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Home > Accountancy Best Practice > The LIFO Conundrum: Convergence of US GAAP with IFRS and Its Implications on US Company Competitiveness

Accountancy Best Practice

The LIFO Conundrum: Convergence of US GAAP with IFRS and Its Implications on US Company Competitiveness

by William C. White IV

Table of contents

Executive Summary

  • The long-term goal of the SEC and the International Accounting Standards Board (IASB) is to establish one set of financial reporting standards for all publicly owned companies to follow.

  • IFRS does not permit the use of LIFO as an inventory valuation method.

  • The switch to a permitted inventory valuation method under IFRS for US businesses employing LIFO could result in the acceleration of payments for deferred tax liabilities affiliated with the companies’ LIFO reserve.

  • In many cases, the tax obligations generated by the adoption of IFRS could result in significant, unplanned cash outflows putting US businesses at a distinct competitive disadvantage, relative to their peer companies, and lowering their market valuations.

  • The change from LIFO to FIFO or weighted average cost, both accepted IFRS methods of inventory valuation, typically results in higher-ending inventory balances, lower cost of goods sold, and higher earnings per share (EPS) in a rising cost environment.

  • Some of the possible solutions the US Treasury Department should explore are eliminating the current LIFO conformity rule, and enabling companies adopting IFRS to extend the period over which the tax liabilities generated by the switch from LIFO to FIFO can be settled.

  • IFRS adoption would be required for companies whose equity is traded on public markets; however, smaller companies may simply keep LIFO and never adopt these standards.

  • Adoption of IFRS would mean that financial statement users would need to adapt to the new method of inventory valuation, and its impact on earnings, cashflow, assets, and equity.

Introduction

Since August 2008, when former Securities Exchange Commission (SEC) chairman, Christopher Cox, presented a timeline for public companies to transition away from US GAAP (generally accepted accounting principles) to (IFRS) international financial reporting standards, many executives and policy-makers have been concerned about the implications of the differences between the two standards of reporting. The goal of the SEC and the International Accounting Standards Board (IASB) is ultimately to put both US and other international public companies on a consistent, comparable financial reporting basis. This, in turn, would enable analysts, shareholders, and company management to evaluate financial performance among industry competitors, no matter where they are domiciled around the globe.

However, as Mary Smyth, Controller for United Technologies Corp., warned in CFO Magazine recently, “The transition from US GAAP to IFRS is not an accounting-standard adoption exercise, but rather a global project, impacting every facet of a company’s operations.” One of those facets is the method of inventory valuation used by US companies. Under US GAAP, US companies are allowed to use an inventory valuation method referred to as LIFO (last in, first out). Under IFRS, LIFO is not permitted as a basis for valuing inventory for financial reporting purposes. This has many implications for US businesses that currently employ LIFO, one of the most significant of which is the potential acceleration of deferred tax liabilities that have accumulated on their balance sheets over many years of operations.

LIFO Defined

LIFO implies that as inventories turn over, companies using this method to account for their inventory transactions will use their most recent purchases of inventory to sell first. This enables companies to deduct the most recent costs associated with their inventory from their sales proceeds. Consequently, companies using LIFO better match current revenues with current costs. This concept rarely reflects that actual flow of inventory. Most companies prefer to sell their oldest purchases of inventory first—called FIFO (first in, first out). LIFO has been permitted for US companies since the early 1970s. During this period of high inflation in the United States, many companies adopted LIFO to lower their taxable earnings, and thereby, lower their then-current tax payments. Under current IRS tax regulations, a company that uses LIFO for tax reporting must also use it for financial reporting purposes. This is referred to as the LIFO conformity rule.

The computation of cost of goods sold (COGS) is:

COGS = Beginning Inventory + Purchases − Ending Inventory

When valuing their ending inventory using LIFO, most companies start with the inventory valued on a FIFO basis, then use a method called dollar-value LIFO to revalue their inventory to LIFO. This approach uses a cost index, similar to the US Consumer Price Index, to value pools of like inventory items, versus revaluing individual inventory items, at current costs. In times of rising costs, this restatement typically drives up COGS, and, therefore, lowers the cost of ending inventory. On the balance sheet, inventory is typically stated on a FIFO basis with an offsetting contra-asset account, called a LIFO reserve, that nets inventory to a LIFO value.

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Further reading

Articles:

Report:

  • Comiskey, Eugene E., Charles W. Mulford, and Joshua A. Thomason. “The potential consequences of the elimination of LIFO as part of IFRS convergence.” Georgia Institute of Technology, December 2008. Online at: tinyurl.com/y9yqrht

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