Accounting Techniques and Firms' Equilibrium Values: Tax Methods and the Lifo/Fifo Choice

Nicholas J. Gonedes

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: The effect of firms’ accounting techniques on firms’ equilibrium values is the general topic considered here. The specific technique examined is the inventory-costing method -- e.g., LIFO or FIFO -- adopted for tax reporting. The connection between firms’ selections of accounting techniques and the characteristics of firms’ production-investment decisions is emphasized. Our framework provides a basis for getting theoretical insights into firms’ selection of techniques, for explaining some available empirical results heretofore regarded as somewhat mysterious, and for improving the experimental designs used for work on accounting techniques’ effects. Our results indicate that the optimality of an inventory method is inextricably bound to the characteristics of firms’ production-investment decisions and that all value-maximizing firms pursuing the same type of decisions will opt for the same inventory method. Of course, the same method will be optimal for different types of decisions if the number of methods is less than the number of decision types. In spite of its alleged favorable tax effects under inflation, LIFO is not always the optimal method under inflationary conditions. Moreover, LIFO may be the optimal method even when the expected value of tax deductions under LIFO is less than the expected value of tax deductions under FIFO. Finally, the oft-inferred association between risk changes and changes in inventory methods is not due to a quirk of available sample evidence. It is precisely what one should expect.

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