Inventory conformity rule
/What is the Inventory Conformity Rule?
The inventory conformity rule states that, if a business elects to use the LIFO cost flow assumption for its tax reporting, it must also use LIFO for its financial reporting . This rule was enacted by the Internal Revenue Service, because companies were using LIFO to report a lower level of taxable income, while using other cost flow assumptions (such as FIFO ) to report a higher level of income in their financial statements . This resulted in a disparity in reported income levels between the two methods of accounting, as well as a disparity in the amount of inventory reported on a firm’s balance sheet.
This rule has tended to result in a lower usage rate of LIFO by businesses.
Example of the Inventory Conformity Rule
Rock Company has the following information for the year:
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Beginning Inventory: 1,000 units @ $10 = $10,000
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Purchases during the year: 1,000 units @ $12 = $12,000
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Total units available for sale: 2,000 units
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Units sold during the year: 1,500 units
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Selling price per unit: $20
If the company uses FIFO (first in, first out) for its financial reporting, then its financial outcomes will be as follows:
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COGS Calculation:
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1,000 units @ $10 = $10,000
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500 units @ $12 = $6,000
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Total COGS = $16,000
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Sales Revenue:
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1,500 units × $20 = $30,000
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Gross Profit:
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$30,000 - $16,000 = $14,000
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Or, if the company were to use LIFO (last in, first out) for its tax reporting, then its outcomes will be as follows:
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COGS Calculation:
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1,000 units @ $12 = $12,000
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500 units @ $10 = $5,000
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Total COGS = $17,000
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Sales Revenue:
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1,500 units × $20 = $30,000
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Gross Profit:
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$30,000 - $17,000 = $13,000
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Without the inventory conformity rule, the company could use LIFO for its tax return to get lower taxable income (gross profit of $13,000), while using FIFO for its financial statements to show higher net income (gross profit of $14,000) to investors. But, because of the inventory conformity rule, if the company uses LIFO for taxes, it must also use LIFO for its financial statements. Therefore, Rock Company must show the $13,000 gross profit on both tax and financial statements, even if it would have preferred to show the higher $14,000 gross profit to outside users.
