One of the major tools that metal manufacturers and distributors use to help boost cash flow and on-the-ledger profitability has nothing to do with the plant floor or a piece of equipment; it is an accounting measure known as last-in, first-out (lifo).
But for companies big and small--especially for those that are bigger--lifo presents accounting, spreadsheet, information technology and even public policy and political challenges. (As to the latter, the Obama administration has attempted to do away with the practice.)
Lifo isnt something new; rather, lifo has been used and accepted as a legitimate accounting method by accountants, tax lawyers, the IRS and Congress since the 1930s, a spokesman for Washington-based trade advocacy group Lifo Coalition said. In fact, when lifo was officially recognized almost three-quarters of a century ago, Congress imposed a financial reporting conformity requirement making the use of lifo for financial reporting a condition of its use for tax purposes.
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 in the past and has been sitting on the shelf, according to the Georgia Tech College of Management. That boosts the cost of goods sold, which lowers profits--and, thus, taxable income. Lifo is particularly important to companies that have slow-moving inventory--such as industrial manufacturers and distributors--and are therefore vulnerable to rising prices.
Lifo is used in numerous industries, including metal producers and service centers, where large inventories are commonplace. In fact, New York-based ratings agency Moodys Investors Service Inc. estimates that the metal and mining industries are among the top sectors benefiting from the use of lifo.
For the large amount of tax savings provided by lifo, many companies have not assigned a high-enough priority to the accuracy of their lifo calculations, said a spokesman for Omaha, Neb.-based Lifo Pro Inc., a company that produces inventory software. It is ironic that most companies spend a great deal of time gathering data to use in the lifo calculations but then make errors--and no lifo error is small--in the final part of their lifo calculations. They also do not provide adequate documentation for their lifo layers history.
One of the unique aspects of lifo calculations is that lifo inventory amounts are accumulations of layers from numerous years and link-chain indexes are the products of all past years inflation indexes, the spokesman said. The accuracy of the lifo inventory balance today depends on lifo calculations made in all the years since lifo adoption. Because of this, the IRS requirements of adequate books and records with respect to lifo are more demanding than normal.
The use of lifo provides a different impression of a firms financial position and performance than if, for example, the first-in, first out (fifo) method were used, a former tax partner with a prominent national accounting firm said. These differences arise because the lifo method assumes that the costs of the most recently purchased goods are expensed as part of cost of goods sold for the period. As a result, older costs remain in inventory on the balance sheet. When inventory costs are rising, lifo will result in a higher cost of goods sold, lower earnings and lower measures of inventory. In contrast, the fifo method assumes that the most recent purchases remain in inventory and older costs are expensed through cost of goods sold. With rising inventory costs, fifo will result in a lower cost of goods sold, higher earnings and higher measures of inventory.
This means the income, cash-flow and balance-sheet effects of lifo are far different than those of fifo. Although there is little in the way of off-the-shelf software available to help metal companies with lifo needs, several firms offer programs, processes and consulting to help boost the use, and efficacy, of these accounting measures.
Accenture Plc, a Dublin-based IT and business consulting company that provides finance and accounting solutions, said a businesswide approach to lifo could lead to many benefits but cautioned that, historically, problems with inventory valuation--such as inaccurate accruals, revenue recognition and asset impairment--have been a major factor behind financial restatements.
A spokesman for New York-based Deloitte LLP, an audit, financial advisory, risk management and tax consulting firm, said companies can be at risk of calculating their lifo internal inflation index incorrectly, using resources inefficiently and missing value-added opportunities. This is especially true if a company has implemented a new enterprise resource planning (ERP) system, employs a statistical sampling method or an outdated process to calculate lifo, spends weeks or more of employees time preparing rather than analyzing the lifo calculation, has documentation issues with lifo, has had a personnel ownership change in its lifo process or is often surprised at year-end with the results of a lifo calculation and cannot explain the cause of the results.
New York-based accounting and consulting firm Crowe Horwath LLP offers what it calls a cost-effective technology-enabled lifo processing solution that reduces the cost to perform lifo computations that help to comply with IRS rules and procedures; frees up internal resources needed during busy times of the year; and provides calculations that have been reviewed by lifo professionals.
Although numerous companies use the lifo method, President Obamas current tax proposal would repeal it. The proposal is not new, but industry lobbying over the past few years has stalled prior attempts to repeal it.
Lifo is a specifically authorized tax accounting method under a section of the U.S. tax code. There are two ways it could be eliminated. The first would be an outright ban, such as that proposed under Obamas corporate tax reform proposals. The other would be through the adoption of international financial reporting standards (IFRS), globally accepted accounting standards for financial reporting that do not allow the use of lifo. The U.S. government is considering adopting IFRS, which is administered globally by the International Accounting Standards Board and by the Financial Accounting Standards Board within the United States.
The U.S. Treasury Department recently estimated that by adopting either proposal to drop lifo, the government would see about $60 billion in additional annual tax revenue, while the Joint Committee on Taxation put the revenue pickup at about $80 billion. Both estimates are less than an estimate in excess of $100 billion in a House bill.
The transition from lifo to an alternate inventory method will have a direct impact on many companies cash taxes, a study by New York-based PricewaterhouseCoopers LLP (PwC) said. Many U.S. companies with a foreign parent that have already converted, or are in the process of converting, to IFRS have already faced this issue.
Even if lifo somehow survives another year of federal budgeting, it still faces the long-term threat of being wiped out if the U.S. adopts IFRS, a spokesman for advocacy group SaveLIFO said. That would stop companies from using lifo entirely, because companies that use the method to reduce taxable income reported to the IRS must also use it for financial reporting rather than potentially more-flattering methods, such as fifo or average cost
Unfortunately, Obama sent a 2014 budget proposal to Congress which once again proposed lifo repeal. Repealing lifo would force companies currently using this method to report their lifo reserves as income, resulting in a massive tax increase for large and small businesses across the country. Additionally, repealing lifo would mean potentially higher future tax bills and would make it harder for companies to manage inflation, SaveLIFO said.
Regardless of whether a company changes from lifo to fifo as a result of adopting IFRS or because of legislative repeal, such change is likely to have a significant impact on its cash taxes, the PwC study said. Assuming lifo is not repealed through legislation, in certain situations a company may qualify for an exception from the lifo conformity requirement. As a result, the company may be able to continue to use lifo for tax reporting purposes even after they convert to IFRS for financial reporting purposes.