Accounting Hanky-Panky

Today is Science Sunday. I should be blogging about pathology today. But I'm too tired to focus. The new policy at work is to hire new help at a dollar per hour less than starting wages were at the company twelve years ago. The result has been predictable.

The parade of disillusioned or incompetent employees has resulted in an expanded workload for me. Combined with the constantly changing hours and the resultant interference with my sleep patterns, I've been alternately ill, tired, or demoralized. Not exactly the kind of fuel one needs for writing.

My displeasure with myopic corporate types has thus lead to inspiration for a post about a little-known (among business laypersons) practice for avoiding taxes: using the most expensive inventory to deduct against taxable income - even though the inventory hasn't sold.

Here's how it works: a business is subject to inflationary pressures when it purchases inventory. The most recently purchased inventory is likeliest to be the most expensive. So a company elects to use an inventory accounting method called LIFO. Short for Last In, First Out, this method expenses the most recently purchased inventory for tax purposes, artificially reducing net income to reduce a company's tax liability.

Nobody enjoys paying taxes. But when one person or corporate entity gets it over on the tax man, that individual also gets it over on the rest of us. That's why this practice is not permitted in other countries. Here, however, where "the business of America is business," it is no surprise that business interests have convinced the government to allow this practice.

Just to show how ingrained this LIFO practice is, I'll share something else. One of my accounting textbooks calls the income that results from using the FIFO method "phantom income"(FIFO stands for First In, First Out, which is how inventory is actually sold in the overwhelming majority of cases). The complaint is that replacement costs for the inventory will be higher.

My view? Tough crap. Future costs aren't relevant to currently reported net income. But the perception of authority has reinforced this rhetoric with the next generation of accountants.

Because you, my loyal reader(s), may not be versed in accounting, I offer the following example of how inventory accounting methods for the very same business offer different outcomes (shamelessly self-plagiarized from my own post in an online class at Phoenix):


LIFO Inventory Table
Units - - Cost
100 - - - $4
100 - - - $5
100 - - - $6

year-end units 150 (this means 150 units were left over at the end of the year)
LIFO value $650 (we used the most recently purchased units to determine the value of the inventory sold, even though we may not have sold those units, so we use the earliest values to price remaining inventory - the cost of what we bought first)

We sell our inventory at a retail price of $6.67, yielding a gross income of $1000 for the year. Our end of year figures look something like this:

Gross sales - - - - - - - $1000
Less: COGS - - - - - - -$850
Net sales - - - - - - - - -$150
Less: income tax (5%) $8
Net income - - - - - - - $142

Beginning cash - - - - - - - -$1000
Add: gross sales - - - - - - -$1000
Total - - - - - - - - - - - - - -$2000
Less: inventory purchases $1500
Less: income tax - - - - - - $8
Ending cash - - - - - - - - - $492

We ended the year with $492 in cash (yeah, we didn't do too well). Remember that number and compare it to the same business year below, using a different inventory valuation system:

FIFO Inventory Table
Units - - Cost
100 - - - $4
100 - - - $5
100 - - - $6

year-end units 150
FIFO value $850


Gross sales - - - - - - - $1000
Less: COGS - - - - - - -$650
Net sales - - - - - - - - -$350
Less: income tax (5%) $18
Net income - - - - - - - $332

Beginning cash - - - - - - - -$1000
Add: gross sales - - - - - - - $1000
Total - - - - - - - - - - - - - - $2000
Less: inventory purchases $1500
Less: income tax - - - - - - -$18
Ending cash - - - - - - - - - -$482

Due to income tax savings incurred using LIFO, the business made more in the first example than in the second. No mystery, then, why so many businesses use this valuation method. Now extrapolate these figures to the millions or billions that large enterprises make . . . see how much more your share of taxes becomes when businesses are permitted to engage in this accounting hanky-panky?

The trickle-down crowd will argue that we end up getting paid more if the corporation keeps more, but that is hogwash. CEO compensation has outpaced everybody else's pay in absolute and comparative terms in the last two decades, putting that economic theory firmly to rest. Capitalism works because people are greedy. Acknowledging this makes for better economic policy - which means adhering to capitalism, but mitigating its effects.

Disagree if you must. But break out your wallet in the meantime - you and I have tons of government debt to pay for.