What is the Deal With Overhead In Inventory?
Aug 22, 2013
A few days ago I got a call from an old friend who is working as a CPA in another state. Although he doesn’t do much manufacturing work, he has several clients who are manufacturers. One of these manufacturing clients just recently went through a very tough IRS audit. In fact, at the conclusion of the audit, the agent made a very large adjustment to the profitability of the company because the company had failed to include any overhead in its ending inventory. This prompted my friend to call me because he knew that we do extensive amounts of costing work particularly as it relates to valuing inventory and production in manufacturing companies. As we talked, I realized that in spite of the fact that he was an experienced CPA, his limited work experience with manufacturers had resulted a lack of knowledge regarding what needed to be capitalized as part of an inventory cost.
That got me thinking that perhaps there are other businesses out there that are attempting to value their inventory for either book or tax purposes on just direct cost. Meaning labor and material without considering what overhead needed to be included.
For both book and tax purposes there are very specific guidelines as to what overhead should be included in inventory. For accounting purposes, accounting pronouncement FASB ASC 330 has a very specific guidance for businesses in the manufacturing sector as to what needs to be included in inventory cost to be in compliance with Generally Accepted Accounting Principles. Those rules are significantly different than what the Internal Revenue Service requires.
For many years, code section 471 has been in place and it requires specific overhead to be included in inventory. Although there are differences in how overhead can be applied for GAAP and tax purpose the requirements in 471 are roughly similar to the accounting requirements to be in compliance with GAAP.
However, a number of years ago, the IRS came up with yet another code section related to primarily manufacturing companies but also other qualified companies that requires even more overhead to be apportioned to ending inventory. This is code section 263A and it gives businesses specific guidance as to what overhead needs to be added to the code section 471 requirements. It also gives businesses a simplified method of computing the add-back so that these costs can be readily added to inventory when tax returns are prepared.
It has been our experience that if a manufacturing company keeps it’s overhead apportioned to inventory in compliance with GAAP and does so with consideration to code section 471 allocations of cost it can readily be compliant with both GAAP and tax accounting methods. We typically then make an add-back only to the tax return for the 263A portion of the additional overhead and do not attempt to make book adjustments to reflect those additional costs.
We have also discovered that if you have an opportunity to design a costing system from the ground floor up that apportioning overhead cost under 263A can be an add-on calculation to your book overhead and in many cases if it’s done correctly will meet the requirements of 263A for the additional cost without forcing a much larger allocation of overhead that the simplified method would cause. If you have had similar experiences with your inventory accounting methods we like to hear about them.
Categories: Cost Accounting
- Audit & Accounting
- Construction & Real Estate
- Cost Accounting
- Estate Planning
- Fraud & Forensics
- Healthcare & Dentistry
- IT & Risk Services
- Manufacturing & Distribution
- Other Resources
- Restaurant & Hospitality
- Risk Services
- Tax Compliance
- Tax Planning