George White is a retired national tax partner with Ernst & Young LLP; more recently he was with the American Institute of Certified Public Accountants. He is the author of several publications on consolidated returns and tax accounting and he is an adjunct professor at the George Washington School of Business, where he teaches graduate courses in tax accounting and corporate tax. White is an attorney and a CPA.
"International Financial Reporting Standards do not permit the use of the LIFO method, and their adoption by the Securities and Exchange Commission would cause violations of the current LIFO book/tax conformity requirement. Repealing LIFO removes this possible impediment to the implementation of these standards in the United States."1
-- Department of the Treasury, May 2009
Repeal of the last-in, first-out method of accounting is the piñata of revenue raisers, holding out the prospect of billions in increased revenues. Curiously, as we'll see below, there is a fleeting, "fish or cut bait" quality to repeal.2
The LIFO method of valuing inventories is one that matches current costs of purchased (or produced) goods with current revenues. LIFO is a specifically authorized tax accounting method under section 472.3 LIFO's polar opposite is the first-in, first-out method of valuing inventories that matches historical costs with current revenues. International financial reporting standards are the globally accepted accounting standard for financial reporting, whose adoption is being considered in the United States. IFRS is administered by the International Accounting Standards Board, the U.S. counterpart of which is the Financial Accounting Standards Board.
In a period of rising prices, the value of ending inventory on LIFO is lower than under FIFO. The difference between the values is the LIFO reserve.4 As the balance in the LIFO reserve increases, there is a corresponding increase in cost of goods sold and a decrease in tax liabilities. Repeal raises revenue because it reverses amounts accumulated in the LIFO reserve. Under the Treasury proposal, the balance in LIFO reserves would be required to be restored to income ratably over eight tax years.5 The Treasury proposal would repeal the LIFO method in the first tax year beginning after December 31, 2011.
In 2006 there was a short-lived repeal proposal under consideration by the Senate Finance Committee, then chaired by Sen. Charles Grassley, R-Iowa.6 In his testimony before the Finance Committee, Prof. George A. Plesko of the University of Connecticut School of Business was critical of the LIFO method for a variety of reasons. Later, Plesko joined with Edward Kleinbard in an article criticizing the LIFO method as a "tax holiday."7 Critics have even taken to calling Delaware a "tax haven" because it does not impose an income tax on corporations.8
In 2007 a comprehensive corporate tax reform bill, H.R. 3970, was introduced by House Ways and Means Committee Chair Charles B. Rangel, D-N.Y. The bill would have repealed LIFO as part of a package of corporate measures designed to lower the top corporate tax rate from 35 percent to 30.5 percent. H.R. 3970 was not acted on by the full Ways and Means Committee.
The estimated revenue pickup in the Treasury proposal is approximately $60 billion. The Joint Committee on Taxation recently scored the revenue pickup at approximately $80 billion.9 Both estimates are considerably less than the estimate in H.R. 3970, which was in excess of $100 billion. The decreased revenue estimate has been the subject of some speculation. Some think that the lower estimate reflects the impact of the recession, with its deflationary effect on inventory values. Two groups in particular may be hardest hit: retail outlets and car dealers. The use of LIFO is quite widespread by both groups.10 As thousands of car dealerships are forced to close, their inventories are sold off, and LIFO reserves disappear. It would be a nasty hardship for those dealers if their tax bill balloons in their final tax returns as a result of liquidating LIFO inventories.11 Perhaps the blow would be softened by the availability of net operating loss carryforwards.
Regardless of which revenue estimate is more realistic, there is an air of impermanence about those calculations. The explanation is somewhat tortured but, basically, it stems from congressional budgeting rules. Under "pay as you go" rules, tax cuts must be offset by tax increases.12 Further, the tax increases must result from explicit congressional action. An increase in revenues resulting from existing law cannot be counted. If IFRS were, say, made mandatory tomorrow, there would be an immediate increase in tax revenues as taxpayers are involuntarily thrown off LIFO. But because the increase in tax revenues would result from existing law (the conformity requirement, as discussed below), it could not be counted as offsets to tax cuts. Unfortunately for LIFO taxpayers, this places a certain urgency on pre-emptive repeal.
The link between LIFO and IFRS is composed of two interlocking elements. One is the prohibition of the LIFO method by IFRS. Ordinarily, an accounting standard would be of no relevance to a tax method like LIFO. But a unique provision in the Internal Revenue Code provides the connection. Section 472(c) and (e) condition the use of the LIFO method for tax purposes on taxpayers' use of the LIFO method in their financial reports. It would not be possible for LIFO taxpayers to satisfy this conformity requirement if they were required to use IFRS in their financial reporting.
Regarding the rationale for the conformity requirement, there has long been speculation that it was a "poison pill" included in LIFO's initial enactment at the urging of its opponents in Treasury who, according to this theory, believed taxpayers would not adopt LIFO because of its negative impact on reported earnings (compared with FIFO). It was the consistent Treasury opposition that led LIFO advocates to take their case to Congress for legislation specifically authorizing LIFO. Whatever its original rationale, the conformity requirement has lost much of its deterrent value over the years because of its relaxation in the regulations.13 Despite its diminished potency, the statutory requirement still poses a formidable challenge for LIFO taxpayers contemplating the possible adoption of IFRS.
In February 2009 this challenge led a group of LIFO supporters known as the LIFO Coalition to appeal to the Securities and Exchange Commission for assistance.14 The LIFO Coalition requested that the SEC meet with Treasury to fashion a work-around of the conformity requirement. The letter was submitted several months before the Obama Treasury made its LIFO repeal proposal, a move that obviously made it pointless for the SEC to approach Treasury.15
At the risk of oversimplification, the LIFO Coalition letter presents an interesting argument. The argument is that Treasury has the authority to approve the LIFO method under its general authority over accounting methods in section 471, that is, separate and apart from its specific regulatory authority under section 472.16 For strict constructionists who might ask why the specific provisions of section 472 do not trump the general provision of section 471, the argument notes that the legislative history of section 472 provided that Treasury had (and has) the authority to approve the LIFO method under section 471, the enactment of section 472 aside.17
Future of IFRS
The critical question is how imminent is IFRS? If it's really just around the corner, it makes sense for Congress to act now before the prize gets away. On the other hand, if IFRS is over the horizon, like Social Security bankruptcy, perhaps it's best to consider LIFO repeal on its own merits, and not as a one-time opportunity.
The IFRS initiative was undertaken by the Republican-controlled SEC when Christopher Cox, a former congressman from California, was chair. Last November the SEC issued its "road map" for adoption of IFRS. The road map called for a decision on adoption to be made in 2011, with an eye toward a 2014 effective date for U.S. public company filers.18
Clearly that timetable has been thrown into question by the confluence of two events: the financial crisis and the election of President Obama. With Obama's election, control of the SEC passed into the hands of the Democrats. Christopher Cox's successor as chair is Mary Schapiro. During her confirmation hearing, Schapiro expressed reservations about continuing Cox's IFRS initiative.19 More recently, Schapiro repeated her concerns, stressing that the goal of high-quality accounting standards must not be compromised for the sake of uniformity.20 At about the same time, SEC Commissioner Luis Aguilar confirmed that the SEC will be proceeding on IFRS with less urgency because of the changed economic situation.21 An outside observer has speculated that the adoption date might be pushed back as far as 2017.22
Finally, let's circle back to the Treasury rationale for repeal. Treasury argues that repeal of LIFO would clear the way for adoption of IFRS, the implication being that LIFO is an obstacle to adoption. That implication is open to question, considering the attitude of the U.S. accounting establishment. It has already decided that LIFO must be sacrificed to adopt IFRS. In 2007 FASB submitted its formal approval of IFRS to the SEC.23 In its endorsement letter, FASB noted that IFRS "does not allow LIFO." Creating an exception for LIFO would amount to a "U.S. variant for IFRS," a development that would undermine the goal of a globally uniform set of accounting standards, as other countries pushed for their own local variants to IFRS. FASB stated its strong opposition to creating a U.S. exception for LIFO. Translation: LIFO should not be allowed to stand in the way of adopting IFRS.
Ultimately, the decision on IFRS is a political one for Congress. If, as famously said during World War I by France's Georges Clemenceau, war is too important to be left to the generals, it's probably equally true that financial reporting standards are too important to be left to the accountants.24 Fairly or not, IFRS has been characterized as a system of principles, in contrast to the rules-based U.S. system. It seems inevitable that regulatory enforcement of IFRS by the IASB will be looser than under a rules-based system. In calling for a total overhaul of the U.S. regulation of the financial industry, Obama has blamed the financial crisis on a lack of effective regulation. Also, it's been less than 10 years since Congress enacted the Sarbanes-Oxley Act of 2002, which placed responsibility for U.S. accounting standards in the hands of the SEC. Given this background, it seems a bit problematic to think that Congress would now turn over the responsibility for U.S. accounting standards to an international body like the IASB.
1 For General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals, commonly referred to as the Treasury green book, see Doc 2009-10664 or 2009 TNT 89-44.
2 Political junkies will always associate this expression with President Richard Nixon when he was the vice presidential candidate on the 1952 Republican ticket with General Dwight D. Eisenhower. Eisenhower was urged to dump Nixon after the latter became entangled in scandal. Eisenhower seemed unable to make a decision. Nixon supposedly told Ike, the political neophyte, that in politics there was a time to "fish or cut bait." It's highly unlikely that Nixon would have used such a dainty expression with a career Army officer like Eisenhower.
3 LIFO has been part of the code for over 70 years, having been enacted in 1938.
4 Rodney P. Mock and Andreas Simon, "The LIFO, IFRS Conversion: An Explosive Concoction," Tax Notes, May 11, 2009, p. 741, Doc 2009-8361, 2009 TNT 89-28.
5 For LIFO taxpayers voluntarily switching off the LIFO method, the IRS permits the LIFO reserve to be spread over four tax years. Rev. Proc. 2002-19, 2002-1 C.B. 696, Doc 2002-6514, 2002 TNT 51-9.
6 With the Democrats assuming control of the Senate in the 2006 elections, Sen. Max Baucus, D-Mont., is now chair of the Finance Committee.
7 Edward D. Kleinbard, George A. Plesko, and Corey M. Goodman, "Is It Time to Liquidate LIFO?" Tax Notes, Oct. 16, 2006, p. 237, Doc 2006-20617 , 2006 TNT 200-29 . At the time, Kleinbard was in private practice. Later he became chief of staff for the Joint Committee on Taxation, a position that he recently left. (For prior coverage of his departure, see Tax Notes, Apr. 27, 2009, p. 391, Doc 2009-8963 or 2009 TNT 75-2.)
8 "Critics Call Delaware a Tax Haven," The New York Times, May 29, 2009. This article mirrors an earlier article in The Economist, "Haven Hypocrisy," Mar. 26, 2009.
9 Joint Committee on Taxation, "Estimated Budget Effects of the Revenue Provisions Contained in the President's Fiscal Year 2010 Budget Proposal," June 11, 2009 (JCX-28-09), Doc 2009-13321, 2009 TNT 111-11.
10 For 2006, approximately one-third of car dealer and two-thirds of general merchandiser inventories were on LIFO. "Tax Matters," Journal of Accountancy, July 2009, at 76.
11 The politics of the forced closings could prove interesting, as Congress considers the impact on their local communities. See "G.M. and Chrysler Defend Dealer Closings to Senate Panel," The New York Times, June 3, 2009.
12 Critics argue that the pay-go rules, because of their numerous exceptions, are illusory.
13 Reg. section 1.472-2(e)(3).
14 LIFO Coalition letter to the SEC, Feb. 18, 2009, Doc 2009-3650, 2009 TNT 31-33.
15 In the closing months of the Bush administration, LIFO advocates presented this argument to Treasury officials. Treasury was later engulfed in the financial crisis, so no action was taken on the argument. If Sen. John McCain, R-Ariz., had won the presidency, perhaps a Republican-controlled Treasury would have considered the argument. But Obama's election made the point moot. As the old saying goes, the fastest way to change policies is to change politicians.
16 The LIFO Coalition's argument is set out in great detail in its letter to the SEC, supra note 13.
18 222 DTR, Nov. 18, 2008.
19 Thomas Jaworski, "Nominee for SEC Chair Says She Would Proceed Carefully in Possible Shift to IFRS," Tax Notes, Jan. 19, 2009, p. 315, Doc 2009-940, 2009 TNT 10-6.
20 117 DTR, June 22, 2009. Schapiro also expressed concern over the cost of converting to IFRS, noting that she had heard the conversion cost for one U.S. company could run as high as $20 million.
21 Jaworski and Carolyn Wright LaFon, "SEC Official Hints at Slower Action on IFRS," Tax Notes, June 8, 2009, p. 1193, Doc 2009-12585 , 2009 TNT 105-3.
23 Letter of November 7, 2007.
24 A similar point was recently made by Peter Wallison of the American Enterprise Institute, Financial Times, May 1, 2009. Quoting Clemenceau, Wallison argued that "just because fair-value accounting is favored by accountants does not mean that it is ideal."
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