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Estimating the Potential Revenue Impact of Taxing LIFO Reserves in the Current Low Commodity Price Environment
Abstract
Public company LIFO reserves fell from 2012 to 2015, a time when commodity prices generally fell, and LIFO reserves and commodity prices both rose moderately in 2016. Using a combination of IRS and public company data, we estimate overall U.S. LIFO reserves from 2012 to 2016, and the potential tax revenue impact of LIFO repeal. At a 35% (20%) rate, taxing the 2016 LIFO reserves would yield between 11) and 14) billion.
Although fewer than 1% of 2013 corporate and partnership tax returns with inventory used LIFO, LIFO inventories comprised about 14% of the dollar value of U.S. company inventories.
The findings on LIFO usage and the magnitude of LIFO reserves are relevant to deciding whether LIFO should be retained as an acceptable inventory method for taxes and U.S. GAAP, and also provide context for instructors teaching about inventory methods.
The choice of inventory cost flow assumption is a key financial reporting decision. The resurgence of inflation has renewed interest in this option. We derive algebraic models of the LIFO‐FIFO difference in cost of goods sold and the LIFO tax savings as a function of inflation, turnover, inventory increments, and tax rates. Managers and researchers can use these models to estimate the likely financial and tax impacts of LIFO adoption. Historic trends in public company LIFO usage since 1971 are consistent with the changing impacts estimated by our model. We infer an approximate cost level of using LIFO based on historic public company behavior. In the 1971–2022 period, LIFO adoptions were only common when the tax benefit in our model exceeded about 0.35% of COGS. Even when inflation rose in 2021 and 2022, the tax savings remained below this threshold, and there were far more LIFO abandonments than adoptions.
We trace the history of LIFO from the 1930s to 2021. LIFO usage rose sharply in the 1970s. LIFO’s supporters praised its matching of recent costs against sales, and its nonrecognition of inventory holding gains. Managers appreciated its tax-lowering effects in inflationary periods. The 1970s LIFO adoptions spurred accounting research into market efficiency and accounting choice. LIFO’s tax advantages began decreasing in the 1980s due to lower tax rates, low inflation, and changing inventory practices. Its theoretical justification weakened as the FASB adopted a Conceptual Framework in the 1980s that deemphasized matching, and instead valued relevance, decision-usefulness, representational faithfulness, and comparability. Without major tax advantages or strong theoretical justifications, LIFO usage declined markedly beginning in the mid-1980s. The IASB disallowed LIFO in 2005. By 2020, LIFO had become a niche method, surviving mainly due to the LIFO conformity rule. Whether its use will increase with renewed inflation is unclear.
For years, LIFO (Last in First Out) inventory method has been used by the U.S. companies for its tax advantages as long as LIFO is also used for financial reporting purposes (the “conformity rule”). However, LIFO is prohibited under IFRS (the International Financial Reporting Standards). With the impending acceptance of IFRS by the SEC and the Obama administration’s budget proposals (2010, 2011 and 2012) which contained a provision to eliminate LIFO for tax purposes, LIFO is expected to be repealed. This study examines the use of LIFO in the manufacturing industry from 2008 (the start of recession) through 2014 with a focus on income distortions & liquidity measurements. This study provides transparency of LIFO accounting information in the manufacturing industry.
We discuss the role and economic significance of the last-in, first-out (LIFO) inventory accounting method in the current tax system, both as a matter of practice and of policy. After examining the traditional justifications for LIFO we argue that LIFO, as it is administered, is inconsistent with both its own objectives and with broader income tax principles. LIFO, as practiced in the United States today, benefits only a narrow range of businesses; they in turn rely on it entirely for its tax benefits, rather than to complement normal business operations. Further, the evidence on LIFO suggests that it creates inefficiencies in business operations, and may facilitate earnings management. We conclude that any discussion of fundamental tax reform must consider the repeal of LIFO.
An introductory one-semester accounting text for MBAs, integrating financial and managerial accounting.
In this study, we discuss the potential consequence of a repeal of the Last-in, First-out (LIFO) inventory method. In 2012, U.S. companies reported a total of 3,207 million LIFO reserves. Assuming a 35% tax rate, this reserve reflects approximately 1,122 million in tax savings. More importantly, there has been a significant increase in LIFO reserves during the past decade. If LIFO is repealed, the substantial tax burden might destroy some firms. Although it is crucial to converge toward International Financial Reporting Standards (IFRS), a repeal of LIFO will significantly affect firms with large LIFO reserves. As a result, we suggest that regulators be cautious about the potential repeal of LIFO.
The history of LIFO illustrates the interplay of taxes and the general ac-ceptance of accounting principles. In this paper, the gradual acceptance of LIFO in the United States is traced. The study focuses on both the theoretical evolution of LIFO and its acceptance by taxing authorities and accountants.
This study examines the association between a firm’s LIFO reserve and its equity risk. We hypothesize that LIFO reserve has favorable implications for equity risk as it confers tax benefits and represents unbooked profits, which prompt firms to lower their borrowings and effectively increase equity. Consistent with this hypothesis, we document a negative association between LIFO reserve and two measures of risk: standard deviation of stock returns and beta. We document a negative association between LIFO reserve and debt, consistent with the proposition that UFO reserve and debt are tax shield substitutes. However, the negative association between LIFO reserve and equity risk remains even when the level of debt of firms is controlled. Further tests show that adjusting the denominator of the debt-equity ratio for LIFO reserve improves its explanatory power with regard to risk, consistent with the notion that LIFO reserve is viewed as a component of equity in assessing risk. Additional tests indicate that LIFO reserve has explanatory power with regard to future risk. Also, variability of LIFO reserve is positively associated with equity risk, suggesting that firms with high temporal variability in their LIFO reserve may be unable to fully avail of the future benefits of LIFO accounting. Collectively, these results indicate that LIFO reserve is negatively associated with equity risk and conveys information that is potentially useful in assessing equity risk.
This paper examines how the probable demise of the LIFO inventory costing method will affect companies currently using LIFO as well as the financial analysis of those companies. Key financial ratios are examined along with how these ratios may be affected by the switch away from LIFO. A mixed bag of changes to key ratios, both improvements and deteriorations, are presented, along with a discussion of more complex topics for whom the impact of these changes are less clear.
Recent calls to repeal the use of LIFO raise questions about the number of firms that will be impacted, the extent of that impact, as well as the demographics of the impacted firms. The present study assesses the population of publicly-traded companies to determine the frequency of usage of LIFO, the dollar impact of using LIFO, and the connection between firm size and the use of LIFO. This study finds that the tax impact of repealing LIFO may be more manageable than has been reported in the financial press. In addition, this study documents the connection between absolute and relative firm size and the use of LIFO.
Recent legislative consideration to end the use of the Last-in, First-out (LIFO) inventory method, as well as the movement to adopt international accounting standards which do not permit LIFO, have created anew the debate over how important LIFO is to U.S. businesses. This paper catalogs the use of LIFO during 2007 among the largest 500 U.S. companies by analyzing disclosures from the Form 10-K annual report (or the corporate annual report for privately-held firms). Analysis of the data provides evidence of the frequency of use of LIFO, the financial impact on reported income and on reported assets due to its use, and the particular industry categories that are the major beneficiaries of the method.
The widespread decision of small companies to avoid using LIFO is discussed as a function of the difficulties that companies have in complying with LIFO requirements. 1983 survey estimates indicate that small companies face considerably higher costs in switching to LIFO than do large companies. Both large and small companies could save a large proportion of their LIFO conversion costs if LIFO regulations were modified to permit use of government price indexes in determining price changes.
A valuation approach is used to examine the effect of the LIFO inventory method on the relation between the market value of a firm's stock and the book value of equity. The paper develops three competing hypotheses that have different predictions regarding the relation between the LIFO reserve and the market value of equity. Results indicate a significant negative relation between the LIFO reserve and the value of equity, inconsistent with the pricing of LIFO reserves as unbooked assets, but consistent with a model that views the LIFO reserve as a measure of the effect of increases in factor input prices on firm value.
Résumé. Les auteurs ont recours à une évaluation pour examiner l'incidence de la méthode DEPS de détermination du coût des stocks sur la relation entre le cours de l'action d'une société et sa valeur comptable. Ils élaborent trois hypothèses concurrentes qui débouchent sur des prédictions différentes en ce qui a trait à la relation entre la réserve résultant de l'utilisation de la méthode DEPS et la valeur marchande de l'entreprise. Les résultats indiquent une relation négative significative entre cette réserve et la valeur comptable de l'entreprise, relation qui ne concorde pas avec le prix de ladite réserve que l'on voudrait assimiler à un actif non comptabilisé, mais qui cadre avec un modèle selon lequel la réserve résultant de l'utilisation de la méthode DEPS est considérée comme une mesure de l'incidence des hausses du prix des intrants sur la valeur de l'entreprise.
This study examines the effect on firm value of repealing the last-in, first-out (LIFO) inventory method for tax purposes. Our model extends prior literature by determining quantities and prices in equilibrium rather than specifying them exogenously. We find that LIFO repeal could increase the future after-tax cash flows of firms that had used LIFO because the higher tax costs associated with FIFO result in lower equilibrium quantities and higher equilibrium output prices that increase pretax cash flows. We illustrate our model by examining inventory methods used by firms in the oil industry.
Using matched samples of JIT adopters and non-adopters, we examine the association of JIT adoption with firms' financial reporting and tax incentives, earnings management histories, and LIFO reserve levels. We find evidence that adoption decisions are influenced by the interaction of firms' LIFO reserves with their income smoothing, debt covenant, and tax incentives. We also find that adoption is less likely for firms historically engaging in high degrees of earnings management, particularly when such firms have no substantial LIFO reserves. Our study extends earlier research demonstrating a relation between inventory valuation method and year-end inventory transactions, and documents a relation between earnings management incentives and a fundamental supply chain design choice.
The SEC has proposed the full adoption of IFRS by U.S. filers by 2014, with larger firms adopting the international standards as early as 2010. One important change to U.S. accounting standards that would accompany a move to IFRS is the elimination of the Last-in First-out (LIFO) accounting method for inventory. Moreover, because of the LIFO conformity rule, a move away from LIFO for financial reporting purposes also means that the advantages of LIFO for tax purposes could be lost to these firms. The purpose of this study is to examine the income, balance sheet, cash flow and tax effects of a required move to FIFO from LIFO. Presently, approximately 36% of U.S. companies use LIFO for at least a portion of their inventories. We examine a sample of 30 such companies with the greatest LIFO exposure. We find that on average, had FIFO been used by these firms in 2007, pre-tax income and net income would be higher by 11.97% and 7.42%, respectively, the current ratio would be higher by 26.2% and shareholders’ equity would be higher by 34.2%. Of particular note is the significant amount of income taxes that these firms would owe, ranging up to the hundreds of millions if not billions of dollars, if they were required to adopt FIFO accounting. Accordingly, investors, lenders and other users of financial statements will want to watch developments on this front carefully.
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