Adopting International Financial Reporting Standards could have profound—that means costly—implications for how inventory values affect corporate tax bills, according to a new study.
The Georgia Tech Financial Analysis Lab has pored over the financial reports of 30 large companies to see how adopting IFRS would change accounting for inventory, since IFRS prohibits the last-in-first-out (LIFO) method of inventory accounting that’s commonly used in the United States. The damage to that small group from that single change: $15 billion.
Pounder
The LIFO problem has LIFO-reporting companies shaking in their boots, according to Bruce Pounder, president of consulting firm Leveraged Logic. If companies cannot use LIFO for financial reporting purposes, they won’t be allowed to use it for tax reporting purposes either. That’s because the U.S. Tax Code includes a “conformity” requirement that says companies have to use the same inventory method for tax reporting as they use for financial reporting.
LIFO keeps older-priced inventory on the balance sheet, expensing through to earnings the most recently purchased goods. “The most recently acquired inventory is the most costly during periods of rising prices, so you get the highest cost of goods sold on the income statement, and you get the lowest tax liability as a result,” Pounder says.
That’s why a switch away from LIFO is so frightening, he says. “If companies are using LIFO, they probably have for decades,” he explains. “That means they have inventory on the books at extraordinarily low prices. If they lose the tax benefit of using LIFO, all the benefit they’ve ever gotten from using LIFO is going to come back to bite them. All the benefit that a company has ever gotten from using LIFO comes undone essentially all at once.”
The move away from LIFO has implications for cash flow and the balance sheet as well, according to the George Tech study. Because the LIFO method suppresses income, companies typically have higher cash flow and lower shareholder’s equity in the form of lower retained earnings. Lower inventory levels result in lower current assets and lower working capital. As such, a switch away from LIFO would pressure various leverage ratios and financing covenants, the study observes.
Financial reporting executives don’t need to pop the antacids just yet; the Securities and Exchange Commission has only proposed adopting IFRS in this country, and not until 2014 or so. But already tax professionals are brainstorming the panoply of issues that could crop up as their clients prepare for the monumental shift away from U.S. Generally Accepted Accounting Principles to IFRS.
Robason
LIFO inventory accounting is only one such pitfall. Randy Robason, a national tax partner at the auditing firm Grant Thornton, says his firm keeps a running list of possible tax headaches related to IFRS adoption. Current length is 40 pages—in very tiny type.
“The overall convergence from GAAP to IFRS and related tax consequence will be the greatest change to have occurred within the field of accounting within anybody’s memory,” says Randy Robason, a national partner in tax accounting at Grant Thornton. “It will make the Sarbanes-Oxley issues seem minor in comparison.”
The Broader Context
The prospect of a sudden avalanche of tax revenue must have folks in charge of the federal coffers salivating. “There has been an interest in Congress for a long time in eliminating LIFO,” says Chuck Mulford, co-author of the Georgia Tech study. “This would be a very easy way to do it. Just blame it on IFRS.”
A TAXING MOVE
Some of the larger hits to corporate tax bills (in millions) tracked by the Georgia Tech study:
Company
Taxes Due on Switch to FIFO
Taxes due % Total Assets
A.K. Steel
$16
16%
Allegheny Technologies
$131
3%
Applied Industrial Technologies
$49
6%
Carpenter Technology Corp.
$175
9%
Castle (A.M.) & Co.
$50
7%
Eastman Chemical Co.
$179
3%
Encore Wire Corp.
$26
5%
Exxon Mobil
$8,890
4%
Friedman Industries
$2
4%
Gorman-Rupp Co.
$16
7%
Grainger Inc.
$101
3%
Graybar Electric
$40
2%
Hancock Fabrics
$13
8%
Holly Corp.
$70
4%
Longs Drug Stores
$72
4%
Marathon Oil Corp.
$1,412
3%
North Amer. Galvanizing & Coating
$3
6%
Sifco Industries
$2
4%
Solutia Inc.
$84
3%
Spartan Stores
$16
2%
Standard Register Co.
$12
3%
Starrett Co.
$10
4%
Sturm, Ruger & Co.
$16
16%
Sunoco
$1,354
11%
Tennant Co.
$10
2%
Tesoro Co.
$490
6%
Twin Disc Inc.
$8
3%
United Refining Co.
$22
3%
Valero Energy Corp.
$2,170
5%
Winnebago Industries
$12
3%
Source
Georgia Tech Study: LIFO as a Part of IFRS Convergence (December 2008).
The interest in Congress, however, predates the economic meltdown that continues to grip the global economy, Mulford says. Now that the economy is the centerpiece of virtually all public policy, the question of what tax policies may be adopted with the move to IFRS gets much more complicated.
Mersereau
Companies that do use LIFO will not rush to early adoption of IFRS, says Dwight Mersereau, a lawyer at the law firm at Miller & Chevalier and a former staffer at the Internal Revenue Service. Instead, those companies will prefer to watch the debate over tax policy unfold and lobby for change that would soften the blow of a conversion to IFRS.
Mersereau says several scenarios could transpire. First, the United States could adopt a version of IFRS that permits LIFO accounting. Mersereau doubts this outcome will ever happen considering how loudly the SEC and the Financial Accounting Standards Board have called for a single global accounting standard, but it can’t be dismissed.
Congress may also choose to repeal the conformity requirement, so that companies could still use LIFO to calculate their tax liability even if they can’t use it for financial reporting under IFRS. “That would be difficult, given that Congress is looking for ways to raise money to pay for all the legislative initiatives that are out there, but it might be considered as part of some sort of stimulus package,” Mersereau says.
Pounder believes a complete abandonment of the conformity requirement is unlikely. “Companies will argue to get a pass on the whole deal and let bygones be bygones,” he says, “but there’s no way politically Congress is going to allow that pass on income that’s effectively been shielded from taxation all these years.”
Mersereau says Congress may also consider giving companies a longer period of time to catch up. Currently, companies can take four years to pay taxes that result from such a change in accounting method. That period could be extended to, say, 10 years.
Regardless, companies reporting under LIFO today would be wise to come up with some kind of contingency plan, Mersereau warns. “Look at what the impact would be, how you’ll convert, what systems need to be in place, and what it would cost you,” he says.
Mulford
Mulford says some LIFO-using companies will see relief simply because prices have declined—especially in oil, for example. For companies facing the prospect of a bigger tax bill, “it’s just a matter of planning,” he says. “You’ll have time to pay the taxes, so it’s a matter of working that into their plan and getting ready for it.”
And then prepare for myriad other tax issues that also need to be addressed, Robason adds. In that 40-page draft document Grant Thornton is preparing for its clients, the LIFO issue takes up no more than a single page, he says. “When companies are thinking about the LIFO change, it’s the tip of the iceberg—and that’s enough to petrify them.”
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