LIFO ACCOUNTING

EXECUTIVE SUMMARY
For over 70 years, US taxpayers have been able to value the cost of their inventories using the last-in, frst-out inventory method of accounting (LIFO). In general, to use LIFO for federal income tax purposes, taxpayers must also use LIFO for fnancial reporting purposes (herein referred to as the LIFO conformity requirement).
The use of LIFO for fnancial reporting purposes is not permitted under International Financial Reporting Standards as promulgated by the International Accounting Standards Board (IFRS). As a result, a conversion from US generally accepted accounting principles (GAAP) to IFRS likely will eliminate a taxpayer’s ability to use LIFO for federal income tax purposes.
Moreover, the fact that LIFO is not permissible under IFRS has led many policymakers to debate whether LIFO should be permitted for tax purposes, irrespective of IFRS conversion. As a result, Congress and the Obama Administration are considering a repeal of LIFO, while taxpayers and practitioners are defending the merits of LIFO as sound tax policy and are seeking an administrative exception to the LIFO conformity requirement.
The transition from LIFO to an alternate inventory method will have a direct impact on many companies’ cash taxes. This article explores the uncertain future of LIFO, examines a potential exception to the LIFO conformity requirement that could allow the use of LIFO for qualifying companies even after their conversion to IFRS, and discusses planning opportunities that may be available to US taxpayers to help them alleviate the tax burden caused by a LIFO termination.

INTRODUCTION
LIFO is an inventory accounting method used by companies to determine both book income an tax liability. In tax code use since 1979, LIFO is considered a more accurate accounting method when inventory costs are rising because it takes into account the greater costs of replacing inventory. In his administration’s Fiscal Year (FY) 2014 Budget, President Obama has proposed repealing the LIFO method as a revenue offset for federal spending and deficit reduction. The Obama Administration previously has proposed repeal of LIFO as part of debt limit, deficit reduction, and tax reform negotiations. Any repeal of LIFO would dramatically impact organizations and their industries.
LIFO is used by manufacturers, distributors, wholesalers, and retailers of all sizes. It is used particularly by small businesses because of thin capitalization and those sensitive to rising supply and materials costs. Under LIFO, as opposed to FIFO, businesses with increasing inventory costs would have a lower tax liability in a given year; however, if prices fall, the taxpayer would have to repay the LIFO benefit through greater tax liability in the following year. Repeal of LIFO would be a burdensome, unnecessary change in fundamental accounting for such businesses and would result in a massive tax increase on those businesses. As policymakers debate fiscal issues, including deficit reduction efforts, some have called for a retroactive repeal of the “last-in, first-out” – or “LIFO”— inventory accounting method for the oil and gas industry. AFPM strongly opposes singling out the oil and gas industry for repealing this generally accepted accounting method. AFPM also encourages policy makers to consider the impacts on domestic manufacturing jobs from the repeal of LIFO when judging the trade-offs between base-broadeners and rate reduction in comprehensive tax reform. LIFO is the tax-friendly “last in, first out” method of accounting for inventory that has become increasingly touchy in recent years. It keeps lower-priced inventory on the books and expenses more recently purchased, usually higher-priced inventory, which suppresses the immediate tax liability.

The proposed budget offers no discussion of a plan to repeal LIFO except to include it as a line item among planned federal receipts. The table suggests a LIFO repeal would have no impact on the federal budget until 2012. Then it projects revenue of up to $61 billion through 2019 that would help offset the federal deficit.

“LIFO has been around for 70 years,” said Mike Metz, executive vice president of tax services for RSM McGladrey. “Repealing it would have a negative impact on a lot of businesses, especially manufacturers, wholesalers, distributors, and retailers.”

The debate around LIFO has erupted in recent years in the context of a U.S. move to adopt International Financial Reporting Standards. While U.S. Generally Accepted Accounting Principles permit the use of LIFO in financial reporting, IFRS does not. That already has U.S. companies concerned they will have to give up their LIFO ways as the United States moves closer to adopting IFRS for financial reporting purposes.

The Obama budget blueprint seems to step up the pace of such a transition, Metz said. Based on the way numbers in the budget table progress, it appears the administration proposes to phase in a repeal of LIFO over at least a few years, said Metz, but there are no further details provided. He said the idea of repealing LIFO certainly isn’t new, but it’s hard to tell if it will remain in the budget as it proceeds through the debate and approval process.

Also significant, said Metz, is another line item in the budget plan to “implement international enforcement, reform deferral, and other tax reform policies.” Though offering no further detail on what those proposals mean, the plan provides for an additional $210 billion through 2019 as a result of them.

Metz said the administration apparently is planning increased enforcement of transfer pricing, or the tax related to inter-company transfer across international borders. “Reform deferral would result in pretty significant change to tax policies,” he said. “It could include taxing companies on profits earned outside the United States currently instead of when they are repatriated (or brought into the U.S. parent company).”

According to Metz, tinkering with international tax policy could erode U.S. competitiveness in the global economy. “We already have the second highest tax rate, and in some cases it’s significantly higher than a lot of countries,” he said. “Most countries have been lowering corporate tax rates to remain competitive. That’s not something we’ve been doing in the United States.”

Repeal proponents argue that LIFO has no value as an accounting system and is only used to reduce tax liability. Puteven more bluntly, critics have described LIFO as a "massive tax holiday for a select group of taxpayers." Repeal would end a system where taxpayers can permanently defer taxes on gains from rising prices. In addition, they argue that LIFO encourages an economically inefficient accumulation of inventory. In their view, LIFO is "the equivalent of a deduction for a cost that is never incurred" because of the tax deferral it represents.
Proponents of retaining LIFO, on the other hand, argue that LIFO encourages economically-valuable inventory investment and keeps inventory on comparable footing with other investments like machinery and buildings that benefit from accelerated depreciation. LIFO proponents also argue that LIFO accounting offsets what would otherwise be a tax on inflation, since inventory value may increase simply because prices do. Finally, they argue that repealing LIFO would mean taxing past decisions – as far back as 70 years ago – and claim "the extent of this retroactive reach by the government appears to be unprecedented in the history of the Internal Revenue Code."
Most comprehensive tax reform plans would repeal LIFO accounting, including the President’s Business Tax Reform Framework, the Simpson-Bowles tax reform plan, the Domenici-Rivlin tax reform plan, and even the 2007 tax reform billintroduced by Charlie Rangel. The Wyden-Gregg bill from 2010 does not repeal LIFO, though it does propose a one-time adjustment for large oil companies which reduces the benefit of LIFO by re-valuing their inventory.

LIFO IN US BUSINESSES
The LIFO Coalition, a 126-member advocacy group, has urged House of Representatives Ways and Means Committee Chairman Dave Camp (R – Michigan) to drop proposals to repeal the last-in, first-out (LIFO) method of accounting from his proposed United States comprehensive tax reform plan.
There are two primary inventory accounting methods: LIFO and first-in, first-out (FIFO). Under the LIFO inventory accounting method, it is assumed that the last item entered into the inventory is the first item sold. Accordingly, the taxpayer's ending inventory is valued at historical costs rather than the most recent costs.
Taxpayers that use LIFO are required to calculate and track their LIFO reserves, which is the difference between the accounting cost of inventory calculated using the FIFO method and the same inventory using the LIFO method. The LIFO reserve is the deferred taxable income that results from using the most recent inventory costs to calculate cost of goods sold, rather than the lower cost associated with historic inventory.
Within Camp's draft plan, the LIFO inventory accounting method would no longer be permitted from 2015. A business would include its LIFO reserve in its taxable income, which would be subject to tax at 25 percent over a four-year period, beginning with 10 percent of this reserve in its 2019 income, 15 percent in 2020, 25 percent in 2021, and the remainder in 2022.
Additionally, because the repeal of the LIFO method and the inclusion of the LIFO reserve in income could have a substantial effect on cash flow for small and family-owned businesses, the provision provides that LIFO reserves of closely held businesses (generally defined as having no more than 100 owners) would be subject to a reduced tax rate of 7 percent.
The Joint Committee on Taxation previously estimated the abolition of the LIFO method would increase revenues by USD79.1bn in the ten years to 2023.
In her letter to Camp, LIFO Coalition Executive Secretariat Jade West, who is also Senior Vice President-Government Relations at the National Association of Wholesaler-Distributors, wrote that "we strongly oppose the draft's proposed repeal of the LIFO inventory accounting method, and urge you to reconsider this provision."
She stressed that the "repeal of LIFO would significantly and permanently harm broad sectors of America's economy, endangering the viability of thousands of businesses and the livelihood of their employees and their families. LIFO's repeal's damaging effects arise from … the prospective loss of the accounting method which most accurately and fairly states business income for businesses with ever-rising costs of replacing inventory."
"Recapturing up to 70 years of (deferred) income simply in search of additional revenue to fund other tax priorities is unfair, and is unjustified," West concluded.
The LIFO Coalition, set up in 2006, represents hundreds of thousands of businesses in manufacturing, wholesale distribution and retail.

LIFO IN MANUFACTURING COMPANIES
Among the top revenue raising topics included in the current budget proposal is the repeal of the LIFO method. Though this is not the first time the LIFO repeal has been included in a proposed budget, some are worrying that it may just pass this time. This could be a nightmare for some manufacturing companies. If repealed, taxpayers would have to write-up their beginning inventory as of Dec. 31, 2013 to its FIFO (first-in, first-out) value. In an attempt to alleviate some of the pain that would stem from having to recognize all of the income associated with eliminating the taxpayer’s LIFO reserve, the proposal states that the taxpayer would have the ability to recognize the Section 481(a) adjustment ratably over a period of 10 years.
The LIFO (last-in, first-out) method enables companies to expense their priciest inventory (last purchased) in a time of rising prices, in order to drive-up their cost of goods sold. This in turn offsets the gross sales, thus resulting in a lower tax liability in the current year. On the other hand, when prices are falling, just the opposite is true in that cost of goods sold would be lower and the tax liability would be increased. The LIFO method has been considered a permissible method by the IRS for years. The only stipulation to electing this method for tax purposes is that the taxpayer must also use LIFO for financial accounting purposes in conformity with generally accepted accounting principles (GAAP).
The government has a few reasons for its push to repeal LIFO. Among the most obvious is the mere fact that this would raise revenue and eliminate the ability of taxpayers to defer their tax liabilities. Another important reason the government wants to repeal LIFO is that it is not permissible under International Financial Reporting Standards (IFRS). As long as the U.S. allows LIFO to be used, it stands as one more obstacle in the way of implementing IFRS into the U.S. Many large companies that are under a foreign parent company have already had to adopt and adhere to IFRS. Repealing LIFO would also simplify the Internal Revenue Code. The accounting method associated with LIFO is complex and has often been scrutinized by the IRS. The General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposal outlines these reasons for the proposed repeal.
The Indiana Manufacturers Association (IMA) is opposed to repealing the LIFO method. The LIFO method has become such a commonly used method and outside of the reasons stated above, the government has not provided any true tax policy justification for the change. IMA Policy Guide states, “Rather it is an attempt at a tax reporting uniformity that will increase the taxes of many smaller Indiana manufacturers. These companies are the central driver in job creation as economic recovery takes hold. The proposed tax increase is not only unwarranted but could be economically counter-productive if implemented at this time.”
If you are a company that utilizes the LIFO method, there is no need to panic, but you do need to be aware of the issues. If in fact LIFO gets repealed, keep in mind that there are ways to mitigate the tax consequences; it just requires some thought and planning. Two of the key tax planning factors to consider are (1) the favorable Section 481(a) adjustment spread period, and (2) choosing an advantageous inventory valuation method. Then again, LIFO could stick around for a while.
U.S. manufacturers know firsthand how tough it is to compete and prosper under our nation's antiquated and uncompetitive tax system. A pro-growth, pro-manufacturing tax plan will help spur investment and job creation and kickstart our economy. We eagerly awaited the comprehensive tax-reform plan unveiled last month by House Ways and Means Committee Chairman Dave Camp, R-Mich.
We applaud Camp for his leadership in advancing a plan that includes a number of pro-business tax provisions, such as lower rates for manufacturers of all sizes and a strong and permanent research-and-development credit.
But we are concerned about the proposed repeal of sensible, well-established, tax policy: the last-in, first-out (LIFO) inventory method.
LIFO is critically important to many companies and their employees. It allows manufacturers in industries as diverse as medical devices, natural resources and distilled spirits to match current sales revenues with current inventory-replacement costs in determining financial statement earnings and tax liability. By taking into account the greater cost of replacing inventory, LIFO results in a more-accurate measure of the financial condition of the business and the income subject to tax.
Not only would LIFO companies lose the ability to assess business income accurately, they also would be hit with a $79 billion tax increase: a one-time retroactive tax on phantom income in their LIFO “reserves” and higher future tax bills on the appreciated value of their inventory. These additional costs and the impact on working capital will make it more difficult for manufacturers to expand their business and hire workers.
In some cases, the additional tax burden could exceed a company's annual capital budget, and the cash outlay for the new taxes could impair manufacturers’ borrowing ability. The impact of the tax would be felt throughout the U.S. economy.
Our message to Camp is simple: While a simpler, forward-looking tax code will help us compete and spur economic growth, don't use a retroactive tax on manufacturers to generate revenue to pay for changes. LIFO is sound policy that deserves to be part of a 21st-century tax system.

LIFO IN WHOLESALE
The National Grocers Association (N.G.A.) is strongly opposed to repeal of the accounting method Last In, First Out, most commonly referred to as LIFO. Repeal of LIFO, which has been an accepted accounting practice since 1939, and the subsequent retroactive “write up” or taxing of a company’s LIFO reserve will have a crippling effect on many N.G.A. member companies and in particular many family-owned operators. Due to the inflationary nature of food products LIFO is widely used among many supermarket retailers and wholesalers.
BACKGROUND
LIFO is a widely accepted accounting practice that has been recognized by the Internal Revenue Code since 1939. LIFO is used for both financial statement and tax purposes and is the most accurate means of determining inventory asset value and tax liability for certain businesses, in particular many in the supermarket industry. LIFO assumes that the inventory sold by a company in a given year is the inventory last acquired by the company. The most used alternative accounting method, first in, first out (FIFO), assumes that the inventory sold is the inventory first acquired or produced. LIFO allows industries that experience inflationary inventory cost to more accurately report taxable income by allowing inventories that have been increased by inflation to be matched against similarly inflated inventory costs. As an advantage over FIFO, LIFO takes in account the increased costs with replacing inventory during an inflationary period. Using LIFO prevents a company from paying income taxes on “phantom profits” that are created due to inflation and not market forces.
Why the Supermarket Industry Uses LIFO:
Many supermarket retailers and wholesalers have elected to use LIFO in order to more accurately valuate their actual inventory replacement cost. Most retailers and wholesalers maintain significant inventories of product that are subject to consistent inflation. Due to the large variety and quantity of items that many supermarkets stock a single store cost inventory balance can range from less than $300,000 to over $2,000,000. Many companies have elected to use LIFO to avoid being penalized by having to pay taxes on “phantom profits” that do not exist.
LIFO Repeal Would Tax Reserves and Have Devastating Consequences:
The Administration’s proposal would repeal these deductions retroactively, in effect slapping a massive federal tax on companies. These reserves are neither cash nor assets and are by no means liquid. The reserve figure simply represents the total amount of deductions the company has taken over the years under LIFO that exceed the deductions that would have been available had the company used FIFO. The IRS’s Revenue Code’s LIFO provisions provide that LIFO reserves will not be taken into income unless a company liquidates or voluntarily changes its inventory accounting method. This unprecedented tax would have a devastating effect on many N.G.A. member retailers and wholesalers and in the case of one family-owned operator in the Northwest this tax would simply put him out of business. Repeal would also cause a “trickle down effect” in the case of voluntary wholesaler cooperatives, which are owned by the independent retail customers they service. Repeal of LIFO and the subsequent taxing of the company’s reserves would not only affect the company itself, but would inadvertently reduce the equity position of the hundreds or in some cases thousands of retail owners who rely on their equity in these cooperatives to fund new growth and reinvestment in their businesses. At a time when credit it tight and the return on investments in financial markets is poor many independent retailers have used their equity investments in their voluntary cooperative to reinvest and grow these businesses. Repeal of LIFO would deal a financial blow to many of these companies, which include many family-owned businesses.
STATUS
The Obama Administration has included a call for repeal of LIFO and a requirement for companies to “write-up” their beginning LIFO inventory to its FIFO value, in effect taxing a company’s reserves. No legislation has been introduced thus far to include repeal of LIFO.

LIFO IN RETAIL INDUSTRIES
Last-in, first-out accounting, or LIFO, is a preferential method of measuring profits from inventory sales and is one of the ten largest tax breaks in the corporate code. LIFO accounting has been part of the U.S. tax code since 1939, but it is a uniquely American invention; it is not permitted under International Financial Reporting Standards.
To determine taxable profit, a company must subtract costs from gross revenues. LIFO accounting allows companies to sell inventory and calculate the purchase cost of that inventory -- which determines the deduction they may take -- as if the most recent product sold was the most recent bought and stored as inventory.
By contrast, for normal accounting, most companies use first-in, first-out (FIFO) accounting, which assumes that the item sitting on the shelf for the longest is sold first. Since prices tend to rise over time, being able to sell the last product first often allows companies to claim they paid the highest price and therefore achieved the lowest amount of profit for tax purposes.
For many retail industries, where goods are bought and sold quickly, there is little difference between the accounting methods. However, in industries where inventories move slowly and prices change quickly (like industrial equipment or petroleum), the difference can be significant. This difference is most pronounced for companies that bought their first inventories decades ago.
To take an extreme example, assume a company purchased a barrel of oil for $1 in 1939, when LIFO was first adopted, and then purchased an additional barrel each year with the hopes of selling that oil starting in 2013. Under standard accounting "FIFO" rules, the first barrel of oil the company sold would generate about $100 of revenue at a $1 cost, leaving a $99 taxable profit. By comparison, LIFO rules would allow the company to subtract last year’s cost of about $90 and pay taxes on only $10 of profit – allowing a 90 percent reduction in the company’s tax burden.
Though the above example rarely occurs so starkly, many companies keep some inventory indefinitely, leading to a permanent deferral of some of their tax liability.

CONCLUSION
New taxes on business proposed in the Administration’s FY 2010 budget include those from proposed repeal of LIFO (Last In, First Out), a well-accepted accounting method used by American industry and approved by the IRS since the 1930s. Congress should not repeal LIFO. Here’s why. It would reduce jobs across American industry, hurting workers and families everywhere already struggling with the economic downturn. It would reduce investments in domestic energy production. This would result in a greater reliance on imports and cause money to leave the American economy. LIFO more accurately reflects the finances of a business that has rising inventory costs since it pairs current income with the current higher cost of inventory (such as with supplies of crude oil used at a refinery). Repeal of LIFO accounting would result in a significant up-front tax increase for businesses, placing significant cash constraints on them and limiting their ability to manage inflation. With respect to the petroleum industry, the proposed change would represent a one-time, multi-billion dollar tax penalty on petroleum refiners. Congress has failed to advance any tax abuse problem or other policy reason for changing the LIFO rules. LIFO is not a gimmick. It is a useful tool to determine taxable income for companies that anticipate inflation or rising prices. Repealing LIFO would require companies to redirect cash or sell assets to cover tax payments, potentially destroying some businesses.  For U.S. fuel manufacturers, repealing LIFO would amount to a retroactive tax hike totaling nearly $25 billion in accelerated tax liability. Refiners and petrochemical manufacturers are th first purchasers of crude oil and natural gas off the world market and are therefore particularly sensitive to crude oil price inflation and volatility.
 LIFO is not a “tax loophole.” It is a textbook accounting method that has been taught in business schools since 1939 and used by a variety of businesses, such as manufacturing, wholesalers, retailers, newspapers, automobile and equipment dealers.  In fact, according to studies by the Georgia Institute of Technology and American Institute of
Certified Public Accountants, 36-40 percent of all businesses use LIFO to determine both book income and tax liability.  LIFO refers to the assumption made by a business in establishing the value of its inventories when calculating the cost of producing manufactured goods. It is considered a more accurate accounting method because it takes into account the greater costs of replacing inventory when inventory costs are rising, as well as taking into account the lower costs of replacing inventory when costs are falling. This gives a better measure of both the financial condition of the business and the economic income that should be subject to tax.
 The difference between LIFO and FIFO accounting values is known as the “LIFO reserve.” The reserve simply represents the difference in the valuation of the cost of producing goods.
 However, there is not – nor has there even been – actual cash in a company’s LIFO reserve.
Therefore, retroactively repealing LIFO will force companies to divert their operating cash flows away from productive investments or borrow funds (using up part of a company’s borrowing finite borrowing capacity) to pay the recapture tax. This will likely result in reduced capital investment in new productive assets and projects (meaning fewer jobs) or higher prices at the pump.