COGS: Impact of Negative 263A costs

Your question:

Would you include negative section 263A deductions to a manufacturing
company’s cash flow?

Linda says:

Short answer: I would not make an adjustment for this.

Longer answer: Section 263a costs are part of Cost of Goods Sold and, when positive, are a required allocation of some of the costs that might normally be recorded on page one of the return but are indirectly related to inventory. Generally, they include:

  • Off-site storage
  • Purchasing or Handling department (processing, assembling, repackaging, transporting)
  • A portion of general and administrative costs (called mixed service costs)

To the extent these costs are allocated to Cost of Goods Sold, they have not been reported on page one of the tax return. If you take them out, you remove some of the costs that do use up cashflow.

When calculating based on simplified rules, there is sometimes a negative result due to timing of depreciation between financial statements and tax returns. If the 263a costs are high enough, that negative amount is absorbed and you and I do not even see it. Sometimes, the negative amount is high enough to offset the rest of the costs, resulting in a negative 263a amount.

I recommend we make no adjustment as a general rule.

The real impact on cashflow:
Costs allocated to inventory can throw off our sense of cashflow from operations available to pay debt. To the extent that cashflow is tied up in increasing inventory, it is not available to pay debt. When we review a CPA prepared Statement of Cashflows we note the ‘use’ of cash when inventory increases.

As long as inventory stays fairly level, the allocation of expenses to Cost of Goods Sold does not distort cashflow available to pay debt.

In my manual on ‘Beyond the 1040: Corporation, Partnership and LLC Tax Return Analysis’ I include a worksheet you can use to create a Statement of Cashflows similar to the CPA version using information found on the 1120, 1120S or 1065. I recommend a commercial lender do so with new business borrowers or in complex cases if you do not have the CPA statement.

It gives you a good feel for where the cashflow from operations is going… including to increase inventories.

Update your manuals:
If you don’t have the current manual set comprehensive self-study manuals .

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