Appendix

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Appendix 4-A

ESTIMATING OPERATING LEVERAGE

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Appendix 4-B

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ADDITIONAL ISSUES

Earnings per share is probably the most

Earnings per share is probably the most widely used indicator of corporate performance. Yetwidely used indicator of corporate performance. Yet most of those who use it do not understand how it is computed. Fewer still understand how it most of those who use it do not understand how it is computed. Fewer still understand how it is affected by the issuance

is affected by the issuance of convertibles, options, or other potentially dilutive securities. Inof convertibles, options, or other potentially dilutive securities. In the text we have outlined the procedures used in its calculation. In this appendix, we discuss the text we have outlined the procedures used in its calculation. In this appendix, we discuss computational issues, disclosure requirements, and the few differences between US and computational issues, disclosure requirements, and the few differences between US and IASB standards.

IASB standards.

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Weighted Average Number of Common Shares Outstanding

The denominator must reﬂect all stock dividends and stock splits effective during the period The denominator must reﬂect all stock dividends and stock splits effective during the period and those announced after the end

and those announced after the end of the reporting period (but before the of the reporting period (but before the ﬁnancial statementsﬁnancial statements are issued) as if they had

are issued) as if they had been effective at the beginning of the reporting period. Abeen effective at the beginning of the reporting period. A ll prior pe-ll prior pe-riods presented are restated for

riods presented are restated for comparability.comparability.

Acquisitions

Shares issued in purchase method acquisitions (see Chapter 14) are included in the Shares issued in purchase method acquisitions (see Chapter 14) are included in the denomi-nator only for the period following the acquisition date. Similarly, only the postacquisition nator only for the period following the acquisition date. Similarly, only the postacquisition results of operations of the acquired ﬁrms are included in

results of operations of the acquired ﬁrms are included in the numerator of the EPS the numerator of the EPS computa- computa-tion. Note that no

tion. Note that no restatement of prior periods is permitted for purchase method acquisitions.restatement of prior periods is permitted for purchase method acquisitions. The impact of the pooling method is quite different. Merged firms are considered The impact of the pooling method is quite different. Merged firms are considered com-bined entities for all years presented. The shares issued in the combination are assumed to bined entities for all years presented. The shares issued in the combination are assumed to have been outstanding for all periods presented, and the results of operations for the two have been outstanding for all periods presented, and the results of operations for the two firms are also combined for those periods

ﬁrms are also combined for those periods in the EPS calculation.in the EPS calculation.

Contingent Shares

Acquisitions and incentive compensation plans may require the issuance of common Acquisitions and incentive compensation plans may require the issuance of common shares if specific conditions, such as the passage of time, achievement of income levels, or shares if specific conditions, such as the passage of time, achievement of income levels, or specified market prices of the common stock,

specified market prices of the common stock, are met. Securities whose issuance dependsare met. Securities whose issuance depends solely on the passage of time are

solely on the passage of time are always included in the weighted average shares outstand-always included in the weighted average shares outstand-ing. Other contingent shares are included in the computation of basic and diluted EPS if ing. Other contingent shares are included in the computation of basic and diluted EPS if the required income levels or market prices have been reached at the end of the reporting the required income levels or market prices have been reached at the end of the reporting period.

period.

When the issuance of contingent shares depends

When the issuance of contingent shares depends on the achievement of earnings targets,on the achievement of earnings targets, and when it is likely that those targets will be achieved, the computation of diluted earnings and when it is likely that those targets will be achieved, the computation of diluted earnings per share includes both the incremental shares and the level of

per share includes both the incremental shares and the level of income assumed to have beenincome assumed to have been achieved. These adjustments to the EPS

achieved. These adjustments to the EPS measures are required even if measures are required even if the incremental sharesthe incremental shares are to be issued at a later date.

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EPS Computations for Two-Class Securities

Some ﬁrms issue more than one class of common stock or have “participating” securities Some ﬁrms issue more than one class of common stock or have “participating” securities that are entitled to share in the dividends paid on common stock. EPS computations for each that are entitled to share in the dividends paid on common stock. EPS computations for each class of nonconvertible

class of nonconvertible11two-class securities are based on an allocation of two-class securities are based on an allocation of earnings accordingearnings according to dividends paid and participation rights in undistributed earnings.

to dividends paid and participation rights in undistributed earnings.

Adjustments for Rights Issues

Both SFAS 128 and IAS 33 mandate the use of the ex-rights method in the computation of Both SFAS 128 and IAS 33 mandate the use of the ex-rights method in the computation of basic and diluted EPS for the bonus element (discount to market price prior to the offering) basic and diluted EPS for the bonus element (discount to market price prior to the offering) in a rights issue. Under prior US GAAP, the bonus element was ignored. The ex-rights in a rights issue. Under prior US GAAP, the bonus element was ignored. The ex-rights method recognizes dilution when rights are issued to buy shares below the current market method recognizes dilution when rights are issued to buy shares below the current market price.

price.

Impact of New and Proposed Accounting Standards

SFAS 144 (2001) broadened the definition of discontinued operations as discussed on pages SFAS 144 (2001) broadened the definition of discontinued operations as discussed on pages 54 and 275 of the text. This change means that, for firms disposing of unprofitable 54 and 275 of the text. This change means that, for firms disposing of unprofitable opera-tions, income from continuing operations will be higher than it would have been under prior tions, income from continuing operations will be higher than it would have been under prior accounting standards. Because income from continuing operations is the “control number” accounting standards. Because income from continuing operations is the “control number” used to determine whether options and convertible securities are dilutive, higher income used to determine whether options and convertible securities are dilutive, higher income from continuing operations will result in more of these potential common shares entering from continuing operations will result in more of these potential common shares entering into the computation of dilutive EPS.

into the computation of dilutive EPS. In its proposed reporting for

In its proposed reporting for securities with characteristics of liabilities or equity or securities with characteristics of liabilities or equity or bothboth (see Box 10-2 on page 338 of the text), the FASB intends to redefine the control number as (see Box 10-2 on page 338 of the text), the FASB intends to redefine the control number as income from continuing operations attributable to controlling shareholders. Under current income from continuing operations attributable to controlling shareholders. Under current GAAP, income allocated to minority or noncontrolling shareholders is deducted in GAAP, income allocated to minority or noncontrolling shareholders is deducted in comput-ing the income from continucomput-ing operations. Thus, companies with profitable majority-owned ing the income from continuing operations. Thus, companies with profitable majority-owned subsidiaries will report higher control numbers under this proposed standard. Again, more subsidiaries will report higher control numbers under this proposed standard. Again, more potential common stock will be classified as dilutive securities.

potential common stock will be classiﬁed as dilutive securities.

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As stated in the text, the FASB and IASB developed their new standards together. As a As stated in the text, the FASB and IASB developed their new standards together. As a re-sult, there are few differences between the two. The most important difference is that US sult, there are few differences between the two. The most important difference is that US GAAP requires that EPS be reported for all components of net income. IASB GAAP GAAP requires that EPS be reported for all components of net income. IASB GAAP re-quires disclosure of EPS only for net income; any other components of EPS reported, quires disclosure of EPS only for net income; any other components of EPS reported, how-ever, must accord with the new standard.

ever, must accord with the new standard.

Under SFAS 128, earnings from continuing operations is the “control number” used to Under SFAS 128, earnings from continuing operations is the “control number” used to determine whether potential common shares are dilutive (see previous section). Thus, determine whether potential common shares are dilutive (see previous section). Thus, ac-counting changes, discontinued operations, and extraordinary items do not affect counting changes, discontinued operations, and extraordinary items do not affect determina-tion of the dilutive effect. Under IAS 33, net income is the control number. Given the high tion of the dilutive effect. Under IAS 33, net income is the control number. Given the high frequency of extraordinary items and other differences between earnings from continuing frequency of extraordinary items and other differences between earnings from continuing operations and net income, it is likely that, for some ﬁrms, the dilutive effect will be different operations and net income, it is likely that, for some ﬁrms, the dilutive effect will be different depending on whether they use US GAAP or

depending on whether they use US GAAP or IASB GAAP.IASB GAAP.

1

1_{If shares of one class are convertible into shares of another class, as is normally the case, the if-converted method}_{If shares of one class are convertible into shares of another class, as is normally the case, the if-converted method}

must be used for the convertible securities if the effect is dilutive. must be used for the convertible securities if the effect is dilutive.

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Appendix 6-A

LIFO MEASUREMENT ISSUES

This appendix is concerned with two measurement issues that arise when the LIFO method This appendix is concerned with two measurement issues that arise when the LIFO method is used:

is used:

•• Different varieties of LIFODifferent varieties of LIFO

•• Difﬁculties when LIFO is applied to Difﬁculties when LIFO is applied to interim earningsinterim earnings

Although these issues arise frequently, they are segregated within this appendix to simplify Although these issues arise frequently, they are segregated within this appendix to simplify the presentation in the chapter itself.

the presentation in the chapter itself.

LIFO INVENTORY METHODS

The discussions in the chapter implicitly assume that: The discussions in the chapter implicitly assume that:

•• Firms account for each inventory itemFirms account for each inventory item

•• There is only one manner of applying the LIFO method of accountingThere is only one manner of applying the LIFO method of accounting

Neither assumption is correct. In practice, all but the smallest firms have far too many Neither assumption is correct. In practice, all but the smallest firms have far too many inven-tory items to use specific

tory items to use specific item-based costing methods efficiently. The potential for LIFO liq-item-based costing methods efficiently. The potential for LIFO liq-uidations and the resulting loss of tax benefits are additional deterrents to the use of specific uidations and the resulting loss of tax benefits are additional deterrents to the use of specific item methods. More efficient methods of applying LIFO to inventories involve the pooling item methods. More efficient methods of applying LIFO to inventories involve the pooling of “substantially identical” inventory units to compute unit costs and physical quantities. of “substantially identical” inventory units to compute unit costs and physical quantities.

Reeve and Stanga (1987) found that a majority of LIFO method companies use a single Reeve and Stanga (1987) found that a majority of LIFO method companies use a single pool, generally defined by the natural business unit, and they use the same pooling method pool, generally defined by the natural business unit, and they use the same pooling method for financial reporting and taxes although conformity is not required. The number of pools for financial reporting and taxes although conformity is not required. The number of pools used was inversely related to the magnitude of tax benefits

used was inversely related to the magnitude of tax beneﬁts (companies with large tax savings(companies with large tax savings from LIFO tended to use fewer pools).

from LIFO tended to use fewer pools).

They also reported substantial variation in the number of pools used within an industry They also reported substantial variation in the number of pools used within an industry and across all the firms in their sample. The impact on cash flows and financial statements and across all the firms in their sample. The impact on cash flows and financial statements suggests that analysts should carefully evaluate announcements of changes in LIFO pools to suggests that analysts should carefully evaluate announcements of changes in LIFO pools to understand the impact of the change on

understand the impact of the change on reported earnings.reported earnings. E

Example: Oxample: Oxford xford

Oxford [OXM], a clothing manufacturer, uses the LIFO method for most inventories. In Oxford [OXM], a clothing manufacturer, uses the LIFO method for most inventories. In fis-cal 2002, Oxford reduced the number of inventory pools used to compute LIFO from five to cal 2002, Oxford reduced the number of inventory pools used to compute LIFO from five to three. As a result, the company

three. As a result, the company avoided a LIFO liquidation that would have increased net in-avoided a LIFO liquidation that would have increased net in-come by 30% (and would have resulted in signiﬁcant tax payments).

come by 30% (and would have resulted in signiﬁcant tax payments).11 _{The company stated}_{The company stated}

that one reason for the change was

that one reason for the change was to “reduce the likelihood of LIFO layer liquidations.” Theto “reduce the likelihood of LIFO layer liquidations.” The change was reported as a

change was reported as a change in accounting principle.change in accounting principle.

Inventories may also be pooled on the basis of similarity of use, production method, or Inventories may also be pooled on the basis of similarity of use, production method, or raw materials used. Liquidations are reduced because these “dollar value” LIFO methods raw materials used. Liquidations are reduced because these “dollar value” LIFO methods compute inventories using dollars, facilitating substitutions of items in the pools. Inventory compute inventories using dollars, facilitating substitutions of items in the pools. Inventory

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layers may be priced using indices published by the Bureau of Labor Statistics or internally layers may be priced using indices published by the Bureau of Labor Statistics or internally developed indices. The differences can be substantial.

developed indices. The differences can be substantial.

For example, during 1990 Kmart switched to internally generated indices (from the U.S. For example, during 1990 Kmart switched to internally generated indices (from the U.S. Department of Labor’s Department Store Price Index) for its U.S. merchandise inventories. Department of Labor’s Department Store Price Index) for its U.S. merchandise inventories. The financial statement footnote stated the firm’s belief that the internal index “results in a The financial statement footnote stated the firm’s belief that the internal index “results in a more accurate measurement of the impact of inflation on the prices of merchandise sold in its more accurate measurement of the impact of inflation on the prices of merchandise sold in its stores.” The change reduced its COGS by $105 million (net of tax), increasing income by stores.” The change reduced its COGS by $105 million (net of tax), increasing income by $0.52 per share (32.3% of reported income for the year).

$0.52 per share (32.3% of reported income for the year). Retailers use more complex LIFO

Retailers use more complex LIFO methods. Interested readers are referred to methods. Interested readers are referred to intermedi- intermedi-ate and advanced accounting texts for explanations of the LIFO Retail and Dollar Value ate and advanced accounting texts for explanations of the LIFO Retail and Dollar Value LIFO Retail methods.

LIFO Retail methods.

INTERIM REPORTING UNDER LIFO

As discussed in Chapter 1, interim reporting creates special problems for both financial As discussed in Chapter 1, interim reporting creates special problems for both financial re-porting and financial analysis. Because LIFO is a tax-based inventory method, its use creates porting and financial analysis. Because LIFO is a tax-based inventory method, its use creates additional problems. The actual LIFO effect for the year cannot be known until the year is additional problems. The actual LIFO effect for the year cannot be known until the year is complete.

complete.Thus, LIFO charges for interim periods require management Thus, LIFO charges for interim periods require management assumptions regard-assumptions regard-ing both inventory quantities and prices at the end of the year.

ing both inventory quantities and prices at the end of the year.

Technological changes, ﬂuctuations in demand, and strikes may also result in a Technological changes, ﬂuctuations in demand, and strikes may also result in a reduc-tion in LIFO layers during the year. The applicareduc-tion of LIFO during interim periods may tion in LIFO layers during the year. The application of LIFO during interim periods may re-sult in substantial distortions (income statement and balance sheet) if the factors causing the sult in substantial distortions (income statement and balance sheet) if the factors causing the LIFO liquidations are temporary and the layers will

LIFO liquidations are temporary and the layers will be replenished prior to year-end.be replenished prior to year-end.

Financial reporting for interim periods is governed by APB Opinion 28, which provides Financial reporting for interim periods is governed by APB Opinion 28, which provides special inventory valuation procedures during interim periods when the ﬁrm experiences a special inventory valuation procedures during interim periods when the ﬁrm experiences a LIFO liquidation during one or more

LIFO liquidation during one or more of the ﬁrst three quarters.of the ﬁrst three quarters.

Permanent liquidations must be reported in the quarter of occurrence. However, when Permanent liquidations must be reported in the quarter of occurrence. However, when management believes that the liquidated layer(s) will be replenished before year-end, the management believes that the liquidated layer(s) will be replenished before year-end, the cost of goods sold for the quarter must include the estimated cost of replacing the temporary cost of goods sold for the quarter must include the estimated cost of replacing the temporary liquidation rather than the LIFO cost of the goods sold. The application of this method is liquidation rather than the LIFO cost of the goods sold. The application of this method is il-lustrated using the following

lustrated using the following example:example:

Assumptions: All transactions occur during the second quarter Assumptions: All transactions occur during the second quarter

Beginning inventory (FIFO): 10 units @ $30

Beginning inventory (FIFO): 10 units @ $30  $300$300 LIFO reserve (@ $20)

LIFO reserve (@ $20) ($200)($200)

LIFO inventory 10 units @ $10

LIFO inventory 10 units @ $10  $100$100 Purchases: 20 units @ $30

Purchases: 20 units @ $30  $600$600 Goods available for sale

Goods available for sale  $700$700

Sales: 21 units @ $40

Sales: 21 units @ $40  $840$840

Management determines that the liquidation is temporary and expects the next purchase Management determines that the liquidation is temporary and expects the next purchase price (cost to replace) to be $35. GAAP requires the use of $35 rather than the unit cost of price (cost to replace) to be $35. GAAP requires the use of $35 rather than the unit cost of the liquidated layer. COGS is reported at

the liquidated layer. COGS is reported at

Inventory is reduced by Inventory is reduced by

The firm recognizes a current liability (called the LIFO base liquidation) for the The firm recognizes a current liability (called the LIFO base liquidation) for the differ-ence of $25, indicating that the firm has temporarily “borrowed” a unit from the base layer. ence of $25, indicating that the firm has temporarily “borrowed” a unit from the base layer.22

The next purchase of inventory is used to eliminate the current liability and replenish the The next purchase of inventory is used to eliminate the current liability and replenish the

$610 (20 units @ $30 and 1 unit @ $10) $610 (20 units @ $30 and 1 unit @ $10) $635 (20 units @ $30 plus 1 unit @ $35) $635 (20 units @ $30 plus 1 unit @ $35)

2

2_{An AICPA issues paper, “Identiﬁcation and Discussion of Certai}_{An AICPA issues paper, “Identiﬁcation and Discussion of Certai n Financial Accounting and Reporting Issues Con-}_{n Financial Accounting and Reporting Issues}

Con-cerning LIFO Inventories” (AICPA, 1984), suggests that the interim liquidation may also be credited directly to cerning LIFO Inventories” (AICPA, 1984), suggests that the interim liquidation may also be credited directly to inventories.

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LIFO base layer. This method eliminates any distortion in reported gross proﬁt and income LIFO base layer. This method eliminates any distortion in reported gross proﬁt and income numbers due to

numbers due to temporary interim period liquidations.temporary interim period liquidations.

Year-end LIFO liquidations are permanent reductions in LIFO layers, and the reported Year-end LIFO liquidations are permanent reductions in LIFO layers, and the reported gross profit must include the impact of the reduction in LIFO reserves. If the foregoing gross profit must include the impact of the reduction in LIFO reserves. If the foregoing sce-nario occurs during the fourth quarter, the firm would report COGS of $610 [(20

nario occurs during the fourth quarter, the ﬁrm would report COGS of $610 [(20  $30)$30)

(1

(1  $10)] and separately disclose the impact of the LIFO liquidation on COGS and net in-$10)] and separately disclose the impact of the LIFO liquidation on COGS and net

in-come in the footnotes. come in the footnotes. Example: Nucor Example: Nucor

The following example illustrates the impact of volatile prices and the procedures required The following example illustrates the impact of volatile prices and the procedures required for interim reporting. It is based on Nucor Corp., a steel and steel products manufacturer that for interim reporting. It is based on Nucor Corp., a steel and steel products manufacturer that uses the LIFO method of

uses the LIFO method of inventory accountinginventory accounting. Steel scrap is . Steel scrap is a major component of inventorya major component of inventory cost, and since scrap prices can be volatile, Nucor must estimate its year-end position at the cost, and since scrap prices can be volatile, Nucor must estimate its year-end position at the end of each interim period. That is, it must estimate both physical inventory and the price of end of each interim period. That is, it must estimate both physical inventory and the price of scrap at year-end to establish the appropriate LIFO reserve at the end of each interim period. scrap at year-end to establish the appropriate LIFO reserve at the end of each interim period. In 1981, scrap prices rose during the first part of the year, but declined in the second In 1981, scrap prices rose during the first part of the year, but declined in the second half. The LIFO reserve declined for 1981 as a whole, reflecting a decline in the price of steel half. The LIFO reserve declined for 1981 as a whole, reflecting a decline in the price of steel scrap. (At the end of 1981, the difference between the LIFO and FIFO cost of its inventory scrap. (At the end of 1981, the difference between the LIFO and FIFO cost of its inventory was lower than it had been one year earlier.)

was lower than it had been one year earlier.) During the ﬁrst two quarters, Nucor

During the ﬁrst two quarters, Nucor assumed that scrap prices would be higher at assumed that scrap prices would be higher at the endthe end of 1981 than one year earlier and accrued additional LIFO reserves. Because of the decline in of 1981 than one year earlier and accrued additional LIFO reserves. Because of the decline in steel scrap prices late in the year, these earlier accruals were reversed in the fourth quarter. steel scrap prices late in the year, these earlier accruals were reversed in the fourth quarter. The impact of the interim changes in the LIFO

The impact of the interim changes in the LIFO reserve can be seen in the reserve can be seen in the following table:following table: Reported Nucor Quarterly Results 1981 ($ in

Reported Nucor Quarterly Results 1981 ($ in thousands)thousands) Q

Quuaarrtteerr II IIII IIIIII IIVV YYeeaarr

P

Prreettaax x iinnccoommee $$1133,,008877 $$1111,,220044 $$44,,663377 $$1155,,990011 $$4444,,882299 L

LIIFFO O eeffffeecctt 11,,887733 11,,990000 00 ((55,,113344)) ((11,,336611)) L

LIIFFO O rreesseerrvve e ((eennd d oof f ppeerriioodd)) $$2255,,660000 $$2277,,550000 $$2277,,550000 $$2222,,336666 $$2222,,336666 (12/31/80

(12/31/80$23,727)$23,727)

Source:

Source:Nucor, 1981 annual and interim reports.Nucor, 1981 annual and interim reports.

Although the interim LIFO accruals (LIFO effect

Although the interim LIFO accruals (LIFO effect  change in reserve) were made inchange in reserve) were made in

good faith, in retrospect we can see that they were incorrect and distorted operating results. good faith, in retrospect we can see that they were incorrect and distorted operating results. To correct that distortion, we can (with

To correct that distortion, we can (with perfect hindsight) reallocate the decrease in the LIFOperfect hindsight) reallocate the decrease in the LIFO reserve for the year so

reserve for the year so that an equal amount is credited to that an equal amount is credited to each interim period. We can obtaineach interim period. We can obtain the “true” interim results by restating the LIFO impact as

the “true” interim results by restating the LIFO impact as follows:follows: Adjusted Nucor Quarterly Results 1981 ($ in

Adjusted Nucor Quarterly Results 1981 ($ in thousands)thousands) Q

Quuaarrtteerr II IIII IIIIII IIVV YYeeaarr

P

Prreettaax x iinnccoommee $$1133,,008877 $$1111,,220044 $$44,,663377 $$1155,,990011 $$4444,,882299 LIFO adjustment*

LIFO adjustment* $1$12,2132,213 $1$12,2402,240 $4,$4,340340 $$(4,793)(4,793) $44,82$44,8200 A

Addjjuusstteed d pprreettaaxx $$1155,,330000 $$1133,,444444 $$44,,997777 $$1111,,110088 $$4444,,882299 %

% CChhaanngge e ffrroom m rreeppoorrtteedd 1166..99%% 2200..00%% 77..33%% ((3300..11))%% 00

*Difference between original LIFO effect and

*Difference between original LIFO effect and true LIFO effect (one-fourth of annual). For example, true LIFO effect (one-fourth of annual). For example, the ﬁrst quarterthe ﬁrst quarter adjustment is $1,873

adjustment is $1,873(($1,361/4).$1,361/4).

The Nucor case indicates that management assumptions can play a major role in The Nucor case indicates that management assumptions can play a major role in re-ported interim earnings and the application of LIFO accounting to interim periods can result ported interim earnings and the application of LIFO accounting to interim periods can result in large distortions in interim comparisons. It should also be noted that there are many ways in large distortions in interim comparisons. It should also be noted that there are many ways of making interim LIFO calculations. This illustration also serves as an example of of making interim LIFO calculations. This illustration also serves as an example of fourth-quarter adjustments that have a significant impact on reported earnings and trends reflected quarter adjustments that have a significant impact on reported earnings and trends reflected during the previous three quarters.

during the previous three quarters.

IN

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Appendix 6-B

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EMPIRICAL STUDIES

As noted in the chapter, the LIFO to FIFO choice provides an ideal research topic as the As noted in the chapter, the LIFO to FIFO choice provides an ideal research topic as the choice has

choice has 1.

1. conflicting income and cash flow (tax conflicting income and cash flow (tax effect) implications, andeffect) implications, and 2.

2. data availability allowing for adjustment from one method to the other permittingdata availability allowing for adjustment from one method to the other permitting “as-if” comparisons in research design.

“as-if” comparisons in research design.

Earlier research focused on market reaction to FIFO-to-LIFO switches and the motivation Earlier research focused on market reaction to FIFO-to-LIFO switches and the motivation for using one method as compared to the other. This line of research was consistent with for using one method as compared to the other. This line of research was consistent with the market-based and positive accounting approaches

the market-based and positive accounting approaches11 _{to research prevalent at that time.}_{to research prevalent at that time.}

More recently, in line with the renewed interest in security valuation issues, researchers More recently, in line with the renewed interest in security valuation issues, researchers have examined the relationship between equity valuation and alternative methods of have examined the relationship between equity valuation and alternative methods of in-ventory reporting.

ventory reporting.

Equity Valuation Issues Equity Valuation Issues

Jennings, Simko, and Thompson (1996) examined the

Jennings, Simko, and Thompson (1996) examined the contention thatcontention that 1.

1. LIFO income statements were more useful than non-LIFO LIFO income statements were more useful than non-LIFO statements, andstatements, and 2.

2. Non-LIFO balance sheets were more useful than Non-LIFO balance sheets were more useful than LIFO balance sheetsLIFO balance sheets

by comparing which set of statements better explained the distribution of equity values for a by comparing which set of statements better explained the distribution of equity values for a set of LIFO ﬁrms. The “as if” non-LIFO statements were created by using the LIFO reserve set of LIFO ﬁrms. The “as if” non-LIFO statements were created by using the LIFO reserve disclosures and the methodology described in the chapter.

disclosures and the methodology described in the chapter.

Their results were mixed. Consistent with their expectation, they found that LIFO-based Their results were mixed. Consistent with their expectation, they found that LIFO-based income statements explained more of the variation in equity valuations than non-LIFO income statements explained more of the variation in equity valuations than non-LIFO in-come statements. However, they found that LIFO

come statements. However, they found that LIFO balance sheets were more useful than theirbalance sheets were more useful than their non-LIFO counterparts—a surprising result given that non-LIFO balance sheets are closer to non-LIFO counterparts—a surprising result given that non-LIFO balance sheets are closer to current (rather than outdated LIFO) costs.

current (rather than outdated LIFO) costs.

Jennings et al. explained these results by noting the negative empirical relationship Jennings et al. explained these results by noting the negative empirical relationship (re-ported earlier by Guenther and Trombley (1994))—between a ﬁrm’s value and the ported earlier by Guenther and Trombley (1994))—between a ﬁrm’s value and the magni-tude of the LIFO reserve.

tude of the LIFO reserve.22 _{They argue (and demonstrate using a theoretical model) that if}_{They argue (and demonstrate using a theoretical model) that if}

ﬁrms cannot (fully) pass on

ﬁrms cannot (fully) pass on input price increases to their customers, a input price increases to their customers, a larger LIFO reserve in-larger LIFO reserve in-dicates lower future proﬁtability. In such cases,

dicates lower future proﬁtability. In such cases, a negative relationship is expected betweena negative relationship is expected between ﬁrm value and the LIFO reserve.

ﬁrm value and the LIFO reserve.

Thus, the poor performance of the non-LIFO

Thus, the poor performance of the non-LIFO balance sheet may be explained as follows.balance sheet may be explained as follows. When the LIFO reserve is added to LIFO inventory to create the non-LIFO balance sheet When the LIFO reserve is added to LIFO inventory to create the non-LIFO balance sheet in-ventory, the positive relationship between value and assets may be offset by

ventory, the positive relationship between value and assets may be offset by the loss of infor-the loss of

infor-W8

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1

1_{See Chapter 5 for further discussion.}_{See Chapter 5 for further discussion.} 2

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mation (with respect to the effects of inﬂation) that is provided by the LIFO inventory and mation (with respect to the effects of inﬂation) that is provided by the LIFO inventory and LIFO reserve individually.

LIFO reserve individually.

As the elasticity of output prices with respect to input price changes fall, the LIFO and LIFO As the elasticity of output prices with respect to input price changes fall, the LIFO and LIFO reserve components of non-LIFO inventory have increasingly different implications for future reserve components of non-LIFO inventory have increasingly different implications for future net resource inﬂows, and loss of information through

net resource inﬂows, and loss of information through aggregation increases.aggregation increases.33

An alternative “deferred tax” explanation for the negative relationship between firm An alternative “deferred tax” explanation for the negative relationship between firm value and the LIFO reserve is offered by Dhaliwal, Trezevant and Wilkins (2000). They value and the LIFO reserve is offered by Dhaliwal, Trezevant and Wilkins (2000). They argue that the LIFO reserve indicates a potential future tax liability if the inventory (or firm) argue that the LIFO reserve indicates a potential future tax liability if the inventory (or firm) is liquidated or sold.

is liquidated or sold.

Whichever argument is correct in explaining the negative relationship between ﬁrm Whichever argument is correct in explaining the negative relationship between ﬁrm value and the LIFO reserve, these results and those with respect to the comparison of LIFO value and the LIFO reserve, these results and those with respect to the comparison of LIFO and non-LIFO balance sheets point out the need for well-grounded economic analysis when and non-LIFO balance sheets point out the need for well-grounded economic analysis when preparing a research design for empirical testing.

preparing a research design for empirical testing. The L

The LIFOIFO//FFIIFFO O ChoChoice ice

As the chapter discussion indicates, there may be sound reasons for ﬁrms to stay on FIFO. As the chapter discussion indicates, there may be sound reasons for ﬁrms to stay on FIFO. InIn addition to those related to

addition to those related to LIFO liquidations and declining prices, these reasons LIFO liquidations and declining prices, these reasons include bur-include bur-densome record keeping requirements, the inability to write down obsolete inventory, and densome record keeping requirements, the inability to write down obsolete inventory, and the desire to maximize taxable income when using

the desire to maximize taxable income when using up a tax up a tax loss carryforward.loss carryforward.

Another reason is the desire to avoid the negative effect of LIFO on a firm’s reported Another reason is the desire to avoid the negative effect of LIFO on a firm’s reported earnings. This motivation depends on whether (as discussed in Chapter 5) a market-based or earnings. This motivation depends on whether (as discussed in Chapter 5) a market-based or financial contracting argument is used.

ﬁnancial contracting argument is used.

The market-based argument says that, whether or not the market is efficient and can see The market-based argument says that, whether or not the market is efficient and can see through the FIFO/LIFO choice to the real economics of the firm, managers who believe that through the FIFO/LIFO choice to the real economics of the firm, managers who believe that the market can be fooled by

the market can be fooled by lower reported earnings are reluctant to use LIFO.lower reported earnings are reluctant to use LIFO.

Alternatively, the financial contracting approach considers the impact of the FIFO/ Alternatively, the financial contracting approach considers the impact of the FIFO/ LIFO choice on management compensation and debt covenant restrictions. The bonus plan LIFO choice on management compensation and debt covenant restrictions. The bonus plan hypothesis argues that when top management compensation is based on income, the firm is hypothesis argues that when top management compensation is based on income, the firm is less likely to use the

less likely to use the LIFO method if the resultant lower earnings LIFO method if the resultant lower earnings reduce their compensation.reduce their compensation. The debt covenant hypothesis argues that the negative effect of LIFO on a firm’s The debt covenant hypothesis argues that the negative effect of LIFO on a firm’s ported income and ratios increases the probability that a firm will violate debt covenants ported income and ratios increases the probability that a firm will violate debt covenants re-garding such financial measures as working capital, net worth, income, and the dividend garding such financial measures as working capital, net worth, income, and the dividend payout ratio. Highly leveraged firms may be especially reluctant to use

payout ratio. Highly leveraged ﬁrms may be especially reluctant to use LIFO for that reason,LIFO for that reason, notwithstanding the tax beneﬁts.

notwithstanding the tax beneﬁts.

Studies of the FIFO/LIFO choice generally examine the impact of the choice on firms’ Studies of the FIFO/LIFO choice generally examine the impact of the choice on firms’ financial performance in terms of both market reaction and management behavior, as w financial performance in terms of both market reaction and management behavior, as w ell asell as the effect on firms’ financial statements. These studies and the hypotheses tested are affected the effect on firms’ financial statements. These studies and the hypotheses tested are affected by both the progression in

by both the progression in academic accounting theory and economic factors (such as higheracademic accounting theory and economic factors (such as higher inﬂation) that caused a resurgence in the

inﬂation) that caused a resurgence in the adoption of LIFO in adoption of LIFO in the mid-1970s.the mid-1970s. Market-Based Research

Market-Based Research

LIFO has been permitted in the United States since before World War II, and its rate of LIFO has been permitted in the United States since before World War II, and its rate of adoption understandably follows the rate of inflation. In the 1970s, when the rate of inflation adoption understandably follows the rate of inflation. In the 1970s, when the rate of inflation reached double-digits, LIFO adoptions soared. Approximately 400 companies switched from reached double-digits, LIFO adoptions soared. Approximately 400 companies switched from FIFO to LIFO in 1974 alone. This period coincided with heavy academic emphasis on FIFO to LIFO in 1974 alone. This period coincided with heavy academic emphasis on mar-ket-based empirical research and the efficient market hypothesis, and the effect of the ket-based empirical research and the efficient market hypothesis, and the effect of the FIFO/LIFO switch was viewed as an ideal area for research.

FIFO/LIFO switch was viewed as an ideal area for research.

Given these conditions, the functional ﬁxation hypothesis was tested

Given these conditions, the functional fixation hypothesis was tested to see whether:to see whether: •• The market acceptThe market accepts financial statems financial statements as presentents as presented and thus views ted and thus views the switch tohe switch to

LIFO unfavorably since income is depressed. LIFO unfavorably since income is depressed.

THE

THE FIFFIFO/O/ LIFO CHOLIFO CHOICEICE: E: EMMPIRPIRICAL SICAL STUDTUD IEIESS

W9

3

3_{Ross Jennings, Paul J. Simko, and Robert B. Thompson III, “Does LIFO Inventory Accounting Improve the In-}_{Ross Jennings, Paul J. Simko, and Robert B. Thompson III, “Does LIFO Inventory Accounting Improve the}

In-come Statement at the Expense of the Balance Sheet?,”

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•• The market is efﬁcient in the sense that it sees through reported data and views theThe market is efﬁcient in the sense that it sees through reported data and views the switch to LIFO positively since cash

switch to LIFO positively since cash ﬂow increases.ﬂow increases.

Proponents of the efficient market hypothesis predicted that the market would see through Proponents of the efficient market hypothesis predicted that the market would see through the switch and react favorably to the cash flow effects.

the switch and react favorably to the cash ﬂow effects.

Surprisingly, the results were equivocal. Sunder (1973) examined a sample of ﬁrms that Surprisingly, the results were equivocal. Sunder (1973) examined a sample of ﬁrms that changed to LIFO in the period 1946 to

changed to LIFO in the period 1946 to 1966 and found that prior to the switch these ﬁrms ex-1966 and found that prior to the switch these ﬁrms ex-perienced positive abnormal returns (Figure 6B-1

perienced positive abnormal returns (Figure 6B-1aa). At the time of the change itself, the re-). At the time of the change itself, the re-action was slightly negative or nonexistent, as investors seemed to ignore the positive cash action was slightly negative or nonexistent, as investors seemed to ignore the positive cash flow effect. Moreover, the risk (beta) of firms that switched to LIFO increased in the months flow effect. Moreover, the risk (beta) of firms that switched to LIFO increased in the months surrounding the switch.

surrounding the switch.

This result was similar to that of Ball (1972), who examined the market reaction to This result was similar to that of Ball (1972), who examined the market reaction to sev-eral accounting changes, FIFO/LIFO included. The positive reaction in the year of the eral accounting changes, FIFO/LIFO included. The positive reaction in the year of the switchswitch was interpreted by some as a sign that the market anticipated the switch and had reacted prior was interpreted by some as a sign that the market anticipated the switch and had reacted prior to the actual announcement. Others felt that ﬁrms that switched had been having good years to the actual announcement. Others felt that ﬁrms that switched had been having good years and could thus “afford” the negative impact of the switch, and that these studies suffered and could thus “afford” the negative impact of the switch, and that these studies suffered from a self-selection bias.

from a self-selection bias.

Subsequent studies such as Eggleton et al. (1976), Abdel-khalik and McKeown (1978), Subsequent studies such as Eggleton et al. (1976), Abdel-khalik and McKeown (1978), Brown (1980), and Ricks (1982) extended this research by controlling for earnings-related Brown (1980), and Ricks (1982) extended this research by controlling for earnings-related variables and focusing on the large number of ﬁrms that

variables and focusing on the large number of ﬁrms that switched in the 1974 to 1975 switched in the 1974 to 1975 period.period. Generally, their results conﬁrmed a negative market reaction in the

Generally, their results conﬁrmed a negative market reaction in the year of the switch.year of the switch. Ricks, for example, used a control sample of non-LIFO adopters (matched on the basis Ricks, for example, used a control sample of non-LIFO adopters (matched on the basis of industry and earnings calculated “as if” the

of industry and earnings calculated “as if” the control company was also on control company was also on LIFO) and com-LIFO) and com-puted the cumulative average return differences between the two groups. His results, puted the cumulative average return differences between the two groups. His results, pre-sented in Figure 6B-1

sented in Figure 6B-1bb, clearly indicate better market performance for firms that did not, clearly indicate better market performance for firms that did not adopt LIFO. Although these lower market returns were reversed within a year, the initial adopt LIFO. Although these lower market returns were reversed within a year, the initial pro-longed negative reaction is difficult to understand.

longed negative reaction is difﬁcult to understand.

One explanation for this anomalous behavior is that firms that sw

One explanation for this anomalous behavior is that firms that sw itched to LIFO wereitched to LIFO were those most affected by inflation. Thus, the market may have reacted negatively to the those most affected by inflation. Thus, the market may have reacted negatively to the added risk (higher inflation) of these firms, explaining the lower returns and higher risk added risk (higher inflation) of these firms, explaining the lower returns and higher risk measures.

measures.44

The difficulty with this explanation is that the sample firms were matched by industry. The difficulty with this explanation is that the sample firms were matched by industry. Thus, we must assume that the sample firms were somehow more adversely affected by Thus, we must assume that the sample firms were somehow more adversely affected by in-flation than other firms in the

flation than other firms in the same industry. Biddle and Ricks (1988), discussed shortly, alsosame industry. Biddle and Ricks (1988), discussed shortly, also found evidence consistent with this explanation. Implicitly, these studies help explain why found evidence consistent with this explanation. Implicitly, these studies help explain why firms stayed on FIFO; they wanted to avoid the unfavorable market reaction resulting from firms stayed on FIFO; they wanted to avoid the unfavorable market reaction resulting from the adoption of LIFO.

the adoption of LIFO.

Biddle and Lindhal (1982) attempted to resolve some of these issues by arguing that Biddle and Lindhal (1982) attempted to resolve some of these issues by arguing that pre-vious studies did not consider the amount of tax savings from the LIFO adoption. They vious studies did not consider the amount of tax savings from the LIFO adoption. They found a positive association (see Figure 6B-1

found a positive association (see Figure 6B-1cc) between the market reaction and the esti-) between the market reaction and the esti-mated tax savings:

mated tax savings:

The results in this study are consistent with a cash-flow hypothesis, which suggests that The results in this study are consistent with a cash-flow hypothesis, which suggests that in-vestor reactions to LIFO adoptions depend on the present value of tax-related cash-flow vestor reactions to LIFO adoptions depend on the present value of tax-related cash-flow sav-ings. After controlling for abnormal earnings

ings. After controlling for abnormal earnings performance, larger LIFO tax savings were foundperformance, larger LIFO tax savings were found to be (cross-sectionally) associated with larger cumulative excess returns over the year in to be (cross-sectionally) associated with larger cumulative excess returns over the year in which a LIFO adoption (extension) ﬁrst applied.

which a LIFO adoption (extension) ﬁrst applied.55

Biddle and Lindhal studied 311 LIFO adopters from the period 1973 to 1980. The Biddle and Lindhal studied 311 LIFO adopters from the period 1973 to 1980. The pat-tern of abnormal returns reported is similar to Sunder’s ﬁndings (Figure 6B-1

tern of abnormal returns reported is similar to Sunder’s ﬁndings (Figure 6B-1aa). Neither). Neither study used a control group,

study used a control group,66_{making these results not directly comparable to those of Ricks.}_{making these results not directly comparable to those of Ricks.}

4

4_{This argument is consistent with the Jennings et al. (1996) explanation (discussed earlier) that the negative associa-}_{This argument is consistent with the Jennings et al. (1996) explanation (discussed earlier) that the negative}

associa-tion between equity values and the LIFO reserve was related to the inability of ﬁrms to pass on higher input prices. tion between equity values and the LIFO reserve was related to the inability of ﬁrms to pass on higher input prices.

5

5_{Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association Between}_{Gary C. Biddle and Frederick W. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association Between}

Excess Returns and LIFO Tax

Excess Returns and LIFO Tax Savings,”Savings,” Journal of Accoun Journal of Accounting Researchting Research, Autumn 1982, Part II, pp. 551–588., Autumn 1982, Part II, pp. 551–588.

6

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Thus, it is possible that there was some systematic but unexplained factor affecting the 1974 Thus, it is possible that there was some systematic but unexplained factor affecting the 1974 to 1975 adoptions, and that the research results were sensitive to the research design and the to 1975 adoptions, and that the research results were sensitive to the research design and the time horizon examined.

time horizon examined.

Biddle and Ricks (1988), using daily data, confirmed that there were negative excess market Biddle and Ricks (1988), using daily data, confirmed that there were negative excess market returns around the preliminary dates of firms adopting LIFO in 1974. There is little evidence of returns around the preliminary dates of firms adopting LIFO in 1974. There is little evidence of

THE

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FIGURE 6B-1

FIGURE 6B-1 Abnormal returns: Inventory method studies.Abnormal returns: Inventory method studies. Sources:Sources: ((aa) 1946–1966 Adopters: Shyam Sunder, “Relationship Between Ac-) 1946–1966 Adopters: Shyam Sunder, “Relationship Between Ac-counting Changes and Stock Prices: Problems of Measurement and counting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence,”

Some Empirical Evidence,” Journal of Journal of Accounting ResearchAccounting Research, Supple-, Supple-ment 1973, pp. 1–45, Fig. 2, p. 18.

ment 1973, pp. 1–45, Fig. 2, p. 18. (( bb) 1974–1975 Adopters: William E.) 1974–1975 Adopters: William E. Ricks, The Market’s Respo

Ricks, The Market’s Response to the 1974 nse to the 1974 LIFO Adoption,”LIFO Adoption,” Journal Journal of Accounting Research

of Accounting Research, Autumn 1982, pp. 367–387, Fig. 2, p. 378., Autumn 1982, pp. 367–387, Fig. 2, p. 378. ((cc) 1973–1982 Adopters: Gary C. Biddle and Fredrick W. Lindahl,) 1973–1982 Adopters: Gary C. Biddle and Fredrick W. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association Between “Stock Price Reactions to LIFO Adoptions: The Association Between Excess Returns and LIFO Tax Savings,”

Excess Returns and LIFO Tax Savings,” Journal Journal of of Accounting Accounting Re- Re-search

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significant excess returns (negative or positive) near the preliminary dates of firms adopting significant excess returns (negative or positive) near the preliminary dates of firms adopting LIFO in other years.

LIFO in other years.77

To explain the negative returns, they examined analyst forecast errors for the 1974 To explain the negative returns, they examined analyst forecast errors for the 1974 LIFO adopters. They found that analysts significantly overestimated the earnings and did LIFO adopters. They found that analysts significantly overestimated the earnings and did not fully appreciate the magnitude of the impact of inflation.

not fully appreciate the magnitude of the impact of inflation.88_{In other years, however, the}_{In other years, however, the}

error in analyst forecasts for LIFO adopters was not significant. Further, they found that error in analyst forecasts for LIFO adopters was not significant. Further, they found that the negative returns were positively correlated with the forecast error, indicating that the the negative returns were positively correlated with the forecast error, indicating that the market (as well as analysts) was surprised by the actual reported earnings. Thus, the market (as well as analysts) was surprised by the actual reported earnings. Thus, the nega-tive returns were due to the “surprise” when the market realized that it had underestimated tive returns were due to the “surprise” when the market realized that it had underestimated the impact of inflation. As the firms that adopted LIFO were presumably those most the impact of inflation. As the firms that adopted LIFO were presumably those most af-fected by inflation, the negative surprise reaction hit them hardest. In later years, however, fected by inflation, the negative surprise reaction hit them hardest. In later years, however, the market learned from experience and the impact of inflation was more readily factored the market learned from experience and the impact of inflation was more readily factored into earnings estimates.

into earnings estimates.

Although these studies shed some light on the market reaction to LIFO adoption, they Although these studies shed some light on the market reaction to LIFO adoption, they still do not explain why some firms remain on FIFO. On the contrary, Biddle (1980) found still do not explain why some firms remain on FIFO. On the contrary, Biddle (1980) found surprising the finding that many firms voluntarily paid tens of millions of dollars in additional surprising the finding that many firms voluntarily paid tens of millions of dollars in additional income taxes by continuing to use FIFO rather than

income taxes by continuing to use FIFO rather than switching to LIFO.switching to LIFO.99 Contracting Theory Approach

Contracting Theory Approach

The contracting theories of accounting choice focus on

The contracting theories of accounting choice focus on this issue. Abdel-khalik (1985) exam-this issue. Abdel-khalik (1985) exam-ined the bonus plan hypothesis and its implicit corollary that management-controlled firms, ined the bonus plan hypothesis and its implicit corollary that management-controlled firms, in which ownership is widely held, are more likely to use FIFO than owner-controlled firms. in which ownership is widely held, are more likely to use FIFO than owner-controlled firms. The rationale for this argument was

The rationale for this argument was that when management is more removed that when management is more removed from ownershipfrom ownership of the firm, then management compensation rather than the wealth of the firm becomes the of the firm, then management compensation rather than the wealth of the firm becomes the primary motivator for manager actions. Thus, the LIFO-induced tax savings are less primary motivator for manager actions. Thus, the LIFO-induced tax savings are less impor-tant to the

tant to the management-controlmanagement-controlled ﬁrm.led ﬁrm.

Abdel-khalik found that manager-controlled FIFO firms had relatively higher Abdel-khalik found that manager-controlled FIFO firms had relatively higher income-based bonuses. On the other hand, there was no evidence that differences in compensation based bonuses. On the other hand, there was no evidence that differences in compensation plans were related to the FIFO/LIFO choice. In explaining this (non)finding, Abdel-khalik plans were related to the FIFO/LIFO choice. In explaining this (non)finding, Abdel-khalik hypothesized that either

hypothesized that either 1.

1. ﬁrms switching to LIFO modify their compensation arrangements, orﬁrms switching to LIFO modify their compensation arrangements, or 2.

2. as some executives have indicated to me, the FIFO-based income continues to beas some executives have indicated to me, the FIFO-based income continues to be used in determining annual bonus.

used in determining annual bonus.1010

Hunt (1985) examined the bonus plan and debt convenant hypotheses. His results did Hunt (1985) examined the bonus plan and debt convenant hypotheses. His results did not support the bonus plan hypothesis. Contrary to expectations, he found that LIFO firms not support the bonus plan hypothesis. Contrary to expectations, he found that LIFO firms tended to be less owner-controlled. Hunt, however, did find support for the debt

tended to be less owner-controlled. Hunt, however, did find support for the debt covenant hy-covenant hy-pothesis, especially with respect to the leverage and interest coverage ratios. His evidence pothesis, especially with respect to the leverage and interest coverage ratios. His evidence also indicates a threshold level of dividend payout ratios above which firms are reluctant to also indicates a threshold level of dividend payout ratios above which firms are reluctant to use LIFO.

use LIFO.

Dopuch and Pincus (1988) examined the bonus plan, debt covenant, and taxation Dopuch and Pincus (1988) examined the bonus plan, debt covenant, and taxation hy-potheses in one study and

potheses in one study and found that the taxation effect provided the best found that the taxation effect provided the best explanation for theexplanation for the LIFO/FIFO decision. They compared the holding gain that would have accrued to LIFO LIFO/FIFO decision. They compared the holding gain that would have accrued to LIFO ﬁrms had they stayed on FIFO with the holding gain for ﬁrms that remained on FIFO.

ﬁrms had they stayed on FIFO with the holding gain for ﬁrms that remained on FIFO.

7

7_{Gary C. Biddle and William E. Ricks, “Analyst Forecast Errors and Stock Price Behavior Near the Earnings An-}_{Gary C. Biddle and William E. Ricks, “Analyst Forecast Errors and Stock Price Behavior Near the Earnings}

An-nouncement Dates of LIFO Adopters,”

nouncement Dates of LIFO Adopters,” Journal of Account Journal of Accounting Researching Research, Autumn 1988, pp. 169–194., Autumn 1988, pp. 169–194.

8

8_{At that time, LIFO adoptions were unusual, and it took time for analysts to learn to estimate the impact. That they}_{At that time, LIFO adoptions were unusual, and it took time for analysts to learn to estimate the impact. That they}

did learn is evidenced by the reduced earnings forecast errors for LIFO adopters in later years. did learn is evidenced by the reduced earnings forecast errors for LIFO adopters in later years.

9

9_{Gary C. Biddle, “Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory}_{Gary C. Biddle, “Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory}

Policy,”

Policy,” Journal of Accou Journal of Accounting Researchnting Research, Supplement 1980, pp. , Supplement 1980, pp. 235–280.235–280.

10

10_{A Rashad Abdel-khalik, “The Effect}_{A Rashad Abdel-khalik, “The Effect of LIFO-Switching and Firm Ownership on Executive’s Pay,”}_{of LIFO-Switching and Firm Ownership on Executive’s Pay,” Journal of}

Journal of Ac-counting Research

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They found larger holding gains for LIFO

They found larger holding gains for LIFO ﬁrms, resulting in higher tax savings. In addi-ﬁrms, resulting in higher tax savings. In addi-tion, the holding gain grew as they approached the switch date. Dopuch and Pincus argued tion, the holding gain grew as they approached the switch date. Dopuch and Pincus argued that this indicated

that this indicated

the long-term FIFO firms in our sample have not been forgoing significant tax savings, in the long-term FIFO firms in our sample have not been forgoing significant tax savings, in which case remaining on that method is certainly consistent with FIFO being an optimal tax which case remaining on that method is certainly consistent with FIFO being an optimal tax choice, given other considerations. In contrast, long-term LIFO firms would have forgone choice, given other considerations. In contrast, long-term LIFO firms would have forgone sig-nificant tax

nificant tax savings.savings. .. .. . Finally, . Finally, using the lusing the long-term FIFO saong-term FIFO sample’s average mple’s average holding gains aholding gains as as a base, our change-firms’ average holding gains became significantly larger than the FIFO base, our change-firms’ average holding gains became significantly larger than the FIFO aver-age as they approached the year

age as they approached the year in which they switched, and this difference continued to in which they switched, and this difference continued to growgrow subsequently.

subsequently.1111

Further, Dopuch and Pincus argued that financial analysts could have calculated the Further, Dopuch and Pincus argued that financial analysts could have calculated the creased holding gains for the switch firms and thus anticipated the switch. Therefore, the creased holding gains for the switch firms and thus anticipated the switch. Therefore, the in-conclusive findings of the market reaction studies could be a result of ignoring the “advance conclusive findings of the market reaction studies could be a result of ignoring the “advance warning” market agents had regarding the switch.

warning” market agents had regarding the switch.

More recently, Jennings et al. (1992) supported this advance warning contention. They More recently, Jennings et al. (1992) supported this advance warning contention. They constructed a model that predicted which firms in the 1974 to 1975 period were more likely constructed a model that predicted which firms in the 1974 to 1975 period were more likely to adopt LIFO. The model accurately forecast adopting/nonadopting firms approximately to adopt LIFO. The model accurately forecast adopting/nonadopting firms approximately two-thirds of the time. Furthermore, the prior probability of adoption affected the market two-thirds of the time. Furthermore, the prior probability of adoption affected the market re-action. The less likely candidates for adoption (according to the model) had more positive action. The less likely candidates for adoption (according to the model) had more positive market reactions when they adopted LIFO. Similarly, firms that were originally viewed as market reactions when they adopted LIFO. Similarly, firms that were originally viewed as likely candidates for adoption, but did not adopt, suffered negative market reaction when likely candidates for adoption, but did not adopt, suffered negative market reaction when they failed to adopt LIFO.

they failed to adopt LIFO.

However, in summing up the research in this area, the editor of

However, in summing up the research in this area, the editor of The Accounting ReviewThe Accounting Review

stated stated

We continue to be relatively uninformed about these issues and know little about the real We continue to be relatively uninformed about these issues and know little about the real rea-sons that many ﬁrms do not switch to LIFO

sons that many firms do not switch to LIFO when it appears that they would benefit by positivewhen it appears that they would benefit by positive tax savings.

tax savings.1212

THE

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11

11_{Nicholas Dopuch and Morton Pincus, “Evidence of the Choice of Inventory Accounting Methods: LIFO Versus}_{Nicholas Dopuch and Morton Pincus, “Evidence of the Choice of Inventory Accounting Methods: LIFO Versus}

FIFO,”

FIFO,” Journal of Account Journal of Accounting Researching Research, Spring 1988, pp. , Spring 1988, pp. 28–59.28–59.

12

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Appendix 7-A

RESEARCH AND DEVELOPMENT AFFILIATES

INTRODUCTION

Because GAAP in the United States requires that all expenditures for research and Because GAAP in the United States requires that all expenditures for research and develop-ment (R&D) be expensed, firms have looked for alternative methods of financing R&D that ment (R&D) be expensed, firms have looked for alternative methods of financing R&D that postpone the associated earnings charge. Alternate financing methods may also have the postpone the associated earnings charge. Alternate financing methods may also have the fol-lowing advantages:

lowing advantages:

•• Targeting investors who are attracted by the risk/reward characteristics of specific projectsTargeting investors who are attracted by the risk/reward characteristics of specific projects •• Focusing management attention on specific projects by placing Focusing management attention on specific projects by placing their development in atheir development in a

separate entity. separate entity.

We discuss the two most common forms of these arrangements, R&D

We discuss the two most common forms of these arrangements, R&D partnerships partnershipsandand de- de-velopment companies

velopment companies. The drug and biotechnology industries have been the most common. The drug and biotechnology industries have been the most common users of these techniques, perhaps because R&D is focused on the development of discrete users of these techniques, perhaps because R&D is focused on the development of discrete patentable products.

patentable products.

Appendix Objectives

1.

1. Examine the motivation for the establishment of R&D arrangements.Examine the motivation for the establishment of R&D arrangements. 2.

2. Show the effect of R&D arrangements on the amounts and timing of Show the effect of R&D arrangements on the amounts and timing of research and de-research and de-velopment expense.

velopment expense. 3.

3. Show the effects of R&D arrangements on reported net income, stockholders’ equity,Show the effects of R&D arrangements on reported net income, stockholders’ equity, and ﬁnancial ratios.

and ﬁnancial ratios. 4.

4. Compare the effects of R&D arrangements on companies using accounting methodsCompare the effects of R&D arrangements on companies using accounting methods that expense all R&D with

that expense all R&D with those permitting capitalizatiothose permitting capitalization.n.

RESEARCH AND DEVELOPMENT PARTNERSHIPS

An R&D

An R&D partnership partnershipraises funds from investors. Those funds are then raises funds from investors. Those funds are then used to pay the com-used to pay the com-pany for research. Any

pany for research. Any patents or products resulting from that research belong to patents or products resulting from that research belong to the partner-the partner-ship, but the company can either purchase the partnership or license the product. Thus, the ship, but the company can either purchase the partnership or license the product. Thus, the company controls the technology without reporting the expenses resulting from research company controls the technology without reporting the expenses resulting from research costs, as the “revenue” from the

costs, as the “revenue” from the partnership offsets the research expense.partnership offsets the research expense.

This arrangement has many of the attributes of an option; the ﬁrm has a call option on This arrangement has many of the attributes of an option; the ﬁrm has a call option on the patents or products developed for the partnership, with the purchase price being the the patents or products developed for the partnership, with the purchase price being the exer-cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and cise or strike price. Shevlin (1991) treats such limited partnerships (LPs) as an option and uses option pricing theory to value the LP:

uses option pricing theory to value the LP:

The value of the LP call option to the R&D firm may be decomposed into the present value of The value of the LP call option to the R&D firm may be decomposed into the present value of the underlying project financed by the LP (an asset) less the present value of the payments to the underlying project financed by the LP (an asset) less the present value of the payments to the limited partners if the

the limited partners if the ﬁrm exercises its option (liability).ﬁrm exercises its option (liability).11

W14

1

1_{Terry Shevlin, “The Valuation of R&D Firms with R&D}_{Terry Shevlin, “The Valuation of R&D Firms with R&D Limited Partnerships,”}_{Limited Partnerships,” The Accounting Review}_{The Accounting Review, Jan. 1991,}_{, Jan. 1991,}

pp. 1–21. pp. 1–21.