The Future of LIFO and the Accounting Impacts of Making a ChangeBy Scott Stafford AND Catherine Fox-Simpson
Article Date: 09-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.
LIFO faces threats both domestic and international, and in the event of its demise, dealers using this inventory valuation method must prepare for tax repercussions following different sets of rules.
In CED’s February issue, we introduced you to the impending convergence of U.S. generally accepted accounting principles (GAAP) with the International Financial Reporting Standards (IFRS). That article addressed the future of the operating lease concept upon adoption of IFRS. While the operating lease concept and its future is important to the equipment distribution industry, there are other accounting principle differences between GAAP and IFRS that could have significant impact on both your financial statements and cash balances following IFRS adoption in the U.S.
One such principle relates to inventory valuation accounting, more specifically, the future of the last-in-first-out (LIFO) method. Under the LIFO method, it is presumed that the most recent purchases of inventory are sold first; this is based on the notion that during periods of inflation dealers are reinvesting money into their business by purchasing inventory at current market prices rather than saving money by selling older, less expensive inventory. As a result, in order to value ending inventory, a dealer utilizing LIFO must establish a “reserve” that essentially represents the amount reinvested into inventory by the dealer.
Presently, IFRS does not recognize LIFO as an acceptable inventory valuation method; therefore, adoption of current IFRS in the U.S. would end the allowance of LIFO as a valid inventory valuation method for book and tax purposes. Generally, a dealer can have different methods for book and tax inventory, except if LIFO is used, as the IRS requires book and tax conformity if LIFO is the elected inventory valuation methodology for tax purposes.
Similar to the operating lease concept, in addition to the potential changes resulting from adoption of IFRS, there are other forces at work that threaten the future of LIFO. The White House has proposed repealing LIFO in order to generate tax revenues to offset the costs of other programs they are proposing.
Due to the tax advantages generated by the use of LIFO during times of economic inflation (by matching increasing inventory costs with increasing sales prices, thus lowering taxable income), it has historically enjoyed widespread use within the equipment distribution industry. Dealers commonly utilize LIFO to value both new equipment and parts inventory. However, in the face of these threats to LIFO’s future, it is important for dealers to contemplate the effects that changing from LIFO to another inventory valuation method (such as first-in-first-out [FIFO] method) would have on their tax reporting, accounting information systems, and financial reporting. This article is intended to shed light on what these changes could mean to your dealership.
Tax Reporting Implications
Related to tax reporting, the disallowance of LIFO could have significant impact on current year taxable income and could trigger taxes on the historical accumulated LIFO reserve. The current proposed federal legislation would require that dealers write up their beginning inventory using an accepted inventory valuation method for the first taxable year beginning after Dec. 31, 2011. As inventory write-ups are typically recorded against revenues, this write-up would generate additional current year taxable income.
Traditionally, the IRS has spread the additional taxable income generated by a change in accounting methods over a four-year period and, given the significance of some dealers’ LIFO reserves, application of such a recovery period could have dramatic affect on their annual tax liabilities. However, the proposed legislation does afford some relief on the taxation of the LIFO recovery by allowing a proposed eight-year recovery period. In order to assess the potential current year tax liability impact under this proposed recovery period, a dealership would divide its current LIFO reserve by eight and then apply their current effective tax rate to that figure. The resulting calculation would represent the additional current year tax liability.
Effects on Dealers Contingent on How LIFO is Repealed
For financial reporting purposes, there are several possibilities as to how a dealership would report a change from LIFO to another accepted method in its financial statements. The possibilities are based on which source causes LIFO to be disallowed. As we noted, LIFO could end as a result of either (1.) the U.S. adoption of IFRS or (2.) proposed federal legislation favored by the Obama administration.
If LIFO is repealed due to proposed federal legislation, the change would be accounted for following current GAAP. In most circumstances, when an accounting principle is terminated within GAAP, the accounting standard setters will issue specific instructions as to how transition to an acceptable method should be implemented within the financial reporting of a company. Without such implementation guidance in hand, the best method of evaluating the potential required approach is to look at current GAAP concerning an inventory valuation method change.
Currently, under GAAP the method of inventory valuation a dealer utilizes is deemed to be an accounting principle. The current GAAP standard addressing changes in accounting principle (Statement of Financial Accounting Standard No. 154: Accounting Changes and Error Corrections (SFAS 154)) requires that, unless impractical to do so, the effects of the change should be retrospectively presented in all periods presented in the financial statements. As a result, each financial statement would be adjusted to reflect the period-specific effects of applying the new inventory valuation methodology. Therefore, the prior period income statements presented would reflect changes to the cost of sales associated with the revalued inventory (commonly new equipment and parts). These adjustments to cost of sales would, in turn, change the gross profit and pretax income in these prior periods. Additionally, the commonly used non-GAAP financial measurement of earnings before income taxes depreciation and amortization (EBITDA) would also be changed in these prior periods.
Furthermore, SFAS 154 requires:
- Financial statement disclosures concerning the nature of and reason for the change in accounting principle
- The method of applying the change
- A description of the prior-period information that has been retrospectively adjusted
- The effect of the change on income from continuing operations
- Net income
- Any other affected financial statement line items
- Any affected per-share amounts for the current period and any prior periods retrospectively adjusted
- The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position, as of the beginning of the earliest period presented
- And, if retrospective application to all prior periods is deemed impractical, disclosure of the reasons why it is impractical and a description of the alternative method used to report the change.
If LIFO is disallowed as a result of the adoption of IFRS in the U.S., current IFRS rules (IFRS 1: First-Time Adoption of International Financial Reporting Standards [IFRS 1]) would require that inventory be re-valued to an IFRS accepted valuation method in the first balance sheet presented. The offsetting entry to the change in inventory valuation would be recorded into retained earnings in the opening balance sheet. Furthermore, prior period profit and loss statements presented for comparative purposes would have to be presented on an IFRS basis – in other words, similar to current GAAP, IFRS adoption requires retrospective application of the alternative inventory valuation method selected to all periods presented in a dealer’s financial statements.
Currently there are lobbying efforts underway to champion LIFO and dissuade lawmakers and accounting standard setters from ending its availability to U.S. companies – including those led by AED’s Washington office. However, with LIFO under attack from multiple sources that include both domestic and international pressures, it appears that the future of LIFO is bleak.
Dealers currently using LIFO, therefore, should begin to consider the impact of an inventory valuation method change on their future tax liabilities and financial reporting, and begin communicating this information to their stakeholders for discussion. Key factors in these discussions include not only the tax ramifications and financial reporting issues discussed above, but also the information system and internal control changes that may be required for timely and accurate reporting of inventory under a new valuation method.
Because of the complexities that these key factors can generate, consideration of and planning for these issues now will go a long way in providing as smooth a transition as possible in the event LIFO is disallowed.
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