Cost Flow Assumptions Research Articles

Costs and benefits of the LIFO‐FIFO choice

AbstractThe choice of inventory cost flow assumption is a key financial reporting decision. The resurgence of inflation has renewed interest in this option. We derive algebraic models of the LIFO‐FIFO difference in cost of goods sold and the LIFO tax savings as a function of inflation, turnover, inventory increments, and tax rates. Managers and researchers can use these models to estimate the likely financial and tax impacts of LIFO adoption. Historic trends in public company LIFO usage since 1971 are consistent with the changing impacts estimated by our model. We infer an approximate cost level of using LIFO based on historic public company behavior. In the 1971–2022 period, LIFO adoptions were only common when the tax benefit in our model exceeded about 0.35% of COGS. Even when inflation rose in 2021 and 2022, the tax savings remained below this threshold, and there were far more LIFO abandonments than adoptions.

온실가스 배출권 재무공시 현황 및 시사점

[Purpose] This study aims at providing the implications and the improvements of the financial disclosure of the carbon emissions and the carbon credits.
 [Methodology] This paper reviews the current financial disclosure of the companies which have large quantities of carbon emissions from accounting users’ perspectives. This study covers financial disclosures, including financial statements and their notes on their annual and quarterly reports.
 [Findings] This paper documents the gaps between the K-GAAP and the current disclosure practice. There is inconsistency between the carbon credits and carbon liabilities. There are wide deviations across companies with respect to the unit price of carbon credit when companies estimate the amounts of their carbon liabilities. The paper also proposes additional disclosure for the carbon liabilities and cost flow assumptions, etc.
 [Implications] Differentiated from the previous literature that is focused on quantitative analysis, this paper reviews the quality of the carbon related disclosures. This study provides proposals that can enhance the usefulness of carbon disclosure to the accounting information users.

Inventory Cost Flow Assumptions and Limitations of Lifo: A Case Study of a Manufacturing Firm in Albania

Valuing inventory at cost is crucial for understanding a firm's expenses, gross profit, taxes, net income, and ending inventory during a specific accounting period. This study focuses on inventory cost flow assumptions under IFRS and U.S. GAAP standards. In the Albanian accounting system, Specific Identification (SI), First In, First Out (FIFO), and Weighted Average Cost (WAC) methods are accepted. Among these, FIFO and WAC are the most commonly used inventory cost flow assumptions. The study also examines the reasons for the ban on Last In, First Out (LIFO) cost flow assumption by IFRS and Albanian accounting standards. An empirical analysis using a case study of a manufacturing firm reveals that the WAC assumption is more favorable, as it results in lower cost of goods sold (COGS) and an ending inventory cost that closely aligns with current market prices.

INVENTORY COST FLOW ASSUMPTIONS AND LIMITATIONS OF LIFO: A CASE STUDY OF A MANUFACTURING FIRM IN ALBANI

INVENTORY COST FLOW ASSUMPTIONS AND LIMITATIONS OF LIFO: A CASE STUDY OF A MANUFACTURING FIRM IN ALBANI

Judy Gent—Inventory

This case is used at the Darden School of Business in the inventory module of the Financial Reporting course elective, but it would also work well at the advanced undergraduate level. Through five phases, students first become familiar with core terminology and concepts before examining various situations—from what to make of an annual report footnote disclosure and balancing the pros and cons of using LIFO versus FIFO cost flow assumption to examining misreported inventory and inventory write-downs. Excerpt UVA-C-2352 Rev. Dec. 10, 2014 JUDY GENT—INVENTORY Judy Gent was a driven person who had a knack for numerical analysis, deductive reasoning, and quick insights. She also had a desire for maintaining as many career options as possible for as long as possible. Thus as a forward-looking young professional, she had both the CPA and CFA professional certifications in her sights. The CPA exam, as well as Level 1 of the CFA exam, was on her spring schedule, and she had begun her preparation with the resolute dedication that she was always able to muster when she saw hard work and accomplishment on the horizon. One of this week's topics slated for her review was the financial reporting of, and the accounting choices available for, corporate inventories. For most people, she guessed the topic would not hold much attraction, but she knew there were some nuances and interesting aspects of the topic to be explored. It was 9:30 a.m. Saturday. She had already gone for a run, showered, eaten, walked the dog, and set out the materials for her review. She would tackle her review in five phases. Phase One During the week, Gent had assembled materials from her undergraduate days, various online exam study sites, and notes given to her by some of her slightly older friends who had already taken the exams. She had synthesized all of it, and she wanted to succinctly and expertly answer some fundamental background questions pertaining to the topic of inventories in the first phase of study she had set up for herself. The initial questions for which she wanted to be sure she had the comprehensive answers: . . .

Stochastic cost flow system for stock markets with an application in behavioral finance

We introduce a new stochastic cost flow system for stock markets in which the probability distribution of the weighted average purchase price of a stock among all of its shareholders can be explicitly determined. The stochastic system is illustrated in three empirical applications. Through the empirical results, we demonstrate the impact of choosing cost flow assumptions on the reference purchase price estimates, we show the value of high-frequency financial data, and we advocate the need for the stochastic cost flow system when estimating the proportion of gains realized (PGR) and the proportion of losses realized (PLR) which are the most important measures for the disposition effect.

The Impending Demise Of LIFO: History, Threats, Implications, And Potential Remedies

Since its approval by congress in 1939, the last-in-last-out (LIFO) inventory cost flow assumption has historically been utilized by a significant portion of U.S. companies for both tax and financial reporting purposes. However, despite its extensive use and wide acceptance in practice, the LIFO inventory method is currently endangered by two powerful movements that make its future existence far from certain. The first of these movements is the ongoing convergence of U.S. and international accounting standards. Whether future global harmonization of accounting practice come from continued convergence or outright adoption of international accounting standards, this harmonization poses a threat to the continued use of LIFO since LIFO is prohibited under international accounting rules. The second movement is grounded in governmental attempts to lessen the current federal budget deficit. The elimination of LIFO has been targeted as a way of reducing the deficit within the Obama administrations deficit reduction efforts. The momentum of these two threats to LIFO makes the topic of LIFOs future ripe for discussion. This study discusses the history of LIFO, illuminates the current threats the method faces, and outlines the most common remedies that have been proposed to mitigate the financial impact faced by companies that will be negatively affected by any such elimination of the method.

Teaching Inventory Accounting: A Simple Learning Strategy to Achieve Student Understanding

ABSTRACT This learning strategy offers an efficient and effective technique for teaching inventory in the introductory financial accounting course. It is motivated by the belief that many students memorize how to calculate the cost of goods sold and ending inventory under different cost flow assumptions, but that few understand the subject. This fundamental lack of understanding prohibits them from fully appreciating other issues, such as the difference between the physical flow and the cost flow assumption, the relevance of the cost flow assumption when computing cost of goods sold and income, and the irrelevance of the cost flow assumption when computing cash flow unless taxes are considered. Our learning strategy involves a convenience store selling three bottles of water. Inventory flow, cash flow, and the calculations of cost of goods sold, income, and ending inventory are illustrated under the first-in, first-out method; the last-in, first-out method; the weighted-average method; and specific identification.

Bias And Random Measurement Error In Accounting-Based Surrogates For Internal Rate Of Return

<span>Limitations inherent in alternative profitability measures as estimates of internal rate of return (IRR) often require that managers and researchers employ accounting-based profitability measures. Using published accounting and stock market data, this study models accounting rate of return (ARR) and conditional estimate of internal rate of return (CIRR) as functions of product market risk; growth (g) inventory cost flow assumption (INV), and depreciation method (DE). The models support inferences about the bias and efficiency (i.e. systematic and random error) in the relationships between the two accounting-based profitability measure and IRR, as estimated by the bias and efficiency in their relationships with a factor that is suggested in the finance literature as a determinant of systematic risk (product market risk). The results indicate that ARR estimates IRR with bias attributable to g; however, ARR is unaffected by INV and DEP. Whether g, INV, or DEP affect CIRRs ability to estimate IRR depends on the interval over which CIRR is estimated and the assumed cash flow pattern. On the other hand, CIRR generally estimates IRR with significantly greater efficiency. These results have research design implications, as well as implications for both accounting policy formulation and anti-trust policies.</span>

Paragon Electronics, Inc.: Inventory Cost Flow

This case provides the basis for exploring issues pertaining to different cost flow assumptions and their working capital consequences. Students make various cost flow calculations for inventory and cost of goods sold using FIFO, LIFO, and the weighted-average techniques over a five-year time frame, during which inventory prices and quantities rise and fall. It quickly becomes apparent that accounting choices are related to significant managerial concerns and that certain accounting choices often induce certain managerial actions.

Quality of Earnings: An Introduction to the Issues in Accounting Education Special Issue

In September 1998, Arthur Levitt, then Chairman of the Securities and Exchange Commission (SEC), presented an address at New York University, Numbers Game. In that speech, he called attention to an escalating problem with the quality of financial reporting in filings with the SEC. The topic received a great deal of attention over the next several years, both at the SEC and in the business world at large; in the first six months of 2002 the quality of accounting reports has even been discussed in Congress. In 2000, pursuant to an SEC consent order under the Securities and Exchange Act of 1934, the American Accounting Association received a grant funding a multipart of Earnings Project. Recognizing the need to introduce future business professionals to the importance of quality early in their careers, one part of that project included funding for a special edition of Issues in Accounting Education. As stated in the call for papers to be considered for this special issue, submissions [wer e to] address some aspect of quality, and [could] be in financial accounting, managerial accounting, international accounting, auditing, systems, or tax....The overriding requirement [was] that the reader [would] be provided with ideas or materials about the quality of that he or she [could] take into the classroom. The seven cases included here are part of the response to that call. Additional manuscripts still in the review process will appear in Issues in Accounting Education, February 2003. Quality of earnings is a multidimensional concept. There are at least three distinct sets of decisions that affect the quality of earnings: decisions made by standard setters, choices made by management about which accounting methods should be chosen from a set of acceptable alternatives, and judgments and estimates made by management in order to implement the chosen alternatives. The set of accounting standards making up U.S. GAAP is generally considered to be of high quality. However, a perfect set of standards is unattainable due to the inherent tension between relevance and reliability of accounting numbers, and due to the changing nature of economic transactions over time. Even if it were possible for standard setters to agree on a single acceptable accounting alternative for every type of transaction, it might be inadvisable to do so. There may be valid reasons for allowing companies to choose among different allowed accounting alternatives. (Dechow and Skinner [2000], among others, discuss this issue in more depth.) For example, companies may enter into certain business transactions with different intents; allowing three different accounting treatments for certain investments in debt securities allows financial statements to reflect those different business objectives. Earnings management is a concept related to, but clearly not synonymous with, quality. Earnings management activities, broadly considered, can affect quality of on each of the three dimensions mentioned in the preceding paragraphs. Actions of participants in the standard-setting process that affect the quality of the allowed accounting standards could be considered management. For example, opposition to the FASB's proposed mandatory expensing of the fair value of executive stock options affected the quality of earnings. Similarly, managements' choices among allowed accounting alternatives also could be considered management. For example, decisions such as choosing the FIFO inventory cost-flow assumption in a period of increasing prices, or choosing to use straight-line depreciation, will result in earlier recognition of income, other things equal. Finally, as time passes and managements apply selected standards, when using judgments about whether criteria for recognition ha ve been met or whether estimates need revision, management may occur. …

Foreign operations and the choice of inventory accounting methods

Many companies continue to use the FIFO or other inventory cost flow assumption even though empirical research has shown that the LIFO assumption provides significant cash flow advantages over the other methods. One potential influence on the choice of inventory method that has not been investigated in prior empirical studies is the potential effect of a firm's foreign operations. Because LIFO is not commonly used and/or permitted in most foreign countries, high levels of foreign inventory may influence the choice of inventory method for the firm's domestic inventory. The purpose of this paper is to determine if a firm's level of foreign operations influences its choice of inventory cost flow assumptions for its U.S. inventory. A probit model of inventory choice is developed using variables that have been found to differentiate LIFO and non-LIFO firms in previous studies. The results indicate firms with higher relative levels of foreign operations are more likely to use a non-LIFO inventory method for their domestic inventory than firms that are less involved in foreign markets. The results suggest that the level of foreign operations should be considered in future models of inventory choice and possibly other accounting choice models when there are differences in accounting standards since firms with significant levels of foreign operations may be influenced by these differences.

A Simulation‐Based Investigation of Errors in Accounting‐Based Surrogates for Internal Rate of Return

Accounting‐based measures of a firm's ex post performance represent accessible, albeit imperfect, surrogates for its internal rate of return (IRR). Using a cross‐sectional data set obtained via computer simulation, this study calculated the error with which the accounting rate of return (ARR) and conditional estimate of internal rate of return (CIRR) estimate IRR. The study compared the error with which both surrogates measure IRR, as well as the ability of growth in unit demand (gD), inventory cost flow assumption (INV) and depreciation method (DEP) to explain the measurement error in both surrogates.

Testing Accounting Hypotheses: The Association of Accounting Numbers with Stock Values, 1959-1965

This research is aimed at answering accounting questions by measuring the association between alternative accounting numbers and the value of a company's stock. The model includes a financial reporting period and a subsequent stock holding period, with an assumed investment date connecting the two (all historical). The value of a stock at the investment date is the present value of its dividends during the holding period plus the present value (as of the investment date) of its market value at the end of the holding period. For example, the choice of inventory cost flow assumptions (LIFO or FIFO) is tested with matched samples of companies (one sample using LIFO, one using FIFO). The correlation of reported earnings and stock values in the LIFO sample is compared to earnings/value correlation in the FIFO sample Other accounting issues are addressed in a similar manner, as indicated in the table of contents.As an alternative to measurement of association using least-squares calculations, association was measured using median deviation percentages. For example, if earnings is the accounting number being tested, the median of the deviation of each stock's V/E ratio from the sample mean V/E ratio is taken as the measure of association.

Inflation, Taxes, and Optimal Inventory Policies

Inflation, Taxes, and Optimal Inventory Policies

Stock Price Reactions to LIFO Adoptions: The Association between Excess Returns and LIFO Tax Savings

Although long a topic of accounting research, little is known about the motives for or effects of voluntary changes in accounting techniques. Among the motives which have been suggested are attempts by managers to smooth reported earnings (Gordon [1964], Copeland [1968], Cushing [1969], White [1972], and Ronen and Sadan [1981]), to influence man- agement compensation, to reduce regulatory or political costs (Watts and Zimmerman [1978]), and to avoid bond covenant restrictions (Holthausen [1981]).' While some of these motives may be consistent with a value rule, they often fail to provide unambiguous accounting change predictions (e.g., which accounting changes result in lower regulatory costs?). Moreover, empirical verification has been constrained by the unobservability of the variables to which the managers allegedly respond. The stock price reaction which should be expected for a given account- ing change depends not only on its implications for the valuation of securities but also on the extent to which the implications are already known or anticipated by investors.3 Ultimately our ability to detect these stock price effects (if any) depends on the power of our tests. Previous studies of the effects of accounting changes have generally not found significant stock price reactions (Archibald [1972], Ball [1972], Kaplan and Roll [1972], Harrison [1977], and Holthausen [1981]).4 For the most part, these studies dealt with accounting changes which had no direct cash-flow effects. In contrast, changes in inventory costing methods, especially those involving the last-in, first-out (LIFO) cost-flow assumption, can generate potentially large changes in a firm's cash flows due to their impact on taxable earnings. These cash-flow effects provide not only a motive for LIFO changes5 (which is consistent with the market value rule) but also implications for associated stock price effects: if investors react to LIFO's cash-flow implications rather than to its effects on reported earnings, then positive stock price adjustments should be associated with LIFO adjustments. However, the evidence from previous studies of stock price reactions to LIFO adoptions is inconclusive (Ball [1972], Sunder [1973; 1975], Abdel-khalik and McKeown [1978], Brown [1980], and Ricks [1982]). While several factors may account for these results-see section 2-it can be noted that the previous studies have considered only a dichotomous variable, whether or not a firm has adopted LIFO. Yet because the cash- flow consequences of a LIFO adoption decision depend on a number of firm-specific factors, this approach ignores potentially large differences among firms in the economic consequences of LIFO adoptions. Most firms switching to LIFO now reveal in their financial statement disclosures the tax savings which have been realized. This study uses these disclosures to examine the association between unsystematic re- turns and the magnitudes of first-year LIFO tax savings for all NYSE firms which adopted or extended their use of LIFO during the period 1972-80 (subject to data availability).6 The research design employs within-group comparisons based on cumulative monthly unsystematic (excess) returns with appropriate controls for unexpected earnings per- formance.7 This design avoids several methodological weaknesses inherent in the previous studies and allows more definitive tests of hypotheses relating investor reactions to the income and cash-flow effects of LIFO adoptions. As reported more fully below, results based on LIFO adoptions made in 1974 are consistent with a positive association between cumulative excess stock returns and the magnitudes of LIFO tax savings.8 The results also provide evidence that changes in systematic risk may accompany LIFO adoptions. However, contrary to previous studies, most of the sample firms exhibit downward rather than upward changes in systematic risk. Section 2 reviews the previous studies of stock price reactions to LIFO adoptions and suggests explanations for their results. Section 3 discusses the alternative approach employed in this study, while section 4 describes the test methodologies employed. The data and data selection procedures are described in section 5. The results and a discussion are presented in section 6. Section 7 offers some conclusions.

Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy

Considerable attention in the accounting literature is devoted to dis- cussing possible motives for and effects of choices among alternative accounting methods. Although insights have been gained into investor (stock market) reactions to changes in accounting methods, little is known about either management motivations for observed accounting choices or the effects of these choices on subsequent operating decisions. One explanation for the dearth of empirical findings is that few of the proposed theories of accounting choice have offered strong links to real economic incentives. In addition, previous studies have concentrated on firm characteristics existing before and concurrent with the accounting choice. Since managers making accounting choices are likely to consider future conditions as well, this approach may overlook important deter- minants of accounting choices. This approach also precludes the detection of possible changes in operating policies induced by accounting choices. A choice among alternative inventory costing methods, especially between the last in, first out (LIFO) and first in, first out (FIFO) cost- flow assumptions, can generate potentially large changes in a firm's cash flows due to its impact on taxable earnings. These cash-flow effects provide economic incentives for choices between these methods. More- over, these cash-flow effects depend, in part, on the behavior of year-end physical inventories. Because year-end inventory levels are subject to management control, the LIFO-FIFO choice can both affect and be affected by subsequent inventory management policies. The LIFO-FIFO choice offers, therefore, the opportunity both to identify factors which influence accounting choices and to examine associations between these choices and subsequent operating decisions. This study investigates whether associations consistent with LIFO- FIFO tax incentives exist between management choices to adopt or not adopt the LIFO inventory costing method and characteristics of firms' year-end inventories. Both pre- and postchoice characteristics are ex- amined. Because the LIFO-FIFO choice is voluntary, a postchoice association would be consistent with managers both anticipating future inventory characteristics when making a LIFO-FIFO choice and chang- ing inventory management policies in response to that choice. Evidence consistent with the hypothesis that LIFO adoptions are associated with changes in inventory management policies would have important macroeconomic implications. Zarnowitz and Moore [1977] have argued that a failure to recognize the major shift in inventory costing methods which occurred in 1973 and 1974 (primarily FIFO to LIFO) resulted in an underestimation of inventory accumulations by the U.S. Department of Commerce. This underestimation resulted from the different proce- dures used under LIFO and FIFO to assign costs to inventory units. While this effect of LIFO-FIFO choices can bias macroeconomic mea- surements and forecasts, an associated change in inventory management policies by a large number of firms could directly affect underlying macroeconomic stocks and flows. The research design involves comparisons between a treatment group sample of firms which adopted LIFO and a matched pair control sample of firms which continued to use FIFO (or an average cost method). Two primary measures of inventory properties are derived from available financial statement disclosures. One measure approximates physical in- ventory levels, while the other estimates what the difference would have been each year between each firm's cost-of-goods-sold computed under the LIFO and FIFO alternatives. The empirical results based on these measures indicate statistically significant associations between LIFO adoption decisions and inventory properties and reveal striking cash-flow consequences associated with LIFO-FIFO choices.

Relationship between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence

Generally accepted accounting principles allow alternative treatments of several types of accounting events. Financial accounting policy-making bodies such as the Accounting Principles Board and the Securities and Exchange Commission rule on the admissibility of various accounting procedures and on changes from one procedure to another. For this purpose, they need information about the effect of accounting procedures and changes in accounting procedures on the interests of various economic agents in society. Admissibility of alternative procedures implies that corporate managers must select one of the available procedures for their use. For making such selections, managers need information about the relationship of accounting procedures with corporate objectives. In making their investment decisions, investors too need information not only about the meaning of various accounting procedures but also about the relationship of these procedures with stock prices. In this paper, I report on a study of the relationship between alternative inventory cost flow assumptions (Lifo and Fifo) with the behavior of stock prices. The belief that an understanding of this relationship is relevant to the three classes of decision makers mentioned above provides the justification for the study.

The Effects of Alternative Accounting Techniques on Certain Management Decisions

The present study was designed to investigate the influence of alternative accounting techniques on some selected management decisions. In general terms, the investigator was concerned with whether or not the various alternatives available to the accountant in the presentation of financial data evolving from identical facts could have an effect on business decisions. In particular, this study explored the hypothesis that different inventory cost-flow assumptions would affect the decisions. Assume that two decision-makers, identical in every respect including their goal structure (which need not be specified), are given identical sets of data at a given moment in time. A reasonable hypothesis would anticipate identical decisions, except possibly for a random error. Now suppose the data are supplied in the form of accounting statements. Suppose further that, although the underlying economic facts remain identical, the accountant applies two different accounting techniques in reporting the impact of the facts on the enterprise. Would the decisions made still be indistinguishable? The two different accounting techniques chosen for the alternate reports related to the assumed cost-flow through the inventory accounts. The same basic facts were reported using both a first-in, first-out cost-flow assumption (referred to subsequently as FIFO) and a last-in, first-out costflow assumption (referred to subsequently as LIFO). These divergent cost-flow assumptions can affect the final reported profit figures particu-