We have come to realize that it's long past time to question using LIFO to allocate costs first to the cost of goods sold and then inventory. It has survived since it entered both the Federal Tax Code and GAAP in 1939, which means it's been around longer than most everyone reading these words. That longevity gives LIFO a spot on the Hall of Fame roster of POOP -- Pitifully Old and Obsolete Principles.
What makes things even worse is that it didn't gain GAAP status because it provides useful information. Instead, LIFO became acceptable simply because Congress bizarrely created it as a new tax policy to avoid taxing so-called paper profits, while simultaneously imposing the "conformity rule" that requires taxpayers to use it in their financial statements.
Although electing LIFO allows managers to report a lower taxable income, Congress hoped their distaste for lower reported profits would stop them from adopting it. That deterrent didn't work as planned, but has had the negative consequence of coercing LIFO adopters into providing deficient statements for more than seven decades.
FLUMMOXED STANDARD-SETTERS
Starting with the Committee on Accounting Procedure, standard-setters haven't been able to solve the LIFO dilemma: If they were to disallow it, they would deny relief to taxpayers; however, if they were to require it, they would force everyone to present flawed financial statements.
The CAP punted in ARB 29 in 1947 by letting management select the flow assumption "which, under the circumstances, more clearly reflects periodic income." To paraphrase, they said: "Here, you decide!" And that's the way it's been ever since.
FOUR LIFO LIES
Because managers and accountants who use LIFO end up telling four lies, we think it should be spelled "Lie-FO."
• Lie No. 1:Lie-FO is an equivalent alternative to FIFO. In fact, FIFO and Lie-FO are based on entirely different income theories. While FIFO provides an historical cost measure of cost of goods sold, Lie-FO actually produces an approximate replacement cost measure. Because a sale triggers restocking, the reported gross profit equals the revenue less the price paid to replace the sold item.
(In terms of providing useful information about net income, replacement cost theory is actually more complete than historical cost, so that's a good thing.)
• Lie No. 2:Because Lie-FO is acceptable, it surely provides useful and complete information. In fact, Lie-FO reduces reported net income only by the questionable device of omitting realized holding gains related to selling goods after their replacement cost increased. For example, suppose an item purchased for $60 is sold for $130 and replaced by another costing $80. FIFO reports a gross profit of $70 ($130-$60) but Lie-FO reports only $50 ($130-$80). The difference is the unreported $20 realized gain from buying the item at $60 and selling it when it's worth $80.
Thus, Lie-FO saves taxes only by not telling the whole truth.
• Lie No. 3:Because the Lie-FO amount for inventory is presented on GAAP balance sheets, then it surely must be useful information. With a touch of condescension, the Financial Accounting Standards Board officially validated this presumption in SFAS 162 by saying, "The board believes that the selection of accounting principles in accordance with the GAAP hierarchy results in relevant and reliable financial information."
In fact, the Lie-FO amount does not provide any relevant and reliable information about inventory because it is a preposterous amalgamation of original costs of items that the company no longer owns. Although it doesn't faithfully represent anything, its use on the balance sheet clearly signals that the accounting and management professions, including FASB, are content to report useless amounts.
To comprehend what this means, consider the cumulative realized inventory holding gains that have been excluded from a company's net income since it adopted Lie-FO. In a sense, they're similar to unrealized investment gains that are excluded from reported net income. While those unrealized gains are reported as other comprehensive income in equity for all to see, the credit for accumulated Lie-FO gains is surreptitiously offset against the FIFO inventory amount like it's a contra-asset. Astute statement readers can find how large it is by searching the footnotes for the balance of the misnamed "LIFO reserve" account.
As a result of this abominable treatment, users cannot rely on Lie-FO information as presented.
• Lie No. 4:Dollar-value Lie-FO usefully approximates unit-based Lie-FO. Using dollar-value Lie-FO, even companies that completely change out their inventories every year can claim the lower Lie-FO taxable income. In fact, this technique is a fabricated expedient that produces inventory measures that sort of look like Lie-FO. See what you think of this shortcut after reading the next two paragraphs.
The Internal Revenue Service's preferred method involves using an index calculated by double-extending the entire inventory at current year-end prices and again with base-year prices. Because that calculation is seldom (if ever) feasible, the taxpayer can apply an index based on a double-extended sample of the inventory. When that isn't feasible (virtually always), the taxpayer can apply a "link-chain" index that uses annual change indexes to get a cumulative index. When that process is too complicated (often), taxpayers get to use published indexes.
Consider this house of cards: the result of applying dollar-value Lie-FO with a published index approximates a link-chain index result that approximates a double-extended sample index result that approximates a double-extended index result that approximates a units-based Lie-FO result that approximates replacement cost of goods sold!
Surely, it would be far more direct and reliable to just use observed replacement costs instead of applying these Rube Goldberg machinations.
REALITY CHECK?
All the above shows that using Lie-FO leads to untruthful representations in GAAP financial statements. If so, they're unreliable, untrustworthy and not useful. Therefore, this method should trigger a reality check for every CPA who wants to practice ethically.
Alas, we speculate that 99+ percent of practitioners have probably never stopped to evaluate Lie-FO's lack of truthfulness since their introductory accounting course.
You should now see that a new and different reporting standard is needed because Lie-FO is not a genuine financial accounting policy designed to produce useful information for statement users. Instead, it implements a 73-year-old federal policy that aimed to ease tax burdens.
The first step is to somehow get the conformity rule out of the picture. Of course, it ought to be repealed because it doesn't achieve its goal of discouraging taxpayers from adopting Lie-FO. It never has served a useful purpose and produces boatloads of harm through misleading financial statements.
Therefore, it behooves responsible leaders in accounting to mount an effort to have the rule lifted while retaining Lie-FO as a legitimate tax policy. That would give taxpayers appropriate relief while eliminating the massive misinformation that Lie-FO puts into GAAP statements.
If this change could be accomplished, it would allow FASB to remove Lie-FO from the list of acceptable flow assumptions. We note that the International Accounting Standards Board was able to do so years ago because no other countries' taxing authorities permit Lie-FO to be used.
TAKING THE LIE OUT OF LIE-FO
However, FASB shouldn't just endorse FIFO and/or weighted average because they have their own problem in the sense that they don't distinguish realized holding gains from the gross profit from sales. As a result, management might look like merchandising geniuses, even though they merely got lucky by buying stuff at low prices before its value unexpectedly increased. Or they could be very good buyers but lousy sellers. The problem is you just can't tell from the FIFO and average results exactly how much of the reported gross profit came from adding value through effective manufacturing and marketing activities or from holding gains.
As we proposed in the June 2004 issue of Strategic Finance, FASB could enhance reported information by moving to a combination approach that would help take the Lie out of Lie-FO. It would use LIFO (adjusted for liquidation) to describe the replacement cost of goods sold and FIFO to estimate the inventory's replacement cost on the balance sheet. The difference between the FIFO and LIFO measures of cost of goods sold would be separately reported on the income statement as the realized holding gain.
For the previous example, this FIFO/LIFO method would report the replacement cost of goods sold at $80, the gross margin at $50 ($130 selling price less $80), a realized holding gain of $20 (replacement cost of $80 less historical cost of $60), and the ending inventory at its $80 replacement cost.
This solution offers the advantage of providing more useful information without requiring any new measurement techniques.
LIES AND INTEGRITY
We operate under the paradigm that it's far better for financial statements to tell the truth, the whole truth, and nothing but the truth. Further, we know that accountants can be completely ethical only if they insist that their statements do all three.
Alas, CPAs and others unwittingly fall short of that goal because they've been using Lie-FO since 1939 without grasping its deficiencies. Standard-setters haven't helped much by maintaining silence before Congress for the last 73 years.
Regrettably, Lie-FO isn't the only officially endorsed financial reporting prevarication. When GAAP condones -- or even requires -- these lies to be told, is it any wonder so many managers are willing to stretch, bend and hide the truth in other ways?
We think it's high time to boost our profession's integrity and the capital markets' efficiency by establishing truth-telling as the fundamental goal of financial reporting. Fixing Lie-FO would be a great place to start implementing this campaign.
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
