Choice of Inventory Valuation Method and Self-Selection Bias

Abstract

Prior literature recognizes the existence of sample self-selection bias in LIFO-FIFO studies (e.g., Sunder 1973, Jennings et al. 1992, Maddala 1991, Hand 1995). However, these studies do not directly account for the self-selection bias. In this study, we develop a model where the choice of the inventory valuation method and its effects are jointly determined. Using Compustat data from 1973-1981, we find: (1) that the self-selection bias is a significant factor in analyzing a firm's LIFO adoption or nonadoption decision, (2) that correcting for self-selection bias leads to the robust inference that, on average, FIFO firms would pay more taxes if they were using LIFO, and LIFO firms would pay more taxes if they were using FIFO, (3) the probability of a switch from FIFO to LIFO is estimated to be between 12 and 20 percent for a typical FIFO firm, and (4) the average dollar value of tax savings for LIFO adoption lies between $3 to $11 million. We also compare our estimated selectivity-adjusted tax savings for LIFO-FIFO firms with corresponding estimates obtained under the as-if method, similar to one used in the prior literature (e.g., Dopuch and Pincus 1988, Morse and Richardson 1983, Biddle and Lindahl 1982). Our results show that the selectivity-adjusted mean dollar tax savings to LIFO firms are larger than under the as-if method. Our findings suggest that the tax benefits of adopting LIFO firms are smaller than normally understood and that the tax benefits to FIFO firms from remaining as FIFO are larger than is otherwise believed.