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A popular method of inventory accounting, not allowed under international rules, will have some U.S. companies paying higher tax bills.
Sarah Johnson, CFO.com | US
December 22, 2008
Advocates of the move toward international financial reporting standards claim the global rules would make U.S. companies' financial statements look better. And studies show that, more often than not, a company's earnings are higher under IFRS than when calculated under U.S. GAAP.
But while new research from the Georgia Tech Financial Analysis Lab confirms that at least one difference between the two sets of standards will raise the earnings some American companies report, there's a catch: The higher earnings will raise these companies' income taxes.
The difference highlighted by the new report involves how companies treat their inventory accounting. About 36 percent of U.S. companies use LIFO (last-in, first-out)accounting, which is not allowed under IFRS, according to the American Institute of Certified Public Accountants. Under the global rules — which the Securities and Exchange Commission wants all U.S. publicly traded companies to adopt by 2016 — IFRS users are limited to using the FIFO (first-in, first-out) method of inventory accounting or they can apply cost averaging.
Georgia Tech researchers predict that the move away from LIFO for U.S. companies will increase some of their taxes, hurting the perceived worth of these firms. "We think that the tax effects could reduce the market values of the affected companies," Charles Mulford, an accounting professor and director of the lab, notes to CFO.com. In this area alone, the switch could cost companies hundreds of millions or even billions of dollars in taxes over four years.
Indeed, current LIFO users could take "a substantial tax hit," Mulford's report warns, as their total tax bill under FIFO will exceed taxes paid in the past two years. The researchers calculated that Graybar Electric Co.'s tax increase would be equal to 2 percent of its assets, whereas the tax change would equal 16 percent of total assets for Sturm, Ruger & Co., which makes firearms.
Mulford's lab warns that companies using LIFO need to consider the consequences an IFRS switch will have on their investors' and board members' perception. The effects may make them initially think sales numbers or operations have shifted when in fact only figures have moved between the balance sheet and income statement.
Mulford's group looked at 30 firms that would be significantly affected by the elimination of LIFO by picking companies with the highest percentages of LIFO reserves compared to their total assets. Most are in the petroleum, metals, or chemicals business. By applying FIFO to their 2007 financial results, the researchers found that the companies' pretax income would have been nearly 12 percent higher.
Companies that use LIFO tend to prefer it over other methods of inventory accounting because of its favorable tax benefits. For example, Margaret Smyth, controller of United Technologies Corp., has publicly tried to convince regulators that the IRS should make a new exception for companies that use LIFO if IFRS becomes the de facto accounting language for U.S. companies because her company does not want to take on a higher tax burden.
Under current rules, companies can reap LIFO's tax breaks in their tax returns only if the method is applied to the same financial statements supplied to shareholders. Assuming the SEC moves ahead with its IFRS plan, LIFO will no longer be allowed. With LIFO, companies value the cost of goods sold as the cost of the most recent inventory purchases. They go by the assumption that most recent inventory purchases are sold first. When inventory cost are rising, under an inflationary environment, LIFO use results in increasing costs and lower reported profits than under FIFO.
Mulford's lab predicts companies' debt-to-equity ratio will decrease (as much as 23 percent for heavy LIFO users), making them look less leveraged. And their operating cash flow will be reduced.
Because of all the changes, companies may need to revisit agreements made with debtholders and make adjustments to compensation terms tied to earnings. LIFO-turned-FIFO users would have seen their current ratio (current assets divided by current liabilities) increase by 23 percent in 2006, and 26 percent in 2007, the researchers say. They predict this change will not hurt FIFO newcomers as lenders may view the switch favorably, believing it helps the company's working capital position.