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The Wall Street Journal: Big Oil’s Accounting Methods Fuel Criticism

LIFO Leaves the Likes of Exxon
With Big Balance-Sheet Reserves
As Gas-Pump Prices Slam Drivers
By DAVID REILLY
August 8, 2006; Page C1

A string of record profits at Exxon Mobil Corp. has drawn howls from some politicians, but earnings at the world’s largest oil company are, by at least one measure, understated.

Like many U.S. oil companies, Exxon uses an accounting method to value its inventory that has the effect of raising the company’s costs when the price of oil is rising. Those higher costs lower net profit and trim Exxon’s tax bill. In 2005, for example, the accounting method lifted Exxon’s costs by $5.6 billion. If Exxon hadn’t used this approach, a back-of-the-envelope calculation shows its net profit could have neared $40 billion rather than the $36.1 billion it reported.

At four other leading U.S. oil and gas companies, the same accounting method raised costs by a combined $6.8 billion in 2005, according to data from research provider Capital IQ.

There is nothing improper or even unusual about the method, known as last-in, first-out — or LIFO. Companies have used it since the 1930s, and LIFO is permitted for both financial-reporting and tax purposes. But the run-up in oil prices, which leads to higher LIFO-related costs, is fueling debate within tax circles over its use. And lawmakers have tried to do away with the accounting approach to increase the flow of revenue to the government.

An Exxon spokesman said the company’s results are “absolutely not” understated and the company is simply following Securities and Exchange Commission and tax rules in its use of LIFO. He declined to comment on any hypothetical profit Exxon might have generated were it not using the accounting method. The spokesman said use of LIFO isn’t an oil-company issue; “it affects all U.S. businesses.” Any move to repeal LIFO would be “unwise tax policy” that would “adversely impact all industry,” he added.

Companies that use LIFO record the cost of inventory at the latest price paid for those materials in the open market, even though they are selling goods often bought at a lower value. This increases a company’s cost of goods sold, which in turn reduces profit. The upside: higher cash flow because of reduced taxes. Under another inventory-accounting method — used by most public companies — the cost of inventory is recorded at a price that matches initial purchase prices. That is usually a lower price, so this method results in lower costs and higher profit.

International financial-reporting standards, such as those used throughout the European Union, don’t allow the use of LIFO. Thus, net profit at BP PLC and Royal Dutch Shell isn’t directly comparable to those oil majors’ U.S. peers.

While other private companies employ LIFO, oil giants have become a focus largely because they must provide data showing the method’s impact. In its 2005 results, Exxon said the cumulative difference — or “LIFO reserve” — between the value of inventory it was carrying on its balance sheet based on initial cost versus the current replacement cost of that inventory was $15.4 billion. That is the largest LIFO reserve of any publicly traded company, according to Capital IQ.

Critics contend LIFO is nothing more than a tax dodge that lets companies deduct costs they never incur, because actual inventory costs are usually lower than prevailing market prices when the older inventory is figured into the mix.

“This is the biggest single unjustifiable tax expense in the entire internal revenue code,” says Edward D. Kleinbard, a tax attorney with Cleary Gottlieb Steen & Hamilton LLP who recently criticized LIFO in a written submission to the Senate Finance Committee.

LIFO supporters counter that the method allows companies to match current costs with current revenue, protecting against inflation. “Without LIFO, every company would be paying taxes on illusionary paper profits,” said Jade West, a member of a recently formed advocacy group, the LIFO Coalition, and senior vice president for government relations at the National Association of Wholesaler-Distributors, a U.S. trade association.

Exxon isn’t a member of the LIFO Coalition, nor does it contribute funding to it, the company’s spokesman said, although two trade organizations of which it is a member belong to the LIFO group.

Although LIFO is an arcane area of accounting, the debate around it is far from academic. Twice in the past year, members of Congress have tried to repeal LIFO. The first attempt, last fall, sought to repeal LIFO for oil and gas companies. This spring, Senate Majority Leader Bill Frist proposed repealing LIFO for all companies to pay for his ill-fated $100 credit for drivers strapped by soaring gas prices.

Both repeal attempts failed. But the issue is far from dead: Repealing LIFO could generate billions of dollars in additional tax revenue that Congress could use to offset other spending.

LIFO repeal “could come up in the context of tax reform in upcoming months as senators consider ways to broaden the tax base and lower tax rates,” said a spokeswoman for Senate Finance Committee Chairman Charles Grassley (R., Iowa).

The latest flashpoint: a June Finance Committee hearing on tax issues. George Plesko, an associate accounting professor at the University of Connecticut, testified that “it is not clear that there is much of a financial reporting benefit gained” by using LIFO, except for an “indefinite deferral” of taxes. By his estimate, the largest public companies have enjoyed total tax savings of about $18 billion over the years.

Write to David Reilly at [email protected]

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