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If GAAP goes, say hello to higher taxes and cyclicality

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Several years ago, William T. Gimbel, the late chief executive officer of Reliance Steel & Aluminum Co., opened the quarterly financial report of another service center. Thumbing through the Earle M. Jorgensen Co. document—Jorgensen at the time was publicly held and the largest holding in Reliance's retirement fund—he called a visitor's attention to a figure near the back of the report Jorgensen's substantial last-in, first-out (Lifo) inventory reserve.

"There's the value in that company," Gimbel declared, pointing to the Lifo reserve, which gave a fuller picture of Jorgensen's profitability than its net income. Today, Jorgensen is a subsidiary of Reliance, which itself in now publicly held.

For more than 70 years, Lifo—as opposed to first-in, first-out (Fifo) inventory valuation—has been a tool for companies to dampen the tax impact of inflation. Meanwhile, an Internal Revenue Service (IRS) "conformity rule" requires a company that employs Lifo for tax purposes to also use it for financial reporting. While some executives think Lifo can help reduce the volatility of reported earnings due to wildly fluctuating raw material prices, some on Wall Street think it's confusing and would just as soon see it eliminated. And in recent years it's been the target of congressional revenue raisers.

Reliance, which today is the largest U.S. metals service center, is a Lifo user. David H. Hannah, chairman and chief executive officer of the Los Angeles-based chain, said that the main reason most companies use Lifo is for the tax advantage and its positive impact on cash flow. But he also points to a second plus. "From our vantage point as a public company it helps even out the peaks and valleys of earnings volatility caused by cost increases and decreases," he said, adding that a company's reported performance is typically "less cyclical" using Lifo than it is on a first-in, first-out" basis.

However, Hannah noted that Wall Street's view of Lifo isn't always consistent. Some securities analysts tend to ignore Lifo expenses that reduce reported earnings when metals prices are rising but then "adjust out" Lifo income when it occurs in a down market.

David N. Deinzer, president and chief executive officer of steel distributor Denman & Davis Inc., Clifton, N.J., noted that 2008 was one of the periods that could be difficult for Lifo practitioners, marked by an inflationary first half but deflation in the fourth quarter.

"Last year was one of those years when, if you were on Lifo, you wouldn't want to be buying anything from October on," he said, suggesting that, depending on market conditions, Lifo considerations could distract a company by pushing it to manage its inventory rather than its business.

In the slumping market of 2002, after more than 40 years on Lifo, privately held Denman & Davis shifted to a system that Deinzer calls "actual item cost." Every plate purchased by the company, for example, is costed as it comes and tracked until it's sold, a method he acknowledged is probably facilitated today by modern computers and information systems.

However, arguments for and against Lifo might one day be only nostalgia if the U.S. Securities and Exchange Commission (SEC) decides to approve a proposed timetable for public companies to switch from the U.S. framework of Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS), which don't allow Lifo.

The possible consequences for distributors of such a move aren't lost on Jonathan Kalkwarf, vice president of finance and administration at the Metals Service Center Institute (MSCI), Rolling Hills, Ill. "It's a matter of great concern for our U.S. members," he said. (Lifo doesn't exist in Canada.) "It could mean a tremendous increase in business taxes." Kalkwarf said he wasn't able to estimate the percentage of MSCI members using Lifo.

"But the more urgent matter for us is the SEC timeline for IFRS legislation," he said, adding that MSCI's unease isn't limited to its impact on publicly traded service centers. "The concern is that (once) public companies leave GAAP, private companies would be forced to do that by their lenders and auditors."

Thomas F. Cramsey, vice president and chief accounting officer at publicly held Carpenter Technology Corp., a Wyomissing, Pa.-based specialty metals producer, emphasized that IFRS' impact won't be limited to Lifo. It also could involve changes in companies' business processes, business models and information systems.

"Nobody has the luxury of waiting until 2011" to see if the SEC gives the go-ahead to IFRS, he said, stressing that "companies need to run diagnostics" now to prepare for its possible introduction. Cramsey pointed out that while a company might be required to use IFRS for its Form 10-K annual report for 2014, it also would need to restate its earnings to conform with IFRS for 2012 and 2013. This means that most companies could be running dual sets of books—using GAAP and IFRS—for those years.

At Commercial Metals Co., an Irving, Texas-based recycler, steel producer and fabricator, William B. Larson, senior vice president and chief financial officer, said he isn't ready to panic at the SEC's proposed switch to IFRS. "I would not take it as a given that it's just two years away, or five years," he said, noting that the hurdles set by the SEC roadmap "are set pretty high." Other financial executives pointed out that the SEC's new chairwoman, Mary L. Schapiro, had recently voiced doubts about IFRS.

Larson also noted that Lifo has survived a decade in Congress' cross-hairs and enjoys the support of some of the country's corporate heavyweights. "Lifo has been on the hit list each year for congressional revenue raisers," he said.

Larson thinks the best possible resolution for Lifo would be for the IRS to revoke the conformity rule, telling companies in effect that "you can be on it for tax (purposes) but we don't care whether or not you're on it for book." Frank Haflich


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