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the IRS must also use it for financial reporting, rather than potentially more-flattering
methods, such as FIFO (first-in, first-out) or average cost.

A Bad Match?

Companies like LIFO because it stifles inflationary effects by matching current expenses
and current sales more closely than other methods. The accounting convention “protects
us from having to pay taxes on what are not really profits,” contends Jones. Indeed,
proponents of LIFO — 120 of which have formed the LIFO Coalition to lobby against its
repeal — don’t consider the methodology a tax break. “There is an economic reason for
using LIFO, and that is lost on the folks in Washington,” says Beatty D’Alessandro, CFO
of Graybar, a distributor of electrical and industrial components that has been using LIFO
since the early 1980s. Without LIFO, he says, there is a “mismatch between what it’s
going to cost us to put inventory back on the shelf and what we bought it for six months
ago, when it may have cost less.”

To understand the mismatch, consider how LIFO works: Say, for example, that a
company has an industrial compressor in its inventory that it bought for $5,000. It sells
the compressor for $5,500, and replaces it in inventory for $5,200. From an economic
perspective, the profit is only $300, not the $500 difference between the historic and
current price. LIFO allows companies to use that “last-in” price to record $300 in taxable
income. The remaining $200 in income is deferred until the company shutters its business
and is forced to liquidate the inventory, at which time it strips off years of “LIFO layers.”
The $200 — the difference between the taxable income recorded under LIFO and another
methodology — is referred to as the LIFO reserve.

In a liquidation, notes O’Neal’s Travis, the sell-off of old inventory generates revenue to
pay the taxes. But if LIFO is simply repealed, he says, then deferred taxes will be due
without the benefit of any additional revenue. “In effect, the repeal of LIFO is going after
our equity,” the tax director says.

Under the Obama budget proposal plan, companies would be required to “true up” their
retained earnings in the year they stop using LIFO, explains Jason Cuomo, a senior
analyst with Moody’s Investors Service. They would then make annual cash tax payments
on the profits stored in the LIFO reserve over a 10-year period, beginning in 2012.

Graybar’s D’Alessandro argues that LIFO accounting is a “timing issue,” rather than a tax
gimmick, and emphasizes that LIFO accounting reverses itself when demand drops. “You
burn through LIFO layers as you burn through your inventory,” explains D’Alessandro,
who notes that Graybar reached lower-cost inventory layers last year as demand slowed.
At that point, profits rose under LIFO accounting and the company had to pay more in
taxes. The same is true when deflation sets in, says Scott Rabinowitz, a director in
PricewaterhouseCoopers’s national tax practice. As the price of replacement inventory
drops, taxable income increases, and so does a company’s tax obligation.

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