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Know the Tax Implications of Financial Accounting Decisions

Accounting for the cost of inventory is one of the most complex financial and management accounting challenges that manufacturers face. Choosing from a wide range of costing methods, accurately entering inventory transactions into information systems and ensuring that management gets timely and accurate inventory information are just a few of the hurdles manufacturing companies must surmount.

In the course of dealing with those challenges, the tax implications of inventory accounting decisions often get overlooked—which can create errors in your company's tax returns.

Watch these inventory accounting issues

Excess over "normal" production costs. An article in the Spring 2007 Manufacturing Edge, "Are You Properly Allocating Costs to Inventory?" discussed how overhead costs should be capitalized to inventory. This article noted that excess per-unit overhead costs, if incurred in periods where production is abnormally low, should be expensed as period costs rather than capitalized to inventory.

This treatment is consistent with the goal of not overstating the value of a company's assets. However, it is not consistent with the tax authorities' goal of increasing taxable income.

The same costs required to be expensed for financial accounting purposes generally must be capitalized to inventory for tax accounting purposes. In these circumstances, a timing difference results and should be reported as such on the reconciliation between book net income and taxable income on the company's income tax return.

Setting up reserves for obsolescence. Financial accounting rules require companies to account for inventory at the lower of cost or market. In many cases, this requires a company to set up a reserve for slow-moving or obsolete inventory. The reserve enables the company to write down the value of inventory that is not moving or that is completely obsolete and should be liquidated.

Although obsolescence reserves might be required by financial accounting rules, the resulting expenses might not be immediately deductible for income tax purposes. Tax rules regarding inventory are complex and can prohibit the deduction of inventory costs until the inventory has been physically sold or liquidated. When this is the case, a timing difference results and should be reported as such on the reconciliation between book net income and taxable income on the company's income tax return.

Inventory capitalization. The financial accounting standards provide guidance on the costs that should be capitalized to inventory by a manufacturer. In general, manufacturers should capitalize the following costs as part of inventory:

• Material cost
• Direct labor cost
• Overhead that relates to the manufacturing process

Tax accounting rules require manufacturers to capitalize the above costs plus certain additional ones. You might have heard these costs referred to as "263A" costs, a reference to the IRS code section that discusses this issue. This difference in accounting methods will result in a timing difference between book net income and taxable income.

LIFO considerations. If you use LIFO to value inventory, tax rules require you to use LIFO for both book and tax accounting. However, you can use different LIFO methods for book and tax accounting. If this situation fits your company, you should have a timing difference between book net income and taxable income. (See Take Advantage of Year-End LIFO Planning Opportunities.)

Financial accounting rules and income tax laws are not made in concert. In fact, they often are in conflict with one another. The key is to keep this in mind when making decisions about how to account for inventory. In striving to comply with generally accepted accounting principles, manufacturers can expect inventory-related timing differences between book net income and taxable income.  

Questions about making inventory accounting decisions? 
Contact Paul Oetter at 312-980-2920.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.