Who Said You Had To Put Overhead In Inventory
Jan 27, 2015
I had some communication recently with a CFO who was working for a company that for a long period of time valued their inventory using the direct costing method. By using this method, the company had excluded any overhead from the inventory values and was only using direct material and direct labor costs to value the inventory.
The CFO knew this was not in compliance with the rules, but he was really more interested in the logic behind the requiring of overhead in inventory for book and tax purposes.
It is important to remember that direct costing is a disallowed method for both GAAP purposes and federal tax purposes. The only method of valuing inventory, permissible by both, is full absorption costing. With the additional factor that current tax law requires even more overhead to be added into inventory under Code section 263A. Even further, for a business that is on LIFO, the use of direct cost for inventory valuation could be considered as a false representation of the true cost. Therefore, putting the LIFO election at risk.
As we discussed the issues surrounding direct cost, we decided that a possible way to demonstrate the effects of direct cost would be to provide a radical example of the effects on profitability and inventory if there were no sales, only a buildup of inventory. Or the reverse, if there was no buildup of inventory, only sales. The CFO managed to put together a great presentation of what the effects on profitability would in those two scenarios. I’m sure you can imagine there were dramatic effects on growth margin and overall profitability between absorption costing and direct costing.
The discussions with management following the presentation revolved around the fact that they were comfortable doing what they had always done. Even more surprising to me, the outside accountants, who were preparing financial statements and tax returns for the company, were also comfortable in allowing them to continue to use the direct costing method. The CFO’s conclusion was that although he knew full absorption costing was the proper method, he felt the current state of affairs would continue to stand as they had for years.
He further recognized that the comparability of his data to others in his industry, particularly as it related to ratios and gross margins, would likely be skewed. This of course was due to his inventory values being grossly understated compared to those of his competitors. Further, he understood that radical changes in the levels of his inventory from one year to the other could dramatically affect his profitability because of the lack of overhead being included in with the inventory.
As I thought more about this scenario, it occurred to me that the management team was possibly using this as a method to reduce earnings which therefore reduced taxable income, and, as a result a tax deferral.
However, since the outside accountants knew about the direct costing issue, it was likely they were preparing the tax returns in strict accordance with code section 471 and 263A. Meaning they were adding appropriate amounts of overhead to the inventory in spite of the fact that the books were on the direct costing method. This would effectively override management’s intention to minimize their taxable income by using this lower method of valuing inventory.
If that is indeed what was happening, then I believe the outside accountants are following the strict interpretation of the law. This will benefit the company when it comes to an audit, but it may be unintentionally overriding one of their profit control devices.
Another possible concept is the creation of a cookie jar, which could be beneficial sometime in the future. More to come regarding this theory with my next blog post on Monday. Stay tuned. . .
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