The Effect of Losing LIFO

Updated on April 18, 2018

The increasing use of technology in the modern world has led to one of the most beneficial, yet invasive, trends in the world today, globalization. As the accounting world becomes a smaller place, a convergence between two major accounting standards, U.S. Generally Accepted Accounting Principles (U.S. GAAP), and the International Financial Reporting Standards(IFRS) is desired by many. A convergence between the two standards has been in the works for some years, however some differences have caused the process to be long and arduous.

Some of the biggest differences in the two principles are the requirements surrounding inventory valuation. In the United States, companies are given three options of costing inventory under U.S. GAAP. These are the first in, first out (FIFO); weighted average; and last in, first out methods (LIFO). However, under IFRS companies may only use the first two options, FIFO and weighted average.

In the United States certain companies benefit from using LIFO for tax purposes. By using LIFO, companies recognize the cost of the most recently purchased inventory first, when assigning cost to sales. Therefore, the oldest cost of inventory remains, never being transferred to cost of goods sold. When prices are increasing, companies report a higher cost of goods sold, and a lower net income. While this does not seem like a benefit, it is for tax purposes. A lower net income leads to less taxable income, which in turn results in companies having a lower income tax liability.

If reporting inventory with LIFO is lost it will force companies to switch to either FIFO or weighted average, and report a higher net income. This will result in higher taxes, though it will also cause a more realistic valuation of their inventory as costs decades old will not remain in their inventory accounts.

While in time the transition will inevitably work out, the largest implication of a switch to IFRS will be the one-time tax burden companies will face. As many companies have costs decades old trapped in their inventory, upon a switch to FIFO or weighted average those costs will be released. It will have the opposite effect of the benefit of LIFO. A company which has been using LIFO since its inception by The Revenue Act of 1938 (Fosbre 2010) will now have to match costs from 1938 to its cost of goods sold in 2018. With inflation, and rising prices this will result in a lower cost of goods sold, leading to a higher net income, and therefore a higher taxable income until the company can eliminate its LIFO reserve.

To illustrate this, in 2010, with an effective tax rate of 45%, if Exxon Mobile were to switch to FIFO it’s tax liability would have increased by $9.6 billion (Krishnan 2010). According to research done in 2008, while more than 65% of companies used FIFO for a significant amount of inventory, around 35% used LIFO to report most of their inventory (Fosbre 2010). In 2011 the number of estimated LIFO reserves were greater than $100 billion dollars. (Tipton 2012). The most current numbers from the American Accounting Association report published in January 2018 show that the estimated LIFO reserves from 2016 would have provided between $11 and $14 billion dollars at the new 20% corporate tax rate (Tinkelman 2018). With billions of dollars at stake the fight continues surrounding a convergence between IFRS and U.S. GAAP.

A convergence between U.S. GAAP and IFRS is inevitable due to globalization, and the desire for standardization in reporting standards and principles. However, there are implications of such a change that go beyond the numbers on financial statements. Without a system to ease companies into the tax implications of a convergence there will be negative consequences unjustly passed onto them. These companies are not in violation of the current standards and practices. They should be helped, not burdened, by a project whose goal is to make things easier, not harder, on companies. Yet, companies using LIFO must also be willing to adjust to change. When a convergence between US GAAP and IFRS happens if companies using LIFO are still holding their ground they will take on greater losses.

References

Fosbre, Anne B. and Fosbre, Paul B. and Kraft, Ellen M. (2010). A Roadblock to US Adoption of IFRS IS LIFO Inventory Valuation. Global Journal of Business Research, 4(4), 41-49. https://ssrn.com/abstract=1871313

Krishnan, S. (2012). Inventory valuation under IFRS and GAAP. Strategic Finance, 93(9), 51. http://sfmagazine.com/wp-content/uploads/sfarchive/2012/03/Inventory-Valuation-Under-IFRS-and-GAAP.pdf

Tinkelman, Daniel and Tan, Christine E. (2018). Estimating the Potential Revenue Impact of Taxing LIFO Reserves in the Current Low Commodity Price Environment.The Journal of the American Taxation Association In-Press. http://aaajournals.org/doi/10.2308/atax-51992

Tipton, Jonathan S., IFRS and the Repeal of LIFO (2012).University of Tennessee Honors Thesis Projects. http://trace.tennessee.edu/utk_chanhonoproj/1483

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