GAAP Rules on Variable-Costing Financial Statements for External Use

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Though managerial accounting reports and information do not face external regulation, companies must report these figures on their financial statements. The two common methods are absorption and variable-based costing. Generally accepted accounting principles provide companies with the guidelines on the use of absorption and variable costing for managerial and financial accounting.

GAAP Rules

Generally accepted accounting principles do not recognize variable costing as a proper reporting method between managerial and financial accounting. Variable costing methods expense fixed overhead costs on the income statement. The inclusion of these costs as a period expense does not meet GAAP guidelines, which requires all manufacturing overhead costs to go into a company’s allocation pool for produced goods.

Overhead Cost Descriptions

Three costs affect a product’s cost: direct materials, direct labor and manufacturing overhead. Variable manufacturing overhead include items that change with production output. Examples include indirect materials, utilities and similar items. Fixed overhead costs include rent, depreciation, support salaries for the production department and property taxes and similar items. The latter cost group is the items a company excludes from cost calculations in variable costing.

Analysis

Variable costing distorts a company’s income statement. Generally accepted accounting principles do not allow variable costing for the marriage between managerial and financial accounting because of this. Companies can use production costs to offset revenues and lower tax liabilities. The problem is, however, fixed overhead costs do not meet the matching principle. The matching principle dictates that all expenses must be necessary to earn revenue. Fixed overhead costs do not meet this requirement.

Considerations

Companies that fail to adhere to these GAAP requirements may be subject to penalties and fees. Audits will typically discover the use of variable costing in use by a company. Companies must rectify this reporting problem so they comply with all GAAP reporting guidelines. Tax penalties may also be a problem as the company may owe additional taxes from underreporting income through the use of variable costing.

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References

  • "Cost Management: Strategies for Business Decisions"; Ronald Hilton, et al.; 2006
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