Accounting Today - August 16 2010

BY PAUL B. W. MILLER AND PAUL R. BAHNSON
LIFO conformity:
Good riddance to

Summer is when we get to catch up on our reading, and this year’s list in- cluded articles on what, if anything, to do about inventory accounting because of international convergence.

All sorts of contorted logic is being floated to support calls for congressional action or inaction. For example, one commentator argues that Congress should just go ahead and prohibit LIFO for tax returns now because it’s only a matter of time before convergence eliminates its acceptability for financial reporting. This argument strikes us as utterly preposterous. For one thing, when did Congress ever do anything pre-emptively? For another, financial reporting considerations simply must not impact an assessment of whether permitting or eliminating LIFO is good tax policy.

But when we look at this comment from a different perspective, it offers a silver lining on the convergence cloud by bringing the LIFO conformity rule into the spotlight. That’s good because this 70-year-old rule has been abominable since it was first put into place. Why is it so bad?

Simply because it creates unnecessary conflict between good financial reporting policy and good tax policy.

This rule
has been
abominable
since it was
first put into
place.
“
”

because no taxpayer should be compelled
to put out useless financial statements to
legally avoid taxes. Consider these often-
quoted words from Supreme Court Justice
Learned Hand when he was an appeals court
judge: “Over and over again, courts have said
that there is nothing sinister in so arranging
one’s affairs as to keep taxes as low as pos-
sible. Everybody does so, rich or poor; and
all do right, for nobody owes any public duty
to pay more than the law demands: Taxes are
enforced exactions, not voluntary contribu-
tions. To demand more in the name of morals
is mere cant.”
This principle justifies all legitimate ef-
forts to minimize tax payments and exposes
the unfairness of the conformity artifice that
discourages taxpayers from freely choosing
LIFO.

to raise revenue equitably and perhaps encourage good behavior while discouraging bad. The conformity rule has frustrated making those choices for seventy years. Unfortunately, its insidious motives are thoroughly imbedded in both GAAP and the tax law.

The way out of this dilemma is simple: Congress must repeal LIFO conformity immediately and stop the tax law from creating less useful financial statements.

GOOD TAX POLICY?

LIFO can be justified as good tax policy because it acknowledges the unfairness of taxing income that cannot be distributed in the ordinary course of business. It is basically an expression of the “wherewithal” doctrine that says people shouldn’t be taxed on income unless they have the cash to pay the tax. (This idea justifies taxing capital gains only when they’re realized, for example.) By eliminating conformity, Congress would be free to grapple with LIFO’s acceptability on its own merits.

If Congress simply repealed LIFO itself, the transition would force managers to calculate taxable and reported income by subtracting decades-old costs from current sales revenue. Their taxes would take a huge leap upward as unrecognized but realized holding gains would flow into income. The Treasury Department estimates that it would reap a $59 billion tax windfall from this sudden influx of “profit.” We’re staggered to think about the effect on reported income, showing more even though there is actually less because of the taxes. Just as LIFO originally distorted income by invisibly deferring gains as if they would never be recognized, so too would its abandonment distort present income by recognizing those gains long after they occurred. Somehow, we’re reminded of Pinocchio’s lengthening nose as new lies patch over the effects of old ones.

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 paulandpaul@qfr.biz.

TWO COMMENTS

We published a column in February 2001 (“The LIFO conformity rule: Do we really need it?”) that criticized conformity for that very reason. Here is a quote: “Every textbook dutifully explains that managers choose LIFO for its tax benefits. LIFO is widely used, the authors say with a wink and a nod, because it allows managers to enrich a company’s shareholders by reducing the income taxes paid. Isn’t accounting great? In order to achieve higher real net income, managers have to report a lower net income on their income statements. Huh? To be better off, you have to tell people you’re worse off?” In effect, the rule forces managers to report inferior information in order to reap an economic gain, or forces them to forego that gain in order to report useful information.

This absurdity flies in the face of reason,

FROM WHENCE IT CAME

We’re sure no more than a handful of living accountants remember the day LIFO conformity was put into place. For the rest of us, it has become just another piece of the furniture we’re so accustomed to that we no longer notice it. That’s unfortunate because this shameful situation has a peculiar, even devious, origin.

It dates to the late 1930s, when Congress first allowed LIFO for federal tax reporting after being persuaded that FIFO overstates distributable cash profits from selling inventory because management must sustain the company by re-investing a portion of gross margin in higher-cost replacements. LIFO advocates convinced Congress it was unfair to tax these realized but re-invested gains. Although the lawmakers agreed, the record is clear that they tacked on conformity to discourage widespread LIFO adoptions and avoid lower tax revenues. By coercing managers into reporting smaller GAAP profits if they chose LIFO, Congress hoped their desire to show higher earnings would stop them from choosing it.

Here is the crux of the issue: Financial reporting policies should be shaped to generate useful financial statements for investors and creditors, while tax policies should be shaped

GOOD REPORTING POLICY?

The existing inventory accounting standard dates to 1946, when the Committee on Accounting Procedure tried to cope with an unresolvable dilemma that continues today.