Explaining accounting to Congress is never easy. But last spring, Bill Jones, vice chairman of O'Neal Industries, says he witnessed a few "aha" moments as he went door-to-door on Capitol Hill to lobby against the elimination of "last-in, first-out" (LIFO) accounting.

As Ron Travis, O'Neal's vice president of tax, explained to members of Congress why the majority of companies use LIFO, "lightbulbs started going off," recalls Jones. Until then, he says, "they thought LIFO was just a funny-sounding acronym."

LIFO allows companies to calculate the cost of goods sold based on the price of the most recently purchased ("last-in") inventory, rather than inventory that was purchased more cheaply in the past and has been sitting on the shelf. That boosts the cost of goods sold, which lowers profits — and, thus, taxable income. LIFO is particularly important to companies that have slow-moving inventory — such as industrial manufacturers and distributors — and are therefore vulnerable to rising prices. O'Neal, a manufacturer and distributor of metals and metal products, has used LIFO for 63 years, almost as long as the method has been allowed for tax purposes (the Internal Revenue Service first sanctioned it in 1939).

"We normally replace every piece of inventory we sell with a higher-priced piece of inventory," explains Travis. "Under LIFO, all of the inflation that is built into our product is not recognized for tax or book purposes."

Jones and Travis breathed a sigh of relief last year when Congress quietly dropped plans to eliminate LIFO. But it didn't take long before the funny-sounding acronym was back in the taxman's sights. The 2011 federal budget proposed by the Obama Administration again includes a provision to repeal LIFO accounting. The government estimates that the move would boost federal coffers by $59 billion over 10 years.

Even if LIFO somehow survives another year of federal budgeting, it still faces the long-term threat of being wiped out if the United States adopts international financial reporting standards (IFRS), which do not allow LIFO. That would stop companies from using LIFO entirely, because companies that use the method to reduce taxable income reported to the IRS must also use it for financial reporting, rather than potentially more-flattering methods, such as FIFO (first-in, first-out) or average cost.

A Bad Match?
Companies like LIFO because it stifles inflationary effects by matching current expenses and current sales more closely than other methods. The accounting convention "protects us from having to pay taxes on what are not really profits," contends Jones. Indeed, proponents of LIFO — 120 of which have formed the LIFO Coalition to lobby against its repeal — don't consider the methodology a tax break. "There is an economic reason for using LIFO, and that is lost on the folks in Washington," says Beatty D'Alessandro, CFO of Graybar, a distributor of electrical and industrial components that has been using LIFO since the early 1980s. Without LIFO, he says, there is a "mismatch between what it's going to cost us to put inventory back on the shelf and what we bought it for six months ago, when it may have cost less."

To understand the mismatch, consider how LIFO works: Say, for example, that a company has an industrial compressor in its inventory that it bought for $5,000. It sells the compressor for $5,500, and replaces it in inventory for $5,200. From an economic perspective, the profit is only $300, not the $500 difference between the historic and current price. LIFO allows companies to use that "last-in" price to record $300 in taxable income. The remaining $200 in income is deferred until the company shutters its business and is forced to liquidate the inventory, at which time it strips off years of "LIFO layers." The $200 — the difference between the taxable income recorded under LIFO and another methodology — is referred to as the LIFO reserve.

In a liquidation, notes O'Neal's Travis, the sell-off of old inventory generates revenue to pay the taxes. But if LIFO is simply repealed, he says, then deferred taxes will be due without the benefit of any additional revenue. "In effect, the repeal of LIFO is going after our equity," the tax director says.

Under the Obama budget proposal plan, companies would be required to "true up" their retained earnings in the year they stop using LIFO, explains Jason Cuomo, a senior analyst with Moody's Investors Service. They would then make annual cash tax payments on the profits stored in the LIFO reserve over a 10-year period, beginning in 2012.

Graybar's D'Alessandro argues that LIFO accounting is a "timing issue," rather than a tax gimmick, and emphasizes that LIFO accounting reverses itself when demand drops. "You burn through LIFO layers as you burn through your inventory," explains D'Alessandro, who notes that Graybar reached lower-cost inventory layers last year as demand slowed. At that point, profits rose under LIFO accounting and the company had to pay more in taxes. The same is true when deflation sets in, says Scott Rabinowitz, a director in PricewaterhouseCoopers's national tax practice. As the price of replacement inventory drops, taxable income increases, and so does a company's tax obligation.

• 1
• 2
• next »