Global Business

How LIFO Could Stall Global Accounting

Banned in Europe, the inventory reporting method and its tax treatment have staunch advocates in the United States.
David KatzDecember 3, 2007

Will the LIFO method of inventory accounting become a major stumbling block in efforts to get the United States to converge with the rest of the world on a single set of global financial-reporting standards?

At present, the matter does seem to be a case of an irresistible force (global convergence) running smack-dab into an immovable object (LIFO). And the barrier to using last-in, first-out inventory reporting under a single international framework is clear: International Financial Reporting Standards bar LIFO.

On this side of the Atlantic, the U.S. Internal Revenue Code also insists that companies must use the same system of reporting inventory financials to shareholders and lenders that the companies use to file with the taxman.

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Thus, a company that uses LIFO now to report income and profit or loss from inventory is not in compliance with IFRS, nor could it continue to report LIFO numbers to the Internal Revenue Service if U.S. regulators start demanding that companies use the international standard rather than U.S. generally accepted accounting principles.

Yet for many LIFO users, the tax advantages may be too good to give up without a fight. “I don’t want to make an added tax payment as a result of changing to IFRS,” says Peggy Smyth, the vice president, controller of United Technologies Corp., which uses the method for part of its accounting for inventory.

Unlike first-in, first out (FIFO) accounting, LIFO bases the value of the cost of goods sold on a company’s most recent inventory purchases. In an inflationary environment, LIFO enables a company to report higher costs and lower profits than it would using FIFO. Because LIFO users are likely to report lower income in such an economy, they would pay less in income taxes than they would if they used FIFO.

While Smyth says that United Technologies supports the goal of “one global accounting standard,” she thinks that the LIFO issue is part of a broader tax conflict between IFRS and GAAP. Moving to IFRS could force companies to keep separate sets of books for financial reporting and tax purposes if U.S. companies continue to use GAAP as a basis for their tax returns, she thinks.

The issue could grab some of the spotlight from other convergence issues as the Securities and Exchange Commission mulls the responses to a concept release it issued in August. The release floated the notion that U.S. public companies should have the choice of using IFRS rather than GAAP. The question, in the SEC’s view, flowed naturally from its Nov. 15 decision to drop its requirement that non-U.S. companies reconcile their financial reporting with U.S. GAAP.

To be sure, regulators seem to be groping for a way out of the LIFO dilemma. At the Financial Executives International financial reporting conference in New York in November, Conrad Hewitt, the SEC’s chief accountant, said that the commission plans to discuss the conflict with the Internal Revenue Service.

Still, it’s hard to see such talks yielding a solution. Since the requirement that companies that use LIFO for taxes must also use it for their 10-Ks and 10-Qs is hard-wired into the Internal Revenue Code, the only way to resolve the conflict is for the federal government to enact a law dropping the rule, an IRS representative says.

U.S. House Ways and Means Committee Chairman Charles Rangel also brought attention to LIFO recently, namely by proposing its repeal as part of his tax bill. To be sure, there’s little chance of major tax legislation being enacted before next November’s presidential election.

But Rangel’s idea of erasing LIFO has a good chance of sticking around because it offers the unusual combination of a whopping increase in tax revenues for the government and a tax cut for the large majority of companies, according to George Plesko, an associate professor of accounting at the University of Connecticut. The repeal would raise $107 billion over 10 years, according to Congressional estimates.

Since the bill would also slash the top corporate marginal tax rate from 35 percent to 30.5 percent at an estimated cost over 10 years of $364 billion, the revenues resulting from a repeal of LIFO could buy a 1.5 percent cut in the corporate tax rate, Plesko figures.

A relatively small group of corporations would be affected by LIFO repeal in return for “a big chunk of revenue,” the professor contends. Using inventory data from the Compustat database of public companies’ 10-K filings for 1975 to 2005, Plesko and attorney Edward Kleinbard found that while 5,000 to 8,000 companies reported inventories, the number of companies using LIFO exceeded 1,000 from the late 1970s to the late ’80s, “and steadily declined thereafter.”

Companies that use the system report a “LIFO reserve” — the amount they gain in tax decreases from using the method — in their financials. Fewer than 10 percent of companies with inventories reported a LIFO reserve in 2005, according to an article by Kleinbard and Plesko published in Tax Notes magazine in October 2006.

Industry advocates have disputed Plesko’s calculations before, arguing that they understate the use of LIFO in the United States. Les Schneider, an attorney who represents the LIFO Coalition, a group of 50 trade associations of companies who use the accounting method, contends that the $107 billion estimated return from LIFO repeal is itself evidence of the method’s use by “thousands and thousands of companies across multiple industries.”

Some companies have been using LIFO for “30 or 40 or 50 years” and “their accumulated reserves could be equal to their net worth,” he adds.

What’s more, proponents say that LIFO has long been the best way to match what the company has really paid for the inventory with the revenues it gains from it. And by yielding a truer income number than FIFO, they say, it produces a more solid number for tax purposes.

If an IFRS regime is adopted in the United States and results in a ban on LIFO, that would be “very troubling” for the companies that use it, says Christine Turgeon, a tax partner with PricewaterhouseCoopers, noting that the higher taxes would make it more costly for companies to replace aging inventories.

While FIFO may be best for the balance sheet, LIFO produces more accurate income statements, according to Turgeon. In promoting IFRS, however, the International Accounting Standards Board has pushed companies to move “from an income statement view to a balance sheet view,” she adds, noting that a balance sheet could reflect the cost of goods sold from “50 years ago.”

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