Inventory Conformity Rule
The inventory conformity rule, also known as the tax conformity rule or the book-tax conformity rule, refers to the requirement under U.S. Generally Accepted Accounting Principles (GAAP) that a company must use the same inventory accounting method for both financial reporting (i.e., preparing financial statements) and tax reporting purposes if it uses the Last-In, First-Out (LIFO) method for tax purposes.
The LIFO method assumes that the last goods added to inventory are the first ones to be sold. It’s particularly beneficial for tax purposes during periods of rising prices because it results in higher cost of goods sold (COGS) and lower taxable income.
However, for financial reporting purposes, many companies prefer the First-In, First-Out (FIFO) method, which assumes that the first goods added to inventory are the first to be sold. This often gives a better representation of current inventory costs in the financial statements.
Under the inventory conformity rule (Section 472 of the U.S. tax code), if a company chooses to use LIFO for tax purposes, it must also use LIFO for financial reporting. This rule is designed to prevent companies from using one method to minimize taxes and another to make their financial performance look better.
It’s important to note that this rule applies only in the U.S. In many other countries, companies can use different inventory valuation methods for tax and financial reporting. Furthermore, the International Financial Reporting Standards (IFRS) do not allow the use of the LIFO method.
Example of the Inventory Conformity Rule
Suppose a company called TechGears produces and sells electronic devices. TechGears purchases and adds to its inventory at different times of the year, and the costs of the devices increase throughout the year due to increases in component prices.
For example, in the beginning of the year, each device costs $100 to produce, but by the end of the year, each device costs $150 to produce. During the year, TechGears sold 100 devices.
- If TechGears uses the FIFO method for financial and tax reporting: It assumes that the first devices sold are the ones that were produced first (at a cost of $100 each). This results in a lower cost of goods sold (COGS) and higher net income and taxes. For example:
COGS (100 devices * $100) = $10,000
Net income (assuming sales price of $200 per device) = Revenue – COGS = (100 devices * $200) – $10,000 = $10,000
Assuming a corporate tax rate of 21%, taxes would be $2,100. - If TechGears uses the LIFO method for both financial and tax reporting (due to the inventory conformity rule): It assumes that the first devices sold are the ones that were produced last (at a cost of $150 each). This results in a higher COGS and lower net income and taxes. For example:
COGS (100 devices * $150) = $15,000
Net income (assuming sales price of $200 per device) = Revenue – COGS = (100 devices * $200) – $15,000 = $5,000
Assuming a corporate tax rate of 21%, taxes would be $1,050.
So, if TechGears uses the LIFO method, it will save on taxes compared to using the FIFO method ($1,050 vs. $2,100). But under the inventory conformity rule, it must also use the LIFO method in its financial statements, which will show lower net income compared to using the FIFO method ($5,000 vs. $10,000).
This example illustrates the trade-off companies face when choosing an inventory accounting method, and the implications of the inventory conformity rule for companies that choose the LIFO method for tax purposes.
