The Association between Lifo Reserve and Equity Risk: An Empirical Assessment
35 Pages Posted: 24 Oct 2001
Date Written: Undated
This study examines the association between a firm's LIFO reserve and its equity risk. We hypothesize that LIFO reserve has favorable implications for equity risk as it confers tax benefits and represents unbooked profits, which prompt firms to lower their borrowings and effectively increase equity. Consistent with this hypothesis, we document a negative association between LIFO reserve and two measures of risk: standard deviation of stock returns and beta. We document a negative association between LIFO reserve and debt, consistent with the proposition that LIFO reserve and debt are tax shield substitutes. However, the negative association between LIFO reserve and equity risk remains even when the level of debt of firms is controlled. Further tests show that adjusting the denominator of the debt-equity ratio for LIFO reserve improves its explanatory power with regard to risk, consistent with the notion that LIFO reserve is viewed as a component of equity in assessing risk. Additional tests indicate that LIFO reserve has explanatory power with regard to future risk. Also, variability of LIFO reserve is positively associated with equity risk, suggesting that firms with high temporal variability in their LIFO reserve may be unable to fully avail of the future benefits of LIFO accounting. Collectively, these results indicate that LIFO reserve is negatively associated with equity risk and conveys information that is potentially useful in assessing equity risk.
Keywords: Equity risk; LIFO reserve; Inventory valuation
JEL Classification: M41, G12
Suggested Citation: Suggested Citation