LIFO Effect on Oil Company Profits Draws New Scrutiny

Last week’s drop in oil prices resulting from the terrorist plot against airliners bound for the U.S. is likely to prove temporary, as economists predict continued escalation in global demand for fuel. And U.S. oil giants are expected to enjoy healthy profits, some of which are protected from taxation because the companies record their inventories based on the Last In First Out (LIFO) method, a tax benefit designed to protect cash flow in industries where prices increase rapidly.


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Efforts in Congress to repeal the provision failed twice last year, but discussion of repeal continues in Senate Finance Committee hearings on broad tax reform, and news that Exxon recorded the highest LIFO reserve in history, $15.4 billion, has prompted charges that the company seriously understated income for the second quarter, according to the Wall Street Journal.

Companies have used LIFO for both tax and financial statement reporting purposes since the 1930’s. Under LIFO they are permitted to record the cost of inventory at the most recent price paid even though, in the case of oil reserves, some of the inventory was purchased when oil was selling at a much lower price. The higher cost of goods sold under LIFO results in lower reported profit than under the alternative First In First Out (FIFO) method where a company records the value of inventory at the purchase price, CFO.com says.

International Accounting Standards used by European companies like BP PLC and Royal Dutch Shell do not allow the use of LIFO. Net profits at these companies are not directly comparable to the profits of U.S. companies.

The Senate Finance Committee returned to the subject of LIFO repeal in June when it heard testimony from George Plesko, an accounting professor at the University of Connecticut, who estimated a potential revenue gain from LIFO repeal of about $18 billion before credits, CFO.com says. Plesko used public company data amassed from 1975 to 2004 by the American Institute of Certified Public Accountants (AICPA).

PricewaterhouseCoopers (PwC) is collecting data from the types of companies that use LIFO, approximately 8.7 percent of 5,000 publicly traded companies. According to its Web site, the big four firm intends to “organize and represent a coalition of companies to support the retention of LIFO and refute the testimony of Dr. Plesko.”

LIFO repeal would leave companies that depend on the tax savings in the position of having to generate the revenue from somewhere else, David Auclair, a principal at Grant Thornton, told CFO.com. “It might impact prices to customers, which might lead to further inflation, and it could impact on their [firms] ability to sell, which could impact their earnings.” Auclair sees the greatest impact of LIFE repeal on small and mid-sized businesses.

In an interview with CFO.com, Plesko said that he wasn’t proposing LIFO repeal. “There is no attempt to repeal [LIFO] but a desire to think about broad-based tax reform going forward. If you want to talk about broadening the base to lower the [tax rates], then you have to think about LIFO.”

Resistance to LIFO repeal may derive in part from reminders of how fragile the world’s oil supplies can be, most recently, with the shutdown of the aging BP oil pipeline from Prudhoe Bay.

Congress has lifted restrictions on offshore oil and gas exploration, an acknowledgement that the United States will be running on oil for the foreseeable future, even with greater reliance on renewable energy sources, says Dale McFeatters, in an editorial written for sitnews.com in Ketchikan, Alaska. “The trans-Alaska pipeline showed that oil can be drilled and transported in environmentally sensitive and climatically difficult regions, but it takes regulation, inspection and a vigilance over the industry” McFeatters writes.

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