A Critical Analysis on the Impact of Repealing LIFO as an Inventory Valuation Method

Introduction The United States potential conversion to the International Financial Reporting System (IFRS),1 a relentless economic recession; the federal governments need to increase revenues to offset unprecedented budget deficits; and the specter of high inflation looming over the horizon; provide the impetus for policy makers and accounting standard setters to seriously reassess the viability of LIFO as an inventory method of accounting. Accordingly, this report provides a critical analysis on the role of last in, first out (LIFO) as an inventory valuation method of accounting and the implications of its potential repeal as a matter of practice and policy. Battle lines are being drawn over the repeal of LIFO which continues to receive a tremendous amount of scrutiny and pressure from opponents calling for its abolishment while proponents argue to retain it. At stake are billions of dollars, that can either be used as tax revenues to replenish federal coffers or continue to be used as a lucrative tax break for industries that utilize LIFO as an inventory valuation method. At its core, LIFO provides a mechanism to a select group of industries that carry sizeable amounts of inventory, such as the oil, petroleum and steel industries, to underestimate their net income. Opponents of LIFO assert that during periods of high inflation it provides a profitable tax-loophole resulting in lower income taxes for the aforementioned group of industries. It may also provide an opportunity for these industries to manipulate their inventory levels, at year-end, to lower income and lower taxes. Proponents argue that LIFO has been part of the federal income tax law for 70 years and in many cases a companys LIFO reserve may exceed the companys net
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Information regarding the status of the International Financial Reporting System can be found at the following website. http://www.iasb.org/IFRSs/IFRs.htm

worth and that LIFO matches current expenses with current revenues and avoids an impairment of a companys capital that would otherwise result from paying current taxes on inflationary profits that are needed for reinvestment in inventory at the new, higher prices (West, 2009). This will be explained in more detail later in the report. The Fundamentals of Inventory Accounting The three most commonly used inventory valuation methods of accounting are first in, first out (FIFO), LIFO and weighted average. The FIFO inventory valuation of accounting matches historical costs of purchased (or produced) items with current revenues, while LIFO matches current costs with current revenues. The weighted average method is self-explanatory; it takes the weighted costs of all items in inventory. Currently, the oldest and most commonly used inventory valuation method of accounting is FIFO. It is also important to note that inventory accounting and valuation may have little or no relationship to the actual flow of goods or the management of physical inventory. For example, the various inventory valuation methods are basically cost flow assumptions that are used to provide an appropriate measure of costs to match to a periods revenues in order to determine profits (Plesko, 2006). Under LIFO as inventory costs climb, so does cost-of-goods sold. As cost-of-goods-sold climb net income drops and net cash flow increases. History of Inventory Accounting In 1918, the U.S. Congress approved the use of inventory accounting to reflect income. The two methods approved were FIFO and the weighted average method. Prior to LIFO the base-stock method was used. Essentially, the base stock method accounted for the portion of the taxpayers
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inventory that was considered necessary to the ongoing business of the concern like it was a fixed asset and valued it at its original cost basis. When this asset was depleted, new inventory was written down to the original cost basis to replenish the reserve. When the firm bought new inventory, this was valued at lower of cost or market and sold as such by the firm. In this way, when items were removed from inventory, they were removed from items most recently added to total inventory, not the base-stock. As a result, the cost of the reserve would remain at the original price and not fluctuate as prices rose and fell during the years (Romeo, 2009). In 1939 Congress revised the Internal Revenue Code to allow LIFO for tax purposes. It requires companies using LIFO for federal income tax purposes to use LIFO for financial reporting purposes.2 This became known as the LIFO conformity rule which is a specifically authorized tax accounting method under 1.472-2.3 Another import aspect of LIFO is that according to the Generally Accepted Accounting Practices (GAAP), companies are not required to use just one inventory valuation method of accounting for its entire inventory; for example, some of the inventory may be valued using FIFO while the remainder is valued using LIFO or another method. According to George E. Plesko, Professor of Accounting at the University Of Connecticut School Of Business, the use of LIFO dramatically rose during the mid 1970s (a period of high inflation). At its peak, in the early 1980s, companies that reported at least a portion of their inventory as LIFO reached approximately70 percent. During the same period companies that reported their entire inventory as LIFO reached approximately 40 percent.4 The Impact of the International Financial Reporting Standards on LIFO
2

The idea in this paragraph comes from Cooper, Malone, McFadden-Wade at p.1

Department of the Treasury, Internal Revenue Service, 1.472-2, Requirements incident to adoption and use of LIFO inventory method, p. 523.
4

The ideas in this paragraph are from Plesko at p.1

There are approximately 113 countries around the world that currently require or permit IFRS reporting for domestically listed companies.5 The benefits of using IFRS are apparent. In this day and age as capital markets integrate into the global economy, U.S. investor will have an opportunity to increase their international investment portfolios. Promoting a single set of globally accepted accounting standards will benefit investors as more and more companies prepare their financial statements applying a single set of high-quality accounting standards. A single set of accounting standards will facilitate investors to better compare information to be in a better postion to make informed investment decisions. Perhaps the biggest challenge for U.S. implemention of IFRS is LIFO which is not allowed as an inventory valuation method of accounting. The Securities and Exchange Commission has taken action to address this problem. On November 14, 2008, Ms. Florence E. Harmon, Acting Secretary, released: Roadmap for the Potential Use of Financial Statements Prepared In Accordance with International Financial Reporting Standards by U.S. Issuers.6 The original comment period was scheduled to end on February 19, 2009 but was extended to April 20, 2009. The roadmap is essentially a staged implementation requiring large accelerated filer to prepare financial statements according to IFRS by 2014. The responses varied from limited support to complete rejection.

The United States currently uses the Generally Accepted Accounting Principles (GAAP) but continues feasibility studies for implementation of IFRS. IFRS has been enacted by some countries and require compliance accordingly. Implementation and full compliance of IFRS various between various countries the following website provides more information. See http://www.iasplus.com/country/useias.htm.
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Securities and Exchange Commission, 17 CFR 210, 220, 230, 240, 244 and 249. See following URL for Proposed rule. http://www.sec.gov/rules/proposed/2008/33-8982.pdf

The Retail Industry Leaders Association (RILA) expressed principled support stating that requiring U.S. issuers to use IFRS could be a significant step towards the goal of implementation by substantially increasing efficiencies, reducing costs, and diminishing the risk of errors resulting from maintaining reporting systems for IFRS and U.S. GAAP (Kennedy, 2009). As a negative the RILA recognizes that certain RILA members estimate that converting their inventory acccounting system would require expenditures in the hundreds of millions of dollars over several years (Kennedy, 2009). The RILA also recognizes the benefits of having universal accounting standards. The response by the United States Steel Corporation (USS) was completely non-supportive of adopting the use of IFRS. In her letter to Securities and Exchange Commission, Ms. Gretchen R. Haggerty, Executive Vice President & Chief Financial Officer, states It will costs tens of millions of dollars and require significant internal resources to modify our systems and change processes in order to transition to IFRS. Due to the on-going global economic and financial crisis, we cannot afford to reduce our liquidity or allocate our limited internal resources to this project (Haggerty, 2009). Ms. Haggerty also explains that they dont support the adoption of IFRS because of the prohibition of LIFO. She does not provide specifics and makes a general comment that it would have a negative impact on their financial postion.

Proponets of LIFO The biggest proponent of LIFO is the oil and gas industry which benefits the most from this inventory method of accounting. The following was taken from an article from the Associated
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Press, dated October30, 2008 provides an idea on the magnitude of profit an oil company can make during periods of high inflation, Exxon Mobil Corp., the world's largest publicly traded oil company, reported income Thursday that shattered its own record for the biggest profit from operations by a U.S. corporation, earning $14.83 billion in the third quarter (Press, 2008). It would be interesting to find out how much higher the record profit would have been if FIFO would have been used and how much the US Government lost out in taxes. The price of oil peaked in July 2008 at $150 per barrel. The conditions to encourage oil companies to favor LIFO are still prevalent today. As recently as November 18, 2009, Frontier Oil announced its intention to switch to the LIFO inventory valuation method. According to a news article on Earthtimes.org, the inventory valuation change will decrease Frontiers reported pre-tax income for the nine months ended September 20, 2009 by approximately $180 million (Boyd, 2009). If a tax rate of 35 percent is applied to this decrease in income, the result is additional $63 million cash for Frontier Oil. Again this represents $63 million that the US Government lost out on in tax revenue. Another proponent, The LIFO Coalition, a group of about 120 trade association, was established to preserve the right of companies to value their inventories pursuant to the LIFO method for federal income tax purposes. (West, 2009). One of their major concerns is the transition from LIFO to FIFO. Under GAAP, Statement 154, Accounting Changes and Error Corrections, a change from FIFO to LIFO is treated retrospectively. In an article in the Journal of Accountancy, The Death of LIFO, Bloom and Cenker write about the affects of a transition fro FIFO to LIFO. They state, The result (assuming that the accounting basis for inventory under the new method exceeds the corresponding basis under the prior methos) is (1) an increase in inventory, (2) an
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increase in current income taxes resulting from the effective increase in income, and (3) an adjustment to retained earnings for the effect of the accounting and tax bases for the inventory change if it were to remain. 7 The conversion from LIFO to FIFO will also have to address the LIFO reserve. The LIFO reserve is essentionally a tax defferment that companies carry on their book to account the difference between the level of inventory that would have been carried using FIFO and the level of inventory using LIFO. Hence, companies that have been using LIFO for a number of years will have a higher tax deferrment. Proponents of LIFO are concerned that in many small companies may have LIFO reserves greater than their net worth. This could lead to many companies filing bankruptcy if IFRS is implemented as is. Opponents of LIFO The biggest opponent of LIFO is the U.S. Department of Treasury and they are very clear with their position. On page 27 of their General Explanations of the Administrations Fiscal Year 2010 Revenue Proposals they state Repeal the Last-In, First-Out (LIFO) Method of Accounting for Inventories.8 The reason that state for the change is The repeal of LIFO would eliminate a tax deferral opportunity that is available to taxpayers that posses inventories whose costs increase over time. In addition, LIFO repeal would simplify the Code by removing a complex and burdensome accounting method that has been the source of controversy between taxpayers and the IRS9 In conclusion.
7

Cenker et al. at p 1

The U.S. Department of the Treasurys General Explanations of the Administrations Fiscal Year 2010 Revenue Proposals (Green Book), dated May 2009 provides detail plans on who the administration will cut and raise taxes. See http://www.treas.gov/offices/taxpolicy/library/grnbk09.pdf.
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Ibid. 27