Illustration by Bloomberg View
Illustration by Bloomberg View

Suppose you are in the widget business. Thousands of the items are piled up in your storeroom. You buy them for $1 each and sell them for $2 each. Then, one day, the widget wholesaler raises his price. It now costs you $1.20 per widget, but you still keep them piled up in your storeroom and you still sell them for $2. (It’s a competitive business.)

Question: What is your profit on the sale of each widget? Is it $1 ($2 minus $1) or 80 cents ($2 minus $1.20)? You might say that depends on whether you sold an old widget or a new one. But they’re identical. You can’t really tell old from new. And if they’re identical, why should it matter which group -- old or new -- the widget came from?

Believe it or not, this accounting puzzle has become part of the budget debate. Right now, international accounting standards call for use of FIFO accounting. That stands for “first in, first out.” The widgets you bought first are presumed to be the ones you sell first. In the U.S., however, about one-third of all businesses use the LIFO method, “last in, first out”: The newest widgets on the top of the pile are presumed to be used first.

In a world where prices are usually going up, the difference in your taxes between LIFO and FIFO can be startling. When prices are rising, companies that use LIFO will record higher inventory expenses and lower earnings compared with companies that use FIFO. That means lower taxes, too.

Minor Change

The Obama administration wants to join the rest of the world in forbidding LIFO accounting. The White House made the proposal part of a loophole-closing package and had hoped that Republicans would be able to convince themselves that the change didn’t constitute a tax increase. This seemingly minor tweak to the rules would raise about $53 billion in new revenue by 2016, according to the Treasury Department.

The business community, naturally, is opposed -- especially manufacturers, oil and gas companies, and other businesses that carry large inventories. In 2010, about 12 percent of the companies on the S&P 500 Index had a total of $62 billion in LIFO reserves, which represent the difference between inventory valued at LIFO and an alternative method such as FIFO.

Energy companies alone account for more than 82 percent of these reserves, and make up eight of the top 10 companies with the largest LIFO reserve, according to an analysis by Bloomberg Government. To understand the benefits of the accounting rule, consider the case of Exxon Mobil Corp., whose $21.3 billion LIFO reserve is the largest. According to data compiled by Bloomberg, the energy giant’s taxes could increase by $7.5 billion over the next decade if it could no longer use LIFO. Such an increase would have reduced Exxon’s earnings by 24.5 percent if the tax had been paid in full in 2010.

Fair Points

Is LIFO a loophole? Well, not exactly. Put two accountants in a room with a bottle of scotch and you can get a pretty good argument going, with fair points on both sides. But there is no reason that the U.S. should be out of step with the rest of the world on this. In particular, there is no reason this accounting quirk can be justified as yet another subsidy for small businesses. Therefore, we support the Obama administration’s position. In any event, the Securities and Exchange Commission is looking into the matter and may forbid LIFO soon anyway.

Why then, if LIFO is such a great deal for business, do two-thirds of businesses not use it (while they can)? For some, it wouldn’t make much difference. For others, the answer seems to be a cynical and short-term decision by management. Although LIFO accounting saves the company money, it does so by making the company’s profit seem smaller. Management would rather have a higher profit on paper, even at the cost of lower real return for the stockholders once taxes are paid.

Sure, the money generated by ending LIFO is minuscule in comparison with the trillions in spending cuts and revenue raisers that President Barack Obama and Congress are bandying about in the debt-ceiling talks. But the LIFO-FIFO debate is a good example of why tax simplification will never be as easy as it is sometimes made to sound. It illustrates once again that the reason our income-tax system is complicated has little to do with multiple rates, but comes down to the difficulty of defining what constitutes income in the first place.

To contact the Bloomberg View editorial board: view@bloomberg.net.