Must LIFO go to make way for IFRS?

AuthorHoffman, Michael J.R.
PositionLast in, first out (accounting

EXECUTIVE SUMMARY

* Based on recent statements and actions on the part of the SEC and FASB, it is virtually certain that some form of international financial reporting standards will be adopted in the United States.

* Currently, IFRS do not allow for the use of the LIFO inventory method, jeopardizing its use for U.S. tax purposes due to the LIFO conformity requirement in Sec. 472. The disallowance of the use of LIFO for tax purposes would result in a large current tax bill for many of the companies that use the method.

* Although Sec. 472 clearly could be interpreted to require strict LIFO conformity, the statute has been interpreted in such a way that many exceptions to strict conformity are allowed.

* Because LIFO conformity is a tax rule and not a financial accounting rule, the possible problems that the adoption of IFRS could cause for taxpayers using the LIFO method could be eliminated if Congress modified or eliminated the LIFO conformity requirement.

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The Internal Revenue Code has rarely linked itself to financial reporting. One significant instance in which such a link does exist is Sec. 472(c), the LIFO conformity requirement. Interestingly, as financial reporting standard setters around the globe work toward one high-quality set of standards, the use of LIFO for financial reporting purposes may be in jeopardy, at least for U.S. entities required to issue financial statements in accordance with generally accepted accounting principles (GAAP). This article examines whether the time has come for Congress to sever that link between tax and financial reporting of inventory.

According to the Code, inventories must be accounted for if such accounting "is necessary in order clearly to determine the income of any taxpayer." (1) Further, the basis on which inventories are valued must "[conform] as nearly as may be to the best accounting practice ... and as most clearly reflecting the income," (2) To bolster this conformity, the Revenue Act of 1939 included the requirement that taxpayers electing to use LIFO for income tax purposes must also use it for financial accounting purposes. (3) Thus, the LIFO conformity requirement has been in place for as long as LIFO has been allowed for income tax purposes. (4)

From the financial reporting perspective, companies publicly traded in the United States must follow the will of the Securities and Exchange Commission (SEC), which has delegated standard-setting authority to the Financial Accounting Standards Board (FASB) in determining GAAP. However, there is a strong movement toward international convergence of accounting standards--that is, to bring GAAP under one set of international standards (iGAAP).

For most developed nations outside the United States, the source of GAAP has become the International Accounting Standards Board (IASB). (5) Under the international financial reporting standards (IFRS), the LIFO method is not allowed. (6) So, taken at face value, if the international convergence of GAAP results in LIFO's no longer being an accepted accounting practice, compliance with the LIFO conformity requirement of Sec. 472(c) becomes problematic. If companies cannot use LIFO for U.S. income tax purposes, they may incur a potentially staggering cost upon the change from LIFO to, presumably, FIFO. (7)

The question that must be addressed, however, is whether international convergence of GAAP necessarily leads to the end of LIFO for U.S. income tax purposes. A careful reading of the statute and regulations bearing on LIFO conformity clearly indicates that little of substance remains in the requirement. The following sections of this article examine the LIFO conformity requirement in order to provide a clear understanding of what this requirement does (and does not) allow in terms of reporting alternate inventory valuations (e.g., FIFO). If internationally converged GAAP does not allow the use of LIFO, can the Treasury resolve the conflict administratively? Or will Congress have to act to remove this conflict? Before turning to LIFO conformity, the article reviews some of the indicators that international convergence of GAAP is all but inevitable.

International Convergence of GAAP--When, Not If

On November 21, 2008, the SEC published a roadmap toward the mandatory use of IFRS by U.S. issuers that could lead to IFRS use among U.S. filers by the year 2014. (8) And much has already occurred that suggests U.S. GAAP and iGAAP will ultimately converge. The SEC recently finalized rules allowing the submission by foreign firms of financial statements prepared in compliance with IFRS, without reconciliation to U.S. GAAP. In numerous places in this release, the SEC made clear its support for the international convergence of GAAP. For example, the following appears in the executive summary:

The Commission has long viewed reducing the disparity between the accounting and disclosure practices of the United States and other countries as an important objective both for the protection of investors and the efficiency of capital markets. The use of a single set of high-quality globally accepted accounting standards by issuers will help investors understand investment opportunities outside the United States more clearly and with greater comparability than if those issuers disclosed their financial results under a multiplicity of national accounting standards, and it will enable issuers to access capital markets worldwide at a lower cost. Towards this end, the Commission has undertaken several measures to foster the use of International Financial Reporting Standards ("IFRS') as issued by the International Accounting Standards Board ("IASB") and fully supports the efforts of the IASB and the Financial Accounting Standards Board ("FASB") to converge their accounting standards. (9) [Emphasis added.] Consistent with this theme of convergence for global comparability, in 2007 the SEC issued a concept release that solicited comments on allowing U.S. firms to file financial statements prepared in compliance with IFRS. (10) In addition, the SEC has held several roundtable discussions on key issues of concern to SEC fliers. Further, recent recommendations made by the SEC's Advisory Committee on Improvements to Financial Reporting include the desire to reduce the options available to companies in accounting for the same issue (e.g., inventory methods), again in the name of comparability. (11)

FASB is a willing participant in the process of GAAP convergence. In his 2007 testimony before the Senate Subcommittee on Securities, Insurance and Investment, FASB chair Robert Herz stated:

[I]n light of the growing use of IFRS in many other parts of the world, we believe that now may be the appropriate time to consider ways to accelerate...

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