Whether it is an entrepreneurship, corporation or partnership, it is important for businesses to understand the basics of accounting for their transactions in order to run smoothly. Without the knowledge on how these books should be maintained, it may be difficult to present information to stakeholders of the business.

When books are maintained on the Generally Accepted Accounting Principles (GAAP) basis, business transactions are usually recorded as per the rules stated by the financial accounting board. On the other hand, if maintained as per the tax basis, transactions are usually recorded in accordance with the Internal Revenue Service code for purposes of calculating taxable income. Nonetheless, businesses should also maintain another set of books known as 704 (b) books which are prepared according to the defined rules in section 704 (b).

What is 704 (b)?

The objective of 704 (b) books is in disclosing extensive economic effect of the partners’ allocation. This will show the partners’ economic interest in the business. As per the defined regulations under section 704 (b), capital accounts are expected to be maintained as per certain rules which are not part of tax or GAAP. In order to pass the safe haven, the partnership agreement demands that the capital accounts are maintained according to regulations of the sub chapter. In case these capital accounts fail to be maintained in a proper manner in the full time of the partnership, the allocations will be assumed to not have significant economic effect. Generally, capital accounts are deemed to be in accordance with regulations of section 704 (b).

For instance, in a partnership business where a partner contributes a property to be part of the business, section 704 (b) requires that the contributing partner’s capital account should be credited with the property’s fair market value. Equally, in case the property is distributed, the distributee’s capital account needs to be debited with the property’s fair market value. There is no exceptional appraisal needed in identifying the fair market value for books maintenance under section 704 (b). All partners may agree on the fair market value for adverse parties and for transactions under armslength.

What is GAAP?

Abbreviated as GAAP, the Generally Accepted Accounting Principles are normally imposed by a business with the objective of bringing a minimum consistency level in the financial statements useful in analyzing organizations for investment purposes. Various businesses adhere to GAAP rules in preparing stakeholders’ financial reports. As opposed to 704 (b), an asset’s fair market value under GAAP is adjusted only on certain events referred to as ‘book down’ or ‘book up’ events. For instance, for a new partner joining a partnership, the already existing partners may prefer restating their capital account in the books whereas for business purposes, they are allowed to document ownership in assets’ appreciation which accrued prior to the partner joining the firm.

Main Differences on GAAP and 704 (b)

Liquidation

During liquidation, proceeds are required to be distributed among partners as per positive capital accounts. They are thus known as Section 704 (b) capital accounts; not GAAP or tax capital accounts. For GAAP, proceeds are distributed amongst the partners as per profit and loss sharing ratios.

Reasons for maintaining GAAP Books and Section 704 (b)

The reason for maintaining Section 704 (b) is because the tax law generally demands it even though one is not expected to show these books on the balance of the partnership’s tax return. Additionally, the books help in identifying the deal’s economic substance. On the other hand, GAAP books should be maintained for purposes of meeting the business’ reporting requirements and showing consistency in financial information to be shown to the shareholders and other business’ stakeholders.