Gary C. Biddle, [Discussion of Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy]: A Reply, Journal of Accounting Research, Vol. 18, Studies on Economic Consequences of Financial and Managerial Accounting: Effects on Corporate Incentives and Decisions (1980), pp. 292-295

This study investigates whether associations consistent with LIFO-FIFO tax incentives exist between management choices to adopt or not adopt the LIFO inventory costing method and characteristics of firms' year-end inventories. Both pre- and postchoice characteristics are ex- amined. Because the LIFO-FIFO choice is voluntary, a postchoice association would be consistent with managers both anticipating future inventory characteristics when making a LIFO-FIFO choice and changing inventory management policies in response to that choice. Evidence consistent with the hypothesis that LIFO adoptions are associated with changes in inventory management policies would have important macroeconomic implications. Zarnowitz and Moore [1977] have argued that a failure to recognize the major shift in inventory costing methods which occurred in 1973 and 1974 (primarily FIFO to LIFO) resulted in an underestimation of inventory accumulations by the U.S. Department of Commerce. This underestimation resulted from the different procedures used under LIFO and FIFO to assign costs to inventory units. While this effect of LIFO-FIFO choices can bias macroeconomic measurements and forecasts, an associated change in inventory management policies by a large number of firms could directly affect underlying macroeconomic stocks and flows.

Ricks [1982] found that stock returns near the earnings disclosure dates of 1974 LIFO adopters were negative and significantly lower than returns near the earnings disclosure dates of firms not using LIFO. Given that firms adopting LIFO in 1974 were voluntarily switching to an accounting method providing often significant tax savings, it is not obvious why investors would have reacted negatively. Nor is it likely that investors were unaware of many of the firms' LIFO adoption decisions. This study presents evidence suggesting that the negative excess returns observed by Ricks [1982] were associated with, and possibly due to, analysts' systematic overestimates of earnings of firms adopting LIFO in 1974. We are aware of no previous study documenting systematic errors in analysts' earnings forecasts conditional on a voluntary accounting method change.

This study employs an alternative stochastic model which offers important advantages over those proposed by Cohen and Pekelman, and Biddle and Martin. Rather than optimizing with respect to a single order-up-to level determined at the start of each year, the model permits a second order at year-end. This achieves greater descriptive validity by allowing intrayear (as well as interyear) cost changes and additional purchases after demand has been assessed. More important, there is a greater sensitivity to the effects of tax incentives on year-end procurement decisions and a smaller likelihood of year-end stockouts (which unrealistically affect tax incentives by drastically altering inventory cost structures). As a result, the model is uniquely suited for an examination of optimal choices among alternative inventory costing methods and the optimal ordering policies under each. In this study we extend the model to include not only LIFO and FIFO but also AC, a method not previously considered in order quantity models.

Gary C. Biddle, Frederick W. Lindahl, Stock Price Reactions to LIFO Adoptions: The Association between Excess Returns and LIFO Tax Savings, Journal of Accounting Research, Vol. 20, No. 2, Part II (Autumn, 1982), pp. 551-588

Auditors are faced with the task of formulating opinions about the fairness of their clients' financial statements. In doing so, they use their professional judgment to determine the type and amount of information to collect, the timing and manner of collecting it, and the implications of the information collected. This information is rarely, if ever, perfectly reliable or perfectly predictive of the "true" state of a client's financial statements. Nevertheless, auditors may be held liable at common law or under the federal securities laws should the audited financial statements prove to be unrepresentative of this true state. Thus, it is important for auditors to have the ability to formulate appropriately judgments based on probabilistic data. In this paper, we describe the results of experiments designed to assess whether auditors formulate judgments in accordance' with normative principles of decision making or whether a particular alternative to the normative model of decision making under uncertainty 's employed. In the next section, we discuss several alternatives to normative decision models, focusing on the anchoring and adjustment heuristic which forms the basis for our experiments.

The primary purpose of this paper is to test for the use of the representativeness heuristic by auditors in situations in which its use will lead to judgments that systematically depart from the Bayesian optimal responses. No explicit representation of payoffs was made, nor were subjects typically asked to choose a course of action. Thus it cannot be concluded that use of the representativeness heuristic in the experimental situations tested is not cost effective. To the extent, however, that one is willing to assume that action choices are sensitive to judgments of outcome probabilities, and these action choices have differential expected payoffs, a finding of extensive heuristic use by auditors would suggest further research to assess the economic consequences of such use.

Prior evidence that higher-quality financial reporting improves capital investment efficiency leaves unaddressed whether it reduces over- or under-investment. This study provides evidence of both in documenting a conditional negative (positive) association between financial reporting quality and investment for firms operating in settings more prone to over-investment (under-investment). Firms with higher financial reporting quality also are found to deviate less from predicted investment levels and show less sensitivity to macro-economic conditions. These results suggest that one mechanism linking reporting quality and investment efficiency is a reduction of frictions such as moral hazard and adverse selection that hamper efficient investment.