Lifo and Fifo

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Nicole Thorne Jenkins Doctoral Student in Accounting Morton Pincus Associate Professor of Accounting

College of Business Administration The University of Iowa 108 PBAB Iowa City, IA 52242-1000 U.S.A. 319/335-0915 FAX 319/335-1956

September 1998 (version 1.2)

1.0 INTRODUCTION The statutory mandate in U.S. tax law that firms using the last-in first-out (LIFO) inventory costing method for tax purposes must also use LIFO for financial reporting purposes makes inventory accounting an especially interesting research and teaching topic. The constraint on managerial discretion imposed by tax--book conformity highlights the tension that can exist between tax minimization, on the one hand, and achieving financial reporting objectives, on the other hand. Trade-offs between tax minimization and other objectives are a major theme in the Scholes and Wolfson [1992] framework for examining taxation in the context of business strategy. Moreover, a researcher typically can quantify the cash flow impact a firm derives by using (or forgoes by not using) LIFO or FIFO, whereas quantifying the cash flow effects of other financial accounting choices is more problematic.1 This is because the cash flow effects of other accounting choices typically are indirect (e.g., through contracting costs). It thus is not surprising that research in the LIFO/FIFO area has a long history. Two reviews of LIFO research have previously been published in the Journal of Accounting Literature. The first appeared in the initial issue of the Journal and examined LIFO-related research as part of a more general review of capital market assessments of alternative accounting methods [Ricks, 1982a]. The second review, published just six year later, focused exclusively on LIFO. It surveyed three main research streams: the effect of LIFO adoptions on security prices; the determinants of the inventory accounting choice; and the appropriateness of capital market participants’ interpretations of LIFO- and FIFO-based earnings [Lindahl, Emby, and Ashton, 1988].2 Notwithstanding the large number of LIFO studies, a mixed (albeit rich) set of results characterizes much of the research into questions such as the impact of LIFO adoption on stock prices and the effect of LIFO and FIFO on reported earnings and firm valuation. As editor of The Accounting Review, Abdel-khalik introduced a “Forum on LIFO Choice of Inventory

1 Since the early 1970s the S.E.C. has required firms using LIFO to also disclose the excess of current cost over the carrying value of their LIFO inventory. The AICPA’s AuSEC (1984) has recommended disclosure of the “LIFO Reserve” for companies subject to S.E.C. regulations since the mid-1980s. 2 Previous reviews of LIFO/FIFO research also include portions of Lev and Ohlson [1982], on market-based research, and Gonedes and Dopuch [1974], on alternative means of assessing the effects or desirability of accounting methods, including capital market research and behavioral laboratory experiments. A recent paper by Thibodeau-Morin and Patton [1998] surveys the entire body of LIFO/FIFO research to identify major research questions and methodological approaches. In contrast, we provide an update of the literature by detailing, analyzing, and synthesizing major research developments occurring since Lindahl et al. [1988]. Our review and that of Thibodeau-Morin and Patton were written independently.


Valuation” by expressing a generally felt frustration about research in the area. He said researchers “continue to be relatively uninformed about” a number of LIFO-related issues “and know little about the real reasons that many firms do not switch to LIFO when it appears that they would benefit by positive tax savings” [1992, 319]. He was referring to the “LIFO puzzle,” which continues to be invoked in some working papers and textbooks....
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