Since 1939, when the Tax Code's treatment of inventory was modified to permit LIFO, managers and accountants have faced a tri-lemma in that they have to choose among FIFO, LIFO and average flow assumptions. The Committee on Accounting Procedure issued Accounting Research Bulletin 29 in 1947 to provide guidance for this choice, but said two things that have hampered financial reporting ever since. (These provisions were subsequently integrated into ARB 43 in 1953, and remain in force 60 years later.)
First, the CAP said, "A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues." Second, the committee established that, "Cost for inventory purposes may be determined under any one of several assumptions as to the flow of cost factors (such as first-in first-out, average, and last-in first-out); the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income." One thing to note is that "usefulness for decisions" is not mentioned; rather, the tests of acceptability are propriety, appropriateness and clarity.
The bigger flaw is the subjugation of asset valuation behind, even well behind, expense measurement. (Matching has long since fallen out of favor because of the fuzzy amounts reported for revenues and expenses that aren't linked to observable changes in real assets and liabilities. Nevertheless, LIFO endures as a still-functioning memorial to old-fashioned matching.)
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CLASHING POLICIES
Extending a bit of compassion, we understand the committee members' predicament in 1947. Specifically, Congress' inclusion of the conformity rule in the Tax Code forces managers to use LIFO for their financial statements if they want to reap the tax savings. The cost of realizing that savings is reporting an inferior balance sheet that understates the inventory's cost, and an inferior income statement that fails to report realized holding gains on sold inventory items.
Fatal Flaws
The conceptual argument for LIFO is that it associates replacement costs with revenues. Therefore, LIFO is an effort to introduce approximate replacement cost measures into inventory accounting. It is acceptable to auditors because it is based on historical costs, which they consider to be more reliable than market values.
Dollar-value LIFO was created to approximate units-based LIFO by treating the inventory as consisting of layers of dollars, instead of layers of units. In its pure form, dollar-value LIFO double-extends the quantities of all items in the inventory in both base-year and current-year prices. However, double extension isn’t feasible because inventories are constantly being upgraded. To deal with this problem, tax regulations allow companies to compute an index based on a double-extended sample, which is then used to approximate the results of double-extending the entire inventory.
However, it is impossible to double-extend even a sample when most or all of the inventory didn’t exist in the base year. To approximate a double-extended sample, managers take a sample of the inventory and compute a “link chain” index by double-extending the items with costs from the beginning and end of the reporting year. This index is widely used because it generates LIFO tax savings even for companies that replace their entire physical inventory. For example, car dealers completely liquidate their stock every year.
To summarize: Unit-based LIFO approximates replacement cost of goods sold; double-extended dollar-value LIFO approximates unit-based LIFO; double-extended sample dollar-value LIFO approximates double-extended dollar-value LIFO; and link-chain dollar-value LIFO approximates double-extended sample dollar-value LIFO.
Thus, auditors are happy with an approximation of an approximation of an approximation of an approximation of replacement cost. Furthermore, these approximations don’t work if the inventory shrinks, because layers of old costs flow through cost of goods sold, effectively recognizing realized holding gains that were smothered years earlier.
Surely direct estimates of replacement costs are more reliable than this rigmarole. Dumping LIFO altogether is the better solution than trying to individually repair the weak links in this chain.
If the CAP, the APB or the Financial Accounting Standards Board had required FIFO or average, they would have prevented managers from harvesting the tax benefit. And if they had required LIFO, they would have forced managers to publish inferior statements. The only expedient way out of this stalemate has been to let management decide.
60 YEARS LATER
This year brings the 60th anniversary of LIFO's general acceptance, but there may not be many more because of pressure from international standards and proposed tax legislation.
Specifically, LIFO is not acceptable under IFRS 2 (issued in 2003), which is not surprising considering that no other tax jurisdictions permit its use. With so much interest these days in converging U.S. and international rules, eventually LIFO will have to go.
Closer to home, Rep. Charles Rangel, D-N.Y., has introduced H.R. 3970 to attempt various tax reforms, one of which is eliminating LIFO on tax returns. If that were to become law, which is by no means certain, it would be the end of LIFO as we know it. (Incidentally, the bill would also abolish lower-of-cost-or-market.)
