Inflationary Economy Makes Small Firms Look for New Accounting Methods

LIFO can save some businesses money, but it's politically controversial.

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When the economy goes sour, small businesses can usually count on a few safeguards. For example, they can often keep their overhead costs down more easily than larger competitors, which might make it easier to weather the downturn. But if prices in the economy are rising while less money is coming into the business, suddenly contingency plans like that don't necessarily apply. That's why few words are scarier to economists and businessmen alike than "stagflation." Unfortunately, that's the word that comes to mind when the Labor Department reports, as it did this week, that prices last month were 5 percent higher than the year before. The last such yearly increase was in 1991.

Inflation hasn't played a major role in the economy for many years, so many of today's entrepreneurs are not prepared to deal with it. So it's surprising that inflation is now the top problem cited by small businesses, according to a monthly survey by the National Federation of Independent Business. It has been 27 years since the survey, the Small Business Optimism Index, found inflation to be such a pressing issue.

Perhaps entrepreneurs should look to the past for guidance. During that last bout of stagflation (stagnant growth coupled with inflation) in the late 1970s, many businesses found an effective way to reduce costs was through accounting. When you calculate your profit margin for your business income taxes, a higher-cost inventory will lower your profit margins on the books—and that means you lower your tax liability. If the cost of your goods is rising, you would want the last items added to your inventory—the ones affected by inflation—to be the ones that show up in your books as the goods you sold. So when a firm facing higher inventory costs uses the "last-in, first-out" accounting method—known as LIFO—it can often reduce its tax burden.

The problem is that many businesses account for their inventories in a way that makes them pay more in taxes than they otherwise could. Most of the world and about 60 percent of large publicly traded firms use a "first-in, first-out" (FIFO) accounting method. As the name suggests, this is the opposite of LIFO: Each good sold is assumed to be the oldest one added to the inventory. But if those goods have experienced inflation, then your profit margins on your books will be higher than they would under LIFO. The result: You owe more taxes.

This method makes sense for businesses such as high-tech firms, whose inventory tends to depreciate over time. FIFO also is commonly used by businesses with small inventories, says Bill Rys, tax counsel for the National Federation of Independent Business.

But for some small businesses, inflation could tip the balance in favor of using LIFO as a cost-saving method. That's exactly what happened the last time the U.S. economy went through a major bout of inflation. LIFO "was very popular in the '70s, and we're seeing interest in it now as inflation becomes part of the economic landscape," says Brian Reardon, principal at Venn Strategies, a political consulting firm. Already, most grocery stores use LIFO, says Chris Henderson, operations manager at Source Corp., a Houston tax services firm that promotes LIFO.

LIFO is politically controversial, though. Last fall, Rep. Charles Rangel, a New York Democrat who is chairman of the House Ways and Means Committee, put forth a bill he dubbed "the mother of all tax reforms." Among its many provisions was one removing LIFO as an option for businesses.

Why do some in Congress oppose LIFO? One reason is that banning it could unleash a stream of revenue. George Plesko, professor of accounting at the University of Connecticut, testified before the Senate Finance Committee that the amount of additional income that publicly traded companies would have to report if LIFO was eliminated would amount to $60 billion in one year alone. That number doesn't even include all businesses that use LIFO.

So far, this legislation hasn't gone anywhere. That might change, however. The issue seems to have been kicked down the road to be debated during the fight over tax legislation that will occur after the November elections. "LIFO will be part of the major tax reform of the next Congress," says Les Schneider, a tax attorney at Ivins, Phillips & Barker in Washington, D.C.

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