On Optimal Choice of Inventory Accounting Method
[Inventory accounting rules may have a purchase (production) repercussion on the firm that affects stockholders' wealth, because managers, paid by an accounting income-based contract, can potentially distort the operation while maximizing their payoffs. Stockholders, by directly or indirectly dictating the accounting policy choice, can use accounting rules to implement their preferences and control the managers. Analysis of such a scenario indicates that the stockholders' preferences towards accounting rules are driven primarily by three factors, the tax rate, the acquisition price, and the rate of real holding gain. With no taxes, and absent inflation, FIFO (first in, first out) implements the first-best decision rule. When taxes are present, the preferences of owners and managers diverge, which may lead to operating distortions. An optimal accounting policy choice decision must consider this distortion (the incentive effect) as well as the tax gain possible with LIFO (last in, first out). Further analysis shows that FIFO may still be preferred over LIFO under certain conditions because an incentive effect may exceed an "obvious" tax advantage with LIFO. Abdel-khalik (1985) has provided empirical evidence suggesting that there are incentives for corporate executives to stay on FIFO despite the apparent LIFO tax advantages possibly because their incentives are income-based. Larcker (1983) provides independent evidence that often management compensation contracts are indeed based on accounting income. Thus, when incentive considerations are present, the cash flow effects as shown by Sunder (1976) may not be obvious, and our analysis questions the conventional wisdom that firms tend to switch to LIFO at the time of rising prices. Although the effect of LIFO versus FIFO accounting rule on firm cash flow is well-known, many firms continue to follow FIFO in spite of tax advantages with LIFO. Granof and Short (1984) reported that more than 30 percent of firms in their non-LIFO sample rejected LIFO because of "excessive cost" or "other adverse consequences." We argue that investors choose an inventory accounting method to optimize the trade-off between incentive effect and tax gain, and align the managers' interests as much as possible with those of the stockholders.]