Like LIFO?

Below is a very informative article from CFO.comSucking the LIFO Out of Inventory

The government sees billions of dollars in potential tax revenue sitting on the shelves of company warehouses.

Explaining accounting to Congress is never easy. But last spring, Bill Jones, vice chairman of O'Neal Industries, says he witnessed a few "aha" moments as he went door-to-door on Capitol Hill to lobby against the elimination of "last-in, first-out" (LIFO) accounting.

As Ron Travis, O'Neal's vice president of tax, explained to members of Congress why the majority of companies use LIFO, "lightbulbs started going off," recalls Jones. Until then, he says, "they thought LIFO was just a funny-sounding acronym."

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. 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. O'Neal, a manufacturer and distributor of metals and metal products, has used LIFO for 63 years, almost as long as the method has been allowed for tax purposes (the Internal Revenue Service first sanctioned it in 1939).

"We normally replace every piece of inventory we sell with a higher-priced piece of inventory," explains Travis. "Under LIFO, all of the inflation that is built into our product is not recognized for tax or book purposes."

Jones and Travis breathed a sigh of relief last year when Congress quietly dropped plans to eliminate LIFO. But it didn't take long before the funny-sounding acronym was back in the taxman's sights. The 2011 federal budget proposed by the Obama Administration again includes a provision to repeal LIFO accounting. The government estimates that the move would boost federal coffers by $59 billion over 10 years.

Even if LIFO somehow survives another year of federal budgeting, it still faces the long-term threat of being wiped out if the United States adopts international financial reporting standards (IFRS), which do not allow LIFO. 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 (first-in, first-out) or average cost.

A Bad Match?
Companies like LIFO because it stifles inflationary effects by matching current expenses and current sales more closely than other methods. The accounting convention "protects us from having to pay taxes on what are not really profits," contends Jones. Indeed, proponents of LIFO — 120 of which have formed the LIFO Coalition to lobby against its repeal — don't consider the methodology a tax break. "There is an economic reason for using LIFO, and that is lost on the folks in Washington," says Beatty D'Alessandro, CFO of Graybar, a distributor of electrical and industrial components that has been using LIFO since the early 1980s. Without LIFO, he says, there is a "mismatch between what it's going to cost us to put inventory back on the shelf and what we bought it for six months ago, when it may have cost less."

To understand the mismatch, consider how LIFO works: Say, for example, that a company has an industrial compressor in its inventory that it bought for $5,000. It sells the compressor for $5,500, and replaces it in inventory for $5,200. From an economic perspective, the profit is only $300, not the $500 difference between the historic and current price. LIFO allows companies to use that "last-in" price to record $300 in taxable income. The remaining $200 in income is deferred until the company shutters its business and is forced to liquidate the inventory, at which time it strips off years of "LIFO layers." The $200 — the difference between the taxable income recorded under LIFO and another methodology — is referred to as the LIFO reserve.

In a liquidation, notes O'Neal's Travis, the sell-off of old inventory generates revenue to pay the taxes. But if LIFO is simply repealed, he says, then deferred taxes will be due without the benefit of any additional revenue. "In effect, the repeal of LIFO is going after our equity," the tax director says.

Under the Obama budget proposal plan, companies would be required to "true up" their retained earnings in the year they stop using LIFO, explains Jason Cuomo, a senior analyst with Moody's Investors Service. They would then make annual cash tax payments on the profits stored in the LIFO reserve over a 10-year period, beginning in 2012.

Graybar's D'Alessandro argues that LIFO accounting is a "timing issue," rather than a tax gimmick, and emphasizes that LIFO accounting reverses itself when demand drops. "You burn through LIFO layers as you burn through your inventory," explains D'Alessandro, who notes that Graybar reached lower-cost inventory layers last year as demand slowed. At that point, profits rose under LIFO accounting and the company had to pay more in taxes. The same is true when deflation sets in, says Scott Rabinowitz, a director in PricewaterhouseCoopers's national tax practice. As the price of replacement inventory drops, taxable income increases, and so does a company's tax obligation.


A Cash-Flow Issue
Not all companies agree with the mismatch theory. Proponents of FIFO, who tend to be retailers and manufacturers of fast-moving inventory such as electronics or perishable goods, say FIFO better reflects the current value of inventories. For example, in December, packaging giant Pactiv Corp. switched from LIFO to FIFO, telling investors that the change provides "better matching of sales and expenses." Officials at the company, which makes Hefty brand plastic bags, noted that this is particularly true during periods when the price of their primary raw material, resin, is volatile.

Under FIFO, they said, "the lag between resin-price changes and selling-price changes will be reduced by approximately two months."




Moreover, not everyone agrees that LIFO elimination would be such a dire event for companies with slower-moving inventory. The elimination of LIFO "is a cash-flow issue," argues Moody's Cuomo, who co-authored a recent report on the subject. His report, which examined 176 companies rated by Moody's that use LIFO, points out that larger companies with strong cash flows likely will weather the one-time charge of converting from LIFO to FIFO or another methodology without much problem (see the chart at the end of this article). That's because for the largest companies, the charge represents a small percentage of their annual cash flow. However, smaller companies with high LIFO reserves and low cash flows could run into problems.

But some large companies say the change would still hurt. Graybar, with $4.3 billion in revenue, reported a LIFO reserve of $107 million in its most recent 10-K. Assuming a 35% tax rate, and a single payment that is not stretched out over time, D'Alessandro estimates that Graybar's tax bill would amount to $37.5 million on the day it converted from LIFO to FIFO — or a $19 million tax obligation if the company switched to average-cost accounting. More important, a switch from LIFO could mean up to 500 fewer jobs, says the CFO, who figures that, on average, salary and benefits cost the company $70,000 per person. "If we pay it in taxes, we can't pay it in wages. It is as simple as that. [LIFO repeal] is an anti-employment move," insists D'Alessandro.

The demise of LIFO also could affect a company's net operating losses — the deferred tax asset that is recorded by a company and held to offset taxable income in the future. Rabinowitz notes that taking the LIFO reserve into income could reduce the amount of NOL carryforwards.

The sting of LIFO repeal also will be felt by smaller companies that don't have robust information-technology systems, says Stephanie Anderson, a managing director at consultancy AlixPartners. That's because sorting and valuing layer after layer of LIFO inventory is a complex task. That kind of "unwinding" is mandatory before an accurate valuation can be recorded for book and tax purposes. Anderson says companies may also need to hire more cost accountants to ferret through the inventory layers.

Is the End Near?
The brightest hope for LIFO proponents is the possibility that the accounting method could yet survive. It is too early yet to tell how strong industry pushback will be on the Administration's proposed repeal, but lobbying efforts have stopped it before. Similarly, if the Securities and Exchange Commission does make IFRS the accounting system of the land, nonpublic companies won't have to use the standards. Indeed, if the IRS itself isn't the force behind a LIFO prohibition, it might even prove willing, as it has in the past, to water down conformity regulations requiring that certain methods be used consistently for both tax and financial reporting.

Perhaps the biggest wild card affecting the government's decision will be the economy. "It's always a terrible time to look at repealing LIFO," says Jones, "but right now it's just another nail in many corporate coffins."

Marie Leone is senior editor for accounting at CFO.

SEC Hints at U.S. IFRS Adoption

Following a joint meeting of the IASB and the FASB last week, SEC chairman Mary Schapiro provided a hint on U.S intentions on convergence with IFRS.

Schapiro read a 40-word statement last week that included the words "I am greatly encouraged by the commitment of the IASB and the FASB to provide greater transparency to the standard setting process and their convergence efforts. I believe that these efforts will result in improved financial information provided to investors."

Schapiro and the Obama administration have given conflicting signals in the past as to what direction the SEC would take in light of the financial crisis. She has been quiet on the subject of IFRS convergence since taking over as SEC Chairman last in January. Schapiro has now provided a degree of direction for companies looking to decide whether to ramp up their IFRS adoption efforts. The SEC have said that they will decide in 2011 whether U.S. companies will switch from U.S. GAAP to IFRS. The SEC had previously hinted at what the convergence timeline would be.

The IFRS road map would have the largest companies reporting under IFRS in 2014, with all public companies following by 2016. The SEC has sought feedback and received over 200 comment letters. The comments have not had an overall theme and 200 is a small number considering the number of potential stakeholders, which include public companies, investors such as pension funds mutual fund issuers, auditors, educators, and others.

Some U.S.-based companies, such as Microsoft have ramped up their convergence efforts and companies like United Technologies have made a decision to switch to IFRS ahead of the SEC's decision. These companies have significant operations in countries that have already converged, such as the EU. Ultimately they will save on accounting and audit costs by converging.

The SEC has previously indicated that there are a number of significant issues to be resolved including working out convergence paths for differences between IFRS and U.S. GAAP on critical issues and funding and governance.

Obama Package to Change Mark to Market Rules?

Several news sources have stated that mark-to-market accounting rules for U.S. banks may be changing after this week's release of the Obama administration's plan to dole out the second $350 billion of the $700 billion financial rescue fund.

Banks have been facing steep write downs of troubled assets as a result of the accounting standard. Speculation exists that the charges will preserve the existing standard but allow banks to preserve capital.

Chairman of the Senate Banking Committee Sen. Christopher Dodd spoke to reporters last week that they are considering an approach that modifies but does not abandon the mark-to-market standards.

The SEC has already relaxed standards by allowing banks to reclassify assets that are difficult to value because of lack of market comparable information. The changes preserved value in what otherwise might have been fire-sale values applied to bank assets.

The SEC and the Financial Accounting Standards Board are working on more guidance to help banks determine the value of an asset when there is little or no market trading.

The SEC has not posted any response to the statements.

Fair Value, IFRS and Obama

Paul Volcker is the Chair of Obama’s financial advisory team and Chairman of the Trustees of the "Group of Thirty". Recently the Group of Thirty Working Group on Financial Reform published Financial Reform A Framework for Financial Stability. Volcker alsonhas an important history, as Chair of the U.S. Fed and as Chair of the IASB's oversight organization. he is thought to be a propornent of IFRS in the U.S. Below are a few comments by Volcker and an excerpt from the Fair Value section of the report. Fair Value was important enough to comprise one of 17 recommendations in the report.

Quotes from Chariman Volcker:

"The issue posed by the present crisis is crystal clear: How can we restore strong, competitive, innovative financial markets to support global economic growth without once again risking a breakdown in market functioning so severe as to put the world economies at risk? We hope that our proposals, which explicitly relate to the weaknesses that have become evident in the financial system over the last year, will be a useful contribution to the debate about needed reforms both by private financial institutions and by public authorities."

"The pervasive and deep-rooted financial crisis has amply demonstrated that our financial system is broken and it requires thorough-going repair,"

There were no representatives from the accounting community on the group that authored the report.

Excerpt from: FINANCIAL REFORM A Framework for Financial Stability

Fair Value Accounting
Recommendation 12:

a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business model of these institutions, apply appropriate rigor to valuation and evaluation of intent, and require improved disclosure and transparency. These standards should also be reviewed by, and coordinated with, prudential regulators to ensure application in a fashion consistent with safe and sound operation of such institutions.

c. Accounting principles should also be made more flexible in regard to the prudential need for regulated institutions to maintain adequate credit loss reserves sufficient to cover expected losses across their portfolios over the life of assets in those portfolios. There should be full transparency of the manner in which reserves are determined and allocated.

d. As emphasized in the third report of the CRMPG, under any and all standards of accounting and under any and all market conditions, individual financial institutions must ensure that wholly adequate resources, insulated by fail-safe independent decision- making authority, are at the center of the valuation and price verification process.

High Level Obama Advisors Disagree on IFRS

Two key advisors to Barack Obama today expressed different opinions over the SEC move to shift U.S. accounting rules to IFRS.

The clash casts some doubt on the SEC roadmap requiring large public companies to move from U.S. GAAP to IFRS by 2014.

Mary Schapiro, SEC Chair:
“I would proceed with great caution so we don’t have a race to the bottom.”. “I won’t feel bound by the [IFRS] roadmap.”

Paul Volcker, Chairman of Obama's Economic Recovery Advisory Board:
"We ought to be working toward international accounting standards and have them standard around the world under the general aegis of the International Accounting Standards Board, and there's been a lot of progress in that direction."

Volcker is a a former chairman of the International Accounting Standards Committee Foundation, IASB's parent organization. IASB determines the makeup of IFRS. Volcker is also a former chairman of the U.S. Federal Reserve Board.

Schapiro said she has concerns about the pace of the timeline, the independence of IASB, and the quality of the IFRS standards. As well, Schapiro has concerns over the lack of detail in IFRS and the additional room for interpretation, and the cost cost of the conversion to IFRS, estimated by the SEC to be up to $32 million for the largest companies adopting IFRS.

Former Fed Chairman May Bring IFRS to Fore in Obama's Presidency

2009 may see the accounting profession facing a US political regime with a clear mandate to reform and regulate. Predicting accurately the form this will take is more difficult. This is partly due to senator Obama’s meagre voting record – of his three years in the Senate, more than one has been spent campaigning for president. His platform too, gives little indication of his attitudes to accounting issues, or indeed to wider corporate governance, less some populist efforts to curb CEO pay.

The difficulty inherent in predicting an Obama administration’s behaviour can be illustrated by taking the example of US GAAP convergence with International Financial Reporting Standards (IFRS). Senator Obama has appointed Paul Volcker, former Federal Reserve chairman as one of his top economic advisers, and it is expected that he will play a role in any administration.

Volcker is a man who has unequivocally expressed an ‘interest in encouraging international convergence to a single set of global accounting standards’. One would imagine that this would be a clear indication that convergence, or outright adoption of IFRS, would continue unimpeded under president Obama.

Other indicators, however, point elsewhere. Most expect Obama to make good on promises to move toward a more protectionist position, rejecting what could be seen as international interference. This, allied to the dangers of IFRS being seen as de-regulatory, could slow the process.

Some dismiss charges of a protectionist mindset in the Obama camp, and it is true that some of the more strident ‘USA first’ language has been toned down since the need to appeal to the democratic base in the primaries ended. The broader point remains, however. The potential for a democratic controlled congress pressuring a democratic president to dispense with free-trade orthodoxy has implications for the profession that go further than IFRS, extending to the US-UK tax treaty, the debate surrounding auditor consolidation, and, indeed, on efforts to manage the extra-territoriality ramifications of Sarbanes Oxley.

For accountants seeking a ray of sunshine in all this, it is possible that a democratic administration may shy away from the prevailing republican notion that the Wall Street meltdown would not have been nearly so bad were it not for the influence of mark-to-market accounting.

Unfortunately, even that possibility is likely to fall foul of the likelihood that president Obama and his top-dollar advisers will find their room to manoeuvre significantly limited by the reality of economic circumstance.
By Simon Keymer at Accountancy Age