3 Ways Tariffs Impact Accounting
Recently tariffs have been a recurring theme in international trade. The impacts of tariffs on trade and operating a business can be complex and often depend on where in the supply chain a business operates, but how might it impact your business’s accounting?
The following three points may need to be considered as you prepare financial statements:
Perhaps most obviously, tariffs can increase the cost of inventory purchases. Inventories are primarily accounted for at cost, which includes the expenditures necessary to directly or indirectly bring the item to its existing condition and location. Therefore, the cost of inventory includes the purchase price of an item, transportation and handling, plus import duties and other taxes. Tariffs as a form of tax or duty paid by an importer increase the cost of the inventory item for an importer. In addition, companies that use standard costs for their inventories may need to reevaluate their standard costs as new tariffs are implemented. Costs may also increase for those companies that are not the direct importer, as the increased tariff cost may flow through the entire supply chain.
A second inventory effect relates to the impairment of inventory. Most inventories are measured the lower of cost or net realizable value, while inventories on a Last In, First Out (LIFO) or Retail method are measured at the lower of cost or market. In either case, companies will need to consider whether the higher cost of inventories will be recoverable from future sales. A company that is unable to pass on the tariff cost may find that it needs to recognize immediate write-downs of inventory or recognize losses on purchase commitments.
Tariffs may have implications for companies as they apply the new accounting guidance for revenue from contracts with customers (Topic 606). Some companies enter into contracts that include variable pricing (variable consideration) that takes into account changes in the costs of the products or services that are being provided. When applying Topic 606, variable consideration is estimated—subject to a constraint—in order to determine the transaction price.
One example of how this is applied in practice could be a construction contractor that has significant costs related to steel or other materials used in a construction project. The contract may include clauses that allow for the increases in costs to be passed onto the customer. A change in the tariff rate on steel necessary for the project would immediately increase the amount of consideration the customer owes the construction contractor and the transaction price (total revenues) and cost estimates would need to be revised. The changes would result in a cumulative catch-up in the amount of revenues recognized by the contractor.
A second example could be a company with a long-term supply contract that includes the right to increase the price of the product for changes in the costs. The company’s accounting for the contract would depend on whether it has a single performance obligation (similar to the contractor) or separate performance obligations or contracts for each shipment. The latter case may permit the company to avoid estimating the amount of the price increase.
In some cases though, a company may have a contract that does not permit it to pass on the increase in costs from tariffs. If the increase in tariffs causes the company to have a loss contract, the guidance may require recognition of the loss once the contract become onerous.
Companies routinely perform impairment testing. In particular, goodwill impairment tests are performed at least annually (unless goodwill is being amortized). Impairments of long-lived assets, such as property, plant, and equipment and customer lists, are performed when there is a change in events or circumstances that indicate the carrying amount is not recoverable. Under either impairment model, the decrease in cash flows to be generated from the asset caused by increases in tariff costs and any resulting reductions in margins could trigger the need to test impairment. In addition, if tariffs result in a decrease in cash flows, it will be more likely the assets will be impaired and an impairment loss should be recognized.
A complicating factor with any impairment analysis will be how to estimate the future impact of the tariffs. Questions that may be relevant are:
- Will the tariff costs be recoverable?
- Will customers purchase the same volume of goods and services as the price increases?
- How will overall market conditions change as the tariffs go into effect and impact the economy?
Don’t leave your accounting department out of the mix as you plan for how you will deal with the impact of tariffs on your business. Even if you are not directly impacted for accounting purposes, the indirect impacts may be significant. It is good practice to be aware of how the changes in your business will be born out in the financial results to avoid big surprises when it comes time to prepare your financial statements and communicate those results to investors and lenders.
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Related Reading Published on June 11, 2019