Researchers in the disciplines of both Operations and Accounting have studied Inventory Management, though in relative isolation. In this paper, one of our goals is to help inform researchers in Operations Management about an extensively debated question in inventory accounting: whether to repeal the LIFO (Last-In-First-Out) inventory accounting choice? This question has received extensive scrutiny from various stakeholders including academics, businesses, and different levels of governmental agencies such as US Congress. Specifically, we provide a literature review on how LIFO affects and is affected by inventory management. This is done by first reviewing the potential determinants of LIFO inventory accounting choice and then reviewing potential interactions between LIFO and inventory management. It is our hope that this review will help stakeholders have a more comprehensive understanding of LIFO before making their decisions.
There have been two major inventory accounting systems in the world: FIFO and LIFO, standing for First-In- First-Out and Last-In-First-Out, respectively. In Operations Management, FIFO usually means the first item entering a system (e.g., a queue) will physically exit the system first, and LIFO means the opposite. In Accounting, however, FIFO and LIFO could mean something quite different: FIFO means items exiting a system will be evaluated at the purchase price of the oldest items in the system, and LIFO means items exiting a system will be evaluated at the purchase price of the newest items in the system. In other words, FIFO and LIFO in Operations Management imply something physical and in Accounting imply something financial.
Today, while FIFO (first-in-first-out) is widely adopted in almost all countries (e.g., see China Accounting Standards and International Accounting Standards), LIFO (last-in-first-out) is still used in US Generally Accepted Accounting Principles (US GAAP). Therefore, LIFO repealing debate now becomes the central topic of the Congress in the United States and academic research ([
The remainder of this paper is organized as follows. Section 2 introduces the determinants of LIFO choice. Section 3 includes the analysis of inventory liquidation and the inventory management strategy taken to mitigate the effect of inventory liquidation under LIFO choice. Section 4 describes the effect of LIFO reserve on just-in- time manufacturing system adoption. The key challenges and future development directions are given in Section 5. Concluding remarks are presented in Section 6.
Current research is devoted to analyze the determinants behind LIFO choice. As commonly discussed, reducing tax is the most important incentive for many firms, especially large ones, to adopt LIFO inventory accounting system. Meanwhile, it was found that even though the tax saving benefit is obvious, companies remain reluctant to adopt LIFO inventory accounting choice implying that the potential non-tax reasons may force managers to balance the tax benefit with the cost incurred from shifting to the LIFO from the FIFO accounting choice.
It is well understood that during an inflationary period, when companies shift from FIFO to LIFO accounting, the cash flow of the firm increases due to the fact that by matching the revenue with the recent higher cost the taxable income decreases and reduces the tax. Even though there are other non-tax factors constraining firms from adopting the LIFO method, tax incentive is always a very significant variable for a firm’s accounting choice. During periods of inflation, product costs and non-decreasing inventory levels, LIFO may produce the highest cost of goods sold, the lowest net income, and therefore the lowest tax payments if used for tax purposes.
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Common ground regarding the determinant of tax saving has been reached by most researchers that tax saving is one of the most significant factors involved into the inventory accounting choice. But in most cases, the tax rate is assumed to be constant and the non-tax factors were not accurately quantified due to data limitations in analysis. A consistent and stronger conclusion will be made if researchers incorporate the stochastic tax rate into models and additional data could be collected to obtain more accurate proxies of non-tax factors.
Political cost arises when the companies try to use LIFO to defer tax which is prohibited by the government which uses various methods such as anti-trust policy, nationalization as well as other regulatory methods to deter the intention of tax deferral ( [
Executives don’t always align their interests along with that of the shareholders. They act either to increase the total value of the company or try to increase their personal interests at the sacrifice of the interests of the shareholders ( [
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However, the most significant drawback of current research is the assumption that the company is owner-controlled if the largest shareholder has 20% or more of the total shares and the company is manager-con- trolled if no shareholder owns 5% or more of the total shares. Neither the justification for creating such an artificial dichotomy from a sample of continuous data on the concentration of stock ownership, nor the statistical implication of this practice, is evident ( [
As the compensation plans for managers are dependent on the financial performance of the firm, the managers are less inclined to adopt LIFO which can lead to a lower financial performance ( [
However, contradicting to the theoretical allegation, it was proven that, in average, changes to LIFO do not have significant negative effects on executives’ compensation, no matter of whether kind of forms of compensation was provided ( [
where the dependent variable is the dollar amount of the executive’s compensation and the independent variables are the annual profit reported by the companies
1) Before changing to LIFO choice, the companies which shift to LIFO compared with the companies still retain at FIFO enjoy a higher bonus plan.
2) At the changing year, companies successfully align the benefits of the managers with the shareholders to significantly increase the proportion of the bonus plan in the overall compensation plan.
3) After the changing to LIFO, the interaction term EC (Executive Compensation) × lnINC (income) is significant which demonstrate that the companies which shift to LIFO are quite more flexible in reconfiguration of the compensation compared with the companies which are still stick to the FIFO choice.
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There are two streams for the determinants of the accounting choice. One is focused on the deterministic factors such as the firm size, capital structure, and covenant constraints, etc. The other one is concentrated on a more realistic, dynamic and interactive accounting, investment and operational policy choice.
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To summarize the determinants of LIFO inventory accounting choice, the major potential variables which have been extensively studied are listed. Univariate and multivariate analysis is used to test their significance on the LIFO choice. Due to the limit of the current research, common ground has not been reached for all of the analyzed variables and some variables only occur in the analysis of one specific paper, so we don’t put all the possible variables but those which are usually used and largely agreed upon in the current research. Authors and measurement are also included into the table for the convenience of reference and comparison with further research.
The extensively studied area of the interplay between inventory management and LIFO inventory accounting choice is inventory liquidation. As mentioned, the total inventory is treated as integrity with many inventory layers which are the inventory accumulated in the previous years. If the inventory consumption is higher than procurement or production of the new inventory in the new period, the older layer of inventory will be consumed. Such consumption of the previous base inventory is called inventory layer liquidation. Unlike the general understanding of inventory liquidation where inventory are sold at a cheaper price than original price in order to increase the sales volume, the inventory liquidation concept of LIFO analysis here is more focused on the inventory liquidation quantity which is the depletion of the base inventory quantity of the previous years. Papers analyzing inventory liquidation mainly focus on four aspects: the measurement and determinants of inventory liquidation, the consequences of inventory liquidation, the dynamic ordering models to mitigate inventory liquidation, and inventory pooling strategy to interact with inventory liquidation. Papers considering the last two aspects aim to reduce the negative effect of inventory liquidation on LIFO tax minimization purpose by using inventory management strategy consisting of dynamic order policy with purchasing and production strategy, and inventory pooling policy.
As the end inventory level can significantly influence the tax benefit under the LIFO inventory accounting method, it should be treated as a part of the function to maximize the cash flow. When inventory liquidation occurs, current sales revenue matches with the previous lower inventory cost during the inflation period, so taxable income increases respectively. This leads to the decreased current cash flow due to the increased tax. Companies try to avoid the inventory liquidation by means of intra-year purchasing or production in order to keep the end inventory level stable for the tax concern while some companies otherwise liquidate their end inventory for other reasons.
The literature regarding the determinants of the inventory liquidation could be classified into three main groups. Generally speaking, the managers need to consider and balance three relationships before making the inventory liquidation decision: holding cost vs. liquidation cost, cost of capital vs. liquidation cost, and economic changes vs. liquidation lost. Dynamically, the managers need to combine the accounting policy and operation policy simultaneously in terms of integrating inventory management, capital investment management and earnings management.
The most significant consequence of holding an excessive end inventory to avoid inventory liquidation is the increase of inventory holding cost. [
1) the cost of capital for purchased inventory,
2) additional property taxes,
3) warehousing costs,
4) insurance cost,
5) transportation cost,
6) handling cost,
7) deterioration cost,
8) obsolete cost.
Since some of the holding costs are tax deductible, such as cost of capital and property taxes, the decision rule is based on a comparison between the present value of these costs and the present value of the cost of the LIFO layer liquidation.
Before managers make the investment choice, the risks of investment, interest rates and rate of return are the important factors to be considered. The main risk of inventory investment is inventory obsolescence. High interest rates will result in high inventory carrying costs. These high rates also present alternative economic opportunities for funds invested in inventories if there is a belief that the inflation rate will decrease in relation to the interest rate ([
The overall economic condition significantly influences the inventory liquidation choice. The economy in recession leads to a dip of the demand causing the company to reduce its inventory in order to save cost ([
Besides the three main considerations, industry specificity also draws much attention in the literature because certain industries are more sensible to the business cycle phenomenon than others. [
The extant literature provides contradictory perspectives regarding the incentives behind the inventory liquidation and its consequences. On the one side, [
The conventional dynamic order policy problem has already been extensively analyzed in the past. The cost factors normally involved are order cost, carrying cost, obsolete cost, stock-out cost along with other considerations such as customer satisfaction level. However, few studies have ever incorporated inflation and tax, the two most important economic factors, into the models. When inventory cost changes, the optimal order size will also be influenced due to tax concerns. Optimal order size, in turn, will be dependent on the cash flow changes. Firms need to consider the cash flow choice and the order size decision simultaneously. The existing literature treats the end inventory level as an exogenous variable where management has no control. However, since the LIFO firms’ tax liability is partly a function of year-end inventory level, management can control the year-end inventory levels based on the LIFO or FIFO choice.
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· during inventory price inflation, LIFO end inventory level will be higher than that of FIFO;
· during inventory price deflation, LIFO end inventory level will be lower than that of FIFO;
· the existence of additional layer of LIFO inventory price changes will increase the optimal inventory level for sale under LIFO and FIFO.
For the previous models such as the one established by [
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where
chased is
spectively. The salvage value of goods remaining at the end of the year is
is the discount factor. The results present the relationship between tax, inventory order policy and valuation convention. For the single period model, demand is treated as a non-fixed variable and will only be known at the end of the period. Annual order is aggregated into a single quantity which is the total volume of the expected demand of the next periods. Optimal inventory order policy under FIFO inventory accounting choice is a deviation of the typical Newsboy problem. While the optimal inventory order model under LIFO is diminished to be a first-order equation. The single period models of FIFO and LIFO also consider the relationship between relative optimal inventory level under LIFO/FIFO and various responses to the changes in tax rate, inventory costs and inventory level. The single period models of LIFO and FIFO are extended into multiple period problems. For FIFO problem, [
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Within each year there are
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In order to better fit the stochastic demand settings, [
where the procurement cost at year
order and second order, when
only satisfied the excessive inventory which is over the previous up-to-level inventory but also help to maintain the desired minimum end inventory level. In this case the fixed order cost is ignored for simplicity. However, in reality the accumulation of the fixed order cost incurred by multiple second orders across multiple years may outweigh the tax saving from the avoidance of inventory liquidation. In future research, a dynamic variable of the second order cost should be incorporated.
Considered the tax concern of LIFO, the purchasing and operation decisions are intended to keep the end inventory floated to avoid inventory layer liquidation. Such decisions are not always wise to minimize the total cost as far as the holding cost is high if more buffer inventory has to be carried. The intra-year and end-year production and purchasing decisions should be made into a more dynamic way by combing the tax liability, possible holding cost, production and purchasing cost as well as potential inventory cost changes. Under so many assumptions for the current models, further research regarding the end inventory level control could be extended to different areas, considering the tax liability of LIFO. The extended models could reflect a longer planning period, production capacity, stock-out cost and stochastic demand changes. The models should include the factor of fixed order cost which is a major factor for the function of after-tax profit maximization if companies are free to make several additional orders due to demand changes. An integer programming model could be expected if fix cost and decreasing inventory price are included. In order to better catch the interplay between intra-year and end-year operation decision, a more comprehensive stochastic model is going to be established.
In Operation Management area, the concept of inventory pooling stands for the risk pooling strategy in order to diminish the risks and losses caused by the variation of customer demand. The main forms taken are centralized warehousing, common components, delayed differentiation, product substitution and e-tailing. While in LIFO inventory analysis, the main function of inventory pooling is intended to pool the inventory so as to reduce the loss of tax benefit caused by inventory liquidation. As mentioned before, inventory liquidation will match the recent revenue with the previous cost, so the profit will increase so as to increase the tax levied. The most important prerequisite of the inventory pooling strategy in LIFO is the introduction of inventory pooling into dollar values. Different from inventory pooling in units, dollar value provides the possibility to group the products which are counted based on different measurement, such as tons, kilos, etc. Normally, the inventory pooling of units is based on the classification of characteristics of the products, while the subdivision of inventory pooling of dollar values has resulted at least in part from the habits or customs of business management, government policy and, in some cases, mechanical convenience in inventory computation ([
The IFRS has set different pooling regulations for the manufacturing/processing and retailer/wholesale industries. Manufacturing/processing is allowed to have one pooling, while retailer/wholesale is required to adopt the pooling subdivisions to reflect the diversification of the product portfolio ([
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1) How the purchasing decision is going to be influenced by the future inventory cost changes?
2) How the prices of different products move together?
3) How to stock different products?
4) How the inventory will be liquidated in the future?
The key determinant of the pooling decision is how the inventory prices’ changes are interacted with inventory quantity changes. [
However, [
Though there is no specified concept of a just-in-time manufacturing system, the most important characteristic of this new system aims to reduce unnecessary waste and improve operational productivity. One of the most significant achievements of the system is to significantly reduce the WIP (work-in-process) inventory. Inventory accounting choice and end inventory transaction policy are usually combined in order to manage earnings. The significant reduction of the inventory constrains the ability of using earnings management tool to manipulate the profit for the company. [
Normally, the inherent tax incentive behind the LIFO encourages the build-up of the inventory, which increases the cost of holding, maintenance, and obsolescence as well as other inventory related costs. [
Current research is primarily dedicated to find and analyze the potential determinants of LIFO inventory accounting choice. Till now, the variables representing firm’s physical characteristics, operational features, investment, tax policy, etc. have been proposed and analyzed in the univariate and multivariate analysis. Several factors are considered to have significant effect on LIFO choice even though further research is still anticipated for the rest of factors which have not been extensively studied. The univariate and multivariate analysis of the potential determinants is quite helpful because it provides a key list for the companies to consider before an inventory accounting choice is made. Even though multivariate analysis reached some conclusions regarding the collinearity among potential determinants, the interaction effect among factors still needs further attention from the researchers. The incentive behind is that the significance test of the individual determinant benefits the companies before they choose the inventory accounting system based on specified characteristics. The key task for the companies during the using of LIFO system is to make a trade-off between the tax benefit loss and the cost incurred to change their organizational features. Further analysis of the interaction between the potential determinants provides a clear picture of the necessary adjustments to compound the key characteristics at the lowest opportunity cost. Thus, further research on the potential determinants of LIFO choice should be directed into establishing the procedures managing the primary determinants to minimize the tax in the process of using the LIFO system.
Tax and inflation factors have been included into the dynamic order models to reflect the tax liability of LIFO inventory accounting system under inflation. To maximize the after-tax profit, the end inventory should be stable and not less than the beginning inventory level. Various stochastic models were established by including intra-year and end year purchasing and production decisions to consider a trade-off between inventory holding cost, tax cost, purchasing and operation cost, etc. and to minimize the total cost of the company under LIFO. Although some of the models treat inventory price and demand as stochastic variables, none of them intended to provide any method to mitigate the demand and price variance under LIFO. Further research is required in this area in order to lower the demand variance risks and increase customer satisfaction. The possible approach is to find the optimal safety stock level in the dynamic order models to catch the demand variance under LIFO. Meanwhile, models could be used to analyze the interaction between inventory pooling strategy and dynamic order strategy in order to diminish the associated risk.
Inventory pooling decision is one of the strategies to mitigate inventory liquidation risk. Current research discusses the choice of single or multiple inventory pools strategy. However no papers have ever been published regarding the optimal number of inventory pools in order to reduce inventory liquidation. Further research can focus on establishing the models of the interplay between inventory price changes and inventory quantity changes to get the optimal inventory pool number and minimize the total cost considering inventory liquidation minimization requirement.
This study is partially motivated by the current debate in the US Congress regarding the repeal of the LIFO inventory accounting choice. Hence, a detailed literature review of LIFO inventory accounting choice is necessary to provide a more comprehensive view to various stakeholders. Furthermore, this review aims to inform researchers in Operations Management, many of whom are unware of this debate. To this end, this paper classifies the previous research into two areas: the determinants of LIFO inventory accounting choice; the interplay between LIFO inventory accounting choice and inventory management. The effect of LIFO reserve on the just-in- time manufacturing system adoption is also presented. Further research is suggested to provide a more generalized picture to the operation managers regarding the possible determinants behind their inventory accounting choice in order to better fit the company in terms of its investment, operation, and other physical characteristics. The interplay between LIFO inventory accounting choice and inventory management research should be further extended by considering more potential inventory related factors.
Last but not least, although inventory management is a fundamental issue in both Operations Management and Accounting, research on the interface between these two disciplines has been limited. The recent establishment of the Department of POM-Accounting Interface at Production and Operations Management Journal indicates that there has been an increasing interest in this research direction. It is our hope that this research can encourage more research on the Interface of Operations and Accounting.