IntroductionThe use of Last-In-First-Out (LIFO) as an inventory valuation method has been a controversial topic since its inception. Proponents of its use declare that a key benefit is the reduction of taxable income as a result of higher Cost of Goods Sold (COGS), and thus, a lower net income. Supporters claim that this benefit is a major factor that assists U.S.-based companies to remain competitive in the global marketplace. Proponents also point out that the United States Generally Accepted Accounting Principles (GAAP) values COGS at replacement cost when using LIFO and that under First-In-First-Out (FIFO), GAAP values COGS using purchase price of the oldest goods from inventory. Thus, LIFO better reflects both the current market for goods, and generates an income statement with a more relevant net income. In contrast, advocates of LIFO point out that FIFO reports inflated earnings based on old purchases that may distort net income, therefore reducing income statement reliability and misleading users. If LIFO were eliminated, many in the business community argue that the tax liability created upon LIFO liquidation is not matched by additional income, and additional taxes will be levied on paper income. They correctly point out that LIFO liquidation will not generate the necessary cash to pay these taxes. For companies that carry large LIFO reserves, this tax liability could reach several billions of dollars. Even companies that utilize LIFO for only portions of its inventory will experience higher tax bills and negative short term cash flows. The resulting tax liability after LIFO elimination is an undue burden that will disadvantage some U.S. companies within the global marketplace. The competitiveness of companies with a LIFO reserve will be diminished compared to companies that use alternative means of inventory valuation, or those that report under International Financial Reporting

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Standards (IFRS) in which LIFO is not a permissible inventory valuation method. Additionally, many LIFO supporters express serious concern that additional, unplanned tax liabilities in conjunction with the currently stagnant economy will lengthen the timeline of economic recovery in the U.S. Opponents of LIFO strongly believe that its use constitutes an unfair tax advantage. No other inventory valuation method except LIFO creates a tax benefit during inflationary years. Challengers point out that LIFO is not a natural cost flow and does not reflect the actual movement of goods in a company. Furthermore, valuing inventory under LIFO presents a less relevant balance sheet as inventory held within the LIFO reserve is omitted from assets. Standard setters also bring to the fore some issues that may tempt management to engage in questionable practices to the detriment of shareholders. Specifically, LIFO creates incentives to manage for inventory, that is, to build and retain too much inventory to protect or create buffers to the LIFO reserve. In such cases, managers employ methods of earnings management that directly and negatively affect cash flows. Managing for inventory further reduces net income, leads to poor operations management, creates the unnecessary cost of holding inventory, and utilizes cash better spent on income producing activities. The regulating bodies and standard setters must weigh the pros and cons to all of the above mentioned issues and determine whether LIFO should be maintained as is, or be eliminated. If LIFO is to be eliminated, the consideration of provisions for the income tax liability and other concerns mentioned above must be addressed.

HistoryIn 1938, the general counsel for the Treasury Department established a three-member committee consisting of Edward Kracke (Partner, Haskins & Sells), Roy B. Kester (Columbia 2

University Professor), and Carman G. Blough (SEC Chief Accountant & AICPA Research Director) to act as advisors in the preparation of a new tax code and meet the countrys needs while emerging from the Great Depression. The introduction of LIFO as an inventory valuation method was one of the significant changes proposed at that time. Blough adamantly opposed the LIFO method as it does not reflect the natural flow of inventory. Kracke supported LIFO, and noted that as LIFO usually reduces profits, companies would be unwilling to adopt it for financial reporting purposes. Although skeptical, Blough accepted the logic as reasonable and decided to accept LIFO, thinking that few firms would actually adopt its use. The committee's final recommendation was that companies should be allowed to use LIFO, but only if it was used it for both financial and tax reporting purposes. These recommendations were accepted by Congress.(Cooper, 1996) The compromise between Kracke, Kester, and Blough in 1938 created the basis for the conformity rule under U.S. tax law regulations that drives much of the controversy over LIFO today. Specifically, companies that elect to use LIFO for federal income tax purposes are required to use LIFO for external financial reporting purposes as well.(Spiceland, 2008) Congress understood the advantages of LIFO for U.S. businesses and foresaw that a recovery from the Great Depression depended upon a favorable business climate. However, the Treasury Department was reluctant to recommend LIFO as an acceptable inventory method under Section. 471. General rule for inventories, as LIFO was not commonly used at that time, nor provided for natural cost flows. (Turgeon, 2009) Congress preferred Kracke, Kester, and Bloughs recommendations over the Treasury Departments regarding the inventory valuation method and the conformity rule; and in 1939 enacted the LIFO regulations that businesses operate under today.(Kieso, 2010) Unfortunately 2

for the U.S. and the business community, the World War II military buildup further increased prices and inflationary trends. Due to this fact, American companies experienced a growing interest in the LIFO inventory valuation method as a sensible option to take advantage of rising prices at a time when the country needed optimum business efficiency to support the war effort. (Assar, (n.d.)) The use of LIFO increased dramatically over the following 60 years, and the committees prediction of limited LIFO adoption proved to be incorrect.(Cooper, 1996) However, in the past few decades, due to negative and flat inflationary years combined with the knowledge of potential LIFO elimination by the regulating bodies, there has been a downward trend of LIFO users.(Klienbard, 2006)

LIFO Preferred Under InflationDuring times of inflation, the inventory valuation method chosen by a company has a significant effect on the calculated dollar amount of income and income taxes payable to the IRS, state, and local tax authorities. When prices rise, a LIFO firm will have a lower gross margin rate, resulting from the inclusion of the most recently purchased items as COGS. The lower gross profit leads to lower pre-tax income and a lower income tax provision. The following disclosures are examples of such lower profit and gross margin conditions (Mulford, 2008):

Commercial Metals, Inc. On a consolidated basis, the LIFO method of inventory valuation decreased our net earnings by $209.1 million and $33.3 million ($1.78 and $0.27 per diluted share) for 2008 and 2007, respectively. (Commercial Metals, Inc., 2008) 3

Costco Wholesale Corp. Gross margin (net sales less merchandise costs) as a percentage of net sales increased one basis point over the prior year, which included a $32.3 million LIFO charge, resulting from increases in the cost of certain food items and gasoline. (Costco Wholesale Corporation, 2008) When prices rise and inventory quantities are not decreasing (the company is not tapping into LIFO layers), LIFO produces a higher COGS value, and therefore a lower net income and taxes payable than the FIFO or Average Cost methods. Tax liability is not reduced permanently but only deferred, as the difference caused by the LIFO reserve will eventually come payable when either the unit cost of inventory or the quantity of inventory subsequently declines, or the tapping of LIFO layers occurs. However, companies prefer the LIFO method during times of inflation not only due to current reductions in tax liability, but also due to the positive time value of money impact when LIFO layers are exposed in the future and taxes on these layers becomes payable. As a result, firms widely adopt LIFO during times of high inflation. (Spiceland, 2008) According to our research findings, 311 companies adopted LIFO during the mid-1970s, 59% of those companies adopted between June 1974 and May 1975. Inflation rates during this short period were a very high at 10%. (Biddle, 2010) In addition, the number of firms reporting LIFO reserves increased to over 1,000 from the late 1970s through the late 1980s when inflation rates were also significantly high. (Klienbard, 2006)

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Exhibit 1. U.S. Inflation Rate (1975-2005)

Exhibit 2. Use of LIFO by Firms with Inventories (1975-2005)

Impact of LIFO EliminationIf and when LIFO is eventually repealed, the impact on businesses that currently hold significant LIFO reserves will be affected in a multitude of ways. The first major impact is the mandatory liquidation of LIFO inventory (via switch to FIFO or Average Cost). This change would result in an immediate increase in inventory on the balance sheet. As result of the liquidation and increases to inventory in the period of change, cost of goods sold would decrease, net income would increase, and an upward adjustment to retained earnings would be necessary.

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Another major impact, and of prime interest to both the federal government and companies that carry high levels of LIFO reserves, is the increase to income tax payable as a result of the increase to net income. (Bloom, 2009) The increased tax liability further results in a negative cash outflow for the company in question, immediately effecting cash on hand that would otherwise be available for R&D, growth opportunities, disbursements to shareholders, etc. The immediate cash outflow would be highly likely to result in a competitive disadvantage for the companies currently using LIFO, as they will have years of increased future tax payments. While any given LIFO reserve may have been created over years or decades, IRC481(a) requires that any tax due in response to the changing of inventory valuation methods be paid evenly over four years. If LIFO were to end as a result of convergence with IFRS, there is currently no tax liability plan other than the 4 year provision of IRC481(a). If the federal government were to eliminate LIFO, it does propose that the increased taxes payable be due over an eight year period to help ease the negative impact of the change. While the business community has suggested a 10 year period, the IRS continues to insist upon maintaining the four year provision. (White IV, n.d.) (Turgeon, 2009) Compared to companies that currently use FIFO or average cost inventory valuation methods that would have no additional cash outflow if LIFO were eliminated, the cash outflows required from companies with large LIFO reserves would be unparalleled, generating substantive, long term disadvantages. In addition, potential investors may be reluctant to invest in LIFO companies during the transition due to the negative cash impacts explained above. Exhibit 3 includes a listing of the accounts affected by a switch from LIFO to another inventory valuation method (during times of inflation).

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Exhibit 3: Balance Sheet Inventory Retained Earnings Current Tax Payable Deferred Tax Payable Impact Income Statement Net Income COGS EPS Impact

One must make note of the fact that Exhibit 3 impacts would occur during times of inflation, but during times of zero or negative inflation, the impacts may be somewhat different or even reversed. Years experiencing flat or negative inflation are not common, but they do occur (e.g., 2009 in the USA). In addition, years in which a company experiences losses, the impacts may also vary somewhat. IRC481(a) takes notice of this fact, and states that if the switch from LIFO occurs during a year that may benefit the company, the charge can be levied in entirety during the year of change. For example, if a company experienced a net loss during the year of change, a switch to LIFO may simply reduce the losses. The impact on accounts would therefore take on the following appearance (see Exhibit 4). Exhibit 4: Balance Sheet Inventory Retained Earnings Current Tax Payable Deferred Tax Payable Impact ----Income Statement Net Income COGS EPS Impact

Alternatively, in times of negative inflation, the impact on accounts can be shown as in Exhibit 5.

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Exhibit 5: Balance Sheet Inventory Retained Earnings Current Tax Payable Deferred Tax Payable Impact Income Statement Net Income COGS EPS Impact

IRC481(a) also states that if the tax implications are not favorable to the firm during the year of the switch from LIFO to one of the other inventory valuation methods, the increased tax liability may be spread out ratably over a four year period of time. The following is an example of a journal entry that would be used for a company that was required to make a retrospective adjustment as a result of making the switch from LIFO to FIFO (assuming a 35% effective income tax rate and application of IRC481(a) four year rule). (Bloom, 2009) Journal Entry in Year of Change LIFO Reserve/Inventory 10,000,000 Retained Earnings 6,500,000 Current Income Taxes Payable 875,000 Deferred Income Tax Payable 2,625,000 Journal Entry in Years 2, 3 & 4, post change Deferred Tax Payable Current Income Tax Payable 875,000 875,000

Examples of Negative Impact on Real CompaniesCompanies that currently use the LIFO inventory valuation methodology are rightly concerned and oppose the suggestion to eliminate LIFO. The critical reason for the opposition is the disadvantage explained earlier regarding the negative cash flow impact as a result of increased tax liability. Various examples can be drawn upon to demonstrate the magnitude of

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impact that the elimination of LIFO would have on two companies with large LIFO reserves in 2007. Example #1: In 2007, Exxon Mobile Corporation had a difference of $25.4 billion between the carrying value of inventory compared to the replacement cost of inventory. If the elimination of LIFO were to have taken place in the year 2007 and Exxon Mobile switched to FIFO in that same year, under IRC481(a) and the four year rule, the yearly increase in tax liability would have been $2.2 billion (1% of the companys total assets at that time). The negative cash flow impact would have been a total of $8.88 billion over the four year period. The following is the journal entry for the accounting treatment in which Exxon would have been exposed (assuming 35% effective tax rate). (Bloom, 2009) 2007 LIFO Reserve $25.4 billion Retained Earnings $16.51 billion Current Tax Liability $ 2.22 billion Deferred Tax Liability $ 6.66 billion 2008/2009/2010 Deferred Tax Liability $ 2.22 billion Current Tax Liability $ 2.22 billion Example #2 Another example, similar to the one above, is with regard to the Sherman-Williams Company in the year 2005, which reported that a switch from LIFO to FIFO in the same year would have caused an increase in net income by $40.8 million. According to the standards set by IRC481(a), the yearly negative cash flow impact on this company would have been $3.57 million for each of the following four years. (Bloom, 2009) 2

End of LIFO: Who Would be Affected and the CostThis paper has examined how the end of LIFO would affect net income, retained earnings, inventory value, and size of the resulting tax liability and cash flow effect for two specific companies, Exxon Mobile Corporation and Sherman-Williams Company. Now, issues surrounding LIFO in an economy-wide context, rather than a firm-specific context will be examined. Analyzing the American economy, three critical questions emerge when considering the end of LIFO as an acceptable inventory valuation method: 1. What is the size of the LIFO reserves that may require liquidation and the amount of the resulting tax? 2. How many companies will be directly affected? 3. Which industries bear the brunt of the taxes if their LIFO inventory is liquidated? To understand the magnitude of LIFO reserves, Romeo examined LIFO in the context of the approaching convergence of GAAP and IFRS.(Romeo, 2009) In an analysis of all publically traded companies, he extracted and concatenated data from the Compustat North American Industry Annual Database (CNAIAD). The result of the LIFO reserve analysis is startling. In 2007, the sum of all publically traded company LIFO reserves totaled $91.310 billion. The sheer amount of money involved in LIFO reserves sheds light on the extraordinary attention that the standard setters, government, accountants, and companies must divert to the issues surrounding inventory valuations. Determining the calculation for the taxes that will be levied on the $91 billion is much more complex. There is a temptation to apply the current highest statutory rate of 35 percent to the LIFO reserves to uncover the aggregate tax bill due, or $31.958 billion. (See Figure 4 below 1

for potential aggregate tax liabilities). However, to imply that all companies with LIFO reserves will pay tax at the highest statutory rate is not a valid assumption. If a firms marginal tax rate is lower than the statutory rate, especially if the lower rate is expected to continue for several years, the conversion from LIFO results in lower current and future tax liabilities than implied by the top statutory rate. (Hughen, 2011) When discussing a switch from LIFO, it is very common in the research literature to provide statistics for the sum of tax liabilities at the statutory rate, even though a substantive majority of companies do not pay taxes at this rate. For example, Avery Dennison Corporation converted from LIFO to FIFO in 2007, and for the period of 2005 2008, Avery Dennisons tax rate was estimated at 1.39%. At the time of conversion, Avery Dennison had a $25.1 million LIFO reserve, and taxes at the maximum statutory rate of 35% would have been $8.78 million on the LIFO reserve alone. However, at 1.39%, taxes were only $0.35 million if paying taxes at their estimated average marginal rate. Similarly, when Tiffany & Co. switched from LIFO to FIFO in the first quarter of 2008, its estimated marginal tax rate was only 1.27%. These two examples demonstrate the need to apply realistic tax rates to companies that have LIFO exposure when determining firm-specific risk due to changing inventory valuation methods. (Hughen, 2011) In 2008, the actual average rate of taxes paid was approximately 15 percent. Using this tax rate, rather than the statutory rate of 35%, the total LIFO liquidation tax due would calculate to $13.696 billion. Even more surprising, the median marginal tax rate was approximately 3% in the same year (2008), and using this rate would generate a collective LIFO tax bill of $2.739 billion, or a 91.4% reduction from the highest statutory rate.

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See Exhibit 6 for actual corporate tax rates assessed from 1980 - 2008 and Exhibit 7 for LIFO liquidation aggregate tax liability calculations.

Exhibit 6. Tax Rates over time (1975-2005) (Hughen, 2011)

Tax Rate Type Highest Statutory Mean Median

Tax Rate 35% 15% 3% 1

Aggregate LIFO Reserve $91,310,440,000 $91,310,440,000 $91,310,440,000

Aggregate Taxes $31,958,654,000 $13,696,566,000 $2,739,313,200

Exhibit 7. Potential aggregate tax liabilities due for 2008 LIFO reserve liquidation

The two factors that determine the amount of taxes levied on a given companies LIFO reserve have been examined. The first factor is the value of the LIFO reserve owned by the company. Second, is the rate of taxation assessed upon liquidated reserves. In examining potential tax rates, four companies that have explored or made the transition from LIFO to FIFO, Exxon Mobile, the Sherwin-Williams Company, Avery Dennison Company, and Tiffany & Co., have demonstrated divergent tax rates that would be or have been levied upon their LIFO reserves. The companies differing taxes rates are to be expected after reviewing the statistics above regarding the range of tax rates corporations actually pay. One critical factor that remains to be analyzed is the number of companies that must realistically split the LIFO reserve tax bill. Mulford, Comiskey, and Thomason (Mulford et al.) state that, Presently, approximately 36% of U.S. companies use LIFO for at least a portion of their inventories. (Mulford, 2008), and their research is cited and regarded as important in other publications. (White IV, n.d.) However, other researchers do not reconcile 100% with Mulford et al. Specifically, Hughen, Livingstone, and Uptons (Hughen et al.) research, Switching from LIFO, also used the CNAIAD to identify companies that had both inventory balances and also held LIFO reserves at the year-end of 2008. Out of the 4,783 companies identified to have year-end inventories, only 339 reported a LIFO reserve. (Hughen, 2011) At first, one may believe that a direct contradiction of conclusions exists between the two studies, even though the data came from the same database. However, Mulford et al. were simply seeking LIFO users, including those that only use LIFO for a portion of their inventories, users who do not necessarily hold a LIFO reserve at year-end, and companies who use LIFO but not in a material fashion. Hughen et. al. only analyzed companies with LIFO reserves at year-end. While not specified in particular, it is implied that Hughen et al excluded any company who used LIFO, but that did not carry a 2

financially material year-end inventory balance and/or LIFO reserve. (Hughen, 2011)(White IV, n.d.) Therefore, a reasonable conclusion is that approximately 36% of the public companies that used GAAP in 2008, made some use of LIFO. Of the 36% of companies mentioned above, 7.09% reported financially material inventory balances and LIFO reserves at year-end. The remaining 92.91% of this set did use LIFO at some level, yet their use of LIFO neither generated a LIFO reserve nor was material. In actuality, the 92.91% of companies identified here, and other companies with relatively small LIFO reserves and/or low marginal tax rates may be in the best position to utilize the needed mitigation strategies described later, if LIFO is to be eliminated by law, GAAP, or IFRS. The percentage of companies analyzed by Hughen et al. that held inventory balances at year-end and also maintained a LIFO reserve, decreased from 7.91% in 2004 (449 companies) to 7.09% in 2008 (339 companies). While there is resistance to the repeal of LIFO, some companies are voluntarily switching from LIFO, and the number of companies reporting a LIFO reserve actually decreased over the past five years. (See exhibit 8) (Hughen, 2011)

Number of Companies Reporting LIFO Reserves Exhibit 8 2004 Companies w/ inventory balance at year end Companies w/ inventory balance & LIFO reserve at year end Percentage of companies w/ inventory balance & LIFO reserve at year end 5,673 449 7.91% 2005 5,489 420 7.65% 2006 5,301 401 7.56% 2007 5,072 369 7.28% 2008 4,783 339 7.09%

Exhibit 8. Number of Companies Reporting LIFO Reserves

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The small, shrinking percentage of public companies utilizing material LIFO reserves appear to have a voice disproportionate to their size which is affecting both the standard setting and political reform processes. While their argument indicating that the tax liability increases as a result of LIFO liquidation may be destructive must be taken seriously, it should not be accepted as a truism for all companies using LIFO without closer analysis. A research study by Plesko stated that in 2007, 50% of the total LIFO reserve was attributable to only 5 companies, 75% was attributable to 19 companies, and 90% was attributable to 68 companies.(Romeo, 2009) The Mulford et al. study indicates that the elimination of LIFO appears to be a major concern for only 339 companies (in 2008) out of thousands (13,286 in 2008, by mathematical calculation: 36% of 13,286 equals 4,783) of public, domestic companies. Which are the companies with the greatest LIFO use and exposure, and therefore, those with the largest LIFO reserves? Research indicates that the companies with the greatest exposure to a change from LIFO include, petroleum, metals, and chemical firms . [And] Food and drug stores are the most frequent users.(Mulford, 2008) The majority of the LIFO reserves are concentrated in a relatively few number of companies within the petroleum and natural gas and steelworks industries. (Romeo, 2009) As a simple benchmark, assume that LIFO is eliminated and all 339 companies must fully liquidate their reserves in that year. Also assume that the resulting increase in net income places all 339 firms in the 35% corporate tax bracket and that all companies had equivalent reserves, therefore dividing the resulting tax liability equally. Purely based on the liquidation, the average increase in tax liability per company would be estimated to be $93.952 million [($91B/339)*35%]. Any company that has the foresight of an eventual, unplanned $94 million

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cash outflow due to mandatory inventory valuation changes would be wise to take the necessary steps to mitigate the negative impact of this liability. The rounded benchmark of a $94 million dollar tax bill is an assumption that does not attempt to correlate the financial reality of any particular company with a LIFO reserve. However, Mulford et al. did just that, albeit the effort examined the upper boundary of LIFO reserves and not companies with average exposure. Specifically, the study examined the 30 companies with the largest LIFO exposure to gain a better understanding of the potential outcome of an elimination of LIFO. Mulford et al. chose companies with the most extreme LIFO reserves, and therefore conclusions cannot be made that allude to the fact that these results would be typical. In addition, one cannot generalize the findings as representative of all firms; yet they do provide a quantitative light in which to analyze the greatest negative impacts to an artificially created segment of the companies with LIFO reserves. Specifically, the 30 firms with the largest exposure is defined for the 2007 study as firms that had the highest ratio of LIFO reserves to total assets within the CNAIAD. (White IV, n.d.) Mulford et al. calculated that the combined 30 companies would owe an additional $15.624 billion in income taxes upon liquidating their LIFO reserves. Therefore, if the statutory rate is used to calculate the increased tax liability of LIFO reserve companies, the top 8.9% of the 339 companies in 2008 study (0.226% of all public companies at that time) would have carried approximately half of the total burden. See Exhibit 9 for a listing of the 30 firms and selected financial data on LIFO reserves.

Standard Setter Opinions on the Future of LIFOStandard Setters have expressed varying opinions surrounding the potential termination of LIFO. Stakeholders have strong, divergent positions on the subject and most have spent time 3

and money to make their positions known. The exploration of some of these opinions and the rationales that the standard setters maintain in holding their opinions is important. The outlook for the future use of LIFO as an inventory valuation method is bleak; however, the timeline for its termination is still uncertain. Currently, there are two agencies that can take action and terminate LIFO the Securities and Exchange Commission and the U.S. Federal Government. The governments motivation to end LIFO is to gain cash inflows in the form of additional tax revenue intended to be used as a part of the deficit reduction plan. The SECs motivation is to converge U.S. GAAP with IFRS, and under IFRS, LIFO is not an acceptable inventory valuation method. (Turgeon, 2009)

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Exhibit 9: LIFO Reserves as a Percentage of Total Assets (Total Assets, LIFO Reserve and Cumulative Taxes Due in millions)

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Securities and Exchange Commission - Convergence between U.S. GAAP and IFRSThe date for IFRS convergence has not been set in stone, but timelines do exist for its future implementation. The 2002 Norwalk Agreement set the wheels of convergence in motion. This agreement was actually a memorandum of understanding between the FASB and the IASB, acknowledging their commitment to the development of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. The intent of the agreement was to make financial statement reporting easily comparable across the global economy, and also to maintain compatibility GAAP to the degree possible. (fasb.org) In 2008, the SEC published a roadmap that indicated the implementation of IFRS convergence would occur at the end of 2014. In 2010, the SEC further expressed IFRS support and announced that a specific timeline would be announced in June, 2011. However, Mary Shapiro, the new SEC director, declared in May, 2011 that she would not be tied to any timeline previously submitted for the final implementation date of IFRS convergence. The originally planned 2014 implementation date would be delayed at least until December 2015, but convergence might not become fully effective until the end of 2017. In addition, the early adoption option for financial reporting to the SEC under IFRS was cancelled. (PriceWaterhouseCoopers, 2011) (Brice, 2011) (Defelice, 2010)

U.S. Governments Agencys PositionsU.S. Congress/Senate The elimination of LIFO has been on the congressional agenda since at least 2006. It has been a significant point of interest for the federal government because the increased income tax liability from companies forced to liquidate LIFO reserves would be a substantive windfall to a U.S. Government drowning in debt. One must reiterate that only LIFO-utilizing companies would be affected by additional taxes; those companies that currently use FIFO or average cost 1

would not be affected. In 2006, leaders of the Senate pushed for the elimination of LIFO in order to pay for a gas tax rebate. In 2007, the Congress House Ways and Means Committee introduced a $1.3 trillion Tax Reduction and Reform Act, and the expenditures in this act were intended to be partially offset by revenues generated via LIFO elimination. These stances by Congress, Senate, and their publically cited rationales imply that lawmakers see that LIFO creates an unfair tax deferral and also impedes the process of convergence with IFRS. (Turgeon, 2009) The Obama Administration Despite congressional failures to repeal LIFO, the Obama Administration continues to push this effort forward and proposed the elimination of LIFO in both the 2010 and 2011 budgets; neither of which went into effect. (Taxation, 2010) The administration has again included the elimination of LIFO in the 2012 Fiscal Year Budget which would end LIFO effectively at the beginning of 2013, if ratified by Congress. (Pitsor, 2011) The administrations calculations indicate an additional $60 billion could be raised between 2013 and 2021 as a result of eliminating LIFO and intends to use these funds to help to pay for the Health Care Reform initiative and other administrative programs on the agenda (Taxation, 2011). The administrations current plans are to garner new tax revenues and prepare the U.S. for convergence with IFRS. First, Obama Administration has proposed the elimination of LIFO prior to convergence with IFRS to remove a roadblock in the convergence process. Second, the administration hopes to relax IRC481(a), as they have considered the negative impact and disadvantages that ending LIFO may have on US companies with large LIFO reserves. Therefore, the administration has recommended a longer, eight-year period to pay any income taxes resulting from changing from LIFO to FIFO/Average Cost, rather than maintain the current four-year standard. (Turgeon, 2009) 2

The Treasury Department and the IRS The conformity rule is central to the contentiousness surrounding the potential end of LIFO. Established at the same time as LIFO in 1939, the conformity rule requires that the inventory valuation method a company chooses for tax reporting must also be used in financial reporting. The IRS and the Treasury are adamant in supporting IRC 481(a). Their motivation is clear: collect all tax revenues allowed by law.

The Business CommunityArguing to preserve LIFO or end the conformity rule, the potentially affected companies have taken a strong stance against the future potential elimination of LIFO. Under the assumption that convergence of GAAP and IFRS will occur at some future date, many firms are trying to convince the Treasury Department to eliminate the conformity rule. Without the regulations required in the conformity rule, the entity could issue financial reporting of inventory valuations under FIFO or average cost, but tax reporting would continue to allow LIFO. The affected companies (those with significant LIFO reserves) are lobbying for at least a ten year period of time to pay the increased tax liability, if the conformity rule were to remain unchanged. The companies in question indicate that the four year rule is a very short period of time, and the negative cash flows that result from the tax increases would cause undue financial stress. Finally, other recommendations include the use of net operating loss carrybacks and carryforwards to offset the tax liabilities. Such an offset would reduce the negative cash flow impacts that certain companies may incur as a result of the elimination of LIFO. (White IV, n.d.)

The Future and LIFOUnless unknown events intervene, utilizing the LIFO inventory valuation model is nearly certain to end as an acceptable accounting method in the United States. Whether the change is 1

due to U.S. law reform or through convergence with IFRS, it is of little importance to a company using LIFO. Relevant today is the likelihood that the change will most likely occur in the medium-run, and highly probable by 2015 with IFRS convergence. The time window between now and the filing of the 2015 Annual Report with the SEC allows a company four years to implement various business strategies that will mitigate unfavorable effects from the transition. Various options are available to companies to mitigate the risk of high income tax payments due to the expected end of LIFO in 2015.

What can a firm do to mitigate their costs due to the end of LIFO?A firm has numerous options for company management to reduce, eliminate, escape, or even profit from an inventory valuation change from LIFO to FIFO or average cost. Many factors play into developing a successful strategy to create a smooth transition for this change and any successful plan will be firm specific. Factors to consider include the amount LIFO reserve, recent profits or losses, events in the larger economy such as inflation or deflation, marginal tax rates, accumulated tax assets or liabilities, operations quality, existent debt and debt covenants, private or public status, cash and liquidity needs, investments in securities, internal inventory systems, inventory needs, investors awareness of the firms strategy, risk tolerance, and other factors that may be deemed relevant by the firm. While planning and setting up a cross-functional team is highly recommended for all companies, items from the list of mitigating options below are neither appropriate for every firm nor intended to be a complete list of strategies, but rather a starting point for management. First, it is prudent to begin planning and implement as soon as possible, to avoid a large negative impact once LIFO is gone. As it is highly likely that LIFO will end in 2015 because of the convergence with IFRS, actions that assume otherwise should be deemed somewhat risky. 2

The upside of planning today would be to provide the firm with a clear framework to develop and execute an effective plan. The downside of failing to plan for the change is clear a potentially large, negative cash flow arising from paper profits that a LIFO liquidation would generate. Second, the change in inventory valuation method will impact a business in numerous departments. The best operations are now seeking increased integration through the use of cross-functional teams.(Schroeder, 2011) Thus, the recommendation would be to develop a cross-functional team that would generate firm-specific, appropriately timed strategies. An appropriate cross-functional team would likely involve accounting, finance, tax, risk management, operations, management, purchasing and shipping, investor relations and/or public relations, consultants, and marketing. The involvement of each of these functional areas is vital, as each plays a role in the flow and management of inventory throughout a firm and/or understanding the financial position of the firm. The implementation of a change of such magnitude increases the likelihood that a significant portion of the business model would also change. The CEO and CFO must work closely with accounting and finance, and keeping the firms Board of Directors abreast of the plan and changing events would be key to success.

Use a net operating lossConsider a situation with a projected net operating loss in the current year (and potentially, losses in prior years). The switch from LIFO to FIFO could be an excellent opportunity for a company in such an unfortunate situation. USG Corporation faced this situation in 2008. USG reported in 2007 a negative retained earnings balance of $229 million and projected an additional loss of $460 million in 2008. USG 2

Corporation changed from LIFO to average cost on October 1, 2008, when its LIFO reserve was $43 million. (Hughen, 2011) Following GAAP regulations, USG restated its income statements for 2006 and 2007, and produced the audited 2008 financial statements accordingly. The immediate effect of the change was an increase of earnings for all restated years due to the lower cost of goods sold. The 2007 balance sheet gained inventory value of $54 million and the existent deferred tax asset fell by only $21 million, from $53 million. Retained Earnings experienced a net increase of $33 million. In the year 2008, the positive effect to retained earnings was even more pronounced. The inventory method change from LIFO to average cost generated an adjusted gain on USGs inventory valuation of $81 million, decreased the existent tax asset by $31 million, from $99 million. Retained Earnings experienced a net increase of $50 million. Hughen et al. conclude that In 2008, USG reported a net loss prior to the change in inventory valuation method. The switch to average cost decreased the net loss as well as the income tax benefit of the loss. They suggest that USG had chosen an opportune time for such a change [of inventory valuation methods]; if a company is already projecting a loss, then implementing a change from LIFO has the advantage of reducing the loss.

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Exhibit 10 -- excerpts of the USGs financial statements 2006-2008

Sell Available-for-Sale Investments at a lossSome firms have a business model that includes investing in stocks and/or bonds of other corporations. Because LIFO liquidation raises net income without increasing cash flows, generating cash to pay the potential tax liability is just as critical as reducing the amount of paper profits. One method to raise cash and simultaneously to reduce net income is to sell 3

investments previously classified as Available-for-Sale that have declined in value below their tax basis. When purchased, a company classifies its investments and marks them to market price at the end of the year. If the investment is classified as Available-for-Sale, all unrealized gains or losses are added (subtracted) from Other Comprehensive Income (OCI). Only upon the sale of these investments is the accumulated gain (loss) moved from OCI to net income. Such a strategy can become a multi-year effort, as the firm can consider moving trading securities they expect to lose value into the Available-for-Sale categories, hold them in that category, and sell them when needed to mitigate the increased tax liabilities due to the LIFO liquidation tax payment plan. (Spilker, 2011) Other types of net income reducing, yet cash generating strategies surely exist surrounding investments and selling capital assets. As previously discussed, some strategies involve timing beyond one year; hence the need to plan ahead wisely. In addition, the firm must consider how other aspects of its business model may be affected by transferring securities from one category to another. (Kieso, 2010)

Utilize permanent and discretionary accruals to manage the changeCEOs and financial managers have wide discretion over several accruals, including: allowance for doubtful accounts, warranty provisions, and depreciation methods. The alteration of the companys expected allowances or increasing depreciation may cause a rise in current quarter expenses, and therefore decreasing net income in the year of change from LIFO to FIFO or average cost inventory valuation. While no additional cash is generated from these accruals, many discretionary accruals reverse in the next fiscal cycle, which offers the advantage of increasing net income in the net fiscal cycle. (Scott, 2012) 2

Qualify for the single exception to the conformity ruleUnder IRS Rev. Rul. 78-246, if a company is a U.S. subsidiary of a foreign parent, and the foreign parent owns, either directly or through members of its consolidated group, operating assets of substantial value that are used in foreign operations. [then,] For this purpose, a foreign parent corporation is deemed to own substantial foreign assets if the total value of such assets constitutes 30 percent or more of the total operating assets of the consolidated group. Unless the foreign parent currently requires the company to issue financial statements using IFRS, per this ruling, the company may still report to the parent using LIFO (and thus use it for tax purposes in the U.S.), and the foreign parent continues to prepare consolidated statements under IFRS using FIFO or average cost. (Turgeon, 2009) Uncertainty exists as to how Rev Rul. 78-246 would be interpreted after the convergence with IFRS. Thus at best, this strategy would be a delaying tactic to provide time for the implementation of other strategies.

Take advantage of historically low inflation ratesThe switch to FIFO or average cost now may enable companies to take advantage of circumstances currently available that may not exist once the change is mandatory.(Hughen, 2011) LIFO is often cited as the preferred inventory valuation method in times of rising prices, i.e., inflationary times, while FIFO is preferred during times of falling prices. Currently, inflation is abnormally low, over the last five years, the inflation rate has averaged roughly 3% and was actually negative (-0.4%) in 2009. Understanding the current inflationary trend, a financial analysis of moving to FIFO during this time would be prudent. For example, Kraft Foods switched from LIFO to average cost in 2009 and their COGS using average cost ($25,786 million) was $95 million higher than it would have been using LIFO ($25,691 million), implying that recent inventory purchases were less costly than earlier purchases. (Hughen, 2011) In other 1

words, Kraft Foods generated a lower net income under average cost rather than LIFO in 2009, and thus gained the benefit of lower tax liability often associated with the utilization of LIFO. Inflation will unlikely remain at such a low level for years to come, so such opportunities will not be frequent or last long. Kraft Foods seized the opportunity not only to switch away from LIFO and its likely demise, but also to do so at a time that actually lowered taxes contra to the conventional wisdom that LIFO lowers taxes. (Hughen, 2011)

Fresh start accounting when emerging from bankruptcyNow is perhaps the most opportune time of all to value inventory under FIFO when adopting fresh start accounting. (Hughen, 2011)

FIFO tax valuation choiceWhile this strategy alone does not eliminate the potential tax liability due to switching from LIFO to FIFO, it can be a significant element of the overall mitigation plan. The goal would be to choose a favorable valuation method to account the firms FIFO inventories. Under LIFO, taxpayers must value their inventories at cost. Under FIFO, taxpayers have the advantage of being able to value their inventories below cost, including using the lower of cost or market (LCM) method and the subnormal goods method. (Turgeon, 2009) Under tax law, these rules are substantively different than under financial accounting practice. Each item or component in inventory may be valued at market, defined as reproduction or replacement cost. This approach differs from financial accounting LCM rules, which generally do not apply on an item-by-item basis, and generally define market based on selling prices. (PriceWaterhouseCoopers, 2011) Therefore, regardless of the profit an item may bring when sold, tax law allows the company to write down the value of each component of

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inventory by the value it has declined in the tax year, thus, depreciating a companys inventory tax basis. Subnormal finished goods can be written down in two ways. First, use the actual selling price less the costs of disposition. Second, the company may declare the inventory scrap, then the inventory generally can be written down to scrap value without having to offer the goods for sale. (PriceWaterhouseCoopers, 2011). If any raw material within any finished good has declined in value as above described, within tax accounting for FIFO inventory using LCM, subnormal, or scrap, the entire finished good may be written down appropriately, but never under scrap value, here again, lowering the tax basis. (Turgeon, 2009)

Minimize inventory through operational methods such as Just-In-Time productionMany American businesses have produced more inventory than is currently demanded. The push concept of inventory leads to finished goods that cannot be sold in the market and must be held by the company, creating the LIFO reserve. A company can reduce not only its production costs, but also its excess inventory, by adopting a pull inventory concept, wherein the goal is to produce only what is pulled by the customer. A particularly successful alternative method in producing inventory has been developed by Japanese automaker Toyota, named Just-In-Time (JIT). This method seeks to produce goods JIT for customer demand; its successful implementation necessarily reduces levels of inventory. The need to manage a smaller amount of inventory created through a JIT system, can lead to reduced costs and a higher turnover ratio. Moving to a JIT inventory system is a profound change within operations of a company that has been over-producing inventory, and requires efficient management of the new system by many departments. There are costs to implementing a JIT system and arrangements and contracts 2

often need be created between members in the supply chain of production. However, the financial benefit to the company is substantial, and in the long run, firms can save money with a JIT inventory system. (Schroeder, 2011)

ConclusionThe main concern that firms have over the abolishment of the LIFO is the wherewithal to pay the tax liability resulting from LIFO liquidation. Another significant concern is that the U.S. companies affected may slow down any chance of a rapid recovery to the national economic recession. Fortunately, the expectation is that the repeal of LIFO would only affect a very small number of companies. Only 339 out of 13,286 public companies reported financially material LIFO reserves in 2008. Furthermore, in that same year, approximately half of the estimated increase in tax liability resulting from LIFO liquidations would have been concentrated amongst the top 30 public companies. In addition, taxes levied upon LIFO liquidations would be highly specific to the marginal tax rate of the firm in question. The belief is that the firms affected could mitigate their costs through a variety of actions, some of which were made explicit in this paper. Moreover, Congress would likely work with firms with LIFO reserves to lower tax rates upon LIFO liquidations and alter 481(a) to allot an extended period of time to pay the resulting taxes. Firms would be able to benefit from increased efficiencies and better business management practices once FIFO or Average Cost inventory valuation methods were adopted. The implementation of cross-functional teams, improved planning processes, and/or a switch to efficient inventory management systems, such as JIT and other lean inventory management practices, would create more competitive US businesses, rather than put them at a competitive disadvantage. While the transition may be expensive for some firms in the short run, in many cases the additional expenditures would be offset by reducing the increased taxable income due to the LIFO liquidation. 2

The elimination of LIFO in the near future would be an optimal moment, even in the wake of the suffering economy. Periods of low inflation do not offer the same advantages for users of LIFO as do periods of high inflation, and the past 3 to 4 years have experienced negative or minimal inflation. There is no evidence that changes in the inflation rate are going to occur anytime soon. In the meantime, companies that are underperforming due to the poor economy can take advantage of switching from LIFO during a year experiencing a net loss, in which the liquidation of the reserve would simply minimize the loss. Another mitigating technique would be to sell Available-for-Sale investments that are underperforming to offset the increased income. As mentioned previously, there are many mitigating techniques that a LIFO user may take advantage of in order to minimize the potential impact of an increase in taxable income due to the inventory valuation switch, and those mentioned are not an exhaustive list. The information uncovered in the research presented strongly indicates that the elimination of LIFO will not impact the vast majority of companies. Only a few companies would carry a significant burden, and should immediately implement mitigating steps to minimize future tax liabilities. In addition, the standard setters and U.S. government should make the appropriate adjustments in the tax code to further minimize any acute impact that an unmanageable increase in tax liability may cause for some of the few identified firms. Given the above evidence, there is no cause to preserve LIFO as an inventory valuation method and it ought to be allowed to sunset by repeal or convergence with IFRS.

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Bibliography

BibliographyAssar, R. ((n.d.)). What is LIFO Method in Cost Accounting. Publish Your Articles.org .

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