Inventory Costing Research Articles

Inference of Economic Truth from Financial Statements for Detecting Earnings Management: Inventory Costing Methods from an Information Economics Perspective

We introduce uncertainty in the classic inventory costing choice problem to investigate the underlying partitions imposed by two accounting inquiries (processes of generating information): variable costing (VC) and absorption costing (AC). In a contemporaneous reporting environment, we show that absorption costing provides a finer partition of the state space compared to variable costing when a firm arbitrarily increases the production level (opportunistic overproduction) and the predetermined fixed overhead rate is adjusted. Grounded in an information economics perspective, the intent of the article is to propose an approach to detect real earnings management by extracting information from financial statements. The resulting managerial biases arising from earnings management are also discussed.

The Effects of LIFO Inventory Costing on Resource Allocation: A Comment

The Effects of LIFO Inventory Costing on Resource Allocation: A Comment

THE OLD DU PONT COMPANY'S ACCOUNTING SYSTEM LASTING A HUNDRED YEARS: AN OVERLOOKED ACCOUNTING SYSTEM

ABSTRACT Accounting historians have not yet realized that there existed another complete accounting system before the formation of the modern accounting system of today which Johnson and Kaplan's Relevance Lost characterizes by the “integration” of cost and financial accounts supported by “inventory costing.” In that earlier accounting system, cost and profit calculations were made in a past particular ledger account or accounts, namely trading account(s), where accounting practices opposed to “inventory costing” and “integration” were used. The historical existence of that accounting system is overlooked by accounting historians. The example of the old Du Pont Company (DPC) this paper presents will bring it to light. Cost and profit calculation were made in four trading accounts in the double-entry ledger at the old DPC as it was purchased by the new DPC in 1902. One of its trading accounts dated back to 1804 when the old DPC started production of gunpowder. Early cost and profit calculations in that trading account were examined by the new DPC's staff in the early 1940s. They prepared schedules showing the cost data, sales revenues, and profit measurement recorded in the early trading account. These schedules give evidence that the old DPC recorded the costs incurred and used the cost data to compute profit for financial accounting purposes, but in different ways from today's “inventory costing” and “integration.” This old DPC's accounting system resulted from the application of the double-entry system to industrial accounting and was in use throughout the nineteenth century. By revealing the historical existence of that overlooked accounting system, this paper will show that accounting history may be described as evolution of the traditional accounting system made through double-entry bookkeeping in which the trading account was of vital importance and the transition from that traditional accounting system to the modern integrated accounting system supported by inventory costing.

The Income Effects of Alternative Inventory Costing Methods from an Information Economics Perspective

The Income Effects of Alternative Inventory Costing Methods from an Information Economics Perspective

International Financial Reporting—Inventory Costing at Exxon and BP

International Financial Reporting—Inventory Costing at Exxon and BP

Inventory Costing: Developing Business Logic In Accounting Systems

Business logic is the link in an information system between a user interface and a database. Typically it contains formal rules, translated into computer programs, that control how data will be processed to achieve the objectives of the information system. This paper describes a classroom exercise to help students understand this segment of an information system. In addition, it is useful for helping students understand the relation between traditional financial accounting and accounting systems. They are required to describe formally and precisely how FIFO and LIFO inventory values can be derived in an automated system.

Harmonisation of Accounting Measurement Practices in the European Community

Abstract This study attempts to determine the level of accounting harmonisation in the European Community by examining selected measurement practices from the 1992/93 annual reports of companies from Belgium, Denmark. France, Germany, Ireland, the Netherlands. Portugal and the UK. Harmonisation is tested using the chi-square statistic and measured using the / index. The chi-square statistic tests for the equality of the proportions of accounting measurement methods across countries. The / index measures the extent of concentration around a particular accounting measurement method. The results reveal that accounting for foreign currency translation of assets and liabilities, treatment of translation differences, and inventory valuation are harmonised, while accounting for fixed asset valuation, depreciation, goodwill, research and development costs, inventory costing, and foreign currency translation of revenues and expenses are not harmonised. The results also demonstrate that the extent of harmonisation is greater among fairness oriented countries than among legalistic countries.

Analyst Forecast Errors and Stock Price Behavior Near the Earnings Announcement Dates of LIFO Adopters

Between June 1974 and May 1975 over 400 firms on the New York and American stock exchanges adopted the last-in, first-out (LIFO) inventory costing method. Responding to the first round of double-digit since WWII, these firms were able to assign their newer and thus higher inventory costs to units sold, thereby realizing substantial tax savings.1 However, Ricks [1982] found that stock returns near the earnings disclosure dates of 1974 LIFO adopters were negative and significantly lower than returns near the earnings disclosure dates of firms not using LIFO. Given that firms adopting LIFO in 1974 were voluntarily switching to an accounting method providing often significant tax savings, it is not obvious why investors would have reacted negatively. Nor is it likely that investors were unaware of many of the firms' LIFO adoption decisions; Stevenson [1987] found that at least two-thirds of the firms in Ricks' sample had disclosed their LIFO adoptions prior to their earnings disclo- sure dates. If investors were reacting to the effects of the LIFO adoptions, why did they react negatively given the increased cash flows and prior disclosures? If investors were not reacting to the effects of the LIFO adoptions, what caused the significant negative excess returns near the earnings disclosure dates of firms adopting LIFO in 1974? This study presents evidence suggesting that the negative excess re- turns observed by Ricks [1982] were associated with, and possibly due to, analysts' systematic overestimates of earnings of firms adopting LIFO in 1974. We are aware of no previous study documenting systematic errors in analysts' earnings forecasts conditional on a voluntary account- ing method change.' As a first step, we assess the generality of Ricks' finding by examining excess returns near the preliminary earnings disclosure dates (hereafter, prelim. dates) of all New York (NYSE) and American Stock Exchange (AMEX) firms adopting LIFO between 1973 and 1980. The results confirm negative excess returns around the prelim. dates of firms adopt- ing LIFO in 1974. There is little evidence of significant excess returns (negative or positive) near the prelim. dates of firms adopting LIFO in other years. To explain the negative returns of the 1974 adopters, we examine the association between excess returns and earnings forecast errors. We find that Standard & Poor's analysts systematically overestimated the earn- ings of these firms. Analyst forecast errors are found to be significantly correlated with both the excess returns around the prelim. dates and the earnings reductions due to the LIFO adoptions. Finally, we offer two possible explanations for the negative excess returns and the positive correlations between excess returns, analyst earnings forecast errors, and earnings effects of the 1974 LIFO adoptions. First, the availability of information regarding the likely earnings effects of the 1974 LIFO adoptions, combined with the relative novelty of this accounting change, may have led analysts and investors to underestimate the LIFO earnings effects and may have made it difficult for the market to discern immediately the cause of the resulting negative forecast errors. Evidence consistent with this limited information hypothesis is found in the predictions of Value Line analysts of LIFO earnings effects. The actual mean earnings-per-share effect of the LIFO adoptions ($.947) was 62% higher than the average Value Line estimate ($.584). However, tests for the stock price reversals which would be implied by the information explanation are inconclusive. A second possible explanation is that the magnitudes of LIFO earnings effects were caused by and/or provided implications regarding another factor which was important in valuing the firms, yet difficult for analysts and investors to predict. Inflation is suggested as the likely candidate. Since LIFO tax savings are a function of the rate at which inventory costs are increasing, firms experiencing higher rates of would have greater incentives to adopt LIFO.4 Thus, the self-selected sample of firms which adopted LIFO in 1974 may include firms most affected by that year's surge of inflation. Since the extent to which inventory costs have increased is reflected in the magnitudes of the earnings effects of LIFO adoptions, the negative analyst forecast errors and the positive correlation between these forecast errors and the earnings effects of LIFO adoptions could be explained by analyst underestimates of the rates of experienced by these firms. Evidence consistent with this inflation hypothesis is found in the fact that managers of firms adopting LIFO underestimated the impact of on their own firms. In addition, negative excess returns and earnings overestimates are observed for a sample of established LIFO users, consistent with analysts and investors being surprised by the impact of on these firms as well. However, aggregate tests based on cross-industry correlations between changes in wholesale prices and LIFO-related variables are generally inconclusive.

Inflation, Taxes, and Optimal Inventory Policies

Inflation, Taxes, and Optimal Inventory Policies

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.

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

To provide a frame of reference, I should preface my comments with several observations on my personal perspective with respect to the review of Mr. Biddle's study.-First, as a business executive, I have had direct experience with the considerations involved in making a choice between the use of LIFO or FIFO inventory valuation methods. I might add that this involvement has also necessitated the ongoing review and analysis of the impact of such an election. Second, I am personally interested in the economic consequences of accounting choices, both from the standpoint of a businessman and from the viewpoint of a participant in the standard-setting process. Finally, I should note that I do not have the perspective of a statistician experienced in sample structure and mathematical analyses. As a result, my comments are directed toward the approach taken in the study and the possible significance of the results, rather than to the statistical methodology employed. I conclude with a discussion of areas in which future research may be useful.

Optimal Inventory Order Policy for a Firm Using the LIFO Inventory Costing Method

Many firms have adopted the last in, first out (LIFO) method of accounting for inventories in order to reduce taxable income and income tax liability in periods of rising prices. Lower tax liabilities under LIFO are not assured, however, since a LIFO company's of goods could include some very low costs from prior years, if that company's inventory purchases or production for the current year are insufficient to meet the year's demand. Moreover, even if the use of LIFO does result in a lower tax liability, the inclusion of any of the old, low costs in cost of goods sold under LIFO means that the tax liability could have been reduced even further by increasing purchases or production, such that these old costs would have remained in inventory. Increasing production or purchases, however, increases the cost of holding these extra units until the time at which they are depleted from inventory to meet demand. Such costs might include warehousing costs, interest costs, and the opportunity cost of having less funds available for other productive uses. Thus, when prices are rising, a trade-off exists between lower tax costs and higher holding costs associated with more production or purchases. This cost trade-off is further complicated by the fact that there may be a price or cost benefit to increasing purchases or production prior to the end of the time period at which tax liability is computed. In general, when

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

Biddle's study is an attempt to demonstrate empirically an association between LIFO adoption decisions and properties of year-end inventory levels. My comments on the study are divided into five main topics. In the first part, I examine the hypotheses generated. The second part consists of a discussion of the model used to generate these hypotheses. In the third part, I examine the experimental design, and in the fourth, I discuss the test results. I conclude by giving some suggestions for further tests of the hypotheses.

Discussion of Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy]: A Reply

Discussion of Accounting Methods and Management Decisions: The Case of Inventory Costing and Inventory Policy]: A Reply

The Effect of Inventory Costing Methods on Full and Direct Costing

Since about 1950, the controversy over full vs. direct costing has generated a voluminous literature' largely aimed at the relative merits of each (1) for external financial reporting purposes or (2) for internal use in management planning and control.2 The arguments rest on the assumption that each method produces different results; obviously if each method produced exactly the same results then controversy is idle. The analyses to date have largely ignored the effect of the inventory costing method. A typical discussion of the generalized conditions which create differences between direct and full cost profit is: When production exceeds sales (i.e., in-process and finished inventories increasing), absorp-