[This study examines how transfer pricing, in the presence of differential taxation, affects the resource allocation and profitability of a decentralized multinational enterprise (MNE) that uses the same transfer price for tax and performance evaluation purposes. An analytical model is built in which a foreign manufacturing division transfers a single product to a U.S. distribution division, which, in turn, sells it in the marketplace as part of a final product. It is assumed that both divisions have complete information concerning all cost and revenue functions and that tax rates are higher in the United States than abroad. Given this assumption, it is shown that it is in the interest of both divisions to cooperate with each other, and a cooperative equilibrium is used throughout the analysis. When differential tax rates exist, but there are no transfer-pricing rules imposed by the taxing authorities, it is shown that the MNE's optimal resource allocation is the same as in the absence of taxes; however, firmwide profits are not maximized. When the resale-price method of computing transfer prices (Reg. Section 1.482-2(e)(3)) is used, the results differ, depending on the manufacturing division's bargaining power. At low levels of bargaining power, the distribution division will "guarantee" a certain level of profit to the manufacturing division, and firmwide after-tax profits will be maximized. As the manufacturing division's bargaining power increases beyond a certain point, however, firmwide optimal profits will no longer be achieved. In addition, the final product and the most similar product (as defined by Reg. Section 1.482-2(e)(3)) will be produced beyond the firmwide after-tax optimum. When transfer prices are computed in accordance with the cost-plus method (Reg. Section 1.482-2(e)(4)), it is shown that production of the final product first decreases, then increases, and production of the most similar product increases as the distribution division's bargaining strength increases. In addition, there is no guarantee of profit to the manufacturing division. Accordingly, it is unlikely that firmwide after-tax profits will be maximized. Demonstration of these results is achieved with the use of numerical examples. The study concludes with a discussion of the tax policy implications of these results.]

Replies to the comments of A. Seetharaman and T.D. Englebrech on the 1987 article `The Effect of the Thor Power Tool Decision on the LIFO/FIFO Choice,' in the October 1990 issue of `The Accounting Review.' Potential problem with Standard Industry Classification code 3714; Sample selection criteria used; Appropriateness of Fisher's Exact Test in the analysis.

This note examines the extent to which firms affected by a change in the tax law respond by making changes in the accounting methods used for financial reporting. The specific tax issue considered is the Thor Power Tool case that limited the use of formula write-downs for inventories. Since LIFO could be approximated by formula write-downs, we hypothesize that affected firms will tend to switch to LIFO during 1979 (and only during 1979) for tax reporting purposes and (because of the LIFO conformity rule) for financial reporting purposes as well. The empirical analyses of inventory method changes are consistent with this hypothesis.

[This note examines the extent to which firms affected by a change in the tax law respond by making changes in the accounting methods used for financial reporting. The specific tax issue considered is the Thor Power Tool case that limited the use of formula write-downs for inventories. Since LIFO could be approximated by formula write-downs, we hypothesize that affected firms will tend to switch to LIFO during 1979 (and only during 1979) for tax reporting purposes and (because of the LIFO conformity rule) for financial reporting purposes as well. The empirical analyses of inventory method changes are consistent with this hypothesis.]