Limitations of Variable Costing – GAAP and External Reports

Limitations of Variable Costing – GAAP and External Reports:

Learning Objectives:

  1. What are the limitations of variable costing?
  2. Is variable costing acceptable for external reports?
  3. Do financial statements prepared under variable costing system conform to generally accepted accounting principles (GAAP)?

Practically speaking, absorption costing is required for external reports in United States and almost all over the world. A company that attempts to use variable costing (also called direct costing and marginal costing) on its external financial reports runs the risk that its auditors may not accepts the financial statements as conforming to generally accepted accounting principles (GAAP). Tax laws almost all over the world require the usage of a form of absorption costing for filling out income tax forms.

Even if a company must use absorption costing for its external reports, a manager can use variable costing statements for internal reports. No particular accounting problems are created by using both costing methods–the variable costing method for internal reports and the absorption costing method for external reports. The adjustment from variable costing net operating income to absorption costing net operating income is a simple one that can be easily made at year-end.

Top executives are typically evaluated based on the earnings reported to shareholders on the external financial reports. This creates a problem for top executives who might otherwise favor using variable costing for internal reports. They may feel that since they are evaluated based on absorption costing reports, decisions should also be based on absorption costing data.

Absorption Costing Around the World:Absorption costing is norm around the world for external financial reports. After the fall of communism, accounting methods were changed in Russia to bring them into closer agreement with accounting methods used in the west. One result was  the adoption of absorption costing

You may also be interested in other articles from “variable costing system” chapter

  1. Variable Costing Vs Absorption Costing
  2. Income Comparison of Variable and Absorption Costing
  3. Advantages and Disadvantages of Absorption Costing
  4. Limitations of variable costing – GAAP and External Reports
  5. Advantages of Variable Costing
  6. Variable Costing and Theory of Constraints
  7. Impact of Just In Time (JIT) Inventory Methods
  8. Variable | Direct Costing and Absorption Costing Discussion Questions and Answers

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