LIFO Vs. FIFO: The Dying Gasp Of A Beloved Accounting Practice?

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Includes: CAT, COST, CVX, LYB, MO
by: The Motley Monetarist

Summary

The proposed repeal of LIFO will increase the tax liability for companies and also tax revenues.

Even with an allowed adjustment period, the pain will be felt by approximately one third of U.S. companies.

Our calculations show that opportunities to investors through lower valuations will not be uniform across sectors.

The Obama administration has been proposing, since 2011, in order to ease the transition of US companies from GAAP to IFRS, to repeal LIFO as an inventory accounting practice altogether. For over seventy years, US companies have been given the possibility of using LIFO to value their inventory. Under LIFO, US companies must value their inventories at cost. Under FIFO, however, companies can value their inventories at lower of cost or market. For companies facing an inflationary situation, the difference can be very consequential. Under LIFO, companies can use their newest inventories to calculate cost of sales.

Accordingly companies can better match cost of goods sold to inventory. Sectors of the economy that tend to use LIFO include farm equipment dealers, RV dealers, supermarkets and drugstores. LIFO also allows for the deferral of inventory costs; companies favor the usage of LIFO since it allows for the deferral of the tax consequences of inflationary gains on inventories and easier current reinvestment.

IRS 481(A) adjustment period won't reduce the pain.

The tax consequences of the use of LIFO by US companies (calculated at approximately one third) would be to increase cost of goods sold, lower net income, increase cash flow and hence decrease taxes. In a deflationary situation, of course, the reverse is true. The repeal of LIFO (Congress using the excuse, of course of facilitating the transition to IFRS by US companies) would increase net earnings and also the tax liability of the companies that currently use LIFO to their advantage. The other side of the coin is that this potential drastic increase in tax liability might lead to layoffs, which is the reason behind the plea by the US Chamber of Commerce to maintain LIFO (in a recent survey, 39% of dealers stated they would lay off personnel if LIFO were repealed). It is probably too late, though, to preserve LIFO, in advance of the transition to IFRS by US companies.

However, the IRS is not altogether unmerciful. Under Section 481 of the 1986 IRC, any transition away from LIFO which results in a positive adjustment to net income can be taken account over four taxable years. As well, under FIFO, companies can use lower of cost or market. For instance, a company can write down any raw materials that have declined in value since the beginning of the year, regardless of whether the finished goods can be sold at a profit, helping the adjustment process. Notwithstanding the proposed generosity of the IRS in this regard, the pain that US companies will feel in moving away from LIFO will be real.

Which companies or sectors might be the most impacted?

Of course the inevitable transition to LIFO will not be felt uniformly between different sectors or companies. An additional consideration is that the elimination of LIFO will probably lead to an immediate tax liability as companies attempt to recapture their LIFO reserves, a contra reserve account, which reflects the difference between FIFO and LIFO costs. Here are some representative companies which currently use LIFO valuation, and the effect on their price/earnings ratio if they had transitioned to FIFO in 2013. As a rough measure, we revalue cost of goods sold, earnings per share and, consequently, the current price/earnings by the change between beginning of year and end of year inventories, to capture the "FIFO transition effect". Of course, given the adjustment period allowed by the IRS, the effect on companies' balance sheets and earnings will normally not be so drastic. Caterpillar bucks the trend, since the value of its inventories declined by 20% between 2012 and 2013.

Company

Sector

Market cap

P/E

P/E adjusted for FIFO

% change in adjusted P/E

Lyondell Based Industries (NYSE:LYB)

Basic materials

16 billion

16.35

15.73

-4%

Altria (NYSE:MO)

Consumer goods

85 billion

19.93

18.5

-7%

Costco (NASDAQ:COST)

Retail

55 billion

28.10

23.42

-16%

Caterpillar (NYSE:CAT)

Industrial goods

65.7 billion

17.79

22.35

25.6%

Chevron (NYSE:CVX)

Oil and gas

233 billion

11.96

11.52

-3.8%

Source: stock-analysis-on-net and finance.yahoo.com

Retail suffers the most?

The cost of the tax break, according to the Joint Committee on Taxation, is about $5 billion in 2013, or about $60 billion over a decade. Proponents of repealing LIFO point to the increased tax revenue, or the possible eventual decrease of the corporate tax rate by .6%. It is calculated that energy companies hold about one third of current LIFO reserves. However, as the above back-of-the envelope calculations pinpoint, while the pain will not be felt equally across sectors, the potential benefits for investors, in terms of lower valuations, present interesting possibilities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.