The idea behind Generally Accepted Accounting Principles is to enforce some degree of uniformity among varying companies' financial statements and methods of accounting. However, it's possible for a company's financial statements, or books, to differ from its tax returns. In fact, many U.S. companies maintain two sets of books: one that adheres to Generally Accepted Accounting Principles, and another that complies with IRS regulations.
Tax-adjusted basis is a measure of what an asset is worth for tax purposes. The tax-adjusted basis is calculated by taking the original cost or other basis of the asset in question and adjusting it for various tax-related allowances such as depreciation.
Book-adjusted basis is a measure of what an asset is worth from a company's perspective on its books. The book value of an asset can change based on factors like improvements on an asset or depreciation of an asset.
Both methods are acceptable
There are specific tax guidelines that may prompt a company to recognize gains and losses in a manner that differs from how it does so on its books. A company might be able to reduce its tax burden by presenting certain assets on a tax-adjusted basis when it files its tax returns. However, the book value of those same assets might be adjusted in other ways that meet the reporting needs of the company.
The difference between tax-adjusted basis versus book-adjusted basis frequently comes into play with regard to depreciation. Depreciation is a method of accounting for the reduction of an asset's value over time. Companies generally employ two main types of depreciation: straight line and accelerated. With straight-line depreciation, an equal percentage of an asset's value is depreciated every year over the course of its useful life. With accelerated depreciation, a higher percentage of an asset's value is depreciated earlier on during its useful life. Because accelerated depreciation results in higher depreciation amounts, which are tax-deductible, many companies opt to present depreciated assets on a tax-adjusted basis. However, for internal accounting purposes, they might opt to present those same assets on a book-adjusted basis.
Because a company's financial statements and books serve a different purpose from tax returns, it is acceptable to have some differences between the two. As long as a company adheres to the rules and standards of both Generally Accepted Accounting Principles and the Internal Revenue Code, it can employ different reporting methods to its advantage.
Now that you're learning more about stocks, you may want to start investing today. Check out The Motley Fool's Broker Center to find the best broker for you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.