Income Tax Basis Method of Accounting: Key Differences from GAAP for Restaurants
When choosing an accounting method for a business, entities have several options from which to choose. Generally Accepted Accounting Principles (GAAP) follow an accrual method, which lenders and creditors most accept. GAAP is intended to provide complete and accurate financial information to decision-makers and stakeholders. An alternative to GAAP is preparing financial statements under Other Comprehensive Basis of Accounting (OCBOA). OCBOA financial statements for example can include cash basis, modified cash basis or income tax basis. Cash-based financial statements recognize income and expenses only as cash is exchanged. Modified cash basis of accounting includes some accrual accounting principles and generally records short-term items on a cash basis and long-term items on the balance sheet under an accrual method. The most common type of OCBOA financial statement is income tax basis, which allows the entity to use the same accounting methodologies and principles that were used to file its federal income tax return. Income tax basis accounting primarily focuses on compliance with tax laws and regulations.
While less common than selecting GAAP as the financial reporting framework, income tax basis presents unique considerations for businesses, particularly in the restaurant industry. This article explores the key differences between these two accounting approaches, highlighting potential discrepancies in areas like depreciation, operating leases, and gift cards.
What are the key differences between the restaurant’s income tax basis and GAAP accounting?
Depreciation: Under income tax basis, depreciation is generally accelerated compared to the straight-line approach used in GAAP. This can lead to significant swings in net income, especially during years with significant capital projects such as store renovations or new store buildouts. Generally, under the income tax basis, significant tax depreciation would be taken on new assets in year one versus spread out over the useful life of the asset in GAAP financials. This difference, however, is EBITDA-neutral under both methods.
Operating Leases: GAAP treats operating leases as right-of-use assets and lease obligations liabilities on the balance sheet, recognizing rent expense and lease incentives gradually over the lease term. In contrast, the income tax basis generally recognizes rent expense only as cash payments are made. Besides the obvious balance sheet differences, for restaurateurs with escalating lease payments or significant lease incentives, rent expense on the income statement can be materially different under the two methods. The initial adoption and continued compliance with GAAP accounting for leases can also be costly and complex for smaller entities.
For brands closing restaurant locations, remaining lease obligations or termination fees can also drive a difference in the reporting methods. Under GAAP, once the store is closed, the remaining obligations are generally accrued for and expensed within that same period. Under income tax basis, these costs would not translate to expenses until they are due and paid—depending on the lease structure, these could potentially stretch over several years.
Gift Cards: As long as there exists a legal obligation to honor gift cards and/or escheat it to the state, GAAP recognizes a liability for unredeemed gift cards and spreads breakage income over the redemption period. Income tax basis accounting records gift card sales to revenue typically faster than the redemption period, potentially causing significant year-to-year fluctuations, especially with long or erratic redemption patterns.
Acquisitions: Purchase price accounting for acquisitions has differences between GAAP and income tax basis, potentially impacting the financial statements if relevant to your business. A financial advisor can help entities understand how they would differ for each unique deal under GAAP or income tax basis accounting.
Impairment of Assets: GAAP requires impairment testing for long-lived assets, while income tax basis does not consider such losses. This difference could be material if a brand has underperforming stores, for example, near a city-center impacted by the work-from-home-movement.
Consolidations: Complexities arise in related party transactions and consolidation rules under income tax basis, necessitating a clear understanding between the lender and restauranter of which entities are expected to be included in the financial statements.
Windham Brannon’s Restaurant Practice understands the difference
Understanding the distinctions between income tax basis and GAAP accounting is crucial for restaurant owners and lenders to interpret financial information and navigate potential discrepancies, especially in areas like depreciation, leases and gift cards. While converting income tax basis accounting to GAAP is feasible, the cost implications should be carefully evaluated with the help of a trusted advisor. Windham Brannon’s Restaurant Practice can help you understand the differences and consider the best solution for your business. For questions or more information, contact your Windham Brannon advisor, or reach out to Maggie Wise.
