Since 1939, when the Tax Code's treatment of inventory was modified to permit LIFO, managers and accountants have faced a tri-lemma in that they have to choose among FIFO, LIFO and average flow assumptions. The Committee on Accounting Procedure issued Accounting Research Bulletin 29 in 1947 to provide guidance for this choice, but said two things that have hampered financial reporting ever since. (These provisions were subsequently integrated into ARB 43 in 1953, and remain in force 60 years later.)
First, the CAP said, "A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues." Second, the committee established that, "Cost for inventory purposes may be determined under any one of several assumptions as to the flow of cost factors (such as first-in first-out, average, and last-in first-out); the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income." One thing to note is that "usefulness for decisions" is not mentioned; rather, the tests of acceptability are propriety, appropriateness and clarity.
The bigger flaw is the subjugation of asset valuation behind, even well behind, expense measurement. (Matching has long since fallen out of favor because of the fuzzy amounts reported for revenues and expenses that aren't linked to observable changes in real assets and liabilities. Nevertheless, LIFO endures as a still-functioning memorial to old-fashioned matching.)
CLASHING POLICIES
Extending a bit of compassion, we understand the committee members' predicament in 1947. Specifically, Congress' inclusion of the conformity rule in the Tax Code forces managers to use LIFO for their financial statements if they want to reap the tax savings. The cost of realizing that savings is reporting an inferior balance sheet that understates the inventory's cost, and an inferior income statement that fails to report realized holding gains on sold inventory items.
If the CAP, the APB or the Financial Accounting Standards Board had required FIFO or average, they would have prevented managers from harvesting the tax benefit. And if they had required LIFO, they would have forced managers to publish inferior statements. The only expedient way out of this stalemate has been to let management decide.
60 YEARS LATER
This year brings the 60th anniversary of LIFO's general acceptance, but there may not be many more because of pressure from international standards and proposed tax legislation.
Specifically, LIFO is not acceptable under IFRS 2 (issued in 2003), which is not surprising considering that no other tax jurisdictions permit its use. With so much interest these days in converging U.S. and international rules, eventually LIFO will have to go.
Closer to home, Rep. Charles Rangel, D-N.Y., has introduced H.R. 3970 to attempt various tax reforms, one of which is eliminating LIFO on tax returns. If that were to become law, which is by no means certain, it would be the end of LIFO as we know it. (Incidentally, the bill would also abolish lower-of-cost-or-market.)
A GOLDEN OPPORTUNITY
Eliminating LIFO (or merely disabling the conformity rule) would open the door for progress in inventory accounting for the first time since 1947. Reform is needed, because the currently acceptable methods are all deficient when it comes to providing useful information for assessing future cash flows.
LIFO produces an incomplete income number and an asset measure that does not reliably reflect the inventory's cash flow potential. Both FIFO and average are deficient because they cause the reported gross margin to combine realized holding gains on sold items with the company's marketing profits.
Suppose that the FIFO or average cost of a unit is $100 and that its replacement cost is $120 when it is sold for $180. Both methods report $80 gross profit, which is actually the sum of a $20 realized holding gain and a $60 profit from marketing activity. In addition, neither FIFO nor average carry the inventory at current value, although FIFO comes close if the inventory was acquired recently. If the conformity rule were to become moot, the door would be opened for addressing these deficiencies.
Even if the law is not changed, it's time to deal with the flaws of dollar-value LIFO (see "Fatal Flaws," below).
A BETTER SOLUTION
Sixty years of changes in technology and inventory management principles demand a new accounting method that overcomes these deficiencies. The two goals to be accomplished are reporting inventory at its fair value and providing more complete information about the income effects produced by making, buying, holding and selling inventory.
A more useful carrying amount for inventory would be its selling price without any additional marketing effort, which is approximated by its wholesale value. This number is likely to be correlated with the inventory's cash-flow potential.
In addition, a more useful measure of income would disaggregate the different components of value added. All would benefit from revealing the profitability of the company's manufacturing efforts separate from its holding gains and losses and the marketing profits.
Suppose a company puts $500 of materials, labor and overhead into a production process and produces an item with a wholesale value of $1,100. Then, because of changes in input prices, the wholesale value increases to $1,325 before the item is sold. Finally, the marketing process adds time and place utility such that the item is sold to a customer for $1,980. Under existing GAAP, the entire $1,480 profit is reported as "gross profit" in the period of the sale.
Under our approach, three components of income are reported: the manufacturing profit is $600 (wholesale value minus production cost), the inventory holding gain is $225 (change in wholesale value), and the marketing profit is $655 (sales price minus final wholesale value). In addition, these components are reported in their own time period instead of being deferred and compressed into the year of the sale, thus improving the timeliness of the information.
Is this method a radical departure from generally accepted accounting principles? Absolutely, but only because the LIFO conformity rule has forced standard-setters to sit on their hands for six decades.
But if U.S. GAAP is to remain in step with international GAAP and, more important, get in tune with users' needs, now is the time to toss the traditional flow assumptions and start reporting useful information based on observations of real assets and events.
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' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
