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Compliance with the uniform capitalization rules: a study involving smaller manufacturers and resellers.

Compliance with the Uniform Capitalization Rules: A Study Involving Smaller Manufacturers and Resellers

The caption of a recent Wall Street Journal article read, "Codified Confusion: Tax Law is Growing Ever More Complex, Outcry Ever Louder." This article asked the question, "Does anybody really understand the U.S. tax code?" (1) This question is probably nowhere more applicable than in the area of the uniform capitalization of inventory (UNICAP) rules, which were born of the Tax Reform Act of 1986. Section 263A of the Code prescribes uniform rules to determine what costs and expenditures must be capitalized by a taxpayer. Generally, this section requires that costs attributable to inventory be added to the cost of producing the inventory.

Since the 1986 Act, there have been a number of announcements, notices, and statutory revisions that have made compliance with these rules even more difficult. (A listing of these pronouncements and their subject matter is provided in Appendix 1.) The IRS has been petitioned on numerous occasions to simplify these rules and thus make compliance easier. The IRS replied to a request from the American Institute of Certified Public Accountants by asking for anecdotal evidence regarding the difficulties that firms are encountering in complying with these and other tax rules. The AICPA conducted a survey of certified public accountants to document how their clients were complying with the UNICAP rules. (2) The Spring 1988 issue of The Tax Executive presented the results of an earlier study, which examined how retailers and wholesalers were complying with the UNICAP rules. (3)

Building upon these previous studies, the authors conducted a survey ending in May 1990 of not only retailers and wholesalers (hereinafter referred to as "resellers) but also of manufacturing firms that are subject to the UNICAP rules. Since manufacturers were required to use the full absorption rules of Treas. Reg. [section] 1.471-11 in accounting for inventory costs before the enactment of the UNICAP rules, it did not seem that the 1986 rules posed as great a change for them as they did for resellers. Therefore, we expected that the response of resellers to the UNICAP rules would be different from that of manufacturers. To measure this response, the authors conducted a questionnaire study to determine how these different firms were complying with the UNICAP rules.

The next two sections of this article summarize the UNICAP rules as they affect manufacturers and resellers. Following a description of the questionnaire, we present an analysis of the statistical results, along with various comments supplied by the respondents. The results of this study are then compared with those of prior studies. The article concludes with a summary of the survey results and conclusions.

The UNICAP Rules -- Manufacturers

and Other Producers

The UNICAP rules apply to manufacturers with average annual gross receipts in excess of $10 million. If a taxpayer's average annual gross receipts fall below this threshold. Notice 88-86 provides an exception to the general rules of section 263A. The term "gross receipts" means the total received from all of the taxpayer's trades or businesses. This amount is not reduced by any sales returns or allowances, nor does it include investment income, proceeds from the sale of capital assets, or other receipts from transactions not in the ordinary course of a trade or business (e.g., rent receipts).

Treas. Reg. [section] 1.263A-1T itemizes the direct and indirect costs that must be capitalized. Direct materials, direct labor, and certain types of overhead costs are required to be capitalized. In the regulations, overhead costs have typically been placed into three categories. Under pre-1986 Act law, "category I" costs were capitalized; "category II" costs were expended; and "category III" costs were capitalized for tax purposes if they were capitalized for financial reporting purposes. (4) Under the new law, all category I and category III costs (except the costs of strikes and idle time) and certain types of category II costs must be capitalized.

A simplified method of allocating indirect costs is also available to producers as opposed to a more accurate and burdensome method (e.g., the use of multiple burden rates). The simplified production method was designed to relieve the taxpayer of the burden of complying with the UNICAP rules in situations where the mass production of assets occurs on a repetitive basis. According to Teas. Reg. [sub section] 1.263A-1T(b)(5)(ii) and (iii), the simplified production method requires that additional section 263A costs be allocated to the aggregate inventory balances of the taxpayer based on the aggregate turnover rate of the taxpayer's inventory.

Category II costs which are not required to be capitalized under the UNICAP rules include:

* Marketing, selling, advertising and delivery expenses. (Delivery expenses are limited to the costs of delivering goods directly to the customer.)

* Bidding expenses incurred in the solictation of contracts not awarded to the taxpayer.

* General and administrative expenses and officers' compensation attributable to the performance of services not directly benefitting or not incurred by reason of a particular production activity.

* Research and experimental expenses.

* Losses under section 165.

* Depreciaiton, amortization, and cost recovery allowances on equipment and facilities that have been placed in service but are temporarily idle.

* Income taxes.

* Repair expense not relating to the production of property.

The UNICAP Rules -- Resellers

The average annual gross receipts must exceed $10 million for UNICAP to apply to a taxpayer's resale activity. For resellers, there are essentially four categories of costs that must be capitalized. The first of these categories consists of wholesalers' warehouse occupancy costs and retailers' off-site storage costs. An off-site storage facility is one that is neither physically attached to nor an integral part of a retail sales facility where the taxpayer sells merchandise stored at that facility to retail customers. A retail customer is the final consumer, not a wholesaler, contractor, or manufacturer. There is also a de minimis rule: if 90 percent or more of the sales are on-site sales, the taxpayer may treat the sales as 100 percent on-site and, thus, not capitalize these costs.

The second category of costs that resellers must capitalize encompasses purchasing activity costs. Treas. Reg. [section] 1.263A-1T(d)(3)(ii) provides that purchasing costs relating to the following activities must be capitlized:

* The selection of merchandise.

* Maintenance of stock assortment and volume.

* Establishment and maintenance of vendor contacts.

* Comparison and testing of merchandise.

There is also an elective formula for allocating he purchasing labor costs of resellers. If less than one-third of a person's activities relate to purchasing, 100 percent of that person's labor costs must be treated as non-purchasing. If two-thirds or more of a person's activities relate to purchasing, then 100 percent of that person's labor costs must be treated as purchasing (inventoriable) costs. In all other cases (one-third to two-thirds), an allocation must be made. This formula is entirely elective; once made, however, this election is binding upon the taxpayer for all future periods.

The third type of costs that resellers must capitalize is handling costs. According to Notice 88-86, if a retailer has no off-site storage unit(s), no handling costs need be capitalized. If there is an off-site storage facility, however, handling costs that must be capitalized include transportation costs from:

* Place of purchase to taxpayer's storage facility.

* Storage facility to another storage facility.

* A storage facility to a store or outlet.

Handling costs do not include costs of repackaging goods in preparation for shipment, provided repackaging occurs after receipt of the customer's order. Moreover, handling costs do not include distribution costs, which are defined to be those costs incurred in delivering goods directly to an unrelated customer (e.g., costs incurred in delivering goods from a storage facility to a customer's sales facility).

The final category of costs is general and administrative (G&A) costs. Resellers are required to capitalize the same G&A costs that must be capitalized by manufacturers (i.e., category III G&A costs). As with manufacturers, a simplified resale method may be elected by resellers.

The Questionnaire

In an effort to determine how firms were, or were not, complying with the UNICAP rules, the authors prepared a questionnaire and conducted a survey. The survey involved a random sample of 770 manufacturers, wholesalers, or retailers in Missouri and Illinois whose annual sales exceeded $10 million. The list of firms from which the sample was selected was purchased from Dunn & Bradstreet. The questionnaire solicited information in each of the following five areas:

* Business classification.

* Annual sales and estimated total hours and total cost of compliance with the UNICAP rules.

* Degree of professional judgment used in attempted compliance with the UNICAP provisions.

* Practices followed in the implementation of the UNICAP provisions.

* Effect of UNICAP on their accounting system and personnel practices.

Survey Results

The questionnaire was returned by 210 firms -- a response rate of 27.2 percent. Only 194 responses, however, (approximately 25 percent of the firms surveyed) contained usable data. The results of the survey are presented in five tables. In each table, firms' responses are reported first by group membership (i.e., manufacturer (MFG) or reseller (RES)). Second, the same results are then presented for the firms categorized by whether they complied with the UNICAP rules. For purposes of the survey, compliance (C) or non-compliance (NC) with the UNICAP rules turns on whether the respondents filed the required tax forms. (5)

The expectation was that resellers would evidence a high level of noncompliance since the UNICAP rules represented a greater change for them than for manufacturers. The results of the survey, however, did not support this hypothesis. As shown in Table 1, manufacturers and resellers are divided evenly between the compliance and noncompliance groups. Of greatest significance is the fact that only 33 percent of the total respondents demonstrated compliance with UNICAP.

Table 2 stratifies the firms by sales revenue, and presents data on average sales revenue, average hours required for compliance, and the average cost of compliance with the UNICAP rules. In comparing average sales of the responding firms, those of the C group were larger ($38 million) than those firms in the NC group ($30 million). This may suggest that larger firms are more likely to be able to achieve compliance with these complex tax rules.

In contrast to firms falling within the resellers and the NC groups, firms in the manufacturers and the C groups spent fewer hours in attemped compliance with the UNICAP rules. But it cost them more. Since manufacturing firms were subject to the full absorption method of accounting before enactment of the UNICAP rules (and, thus, they had more experience with cost allocation), it was anticipated that they would require fewer average hours in attempted compliance. Although the results bear out this hypothesis, the difference is not statistically significant. (6) Of particular interest is the fact that the average number of hours spent in attempted compliance is greater for the NC firms as compared to the C firms. Again, the difference is not statistically significant, (7) but it suggests that compliance is not necessarily a function of hours spent in attempted compliance.

When comparing the average cost of compliance for the firms, the table shows that there is no significant difference between the groups. (8) This suggests that spending more dollars on UNICAP does not necessarily translate into a greater probability of compliance.

Table 3 indicates the amount of "professional judgment" used by the firms in complying with the UNICAP provisions. Professional judgment was defined in the questionnaire as "decision making without clear guidance." This question was considered important, as one of the purposes of the survey was to determine the degree of uncertainty among firms with regard to the interpretation and resultant application of the UNICAP rules due to their complexity.

On average, respondents in each group indicated moderate to considerable amount of professional judgment. This result was anticipated in ligh of the complexity of the UNICAP rules. Since these rules were altogether new for resellers, we expected that they would exercise a greater degree of professional judgment. The results, however, do not support this hypothesis. There is very little difference among firm groups in the amount of judgment used.

Table 4 contains the effects of the UNICAP rules on the firms' operations. Firms were asked to indicate the degree to which they agreed or disagreed with five suggested effects of UNICAP. The average scores are reported in this table.

As can be seen in Table 4, the average score for each of the five listed effects is relatively consistent across all groups. The effects are presented in the table in descending order of agreement. On average, the firms indicated that the greatest effect of the UNICAP rules was data-generation problems. At the other end of the spectrum, firms on average strongly disagreed with the idea of hiring new employees to comply with the UNICAP provisions. What is noteworthy with respect to all five items is that the average score is below 2.5. This suggests that firms are not making any major changes in their accounting systems or personnel practices as a result of the UNICAP rules.

Table 5 contains general data with regard to the responding firms, as well as information regarding practices followed in the implementation of the UNICAP provisions. A significantly lower percentage of manufacturing firms (13 percent) had separate tax departments as compared to reseller firms (20 percent). This may explain the finding presented in Table 2 that, on average, the manufacturers spent fewer hours in complying with the UNICAP rules than did resellers. Moreover, it would appear that outside accounting firms are doing most of these firms' tax accounting work, which may also explain the higher average cost of compliance incurred by manufacturers. On average, approximately one-third of all respondents used the UNICAP procedures for both tax and financial statement purposes. By using UNICAP for financial statement purposes, taxpayers will defer expenses and inflate net income. This approach may be difficult for an auditor to accept as conforming to GAAP, for it tends to overstate current financial income and may be viewed as a change in accounting principle which requires special treatment and disclosure. These issues should be discussed with the audit staff.

Very noteworthy is the percentage of firms that documented their assumptions in complying with the UNICAP rules. Of those firms that complied with the rules, 95 percent documented their assumptions. On the other hand, only 80 percent of the firms in the NC group documented their assumptions. In the first year of UNICAP, 54 percent of the C firms took advantage of the "estimation procedures" to revalue beginning inventory, while only 47 percent of the NC group elected this procedure. Similarly, the C group made the fullest use of the option to restructure their activities in order to avoid cost capitalization. (9) This is consistent with the notion that firms complying with the UNICAP rules are more likely to be fully aware of the rules, thus being able to take advantage of these provisions.

Following are some specific reactions received from respondents. These comments, along with the results already presented, may provide the kind of anecdotal evidence that the IRS requested in evaluating the compliance burden posed by the UNICAP rules. What is obvious from the following remarks is that firms are frustrated with the UNICAP compliance process. Moreover, judging from the number of firms not in compliance with UNICAP, it seems firms are unsure of what is currently required to comply fully with these rules.

On e firm stated, "We have already spent more time and effort on this totally ridiculous tax gimmick than it deserves. It should go the way of section 89." (10) Another respondent replied, "The UNICAP rules are unnecessary and overly complex. I believe the sole purpose of this legislation was to allow congressional leaders to be able to tell taxpayers that they reduced taxes by lowering tax rates when in turn they increased taxes in some cases with these types of rules." Another firm said, "We took a very casual view towards UNICAP because we felt that our burden pool used for applying burden to labor cost in inventory expressed as a percentage was sufficient. Rather than get into laborious details of calculations we are ready to fight the IRS at agent level if examined. (11)

Another comment was that "[UNICAP] has to be one of the worst played jokes on the U.S. business scene in years!! I wish one of the congressman who voted for it would try running it once!!" Finally, one firm stated, "In the first year of UNICAP, our accounting firm charged our company $2,500 in order to capitalize less than $3,000 in inventory costs. This rule is ridiculous."

Comparison with Prior Studies

Comparing these results with those of the AICPA and the Mark, et al., studies reveals a lower rate of compliance. The AICPA study asked professionals to gauge UNICAP compliance among their clients. These professionals said that 62.5 percent of the firms were in compliance with the UNICAP rules, as opposed to 57.1 percent in the prior year. As indicated in Table 1, we found the compliance rate to be much lower -- approximately 33 percent. Both the AICPA study and our study (Table 2) determined that firms are still expending significant resources in complying with the UNICAP provisions. Similarly, they both show that firms were (are) using considerable levels of professional judgment to comply with UNICAP (Table 3). (12)

In measuring reaction to UNICAP (Table 4), with one exception, all three studies found similar results. The one area in which they differed is data-generation problems. Both the AICPA and the Mark, et al., studies identified significant problems in the generation of data required for compliance with UNICAP. The respondents in the AICPA study consisted of independent accountants, while the respondents in this study were accountants from within the firms. In view of this fact, it is not surprising that accountants from within the firm would have fewer data-generation problems than would outside independent accountants.

Both the Mark, et al., study and this study found that a large percentage of firms had not changed their accounting systems for the purpose of compliance with UNICAP. In general, the Mark, et al., study found that firms had made very few changes in their accounting systems and personnel practices by late 1987 in response to UNICAP. Similarly, this study found that firms still have made very few changes in response to UNICAP.

One change that was found to have occurred since late 1987 was the percentage of firms using the UNICAP rules for both tax and financial statement purposes (Table 5). The Mark, et al., study reported that only 13 percent of respondents were using UNICAP for both purposes. In contrast, 33 percent of the firms responding to this study reported the use of UNICAP for both tax and financial statement purposes. Finally, our study showed that approximately 13 percent of the firms had restructured their activities to take advantage of favorable UNICAP elections by early 1990. Similar results were reported in the Mark, et al., study.

Summary and Conclusions

Since the adoption of the UNICAP rules as part of the Tax Reform Act of 1986, the IRS has introduced new methods, clarified the regulations, and added requirements that have made the arduous job of compliance in many cases even more complex and burdensome. Many firms expressed a high degree of frustration with the UNICAP compliance process. The following results are presented by way of summary.

Manufacturers spent fewer hours complying with UNICAP, but spent more total dollars on compliance than resellers. This may be attributable to the fact that they used public accounting firms more than resellers to perform their tax compliance work. When full UNICAP compliance is defined as filing a Form 3115 and a section 263A checklist, a number of interesting findings emerge. Even though these rules represented a larger change for resellers, the number of manufacturers and resellers were evenly split between compliance and noncompliance firms. Complying firms were generally larger than noncomplying firms. This suggests that larger firms may be more likely to comply with these complex tax rules. All firms made use of considerable "professional judgment" when complying with the UNICAP rules. Resellers and noncomplying firms, however, used more than did the manufacturing firms and companies in the C group. Because of the overall complexity of UNICAP and the relative newness of these procedures for resellers, it was expected that they would use more professional judgment in the implementation of the UNICAP provisions than would manufacturers.

The data gathered in this study should provide the kind of anecdotal evidence the IRS is asking for as a basis to initiate changes in this area. The UNICAP compliance process is an area in which the IRS desperately needs to make some immediate changes so that firms are fully able to comply with the law. Although the survey involves relatively small firms form only the states of Missouri and Illinois, and thus, might be considered not to be generalizable across the nation, there is no reason to believe that there would be any regional differences in results.


(1) Wall Street Journal, April 12, 1990, at page 1, column 6.

(2) This study was conducted by the AIC-PA's Small Business Taxation, Inventory Simplification.

(3) Mark, Solomon, Bagley & Maiorano, The Uniform Capitalization Rules: Business Reaction and Planning Strategies, 40 Tax Executive 249-60 (Spring 1988).

(4) Examples of category I costs are maintenance & repair, utilities, rent, indirect labor, indirect material, small tools & equipment, and quality control. Examples of category II costs are marketing, advertising, selling, distribution & handling, research, engineering, casualty and theft loss, percentage depletion in excess of cost depletion, income taxes, general and administrative (overall activities), and bidding expenses. Examples of category III costs are taxes (other than income), employee benefits and pensions, scrap, rework and spoilage, strikes and idle time, factory administration, insurance (incident to production), and general and administrative (incident to production).

(5) Taxpayers were required to begin compliance with UNICAP immediately. Thus, taxpayers were required to attach a Form 3115, Application for Change in Accounting Method, and a section 263A checklist (included in the text of Notice 88-92) to the return for the year of change. (The adoption of the UNICAP procedures is considered a change in method of accounting.) If a taxpayer had filed its 1988 tax return before October 21, 1988, however, the filing of the form could be postponed until 1989. A firm is not considered to be in full compliance with the UNICAP rules until the form and checklist have been filed.

(6) The T value for this test is -.80, which is not significant at the 10-percent level of significance (p = .426).

(7) The T value for this test is .34, which is not a significant level of significance (p = .732).

(8) The T value for this test (cost CvNC) is -.09, which is not significant at the 10-percent level of significance (p = .925). The T value for this test (cost MFGvRES) is -.95, which is also not significant at the 10-percent level of significance (p = .346).

(9) For example, if less than 10 percent of a department's costs benefitted production, all costs could be allocated to currently deductible policy expenditures.

(10) The final repeal of section 89 of the Internal Revenue Code, setting forth comprehensive nondiscrimination rules with respect to employee fringe benefits, was included in section 202(a) of Public Law No. 101-140.

(11) This firm also stated that the method it used to allocate mixed service costs between production and policy types of expenditures was the "VQE" (very quick estimates) method.

(12) The AICPA study referred to this method as "short-cut" compliance practices.

JOHN R. MCGOWAN is an Assistant Professor of Accounting at Saint Louis University. He received his B.S., M.Acc., and Ph.D. degrees from Southern Illinois University. A certified public accountant, Professor McGowan is a member of the National Taxation Association, the Missouri Society of Certified Public Accountants, and the American Taxation Association.

NORMA JEAN GROSS is an Assistant Professor of Accounting at Saint Louis University. She received her B.S., M.S. in C., and Ph.D. degreed from Saint Louis University. A certified public accountant, Professor Gross is a member of the National Association of Accountants, the American Institute of Certified Public Accountants, and the American Accounting Association.
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Author:Gross, Norma Jean
Publication:Tax Executive
Date:Nov 1, 1990
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