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A Cash-Flow Issue

Not all companies agree with the mismatch theory. Proponents of FIFO, who tend to be
retailers and manufacturers of fast-moving inventory such as electronics or perishable
goods, say FIFO better reflects the current value of inventories. For example, in
December, packaging giant Pactiv Corp. switched from LIFO to FIFO, telling investors
that the change provides “better matching of sales and expenses.” Officials at the
company, which makes Hefty brand plastic bags, noted that this is particularly true during
periods when the price of their primary raw material, resin, is volatile.

Under FIFO, they said, “the lag between resin-price changes and selling-price changes
will be reduced by approximately two months.”

Moreover, not everyone agrees that LIFO elimination would be such a dire event for
companies with slower-moving inventory. The elimination of LIFO “is a cash-flow issue,”
argues Moody’s Cuomo, who co-authored a recent report on the subject. His report, which
examined 176 companies rated by Moody’s that use LIFO, points out that larger
companies with strong cash flows likely will weather the one-time charge of converting
from LIFO to FIFO or another methodology without much problem (see the chart at the
end of this article). That’s because for the largest companies, the charge represents a
small percentage of their annual cash flow. However, smaller companies with high LIFO
reserves and low cash flows could run into problems.

But some large companies say the change would still hurt. Graybar, with $4.3 billion in
revenue, reported a LIFO reserve of $107 million in its most recent 10-K. Assuming a
35% tax rate, and a single payment that is not stretched out over time, D’Alessandro
estimates that Graybar’s tax bill would amount to $37.5 million on the day it converted
from LIFO to FIFO — or a $19 million tax obligation if the company switched to average-
cost accounting. More important, a switch from LIFO could mean up to 500 fewer jobs,
says the CFO, who figures that, on average, salary and benefits cost the company
$70,000 per person. “If we pay it in taxes, we can’t pay it in wages. It is as simple as that.
[LIFO repeal] is an anti-employment move,” insists D’Alessandro.

The demise of LIFO also could affect a company’s net operating losses — the deferred
tax asset that is recorded by a company and held to offset taxable income in the future.
Rabinowitz notes that taking the LIFO reserve into income could reduce the amount of
NOL carryforwards.

The sting of LIFO repeal also will be felt by smaller companies that don’t have robust
information-technology systems, says Stephanie Anderson, a managing director at
consultancy AlixPartners. That’s because sorting and valuing layer after layer of LIFO
inventory is a complex task. That kind of “unwinding” is mandatory before an accurate
valuation can be recorded for book and tax purposes. Anderson says companies may
also need to hire more cost accountants to ferret through the inventory layers.

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