BY PAUL B. W. MILLER AND PAUL R. BAHNSON
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
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.
since it was
first put into
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
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 firstname.lastname@example.org.
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
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
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.
See SPIRIT on 15