100
Fall AIS 2011
Current Event 2: Inventory
Topic
Inventory cost flow assumptions, Inventory tax, Income tax, IFRS, Oil Industry
Directions:
After reading chapters 5 and 6 in the textbook, please read the following article
related to inventory practices in the oil industry. Please answer the questions
following the article.
Accounting Method Sucks Up Oil
Abstract (summary)
"Year after year, we see crude inventories in the Gulf Coast region decline in
December...and it doesn't mean a darn thing in terms of whether the global oil market is
tight or not," said Tim Evans, an oil analyst at Citi Futures Perspective.
Full Text
Author: Dan Strumpf
NEW YORK--An accounting practice is making the millions of barrels of excess crude
that have flooded the oil market disappear--for a few weeks, anyway.
To avoid a tax charge tied to rising oil prices, refiners and other companies that store
crude are scrambling to make sure they end the year with the same inventories that they
had at the start. Stockpiles on the Gulf Coast plunged nearly 7 million barrels in the week
ended Nov. 12, the region's biggest drop in over two years, according to the Energy
Information Administration. Another 25 million barrels need to go for this December's
inventories to match last year's. But if past years are any indication, inventories are likely
to rise just as quickly with the start of the new year.
The oil market has been waiting months for just such a drop in supplies along the nation's
main refining corridor. Prices are poised to soar on any indication that rising demand
from the recovering economy is bringing a two-year-old o il glut to an end.
But the recent draws aren't that sign, and it's being reflected in the price of oil. Crude
prices are off 7.2% since ending at a two-year high on Nov. 11, trading late Friday at
$81.51 a barrel. Futures nearly fell below $80 a barrel for the first time in a month on
Wednesday--after the government inventory report--as U.S. demand looked weak.
"It's not any huge surge in demand that's causing the drawdown," said a spokesman for a
large refiner that is reducing inventories for tax reasons.
Companies usually reduce stocks by importing less oil, then drawing on inventories to
refine into fuel. Last week, oil imports hit an 11-month low, the EIA said.
The refiner, like much of the oil industry, uses a form of accounting called "last in, first
out," or LIFO, to value their inventories. The practice allows a company to claim each
barrel of oil they sell was the most recent one purchased. That creates an incentive to
lower end-of-year inventories when prices climb because the more expensive oil is the
"first out," allowing the remaining oil to be taxed at a lower rate.
Oil inventories are typically valued each year using prices at the start of the year, said Les
Schneider, partner at the Washington, D.C., law firm Ivins, Phillips & Barker and an
expert on inventory taxation. If a refiner builds up one million barrels of oil inventories
over the course of 2009, it could value that crude at the January 2009 price of roughly
$40 a barrel. But if the refiner ends 2010 with 1.5 million barrels in storage, the
additional 500,000 barrels would be valued at around $80 a barrel, the January 2010
price.
In addition, oil companies face taxes in Gulf Coast states based on the level inventory
they of have in storage, providing another incentive to draw down year-end inventories.
Crude stockpiles fell sharply in November and December in three of the past four years,
only to quickly rebound. Inventories are down nearly 3% nationwide in the past two
weeks of government data, though they remain well above the historical average.
"Year after year, we see crude inventories in the Gulf Coast region decline in
December...and it doesn't mean a darn thing in terms of whether the global oil market is
tight or not," said Tim Evans, an oil analyst at Citi Futures Perspective.
The Obama administration has periodically tried to end LIFO accounting, and earlier this
month, the co-chairs of a presidential commission charged with finding ways to reduce
the deficit proposed doing away with the practice.
Companies that use LIFO, however, have opposed its repeal, [...] The American
Petroleum Institute, the main oil-industry lobbying group, has argued that repealing LIFO
would result in a "significant upfront tax increase."
Write to Dan Strumpf at [e-mail]
Credit: By Dan Strumpf
(c) 2010 Dow Jones & Company, Inc. Reproduced with permissio n of copyright owner.
Further reproduction or distribution is prohibited without permission.
Current Event Questions
1. The article mentions two different ways that drawing down inventory levels
at year-end provides tax incentives to oil companies. The following
questions relate to these tax incentives.
a. How does drawing down inventory levels at year-end enable
companies to avoid inventory holding taxes?
b. How does drawing down inventory levels at year-end enable
companies to reduce their income tax expense?
2. Companies that use LIFO are required to report the LIFO Reserve in the
footnotes to the financial statements. The following questions relate to the
LIFO reserve:
a. What is the LIFO reserve? How does this amount originate?
b. What is the significance of the LIFO reserve in the context of tax
savings under LIFO, as compared with FIFO? (Hint: think about
the basic inventory equation: Beginning Inventory + Purchases
COGS = Ending Inventory)
c. Refer to the discussion of Financial Statement and Tax Effects of
Cost Flow Methods on page 292 of the textbook. What tax
consequences would companies face if they were forced to switch
from LIFO to FIFO?
3. Consider the impact that the choice of LIFO vs. FIFO has on both the
Income Statement and the Balance Sheet. Discuss the relevant
information conveyed to investors under both LIFO and FIFO. What
trade-offs are involved with the selection of one of these cost flow
assumptions? (Hint: think about the basic inventory equation: Beginning
Inventory + Purchases COGS = Ending Inventory)
4. The following questions relate to the U.S. govermnents tax policies
allowing the use of the LIFO method for tax purposes.
a. Analyze and discuss the benefits of disallowing the use of LIFO for
tax purposes from the perspective of the U.S. Government.
b. What arguments can be made against disallowing LIFO for tax
purposes from a U.S. government policy standpoint?
c. In your opinion, should the government continue to allow the use of
LIFO for tax purposes?
5. Refer to the IFRS Key Points on pages 330-331 of the textbook. Discuss
the key differences between accounting for inventory under IFRS and U.S.
GAAP.