The Effect of the Lifo Inventory Method on Earnings-Price Ratios
Posted: 4 Aug 1998
This paper investigates why LIFO firms have higher reported earnings-price (EP) ratios compared with non-LIFO firms, a result reported by Lee (1988). Observed cross-sectional differences in financial statement variables between LIFO and non-LIFO firms identified by prior research do not explain EP ratio differences. We explain the differences in EP ratios by controlling for cross-sectional differences in risk and growth, using analysts' expectations of future growth rather than realized growth. Also, we control for expected earnings changes, to mitigate the effect of transitory earnings components on the measurement of EP ratios. When we combine risk, expected growth, and expected earnings changes in our multivariate tests, the EP ratios of LIFO firms are no longer significantly higher than those of non-LIFO firms. When we allow the coefficient on risk to vary between LIFO and non-LIFO firms, as suggested by Watts and Zimmerman (1986), the EP ratios of the LIFO firms are significantly lower than those of the non-LIFO firms.
JEL Classification: M41
Suggested Citation: Suggested Citation