Accounting matters. Case in point: Dozens of companies have switched from a last-in, first-out, method, or LIFO, to the more common approach of first-in, first-out, or FIFO, model of accounting for their inventory amid high inflation that could affect the appearance of the bottom line in financial reporting, according to research from investment research software company Bedrock AI.
The difference between the two methods is whether a company reports its oldest inventory—presumably bought at the lowest prices—as what was sold in a given period (FIFO), or whether a company reports its newest inventory—presumably bought at the highest prices—as what sold in a given period (LIFO).
At the heart of the decision is a question of whether to boost short-term earnings amid inflation, as FIFO does by expanding the margin, versus boosting short-term tax savings by increasing costs, as LIFO does.
The trade-off is especially significant in a high-inflation environment, Bedrock AI’s CEO, Kris Bennatti, told CFO Brew: “In a highly inflationary environment, FIFO accounting delays the impact of rising prices on net income while LIFO accounting has a much more punishing impact on earnings.”
Mixed use. The United States is the only country that allows corporations to use LIFO. About 16% of companies in the S&P 500 used LIFO in 2021, according to a report from Credit Suisse, with about 53% using FIFO, and the remainder using a variety of other methods. And while firms like PWC were advising companies to consider switching to LIFO amid high inflation in recent years, no public companies took that advice, according to Bedrock AI's research; they found not a single public company switched to LIFO. Instead, more than twice as many companies switched from LIFO to FIFO in the two years of 2021–2022, as compared with 2019–2020.
"When inflation started, a lot of the accounting firms suggested companies could save on taxes by switching to LIFO, but that hasn’t been borne out in the data," said Bill Mayew, a professor at Duke University. While “LIFO in theory is good at saving taxes,” Mayew said, “In the US, the federal tax rate is low…and the benefit of using LIFO isn’t consequential.”
Companies using LIFO face additional costs of time, effort, and complexity in their accounting practice, Mayew noted, and fewer firms are choosing to go with it, because “while there’s a tax benefit, it’s just not as high as it used to be.”
With a federal corporate rate as low as 21% since the 2017 tax law, alongside ample opportunities to reduce a corporation’s tax bill outside of LIFO, the approach has simply become less popular, Mayew suggested.
In addition to being the standard outside the US, FIFO is popular in part because “you run your firm on a FIFO basis already,” Mayew said. Companies sell their oldest inventory first as a general matter, so “you already have the FIFO information,” he added.
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Mayew said it’s an extra series of steps for accountants to go the other way: “You transform it so you can be LIFO.” Firms have to identify the most recent additions to their inventory, which actually haven’t sold, and perform a series of calculations as though those items had sold, and remove the calculations of what actually did sell. With that extra burden of LIFO compared to the straightforward approach of FIFO, Mayew said, firms switching from LIFO to FIFO face essentially no costs in performing the transition.
Cost benefit. What’s more, companies that report in LIFO are still required to provide the numbers for FIFO within their disclosures, Mayew said, so a company using LIFO is still doing all the work and sharing all the information with the public that it would under a FIFO practice.
As to why companies are switching to FIFO now, when the tax benefits of LIFO could be greatest, Bennatti said, “Lower net income is beneficial from a tax perspective but is harder to present to investors,” and as a result, “the increase in companies switching to FIFO accounting may indicate that the pressure to present competitive earnings figures is outweighing the tax benefits afforded by LIFO.”
But Mayew thinks companies aren’t trying to manipulate the stock markets with the move. Since FIFO is already included in disclosures for companies that use LIFO, Mayew doesn’t think that companies are switching to LIFO in the hope of boosting their headline earnings, to get better treatment in the public markets.
“In a competitive capital market it’s hard to believe that no one would do the work to create the calculation [of converting the FIFO numbers] and make the firm comparable [to its competition],” Mayew said. “No one gets fooled by a LIFO firm when the FIFO numbers are in a footnote.”
Going concern? So, with LIFO being used by a small number of companies and dropping, is there a future for the accounting practice? The Save LIFO coalition, a group of more than 130 industry associations and corporations, certainly hopes so, arguing that repeal of LIFO “would significantly hinder the competitiveness of US businesses in the worldwide marketplace by placing a significantly increased tax liability on those companies that use LIFO.”
The coalition notes that LIFO is especially advantageous for pass-through entities trying to save money on their tax bill.
Mayew said that LIFO is a persistent issue in presidential elections, because “LIFO keeps tax payments low” and, therefore, keeps government revenue lower than it otherwise could be.
However, the argument in favor of continuing to allow LIFO in the US, “might become less and less if firms voluntarily switch over,” Mayew noted.—SW