Tax Incentives and the Decision to Capitalize or Expense

In 1973, a change in tax regulations provided strong incentives to exclude from inventories broad classes of manufacturing overhead costs for financial as well as tax reporting. Evidence indicates that, prior to this change, most firms were on an absorption costing basis, so it is expected that most firms would take advantage of an opportunity to exclude manufacturing overhead from inventories. A study was undertaken to determine whether significant numbers of US manufacturing firms were expensing their indirect manufacturing costs after 1973 and before passage of the Tax Reform Act of 1986. The results of a survey of reporting practices in the steel industry indicate that most steel firms were expensing (and had been expensing prior to the 1973 change in the tax code) the indirect manufacturing costs that can be expensed under Internal Revenue Service regulations.