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RILA opposes proposals to repeal long-standing accounting methods applicable to retailers, namely the last-in/first-out (LIFO) and the lower-of-cost-or-market (LCM) methods of accounting. LIFO and LCM are essential inventory-accounting methods used for decades by companies throughout the United States for financial reporting purposes as well as for determining their federal tax liability. Because of the nature of the business, LIFO and LCM (particularly under the retail inventory method) are widely used within the retail industry.
In his Fiscal Year 2012 budget, President Obama again proposed to repeal LIFO and LCM, /1/ and the budget assumes both changes would be effective beginning in 2013. The Administration has also raised the LIFO proposal as part of the debate surrounding extension of the federal debt limit for purposes of raising additional revenues.
The Obama Administration estimates /2/ that LIFO repeal would raise more than $52.8 billion through 2021, significantly less than the $69.7 billion estimated by the Joint Committee on Taxation (JCT). /3/ Similarly, the Administration estimates that LCM repeal would raise more than $8.2 billion over 10 years, while the JCT estimated substantially less, approximately $3 billion over 10 years. /4/ The difference in the estimates is likely due to differing assumptions regarding the use of LIFO and LCM by U.S. businesses.
RILA, along with the broader business community, has made headway with many congressional tax-writers in opposing the repeal of inventory accounting methods. However, both of these proposals remain a threat given their significant revenue-raising potential and Congressional deliberation over debt and tax reform.
RILA urges members of Congress to oppose repeal of these widely accepted inventory accounting methods, which the tax law and regulations have permitted companies of all sizes throughout the U.S. economy to use since as early as 1918. Any income-based tax system must include accounting methods that enable businesses, which purchase and sell millions of items of inventory every day, to determine the cost of such inventory and the resulting income or loss in an efficient manner so that taxable income can be reflected accurately.
A fundamental principle of accounting is to match the sale of an item with its cost in order to produce a clear reflection of the selling company’s income. Because of the difficulty in accounting for inventory on an item-by-item basis, businesses are permitted to use several different methods to identify the cost of the inventory sold, including the first-in/first-out (FIFO) method, the last-in/first-out method (LIFO), and the retail inventory method. For purposes of determining a company’s remaining inventory at year end, financial and tax accounting rules also permit businesses in certain cases to write down the book value of an inventory item – under the lower-of-cost-or-market (LCM) method – to take into account a decrease in the economic value of the item offered for sale.
Last-in/First-out Accounting Method
Under the LIFO method, a business assumes that the last item added to inventory is the first item sold. Thus, current sales are reduced by the cost of the most recently acquired inventory to determine the net income from the sale. (Under the FIFO method, the business assumes that the first item added to inventory is the first item sold.)
When inventory costs are rising, as in an inflationary period, the LIFO method results in lower taxable income since the cost of goods sold reflects the more recent, higher inventory values. Conversely, if inventory costs decline during a year, LIFO will increase taxable income as current lower-cost inventory values are used to determine the business’ cost of goods sold. Under the Internal Revenue Code, a business may only use the LIFO method if it also applies it for financial-accounting purposes, and once adopted, taxpayers may not switch between inventory accounting methods without consent of the Internal Revenue Service.
For many retail businesses, LIFO is a more accurate method for measuring financial performance and calculating the associated income tax. LIFO takes into account the greater costs of replacing inventory, thereby giving a more conservative measure of both the financial condition of the business and the economic income subject to tax. Absent LIFO, phantom profits would be taxed. In addition, LIFO improves a company’s cash flow, which allows the company to use its retained capital more efficiently to finance ongoing inventory replenishment.
LIFO repeal would mean a forced change in fundamental tax accounting for any business that has historically relied on LIFO for its tax reporting, including countless retailers. As a result, such businesses would have to recapture their LIFO reserves. The result would be substantial additional income tax, even if spread over several years, especially for businesses that have relied on LIFO for many years or even decades. In effect, elimination of LIFO would amount to an enormous retroactive tax increase by repealing fully authorized deductions from income with respect to products sold, in many cases years or decades in the past. Moreover, since companies would have no economic income from such an accounting adjustment, they would effectively be taxed on non-existent cash flow.
Moreover, LIFO repeal will create future tax increases for businesses if inflation accelerates as some expect due to the fiscal imbalances facing the United States. Since inflation increases prices, a business that can no longer utilize LIFO will have to calculate its taxable income based on older inventory costs that do not reflect the inflationary growth in prices, resulting in a higher future tax bills.
Lower-of-Cost-or-Market Accounting Method
Retail businesses that do not use LIFO, often apply the LCM method to write down the book value of their ending inventory that has declined in economic value. Under this accounting method, the business determines the market value of its inventory at the end of the business’ tax year (generally the cost of replacement or reproduction of the item or comparable sales), and then writes down that value to the lower of the inventory’s original cost or the current market value. The tax law also permits a business to write down the cost of certain “subnormal” goods, such as those that cannot be sold in the ordinary manner due to damage, imperfections, shop wear, changes of style, odd or broken lots, or similar causes). In addition, retailers are permitted to use LCM under the retail inventory method. Unlike the use of LIFO, a business applying the LCM method or subnormal goods method for tax purposes is not required to use it for financial reporting purposes.
In explaining the reasons for the Administration’s FY 2012 budget proposal to repeal the LCM and subnormal goods methods, the Treasury Department stated that “[t]he allowance of inventory write-downs under the LCM and subnormal goods provisions is an exception from the realization principle, and is essentially a one-way mark-to-market regime that understates taxable income.” /5/ To the contrary, these accounting methods, which originated from the principle of conservatism in financial accounting, have evolved to provide relief to businesses in situations where the value of their inventory has declined to create a measurable loss.
The LCM and subnormal goods methods provide an important cushion during economic downturns, including the current economic environment. Without these methods, businesses are precluded from recognizing the loss until disposal of the inventory. The loss in value is a real economic loss, and these methods allow businesses to recognize the loss in the year it occurs. Moreover, any recovery in the value of the inventory in a subsequent year is not lost. Rather, the business will recognize a larger amount of taxable income in the year the inventory is sold.
Repeal of the LCM and subnormal goods methods would mean higher taxes on a retailer that would no longer be able to account for a current economic loss in inventory value, but instead would have to wait until it is able to dispose of such items. In addition, during economic downturns, the value of the LCM write-down will also grow, especially under the retail inventory method as retailers are forced to mark down retail prices. Thus, the repeal of the LCM method will have an even greater adverse effect on businesses’ tax liabilities in a down economy, at a time when businesses can least afford additional tax liabilities.
Legislative and Regulatory Activity
In recent Congresses, significant legislative efforts have included LIFO and LCM repeal as a means to generate revenue. In 2006, Senate leaders proposed repealing the LIFO inventory accounting method to pay for a $100-per-family gas-tax rebate. They eventually dropped the proposal because of backlash from the business community, including a strong response from RILA.
During the 109th Congress, former House Ways and Means Committee Chairman Charles Rangel (D-NY) introduced a $1.3 trillion tax measure, the Tax Reduction and Reform Act of 2007 (H.R. 3970), /6/ which was partially offset by repealing LIFO and LCM over an eight-year period. Although the legislation did not receive a hearing or markup, it continues to serve as a marker for a broader tax-reform agenda.
President Obama’s Fiscal Year 2012 budget follows his first two budget submissions, which also included LIFO repeal to help pay for other policy priorities. The Fiscal Year 2010 and 2011 budgets similarly proposed the repeal of the LCM method, while specifically designating the resulting revenue in 2010 for the Obama Administration’s health care reform initiative. (Repeal of the LCM method was also included in budget submissions by the Clinton Administration.) Additionally, in its final report released in December 2010, the President’s National Commission on Fiscal Responsibility and Reform proposed in to repeal LIFO as part its principles for business tax reform. /7/
On a separate track, the U.S. Securities and Exchange Commission (SEC) has been considering the adoption of International Financial Reporting Standards (IFRS) to replace the United States’ Generally Accepted Accounting Principles (GAAP). /8/ If adopted, IFRS would mean an end to the LIFO accounting method for SEC registrants since LIFO is not allowed under the international accounting rules. (The LCM method would continue to be permitted under IFRS, with certain modifications.) However, it is unlikely that Congress would refrain from acting on LIFO repeal or modification while the SEC considers such a change given the amount of revenue that the repeal would generate under the current congressional budget rules.
For more information, please contact Mark Warren, tax consultant, at mark.warren@rila.org.
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