Summer is when we get to catch up on our reading, and this year's list included articles on what, if anything, to do about inventory accounting because of international convergence.
All sorts of contorted logic is being floated to support calls for congressional action or inaction. For example, one commentator argues that Congress should just go ahead and prohibit LIFO for tax returns now because it's only a matter of time before convergence eliminates its acceptability for financial reporting. This argument strikes us as utterly preposterous. For one thing, when did Congress ever do anything pre-emptively? For another, financial reporting considerations simply must not impact an assessment of whether permitting or eliminating LIFO is good tax policy.
But when we look at this comment from a different perspective, it offers a silver lining on the convergence cloud by bringing the LIFO conformity rule into the spotlight. That's good because this 70-year-old rule has been abominable since it was first put into place. Why is it so bad?
Simply because it creates unnecessary conflict between good financial reporting policy and good tax policy.
We published a column in February 2001 ("The LIFO conformity rule: Do we really need it?") that criticized conformity for that very reason. Here is a quote: "Every textbook dutifully explains that managers choose LIFO for its tax benefits. LIFO is widely used, the authors say with a wink and a nod, because it allows managers to enrich a company's shareholders by reducing the income taxes paid. Isn't accounting great? In order to achieve higher real net income, managers have to report a lower net income on their income statements. Huh? To be better off, you have to tell people you're worse off?" In effect, the rule forces managers to report inferior information in order to reap an economic gain, or forces them to forego that gain in order to report useful information.
This absurdity flies in the face of reason, because no taxpayer should be compelled to put out useless financial statements to legally avoid taxes. Consider these often-quoted words from Supreme Court Justice Learned Hand when he was an appeals court judge: "Over and over again, courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: Taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant."
This principle justifies all legitimate efforts to minimize tax payments and exposes the unfairness of the conformity artifice that discourages taxpayers from freely choosing LIFO.
FROM WHENCE IT CAME
We're sure no more than a handful of living accountants remember the day LIFO conformity was put into place. For the rest of us, it has become just another piece of the furniture we're so accustomed to that we no longer notice it. That's unfortunate because this shameful situation has a peculiar, even devious, origin.
It dates to the late 1930s, when Congress first allowed LIFO for federal tax reporting after being persuaded that FIFO overstates distributable cash profits from selling inventory because management must sustain the company by re-investing a portion of gross margin in higher-cost replacements. LIFO advocates convinced Congress it was unfair to tax these realized but re-invested gains. Although the lawmakers agreed, the record is clear that they tacked on conformity to discourage widespread LIFO adoptions and avoid lower tax revenues. By coercing managers into reporting smaller GAAP profits if they chose LIFO, Congress hoped their desire to show higher earnings would stop them from choosing it.
Here is the crux of the issue: Financial reporting policies should be shaped to generate useful financial statements for investors and creditors, while tax policies should be shaped to raise revenue equitably and perhaps encourage good behavior while discouraging bad. The conformity rule has frustrated making those choices for seventy years. Unfortunately, its insidious motives are thoroughly imbedded in both GAAP and the tax law.
The way out of this dilemma is simple: Congress must repeal LIFO conformity immediately and stop the tax law from creating less useful financial statements.
GOOD TAX POLICY?
LIFO can be justified as good tax policy because it acknowledges the unfairness of taxing income that cannot be distributed in the ordinary course of business. It is basically an expression of the "wherewithal" doctrine that says people shouldn't be taxed on income unless they have the cash to pay the tax. (This idea justifies taxing capital gains only when they're realized, for example.) By eliminating conformity, Congress would be free to grapple with LIFO's acceptability on its own merits.
If Congress simply repealed LIFO itself, the transition would force managers to calculate taxable and reported income by subtracting decades-old costs from current sales revenue. Their taxes would take a huge leap upward as unrecognized but realized holding gains would flow into income. The Treasury Department estimates that it would reap a $59 billion tax windfall from this sudden influx of "profit." We're staggered to think about the effect on reported income, showing more even though there is actually less because of the taxes. Just as LIFO originally distorted income by invisibly deferring gains as if they would never be recognized, so too would its abandonment distort present income by recognizing those gains long after they occurred. Somehow, we're reminded of Pinocchio's lengthening nose as new lies patch over the effects of old ones.
GOOD REPORTING POLICY?
The existing inventory accounting standard dates to 1946, when the Committee on Accounting Procedure tried to cope with an unresolvable dilemma that continues today. If CAP had required FIFO, then it would have denied taxpayers the LIFO tax savings they were otherwise entitled to take. But if CAP had required LIFO, managers would have been forced to publish incomplete financials. The committee ducked the issue by telling managers to decide for themselves. The Financial Accounting Standards Board will remain in the same untenable position unless Congress repeals the conformity rule.
But what about IFRS? Because the International Accounting Standards Board doesn't allow LIFO to be used, one might think LIFO would fade away if the U.S. were to adopt international standards. That would be true, except that the stricture against LIFO could be "carved out" along with other inconvenient and otherwise undesirable parts of IFRS. Despite convergence advocates' claims that IFRS are world-wide standards, such carve-outs are the norm for most developed countries. However, our regular readers know we don't think much of convergence as it is currently envisioned, and we really don't put any stock in the possibility that the Securities and Exchange Commission will (or even can) switch its endorsement to IFRS. Accordingly, we're convinced there is no point in counting on convergence to make the conformity rule irrelevant.
Instead, we think it's more feasible to persuade Congress to eliminate the conformity rule to allow GAAP to at last contain a useful inventory standard. We envision a new method that would combine FIFO and LIFO to report three things:
A FIFO balance sheet valuation that approximates the inventory's current wholesale value;
A LIFO cost of goods sold that approximates replacement cost; and,
A realized holding gain or loss for the difference between the FIFO and LIFO cost of goods sold (net of deferred taxes).
This theoretical but easily implemented (no new information has to be developed that doesn't already exist) method has been around for quite awhile. For those who want to learn more, we wrote about it in the June 2004 issue of Strategic Finance ("It's Time to Get Rid of LIFO Conformity"). We think it makes great sense for FASB and the IASB to issue a joint standard to that effect.
So, there you have it. The key to more useful information about inventory is getting Congress out of the accounting standard-setting arena. They've messed it up for 70 years, which is 70 years too long.
As far as we're concerned, getting rid of the conformity rule is a true no-brainer. There's everything good to gain and nothing but bad to lose.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors
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