Final answer:
Absorption costing is mandated by tax regulations, specifically by the Internal Revenue Service (IRS) in the U.S., for calculating the cost of goods sold on income tax returns. This method ensures all manufacturing costs are included, aligning with the matching principle for appropriate taxation.
Step-by-step explanation:
According to tax regulations, absorption costing must be used when filing income tax returns. Absorption costing, also known as full costing, is an accounting method that includes all manufacturing costs including both fixed and variable costs when calculating the cost of goods sold (COGS). The Internal Revenue Service (IRS) in the United States mandates the use of absorption costing for tax purposes as it provides a complete picture of a company’s production expenses, hence ensuring a comprehensive basis for taxation.
Income taxes are applicable to entities in most countries, and they often have to comply with specific accounting standards set by their tax authorities. For example, in the U.S., the IRS requires that inventory costs be determined under the absorption costing method, stating that all costs that are necessary to prepare a product for sale should be included in inventory valuation. These costs include direct labor, direct materials, and a portion of manufacturing overhead. This requirement is grounded in the matching principle of accounting, ensuring that costs are recorded in the period in which the related revenue is recognized.
The absorption costing method is significant for tax filing because it can affect a company’s taxable income. By including fixed costs in inventory, firms may not expense them immediately but rather when the inventory is sold. This delay can lead to lower taxable income in the period in which the inventory is produced, potentially lowering tax liability in that period. However, once the inventory is sold, the cost is transferred to the cost of goods sold, which then affects taxable income. Consequently, accurate reporting under absorption costing is crucial for compliance with tax laws and the accurate calculation of tax liability.