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:
Beginning Inventory: 1,000 units @ $10 = $10,000
Purchases during the year: 1,000 units @ $12 = $12,000
Total units available for sale: 2,000 units
Units sold during the year: 1,500 units
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:
COGS Calculation:
1,000 units @ $10 = $10,000
500 units @ $12 = $6,000
Total COGS = $16,000
Sales Revenue:
1,500 units × $20 = $30,000
Gross Profit:
$30,000 - $16,000 = $14,000
Or, if the company were to use LIFO (last in, first out) for its tax reporting, then its outcomes will be as follows:
COGS Calculation:
1,000 units @ $12 = $12,000
500 units @ $10 = $5,000
Total COGS = $17,000
Sales Revenue:
1,500 units × $20 = $30,000
Gross Profit:
$30,000 - $17,000 = $13,000
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.