Long Live LIFO

Over the past 12 months, deep in the halls of Congress, a startling idea has been proposed. In an effort to raise federal tax revenue, some leading members of the U.S. Senate have suggested that LIFO, a long-standing, generally accepted accounting principle used to measure inventory value for tax purposes, should be repealed.

Such a move has raised alarm bells across a wide swath of American business. On the surface, such a proposal may not seem like much—a modest change to bookkeeping standards. In reality, however, should the use of LIFO be restricted or repealed, it is likely to have far-reaching and potentially damaging effects on any company or industry that relies on effective inventory management to remain profitable. Despite assurances to the contrary from Congressional leaders, many worry the issue is far from dead.

IN THE DOOR—AND BACK OUT AGAIN

LIFO, which stands for “last in, first out,” is used by many manufacturers, distributors and wholesalers in part because it accounts for the actual cost of replacing inventory in a period of cyclical or rising prices. LIFO often is compared to FIFO, or “first in, first out,” as one of the two main methods to value inventory. The difference is that FIFO assumes that the oldest piece of inventory always is the first sold, not the last.

Conversely, LIFO assumes the most recent inventory in the door always is the first back out. As a result, when it comes time to replace that inventory, the replacement cost is more closely aligned with current market prices, and not with the price of replacement inventory as it may have been months or years ago. In this way, LIFO also helps a business measure the impact of inflation and price volatility on inventory costs.

LIFO has been around since the late 1930s, when Congress first authorized its use. While it may be impossible to know how many companies use LIFO, anecdotal evidence suggests that the numbers are substantial. For example, the accounting firm of RSM McGladrey, in a 2006 survey, found that more than 40% of manufacturing and distribution companies use LIFO, a number that jumps to more than 60% for companies with $500 million or more in yearly revenue.

Any company that uses LIFO builds up a “LIFO reserve,” or the difference between the FIFO ending inventory balance and its LIFO counterpart. This reserve can fluctuate during periods of rising or falling prices. For example, in a period of rising prices for replacement inventory, LIFO assumes higher replacement costs, which in turn can reduce taxable income and taxes paid, and boost the amount of the reserve. However, when prices decline, LIFO produces a lower cost of sales, which increases taxable income and reduces the reserve.

While these reserves are little more than an accounting function and represent no actual increase in income, if LIFO were repealed, any company that uses the method would likely be taxed on this reserve. For many companies, such a tax would be significant.

“Anytime you look at something that could mean a significant tax on the business community, that’s going to have an impact,” says Dorothy Coleman, vice president of tax and domestic economic policy at the National Association of Manufacturers. “This is a huge tax increase. For older companies, it’s not unusual for them to say, ‘This is a $100 million tax hit for me.’ For smaller companies in particular, a hit like that could put them under.”

A BAD PROVISION?

The story of how LIFO came to be a candidate for repeal has its roots in some surprising places. In late 2005, Americans were confronted with large gasoline price increases. As a result, members of the Senate Finance Committee, then chaired by Sen. Chuck Grassley (R-Iowa), inserted a provision into a 2005 tax reconciliation bill repealing LIFO for one year for a handful of large oil companies, which have historically had large LIFO reserves as a result of rising oil prices.

The amount of revenue that could be generated by the federal government from a one-year temporary suspension of LIFO for large integrated oil companies was pegged at as much as $3.5 billion. The amount of total revenue from all U.S. publicly traded businesses using LIFO could be $24.5 billion, an October report based on earlier testimony before the Senate Finance Committee found.

Although the proposal never emerged from the Senate Finance Committee, thanks in part to the threat of a presidential veto, the cat was out of the bag. Last April, as part of a proposed $100-per-family rebate plan designed to offset the pain of higher gas prices, then-Senate Majority Leader Bill Frist (R-Tennessee) suggested expanding the LIFO repeal beyond oil companies to all business as part of a proposed energy rebate plan. His suggestion was quickly shot down.

But in June, the subject came up once again at a Senate Finance Committee hearing to review the corporate tax code.

George A. Plesko, an associate professor at the University of Connecticut School of Business, who testified at the committee hearing, argues that an examination of the current status of LIFO should be part of a broader attempt to overhaul the current corporate tax code.

“The only way that you can lower the corporate tax rate generally while preserving the current amount of revenue is to broaden the [tax] base,” Plesko says. “It’s clear from the rhetoric of the committee members that they’re looking to lay the foundation for fundamental tax reform. So the key issue is, what is going on in the tax code? And what are various aspects of the tax code that benefit narrow groups?”

For some, mere discussion of mandating a change to FIFO is enough to cause concern. “The problem is that once the possibility of that kind of new revenue coming into federal coffers has surfaced, our concern is that it will not go away,” says Jade West, senior vice president of government relations for the National Association of Wholesalers and Distributors in Washington, D.C., and the executive secretariat of the LIFO Coalition, an association fighting LIFO repeal.

“Congress does not ever see potential revenue that it does not relish having to spend.”

A HEAVY BURDEN

Should it ever arrive, a tax on LIFO reserves could raise billions of dollars in new federal revenues in the short term while securing a new revenue stream on future, potential LIFO reserves. Solid numbers are hard to come by, but Plesko in his June testimony pegged LIFO reserves of publicly traded U.S. companies at around $60 billion.

And, even with an extended period in which the tax could be collected, the tax bite would hurt. “Even with a 20-year tax collection schedule, you’re still imposing a $100 billion or so tax increase on the business community,” Coleman says.

Under such a scenario, metals companies could be dealt a blow. For older companies, LIFO reserves can be substantial. Ron Travis, director of tax for O’Neal Steel in Birmingham, Alabama, which has LIFO reserves going back to 1947, says any new tax from the repeal of LIFO would represent “tens of millions of dollars.”

Even if the tax liability were spread out over a number of years, the burden would be substantial. “It would be a drag on investing and would put a damper on our future expansion plans,” he says. “If it were a 20-year schedule [to pay the tax bill], we could bear that, but it would have to be funded out of borrowings. If it all came due in one year, we would be in violation of our debt covenants.”

LIFO repeal also would take away a tool that manages the volatility that metals companies experience as a result of cyclical commodity markets. “One of the things LIFO does for us is it somewhat lessens the volatility that is seen in our industry, mainly on gross margins,” says Karla R. Lewis, executive vice president and chief financial officer for Los Angeles-based Reliance Steel & Aluminum Co. “If you look at a FIFO gross margin percent versus a LIFO gross margin percent, LIFO is usually more consistent. For us, we have had very consistent gross profit margins, and LIFO has contributed to that.”

Lewis says LIFO helps Reliance, as a public company, gain stature in the eyes of shareholders. “Because we are in a cyclical industry, being able to show that you can perform consistently does get you more credibility and more support from the investors,” she says.

THE BITTEREST PILL

Despite the opposition of advocacy groups such as NAM and the LIFO Coalition, along with the grassroots efforts of business owners and executives who have written their representatives to argue against repeal, LIFO proponents worry the battle isn’t over.

“There’s a presumption out there that there is something amoral or un-American in [the use of LIFO],” West says. “So it is our position that we need to address that information and convince people why LIFO is being used, and that it is an extremely valid measure of inventory evaluation.”

On a political level, West says that may mean lobbying and other tactics to make LIFO repeal such a political liability that it isn’t even on the table in a discussion of tax reform or corporate tax overhaul. “If they were to repeal LIFO right now, that would have a very significant impact on cash and earnings on many of the companies in our industry because we are at all-time highs and LIFO reserves have grown significantly,” Lewis says. “If they try to wipe those out, it would be very bad.”