Uniform capitalization rules and inventory planning.

Traditionally, accounting for inventory costs for income tax purposes has differed from the methods used for financial reporting purposes. The Tax Reform Act of 1986 substantially revised the tax provisions to achieve, in many cases, a common set of rules for both tax and financial accounting.

The imposition of the UNICAP rules may require modification of a corporation's inventory policy in ways that are not obvious to management. Specifically, the tax cost of the rules creates an additional inventory carrying cost. CPAs can help identify the incremental tax cost of holding inventory items and thus provide inventory planners with the information they need to make cost-efficient decisions.

UNICAP BACKGROUND

With UNICAP, expenditures that had been period costs and thus currently deductible were converted into inventory costs that must be matched with the sale of the associated inventory. Such a conversion produces a higher taxable income in years in which inventory produced or purchased for resale is not fully disposed of. A lower taxable income will result in years in which inventory from prior periods is sold in the current period (referred to as invasion of inventory).

The UNICAP rules affect almost any corporation that has inventories. To the extend businesses already were required to capitalize most of these reclassified costs, the immediate UNICAP tax impact was negligible. In most cases, however, corporations suffered some increase in capitalizable costs. The extent of the change in inventory cost capitalization policy is largely a function of whether the business is a manufacturer, retailer or wholesaler. The effects of UNICAP on each kind of operation are reviewed briefly below.

Manufacturers were subject to similar capitalization rules before the UNICAP changes. However, the list of capitalizable items was expanded significantly by UNICAP. The revised provisions for manufacturers, in essence, established a new cutoff point for segregating period costs from inventory costs. The cutoff point was moved from the end of the manufacturing process to the point at which inventory is shipped to customers. In addition, significant judgment may be required to identify those costs attributable to inventory and those expensed.

In the case of wholesalers and retailers, capitalization is much more extensive after UNICAP. Newly capitalizable costs include

* Purchasing, ordering and labor handling costs.

* Other direct and indirect purchasing costs.

* Offsite storage costs.

* General and administrative costs related to the above costs.

Thus, many costs related to inventory that previously were deducted as period costs now are accumulated and allocated between cost of goods sold and inventory. Therefore, as a result of these changes imposed by UNICAP, a meaningful increase in tax cost is incurred by many wholesalers and retailers.

Exemptions to the UNICAP provisions provide relief for small retailers and wholesalers. For this purpose, Treasury temp. regs. sec. 1.263A-1T(d)(2)(i) defines small retailers and wholesalers as those having average annual gross receipts of $10 million or less over the past three years. Following temp. regs. sec. 1.263A-1T(d)(2)(iv), gross receipts include income from active sources only. Consequently, items such as rents, royalties, returns and allowances and capital gains and losses are not included. In addition, gross receipts are defined to include receipts from all businesses under common control.

Several methods and bases for allocation of costs are allowable, including certain simplified allocation methods (see temp. regs. sec. 1.263A-1T). The method chosen has a critical effect on the ultimate tax cost borne by the corporation as a result of UNICAP. Accountants can provide their companies or clients with analyses of tax costs versus savings by using different methods; they also can evaluate the relative administrative burdens produced by the different allocation methods (that is, changes required in the cost accounting system).

THE REAL TAX COST OF

UNICAP

The UNICAP changes effectively result in a delayed deduction for newly capitalizable costs. Consequently, tax liabilities generally will occur in earlier periods than under prior law. Accordingly, the real cost to a corporation of the UNICAP changes is the opportunity cost of the tax liability resulting from the delayed deduction. That is, the additional carrying cost for inventory is the current tax cost (including both regular and alternative minimum tax) less the present value of the future tax savings in periods when the delayed deduction becomes a current deduction. An example of how to determine the UNICAP tax cost is given in the sidebar above.

IMPLICATIONS FOR

INVENTORY POLICY

Accountants already are determining capitalizable inventory costs under UNICAP for tax reporting purposes. Thus, the information regarding the additional tax cost of UNICAP is readily available. However, this information is not necessarily passed on to personnel responsible for planning inventory levels. Although the inventory planner may be very efficient at considering changes in traditional carrying costs (such as warehouse space rental), changes in the company's income tax liability associted with holding inventory may escape his or her notice.

Regardless of the particular inventory level planning method used by a company (such as the economic order quantity), inventory carrying costs are important components in determining economically efficient inventory levels. As illustrated above, the additional tax cost imposed by UNICAP is clearly an inventory carrying cost--excess inventory levels can generate substantial increases in a company's income tax liability.

The actual impact of the UNICAP-imposed extra tax cost is a function of several factors, including the following.

* The level of unsold inventory at yearend as compared with total inventory purchases.

* The relationship between carrying costs and other inventory related costs (such as ordering costs).

* The UNICAP extra tax cost as a percentage of the other carrying costs.

Regardless of the magnitude of a companys' various inventory costs and their relationship to one another, the important point is that the additional tax cost imposed by UNICAP must be considered in the framework of a firm's inventory planning.

In many instances, the additional carrying cost generated by the UNICAP tax burden will cause companies to reduce their inventory levels; as carrying costs increase, smaller, more frequent inventory orders may be called for. These are several secondary implications of a reduced inventory level.

Smaller, more frequent inventory orders that result in a lower average level of inventory mean a company has a smaller percentage of its assets tied up in inventory (as compared with cash or short-term investments) at any time. This has the benefit of increasing the company's measures of short-term liquidity (that is, its quick ratio and inventory turn-over ratio). Consequently, the company's ability to borrow funds at attractive interest rates may be improved. Also, the probability of the company suffering from additional inventory costs, such as the cost of obsolescence or inventory property taxes, is minimized.

There also are, of course, negative consequences to smaller inventory balances. Increased chance of stock-outs, invasion of Lifo inventory cost layers, lost costumers or sales and emergency shipment costs could off-set the benefits of a lower inventory level in some businesses. Additionally, long-term contractual arrangements with vendors may prevent meaningful short-run changes in inventory practices. Companies using just-in-time inventory procedures already may have minimal inventories, which would be difficult to alter.

MODIFY POLICY

Managers of affected businesses should respond to the TRA UNICAP rules by examining their inventory control practices. Irrespective of what inventory control model an organization uses, the UNICAP rules can increase the cost of holding inventory. Important questions managers have to face are:

* What is the size of the increase in inventory carrying costs?

* To what extent should inventory policy be modified?

The effects a change in carrying costs can have on decisions about inventory levels should be considered carefully. Then the extra carrying costs imposed by UNICAP can be evaluated more precisely and inventory policy set accordingly. Accountants and tax advisers can point out the usefulness of an inventory policy evaluation and assist in computing the UNICAP-imposed tax costs used in such an evaluation.