Come On, People, Get a LIFO

While accounting policy is not a normal area of comment for me, there was a story in today's Wall Street Journal about LIFO accounting that just made my blood boil. The implication of the story is that Exxon is systematically understating both their profits and taxable income by utilizing LIFO accounting for inventory. Let me say in advance that I am neither a defender nor a critic of Big Oil, but that this article and related commentary is such a piece of garbage that it almost defies comment (but not quite).

The 2 second summary of LIFO is this: LIFO means "Last In, First Out." The idea is to try and match revenues with costs, and given that the acquisition cost of inventory varies over time and generally bears some relationship to the revenues generated that it makes sense to match current revenues (i.e., the money garnered from the retail pump at today's prices) with current costs (i.e., the prices paid most recently for oil delivered to retail, be it at spot or delivered pursuant to forward contracts). This, friends, is called Generally Accepted Accounting Principles (GAAP), which is the basis upon which financial statements are (or, at least, should be) prepared.

Companies have a choice of inventory valuation methods - FIFO, LIFO, Average Cost, etc. - and depending upon your perspective arguments can be made for each. Further, depending upon whether one's cost of inventory is rising or falling, the impact of LIFO may be to "overstate" profits and taxable income (relative to the average carrying value of inventory). However, it cannot be disputed that income statement presentation and earnings power is most accurately reflected using LIFO due to the fact that it reflects TODAY's environment. Any other method distorts the picture and makes financial statements much less useful for the financial analyst.

The thing that really irks me is that nobody seems to have a memory here - this witch hunt goes on EVERY UP CYCLE IN PRICES. Did anybody squawk when oil prices fell from $40 to $10 per barrel in the mid-1990s, and poor Exxon was reporting higher profits and paying higher taxes? No, but they sure did in the 1970s. Can't we stop wasting time and column inches by re-hashing old issues that have no intellectual currency? Listen: Exxon is making a lot of money. Yes, they have a large LIFO reserve and a matching deferred tax liability due to their choice of accounting method. SO WHAT!?! Their acccounting is clear, consistent, GAAP-compliant and provides better income statement and earnings power information than any other method. So let's move on, shall we?

Comments

[Yaser Anwar]

The oil industry is highly cyclical. As energy companies are clocking up big profits now at a high price, they were bleeding red ink when barrel prices were around $10 less than a decade ago, like Mr. Ehrenberg pointed out.

Senate leaders proposed a $100 gas-tax rebate for every American family in May, they intended to do so by repealing the LIFO inventory-accounting method for oil companies. These drastic measures have been taken by congressmen this year, especially due to upcoming midterm elections.

Instead the congressmen should encourage consumers to hedge their gas budgets by owning shares in the oil companies which operate as income trusts. Examples: BPT (even with their pipeline troubles, BPT still looks great) & SJT, to mention a few. These stocks not only offer great dividends but reward investors with the upside of oil, alongside being a hedge.

Investors should note this tax has been tried and failed. President Jimmy Carter imposed a very similarly structured tax in 80s, resulting in huge compliance costs, minimal federal revenue and a steep decline in domestic oil production. The Congressional Research Service estimated that the impact of the tax was an annual decline in domestic oil production of between 3% and 6%.

It is preposterous for the Government (President G.W. Bush was not in-favor) to retroactively prohibit a business practice that is consistent with proper accounting principles, as Mr. Ehrenberg pointed out, and moreover violates the foundations of capitalism on which American firms have thrived over decades.