sales, labor
  • The balance sheet only includes liabilities with cash outlay requirements

Disadvantages of Using the GAAP Method

  • If you use the income tax basis accounting, it will not include adjustments for impairment or closure of stores; although, disclosures will be made in the notes to financial statements.
  • Sometimes debt covenants (agreements between a company and its creditors) may be necessary; most lenders and banks allow for non-cash element of deferred rent to be backed out of calculations.
  • In many private equity or M&A deals, GAAP financial statements are preferred.

Conclusion

GAAP accounting provides a means for a business to have a complete overview of the reality of its operations.  This is because a business, by using this method, can track all monetary relationships, investments and expenditures.  On the flip side, Income tax accounting provides a focus on business or personal expenses that pertain to tax records only.  The GAAP accounting approach is more involved than income tax accounting and provides more details about the monetary reality of daily operations that may or may not pertain to your restaurant’s tax needs.  GAAP also provides an accurate statement of your company’s 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, report reliability for 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 needs to prepare and issue financial statements to investors, GAAP provides greater consistency in 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’re still not sure which accounting method will work best for your hospitality business, you should consult your investor or accounting professional.

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