How an inventory twist is putting new LIFO into companies' tax returns
Their names sound like a couple of friendly old dogs. But one of them could fetch US industry some $21 billion in tax savings, while the other trots off and gives the money to Uncle Sam.
They are FIFO and LIFO, abbrevations for two accounting methods that keep track of inventory and profits. In these inflationary times, a growing number of companies are switching to LIFO. Even now, many of them are spending warm summer days refiguring their 1980 taxes, thanks to deadline extensions granted almost automatically by the Internal Revenue Service.
With LIFO (last in, first out), inventory purchased last is considered to have been sold first. This legal bookkeeping maneuver reduces the margin between the wholesale price and the retail price. In doing so, it also reduces a company's net income and profits, which looks bad; but it also reduces taxes, which is good.
Under FIFO (first in, first out), inventory purchased first is regarded as having been sold first. Because the older inventory was cheaper, the profit margin in wider. While this gives the company a higher net income on its balance sheet, the taxes on the income are higher, too.
The number of converts to LIFO has been growing slowly in recent years. But the pace has stepped up some these days because of double-digit inflation.
"I'm meeting the accountant at the airport this afternoon," said Peter Williamson, treasurer at Early Winters Inc., a Seattle mail order business and retail store. The company sells camping gear and other outdoor recreation equipment. The accountant, Mr. Williamson explained, was going to lead Early Winters through the complicated process of changing to LIFO. But when it is over, he believes, "the marginal profits we've been showing in recent years may turn out not to have been profits, but losses."
Why, then, would a company want to go to the trouble and expense to show apparently inferior performance?
One reason might be that US businesses would have save about $21 billion in taxes last year by using LIFO, says Charles Babin, a partner with H. C. Wainwright & Co., Economists, a Boston economic consulting firm. "Inflation creates illusory profits," he says. This makes the effective corporate tax rate "substantially higher" than the 46 percent currently charged.
A Pitney-Bowes Inc., which announced the switch to LIFO in January after "looking at it for several years," the change saved $2.5 million in 1980 taxes," said James Bass, senior vice-president. He expects that LIFO could save an additional $9 million this year.
Supporters of LIFO charge that some of those companies sticking to FIFO are shortsighted, preferring favorable quarterly earnings reports that sometimes boost stock prices over long-term benefits. In most cases, the switch to LIFO results in a sudden drop in earnings, which can produce a sharp drop in the company's stock price.
At Pitney-Bowes, for instance, earnings per share dropped 14 cents after LIFO , a relatively slim drop compared with the remaining earnings of $4.31 a share.
Explanations of how LIFO and FIFO work vary, but a common one uses the metaphor of a conveyor belt and a rock pile.
Under FIFO, a company's inventory is looked at by the accountant as if it were on a conveyor belt. The first item on the belt (or in the warehouse) is the first one sold.
With LIFO, the inventory is regarded more like a rock pile. The last item on the pile is the first one sold.
Company A, for instance, keeps a constant supply of 10,000 baskets in its warehouse. At the beginning of 1980 it paid its supplier $10 for each basket and sold it for $15. But during the year, the wholesale price climbed to $14. To stay competitive, Company A only raised its retail price to $17, lowering its profit from $5 to $3 a basket.
Under FIFO, the company would have to report the profits for the entire year, the high as well as the low. But with LIFO, it could figure its profits as if it had paid that higher $14 wholesale price all year. With both FIFO and LIFO, the money paid to the supplier would be the same; the income from customer sales would be the same. Only the profit would be different -- lower -- under LIFO, lowering the tax obligation, as well.
This oversimplified example does not take into account the complicated accounting procedures needed to survey a company's entire inventory, including the raw materials and parts required to manufacture a variety of products.
LIFO is particularly useful for businesses with a low turnover of inventory or which cannot raise prices frequently. At Early Winters, for example, the company can raise its prices just twice a year, since the vast majority of its sales are through catalogs sent out every six months. "And if one of our suppliers raises his prices right after we send out the catalog we're cooked," Williamson said.
Not everyone agrees that LIFO is for all industries. "In certain firms, it's not necessarily a valid way to go," said Roger Kennedy, president of Pro-Com Services Inc., an El Paso, Texas, computer services firm. His company provides a number of computerized services for small businesses, including LIFO bookkeeping.
Many high-technology companies, which have a high turnover of inventory as well as wholesale prices that move both up and down, would probably do better with FIFO, he said. Mr. Kennedy is familiar with one Texas industry that would not benefit from LIFO: makers of cowboy boots.
"The price of hides goes up and down so much, these firms need to be able to keep up with the changes," he said. They can only do this with FIFO.
Still, he added, there are many firms that need to switch to LIFO. But they cannot do it because of the complicated procedure involved and the risk that if they do the conversion wrong, the IRS, which understandably does not want to actively encourage methods of reducing its tax revenues, will penalize them.
"You've got to be careful you don't mess it [the conversion] up," Pitney-Bowes's Mr. Bass said. "Because if you do, the IRS will throw you off LIFO for not having 'book-to- tax conformity.' "This means the company's account books do not correspond to the taxes it paid. While a large company like Pitney- Bowes can have sophisticated accountants to help with the changeover, smaller ones often have trouble finding this help.
I"I looked all over the Seattle area and I couldn't find someone who would help us switch to LIFO," Mr. Williamson of Early Winters said. Thus, the accountant he met at the airport the other afternoon was Irving L. Blackman, senior tax partner of the Chicago accounting firm of Blackman, Kallick & Co. Mr. Blackman recently collaborated with John R. Klug to produce a 350-page manual for applying LIFO. The $249 loose-leaf book, published by Mr. Klug's Continental Communication Group Inc., in Denver, is a step-by- step guide for manufacturers, wholesalers, and retailers.
"LIFO's time has come," Klug says. "If there was no inflation, there would be no reason to adopt LIFO. But it looks like inflation is going to be around a while."