For securities analysts, dealing with last-in, first-out (Lifo) inventory accounting is a fact of life. But it probably won't be missed very much if a new set of global financial reporting standards eventually results in Lifo's demise.
The U.S. Securities and Exchange Commission (SEC) has circulated a "roadmap" for introducing International Financial Reporting Standards (IFRS) for publicly held companies by 2014. Unlike the existing framework of Generally Accepted Accounting Principles (GAAP) that currently guides U.S. companies, IFRS doesn't include Lifo.
Lifo is an accounting technique designed to reduce the taxes paid by both public and private companies, but the Internal Revenue Service's so-called conformity rule compels those who use it for this purpose to also use it for financial reporting.
"The main benefit to Lifo is that it reduces taxes during an inflationary period" compared with first-in, first-out inventory valuation, said Charles Bradford, head of Bradford Research, New York. But it also "creates a major complication" for analysts because it's difficult to independently predict a company's Lifo expenses or credits from one quarter to the next.
Perhaps the most striking impact of Lifo in corporate financial reporting during 2008 was a trend from big Lifo expenses early in the year to large Lifo credits in the final three months as an inflationary era of rising prices was transformed after midyear into a commodities pricing rout. Among the companies booking large Lifo credits in the fourth quarter were Pittsburgh-based specialty metals producer Allegheny Technologies Inc. (ATI), with Lifo income of $132.7 million; steelmaker Nucor Corp., Charlotte, N.C., which had fourth-quarter Lifo income of $82.2 million; and Pittsburgh-based aluminum producer Alcoa Inc., whose net loss in the quarter would have been larger than $1.19 billion without a $73-million Lifo gain.
For securities analysts, who like to be able to predict such huge credits, this can be a nuisance. Moreover, some of them point out, the massive credits reported in the fourth quarter of last year won't necessarily take place in the first quarter of this year.
Luke Folta, an analyst at Longbow Research in Independence, Ohio, pointed out that the way a company handles taking a Lifo expense or declaring Lifo income is often at the discretion of management. This can mean it's often impossible for analysts to plug Lifo into their earnings models. "Management isn't locked in, so there's no way to model it," he said about Lifo.
However, Folta looks approvingly on the prospect of U.S. companies moving to international standards. "I think it's a net positive," he said, noting that among other benefits it will "allow domestic investors in general to better understand foreign companies."
Bradford said that while he isn't familiar with all the details of IFRS, he is generally in favor of changes that result in "a more uniform, simpler accounting system" worldwide. He pointed out, for example, that when a company in South Korea buys back its common stock, those shares aren't retired but can be voted by management, something that isn't allowed in the United States. And Brazil's value-added tax is treated as a deduction from revenue, never showing up on companies' income statements, he said. The result is that these companies "look phenomenally more profitable than they would otherwise."
John Tumazos, another veteran analyst who runs Very Independent Research LLC in Holmdel, N.J., said that inventory accounting isn't the issue that's likely to dominate financial reporting going forward. Instead, it will be the huge write-offs that metals and mining companies are being compelled to take as high-priced assets acquired during the "bubble era" of the past five years or so continue to lose value with declining commodity prices. "It will take a couple of years for everything to wash out," he said. Frank Haflich