Tax Incentives and the Decision to Capitalize or Expense Manufacturing Overhead.

Abstract The article investigates whether absorption costing is or is not required for financial reporting, and whether it was required for tax reporting prior to the Tax reform Act of 1986 in the U.S. Despite the common assertion that absorption costing is required for financial reporting, it can be argued that both absorption and direct costing are acceptable under Generally Accepted Accounting Principles. Moreover, a 1973 change in tax regulations provided strong incentives to exclude from inventories broad classes of manufacturing overhead costs for financial as well as tax reporting. Until passage of the Tax Reform Act of 1986, the tax code stipulated that the same method of accounting for certain overhead costs must be used for both tax and financial reporting. This paper is solely concerned with firms' responses to the 1973 change in tax regulations. It reports on practices in the steel manufacturing industry before passage of the Tax Reform Act of 1986. In contrast to the assertions made in most managerial textbooks, this survey of reporting practices in the steel industry revealed that most steel firms were expensing, and apparently had been expensing prior to the change in the tax code, the indirect manufacturing costs that can be expensed under IRS regulations.