Finance

We explain the puzzling empirical evidence on the investory accounting choice through a management signaling argument. We assert that firms with lower nominal production costs than other firms have relatively less to gain from the tax advantages assocaited with LIFO adoption. For these firms, future nominal production costs are lower due to increased efficiency or technological improvements. Because of asymmetric information about future costs, and the moral hazard problem of direct communication, the managers of the more efficient firms are able to credibly communicate their production superiority by using the FIFO accounting method.

We show in this paper that, if firms can choose the fraction of their inventory which is allocated to FIFO and LIFO, then a separating equillibrium exists in which firms with lower production costs signal their greater efficiency by allocating a higher fraction of their invetory to FIFO.