Can we live without LIFO?

By Rick Johnson -- Industrial Distribution, 3/1/2007

The Sarbanes-Oxley Act of 2002 (commonly called SOX or Sarbox) is a federal law passed in response to a number of major corporate and accounting scandals including those involving Enron, Tyco International, and WorldCom.

The legislation is wide ranging and establishes new or enhanced standards for all U.S. public company boards, management, and public accounting firms.

Some believe the legislation was necessary and useful; others believe it does more economic damage than it prevents; still others observe how essentially modest the act is compared to the heavy rhetoric accompanying it.

At any rate, even privately-held companies are paying much closer attention to their accounting systems as a result.

Now, some legislators want to eliminate LIFO.

LIFO stands for Last In, First Out. It is an inventory costing methodology. The LIFO method selects the most recent purchases whose quantities add up to the total number of items sold during the year.

The last in, or most recent purchases, are the first charged out to expense. The primary theory of the LIFO method is that products sold have to be replaced to continue operating, and that the most recent (i.e., the last in) costs are the closest to the costs of replacing the products sold.

From a tax standpoint, LIFO minimizes tax consequences by using the highest cost of inventory which reduces reported profit.

Recently, Congress toyed with the idea that the elimination of LIFO can put billions of dollars into the tax coffers. If the elimination of LIFO becomes a reality, we are in for a devastating impact on our industry.

In distribution, most of the profit is made on the buy side of the equation and the ability to manage inventory. For many of you, inventory management is your key core competence.

Official statements made by Congress indicate that the issue of eliminating LIFO is no longer part of anyone’s agenda. But the question becomes, “Can we believe that?”

Congress authorized the use of LIFO in 1930. Can you imagine the number of companies that have adopted the LIFO system since 1930? Can you imagine the LIFO reserve that is built up just in our industry? (LIFO reserve is the difference between actual inventory cost based on FIFO—First In First Out—and the LIFO cost.)

Currently, these reserves are merely an accounting transaction. That means they are identified but they do not impact current reported profits. However, if the LIFO system was eliminated these reserves could become taxable as profit.

This could be a significant tax liability for most companies that have adopted LIFO. Many of these companies may not be able to pay these taxes and it could threaten their very existence.

Estimates of the amount of tax revenue that would be derived from eliminating LIFO have exceeded $20 billion, according to a Senate committee.

That estimate included only publicly traded companies. Imagine what the number would be if it included the vast majority of privately-held companies in the United States.

Fortunately, this issue never really got off the ground. President Bush threatened to veto it. However, discussions continue to take place even though they may be outside the realm of meetings and official agendas.

Just the thought of government discussing this issue is alarming, in my opinion. But remember, it can mean billions of dollars, and money talks.

This country thrives because free enterprise is our platform–our foundation, if you will. It scares me when we start talking about messing with any part of that foundation.

Eliminating LIFO would be especially harmful to older industries that adopted it in its earliest years of its existence.

Keep your ears to the ground and pay attention to what is going on in Congress. LIFO has become a business lifestyle for many companies.

We can’t afford to eliminate it now. That can’t possibly do anything but damage our economy.

Rick Johnson is the founder of CEO Strategist LLC., a firm specializing in leadership and the creation of competitive advantage in wholesale distribution. Contact him at rick@ceostrategist.com.