LIFO Suction Life after LIFO: If the United States Adopts the International Financial Reporting Standards (IFRS), Companies Will Have to Change the Way They Value Their Inventories. and That Change Will Impact Cash Flow, Underwriting, Loan Monitoring, and, of Course, Taxes
Strischek, Dev, The RMA Journal
HENRY FORD MUST have been a FIFO man because he famously said, "Make the best quality of goods possible at the lowest cost possible, paying the highest wages possible." In an economy with rising prices, the first in, first out (FIFO) method of valuing inventories results in a lower cost of goods sold and a higher profit.
Contrary to Mr. Ford's advice, many firms since 1939 have preferred the last in, first out (LIFO) method because it uses higher-cost inventory to reduce taxable income. However, significant changes in accounting are under way And these changes, when coupled with the political debate over how to pay for economic recovery, could result in business borrowers having to replace LIFO with FIFO or some other method of inventory valuation.
What will happen if the convergence of U.S. generally accepted accounting principles (GAAP) with international financial reporting standards (IFRS) eliminates the LIFO method and our tax laws prohibit its use? IFRS has several other principles that differ from American accounting, such as capitalization of leases and fair valuation of assets. But of all the impending IFRS changes, the end of LIFO is the one that probably affects the greatest number of commercial borrowers.
This article discusses what the probable disappearance of LIFO will mean to lenders and their borrowers. If borrowers must switch to FIFO, how will they deal with higher ending inventory levels, I higher gross profits and taxable profits, and higher taxes? What will these changes in financial statements mean for lenders who secure loans with inventory and monitor borrowers' performance with financial covenants?
Why Does the Accounting World Hate LIFO?
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 and has been sitting on the shelf. LIFO boosts the cost of goods sold, which lowers profits and consequently taxable income. It is particularly valuable to companies such as industrial manufacturers and distributors, which carry slow-moving inventory and are therefore vulnerable to rising prices.
The IRS first sanctioned LIFO in 1939 because the recovery from the Great Depression was precipitating rapid inflation. Rebounding prices were pushed up further by the worldwide military buildup to World War II. However, IRS tax relief came with a catch: the Internal Revenue Code's Section 472(c), the so-called conformity rule.
Section 472(c) requires a company choosing LIFO for tax purposes to also use it in its financial accounting. (1) If U.S. accounting principles prohibit LIFO, then the conformity rule would disallow it for tax purposes. The business community was saved from the tax-man last year when Congress quietly dropped plans to eliminate LIFO, but ongoing fiscal deficits have the measure back in budget planning as a long-term tax generator. The proposal to repeal LIFO accounting estimates that it will result in an additional $59 billion in tax revenues over the next 10 years. (2)
If its tax appeal wasn't enough, LIFO faces another threat from the probable U.S. adoption of some or all of the international financial reporting standards, which do not allow LIFO. Opponents of LIFO argue that it mismatches revenues and expenses just to smooth income. Only a year after the IRS authorized its use, a 1940 article in The Accounting Review criticized LIFO as a manipulation of income because it violated proper matching. (3)
Some 25 years later, Harvard professor Robert Anthony pointed out that LIFO "normally does not reflect the physical flow of material" and that "it confuses two distinct processes, the measurement of income and the utilization of income" by charging only the most recent inventory purchases against revenue instead of the total cost of replacing all the items sold. …