The Effect of LIFO-Switching and Firm Ownership on Executives' Pay

Accounting research on choices of inventory valuation methods has focused on various consequences of two extreme methods: LIFO and FIFO. The main consequence studies relate to effects of the differences in taxes payable between the two methods on security prices. However, tax consequences appear to provide an incomplete explanation for managerial decisions to stay on FIFO or to change to LIFO. In this paper, I provide an analysis of another possible incentive of executives to stay on FIFO despite the apparent tax advantages of switching to LIFO. In In particular, I examine the effects of the change from FIFO to LIFO on managerial compensations — that is, "the bonus-hypothesis." Briefiy, the bonus-hypothesis assumes managers select income-increasing accounting methods because they expect their income-based bonus to increase as a result of having made that choice. This implies that income-decreasing accounting policies will not be chosen if they would result in a decrease in executives' income-based bonuses. The results of this study suggest that, on average, changes to LIFO did not have significant negative effects on executives' compensations, irrespective of whether compensation was defined (a) as salary plus performance-based bonus in cash and in unrestricted stock, or (b) in terms of these components plus fringe benefits and long-term performance-related compensations (termed "total" compensations in the proxy statements). Hence, the bonus-hypothesis was not supported for this sample of (mostly) 1974 firms that switched to LIFO