What is GAAP Accounting? What is GAAP and what are the differences between GAAP and Cash Basis Accounting? GAAP stands for Generally Accepted Accounting Principles. These are a set of principles and assumptions that form the framework for "accrual" accounting. With this system of accounting revenues are recognized when they are earned rather than when cash is received and expenses are recognized when they are incurred rather than when they are paid for in cash. Long-term assets are depreciated and amortized. Credit transactions, such as sales you make via credit cards or on account are recognized as revenue before cash is received and purchases you make on account or via credit card for inventory or other assets or for expenses are recognized before cash is paid out. The Financial Accounting Standards Board (FASB) is the arm of the Accounting Profession that establishes accounting standards. Sometimes the Securities and Exchange Commission (SEC) also plays a part in establishing these standards. All publicly owned companies, those that trade on the stock exchanges, are required to report under and abide by these standards. Cash Basis Accounting recognizes revenue or a sale only when cash is received and recognizes expenses only when cash is paid out. In other words it records the inflows and outflows of cash, as revenue and expense, respectively. Strict Cash Basis Accounting does not recognize any credit transactions, such as receivables and payables. (No credit card transactions are recognized and there are no receivables or payables) Some examples which contrast the difference between cash basis and accrual accounting are: 1. You sell a dishwasher on credit for $600 and it's delivered 3 days later. There is no down payment on the sale. 2. You purchase Inventory worth $30,000 on credit, F.O.B. destination. 3. At the end of second quarter $300 of interest is due and payable on a $20,000, 6%, 5 year note that you obtained 2 years ago. 4. In January, 2019, you paid $2,000 for two year's worth of property insurance that runs from Jan. 1, 2019 through Dec. 31, 2020. Though accrual accounting generally provides a better picture of a business's operational results and financial position, many small businesses which are not publicly owned operate on a cash basis or modified cash basis of accounting. Cash basis generally takes less time to manage and maintain, thereby making it a less expensive method to keep books. Tax Accounting is often close to the same thing as Cash Basis or Modified Cash Basis Accounting, though not in all respects. If the sale of inventory is a material part of a business then the purchase and sale of inventory, at the least, usually must be kept on the accrual basis. With the 2017 Tax Cuts and Jobs Act now public law, this is now a gray area as to how a qualifed “small business” may account for items that were considered “inventory” prior to this new law. Some believe that the new law gives them legal basis to right off or expense items that were heretofor considered inventory as soon as they are paid for. However, some CPAs think that further guidance from the IRS is needed before making the decision to change to cash basis accounting for these items. The IRS states: “ The consent granted under section 9 of Rev. Proc. 2015-13 for a change made under section 22.19(1)(b) of this revenue procedure is not a determination by the Commissioner that the proposed inventory method of accounting is permissible, and does not create any presumption that the proposed method is a permissible method of accounting under a provision of the Code. The director will ascertain whether the proposed method is permissible under the Code.” In other words, changing your accounting for inventory from accrual to cash basis may or may not be permissable by the IRS. https://www.irs.gov/pub/irs-drop/rp-18-40.pdf (See Section 3.19) For businesses with annual gross receipts of $25,000,000 or less that don't sell inventory, keeping a cash basis or modified
Cash Basis vs Accrual
1. No transaction is recorded because so cash has been received. The cost of the dishwasher sold is recorded as Cost of Goods Sold when the dishwasher is paid for in cash. (I emphasize this is strict cash basis accounting, not tax basis accounting.)
1. $600 is recognized and booked as revenue on the day of delivery, before any cash is ever received. An account receivable is recorded for $600. Cost of Goods Sold is charged for the cost of the inventory on day of delivery and Inventory is decreased for the sale.
2. No transaction is recorded because no cash has been paid for the Inventory yet.
2. Upon delivery of the merchandise, Inventory is recorded for $30,000 and an account payable is created.
3. No transaction is recorded because no cash has been paid.
3. Interest Expense is accrued and booked for $300 and an account payable is recorded for the same amount.
4. Property Insurance Expense is recorded for $2,000 at time the cash is paid.
4. In January, 2019, $2,000 is recorded to an asset account called Prepaid Insurance. At March 31, 2019, one- eighth or $250 of the asset has been used and $250 would be charged to Insurance Expense at that time and the asset account reduced by that amount via a contra asset account called Accumulated Amortization, Prepaid Insurance.