the effect of lifo-switching and firm ownership on executives' pay

Journal of Accounting ResearchVol. 23 No. 2 Autumn 1985

Printed in U.S.A.

Editors' Note: The following three papers have been grouped together,alphabetically, because each deals with possible determinants of inven-tory-method choices.

The Effect of LIFO-Switching andFirm Ownership on Executives'

Pay

A. RASHAD ABDEL-KHALIK*

1. Introduction

Accounting research on choices of inventory valuation methods hasfocused on various consequences of two extreme methods: LIFO andFIFO. The main consequence studies relate to effects of the differencesin taxes payable between the two methods on security prices. However,tax consequences appear to provide an incomplete explanation for man-agerial decisions to stay on FIFO or to change to LIFO. In this paper, Iprovide an analysis of another possible incentive of executives to stay onFIFO despite the apparent tax advantages of switching to LIFO.^ In

* Professor, University of Florida. I wish to express my appreciation to two anonymousreviewers for their constructive suggestions and to the participants at workshops andseminars held at the University of Alberta, the 1983 Meeting of the Canadian AcademicAccounting Association, the University of Illinois, the University of Wisconsin-Madison,Case Western Reserve University, Michigan State University, and the AAA WesternMeeting in Tucson. The specific comments of G. Barone-Adesi, T. Bell, T. Frecka, P.Healy, R. Kaplan, J. McKeown, W. Messier, P. Tiessen, S. Tinic, and J. Waterhouse areparticularly appreciated. Data collection and computing assistance were provided by R.Chen (Florida), Y. Chin (Alberta), and C. Chi (Illinois). [Accepted for publication October1984.]

^ Congress has recently simplified "LIFO computations" in order to allow more firms totake advantage of the attendant tax savings. Even with such simplifications the IRS reportsthat the majority of firms have not changed to LIFO (Daily Tax Report [October 5,1983]),even though most FIFO firms would have benefited from the switch to LIFO.

427

Copyright ©, Institute of Professional Accounting 1985

428 JOURNAL OF ACCOUNTING RESEARCH, AUTUMN 1985

particular, I examine the effects of the change from FIFO to LIFO onmanagerial compensations—that is, "the bonus-hypothesis."

Briefiy, the bonus-hypothesis assumes managers select income-in-creasing accounting methods because they expect their income-basedbonus to increase as a result of having made that choice. This impliesthat income-decreasing accounting policies will not be chosen if theywould result in a decrease in executives' income-based bonuses.^

The results of this study suggest that, on average, changes to LIFO didnot have significant negative effects on executives' compensations, irre-spective of whether compensation was defined (a) as salary plus perform-ance-based bonus in cash and in unrestricted stock, or {b) in terms ofthese components plus fringe benefits and long-term performance-relatedcompensations (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.

Two possible explanations for this finding are that (1) firms switchingto LIFO modify their compensation arrangements, or (2) as some exec-utives have indicated to me, the F/FO-based income continues to be usedin determining the annual bonus.^ Both explanations suggest that bonussystems are adaptable presumably because of immaterial costs of rene-gotiation of compensation contracts. These results, however, pertain onlyto the firms that switched to LIFO. The bonus-hjrpothesis may still bevalid for the firms that stay on FIFO during periods of rising input prices.

2. The LIFO Decision

The accounting change to LIFO by a firm is accepted by the IRS fortax reporting only if the method is also concurrently for the firm'sfinancial reports. Consequently, the LIFO change generates conflictingvaluation signals in that it decreases the firm's reported accountingincome, but increases its net operating cash inflows by reducing its taxliabilities."* The fact that reported income will decrease leads to twoconjectures about why firms stay on FIFO: (a) managers' expect theeffects of a LIFO shift to lead to negative changes in shareholders' wealthdue to lower reported income, and {b) their own compensation woulddecrease to the extent that bonus plans are based on reported income.®

As to the first, the cross-sectional empirical evidence on security

hypothesis ignores political costs (Watts and Zimmerman [1978]), and otherconsiderations leading firms to choose income-decreasing methods.

'Unfortunately, companies do not report publicly the accounting methods used incomputing the income base of executives' bonuses. David Lasater (Michigan State Univer-sity) told me that out of 180 proxies he examined, only one company (U.S. Steel Corporation,1981) reported anything about accounting methods as a limitation on the bonus plan,

* This assumes that the firm is either stable or growing, has a positive marginal tax rate,and is subject to increasing input prices,

' As for the tax motivation (Morse and Richardson [1983]), Tom Frecka calculated theratio of taxes payable to sales for each firm (switch and control) in my sample for each of

EFFECT OF LIFO-SWITCHING ON PAY 429

market reactions to the LIFO switch is mixed. Positive associationsbetween the switch to LIFO and security prices have been reported bySunder [1973; 1975] and Biddle and Lindahl [1982]. In contrast. Brown[1980] reported no significant association and Ricks [1982] and Abdel-khalik and McKeown [1978] provided evidence that the reactions couldbe negative (conditional on earnings expectation).

Although differences in research design could account for these mixedresults, the evidence is generally in support of no adverse market reactionto the switch to LIFO. Nevertheless, managers may still believe that thereactions to their decisions to switch to LIFO will be negative. In general,managements' understanding of market efficiency that argues for afavorable positive reaction to an accounting change which increases cashfiows is unclear (e.g., see Mayer-Sommer [1979]).

A second possible explanation relates to the effect of LIFO shifts onmanagers' own annual incomes. Kaplan, for instance, argues that exec-utives retain FIFO because they fear the switch to LIFO will reduce theirown annual pay: "Executives can take many actions that increase re-ported income—and hence increase their [own] income from incentivecompensation plans—but decrease the firm's value from the owner'spoint of view. How else can we explain the persistence of so many UnitedStates corporations in remaining on FIFO for inventory valuation ratherthan switching to LIFO" (Kaplan [1982, p. 570]).

Prior evidence concerning the association between executives' compen-sation and the choice of the inventory method of valuation has beenmixed (e.g., Hagerman and Zmijewski [1979], Zmijewski and Hagerman[1981], and Holthausen [1981]). Moreover, the results reported in thesestudies generally relied on the use of a dummy variable (1-0 classification)to denote the existence or the absence of an accounting-based profitbonus plan, which hardly captures the quantitative differences in variousbonus plans. The 1-0 classification, for example, is impervious to rene-gotiation of the level or the profit-base of the bonus that might result incompletely different incentive schemes. Finally, these studies focusedonly on the effect of an accounting shift on firms' income during theperiod of the switch. There was no attempt to extend the analysis tofuture periods so as to allow for the possibility that managers can

the 1971-80 years. In over 90% of the cases, the marginal tax rate was positive. Theaverages of taxes payable to sales ratios were as follows:

Year: 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

Sample:LIFO 0.024 0.027 0.027 0.022 0.018 0.025 0.023 0.024 0.021 0.014

Con-trol 0.025 0.026 0.025 0.023 0.022 0.026 0.027 0.027 0.024 0.021

430 A. RASHAD ABDEL-KHALIK

renegotiate particular components of their compensation plans. If thecosts of renegotiating compensation contracts are relatively low, corpo-rate compensation committees could modify compensation plans to makethem consistent with top managements' decisions that increase the cashfiows of their firms, even if such decisions reduce their reported account-ing incomes.®

Another factor which might affect managements' choices of accountingmethods is their extent of ownership in their own firms. Some 20 yearsago, Monsen and Downs [1965] advanced what they called the "theoryof large nianagerial firms." Essentially, they argued that decisions madeby managers of large corporations with low or no ownership interestsmay be inconsistent with the neoclassical economic theory of the firm inthat such managers might pursue policies that are not compatible withthe firms' long-run value maximization objective (see also Williamson[1964]). Several accounting researchers have used these arguments tohjTJothesize that different accounting choices are pursued by the execu-tives of owner-controlled and manager-controlled firms. For example.Smith [1976], Tranter [1978], Dukes, Dyckman, and Elliott [1980], andDhaliwal, Salamon, and Smith [1982] investigated whether accountingchoices varied across the two groups of managers. The accounting choicesincluded in their studies, however, did not have cash-fiow effects like theLIFO/FIFO choice. The ownership variable could influence this choiceto the extent executives in owner-controlled firms derive more personalwealth from increases in the value of their stock holdings that wouldcome about from the switch to LIFO. In fact, of three discretionaryaccounting changes studied, Neihaus [1984] found the choice of account-ing inventory method related to ownership structure. The effect of theownership variable is included in this study, as it was in the study byHunt [1985]. As in previous studies (Dukes et al. [1980], Dhaliwal et al.[1982J, and Tranter [1978]), a firm was classified as owner-controlled(manager-controlled) if one party owned 10% or more (less than 10%) ofthe voting stock and exercised active control. Of course, this classificationscheme is subject to the same limitation cited earlier concerning thedichotomous (1-0) classification of bonus plans in other studies.

3. Hypotheses

3.1 HYPOTHESES RELATED TO COMPENSATIONSTRUCTURE PRIOR TO MAKING THE ACCOUNTINGCHANGE

The above discussion leads to three null (and three alternative) hy-potheses. The first is concerned with the structure of compensations in

^At the time I started this study, no empirical evidence existed regarding whethercompensation through bonuses suffers from a switch to LIFO, which is the main issueaddressed in this study. Two recent studies on the same subject came to my attention—

EFFECT OF LIFO-SWITCHING ON PAY 4 3 1

relationship to income prior to the switch to LIFO. This is referred to asthe bonus-hypothesis and relates to the elasticity of executives' pay tothe incomes of their firms. The hypothesis is tested by examining tbe(aggregate) incentive structure before the accounting change for firmsthat subsequently switched to LIFO and comparing it to those that stayedon FIFO. The specific statements of the null and the alternative hy-potheses are as follows:

Hi : Prior to changing to LIFO, the relationship between the firm'searnings and the bonus component of executives' compensation was notdifferent for firms tbat subsequently changed to LIFO than those thatretained FIFO.

Hi^: Prior to changing to LIFO, the bonus component was higher forthe e°xecutives of the firms that retained FIFO than for the executives offirms that subsequently switched to LIFO.

3.2 HYPOTHESES RELATED TO THE STRUCTURE AFTERTHE ACCOUNTING CHANGE

Regardless of how the incentive structures differed between the twogroups of firms before the change, a change to LIFO could have had noadverse effects on the executives' bonuses if (1) executives' bonusescontinued to be based on FIFO-income, even after the change to LIFO,or (2) the bonus arrangement was altered in order to take into accounttbe lower L7FO-income base, thus yielding the same total dollar amountsof the bonus as before. Although I obtained anecdotal evidence fromseveral executives which lends some support to the former case, eitherimplies the existence of relatively low costs of contract renegotiations.The following hypotheses allow for either possibility:

H2^: Tbe change to LIFO was not accompanied by a reduction inexecutives' pay relative to those firms retaining FIFO.

H2^: The bonus component of the executives' pay was relatively reducedfor the switch firms compared to other firms in the year of the change.

3.3 HYPOTHESES RELATED TO THE EFFECT OF FIRMOWNERSHIP

Consistent with the arguments advanced above, manager-controlledfirms (compared to owner-controlled) are expected to have a largerportion of their total compensation in the form of bonuses. This leads tothe following hypotheses:

i/3^: The effect of a change to LIFO on executives' pay is the same formanager-controlled and owner-controlled firms.

H3^: The change to LIFO produces a more negative effect on executives'

one by Hunt [1985] and one by Simon [1983]. Hunt reports results essentially consistentwith mine, whereas Simon's results were somewhat mixed. Overall, however, Simoninterpreted them as providing evidence that the change to LIFO could reduce compensation.Hunt's results are described elsewhere in this issue of the Journal.


compensation for manager-controlled firms compared to owner-con-trolled firms.

4. Method and Research Design

4.1 BASIC MODEL

The models used in this study assume a positive relationship betweenperformance (reflected in reported income) and executives' compensation(Lewellen and Huntsman [1970], Boyes and Schlagenhauf [1979], Cisceland Carroll [1980], and Murphy [1984]). The structure of the models issimilar to that advanced by Boyes and Schlagenhauf [1979], who indi-cated that log-linear transformation of the compensation and incomedata performs as well as the generalized Box-Cox transformation.' Thispaper uses the log transformation of the income and compensationvariables. The basic model Ml is:

i = ao + aiLnlNCi + azOMt +

4- a^OMi*LnINCi + a^ECtLnlNCt (Ml)

-t- aeOMi*ECi*LnINCi + e,-

where:

Pi = the annual pay of CEO for company i (pay included salaryand bonus, in cash and unrestricted stock; also see AppendixA for results using total pay);net income of company i;a dummy variable (intercept-shift) denoted:0 = owner-controlled company1 = manager-controlled company;

ECi = a dummy variable (intercept-shift) denoted:0 = for the switch firm1 = for the FIFO firm;

ao = intercept term;ai, a2, as = coefficients for the INC, OM, and EC;a4, a5, a6 = coefficients for interaction terms (slope-shift);

e; = error term;Ln = natural log.

4.2 MEASURING MANAGERIAL COMPENSATIONS

The dependent variable used here consisted of the dollar amounts ofannual compensations of chief executive officers (CEO) by using twodefinitions of compensation. The first was salary plus bonus, and thesecond was the sum of salary, bonus, long-term performance contingentbonus, and fringe benefits. These data were compiled from the proxy

' Transformation was needed due to skewness in the raw data.


statements that are filed with the SEC and published by Forbes for thetop-paid CEOs (the number varied around 700 from one year to another).**

4.3 INDEPENDENT VARIABLES

Reported annual income numbers were obtained from Compustat forall companies in the sample. These data were supplemented by infor-mation taken from company annual reports, the Wall Street Journal, andother financial records which indicated the income effects (net of tax) ofthe change to LIFO. These income effects were then used to adjust thereported LIFO-income in the year of the change to generate the incomenumbers that could have been reported under FIFO. The regressionmodel {Ml) was estimated for both measures of income (reported LIFO,and as if FIFO) in the year of the change.

The other independent variables were dummy variables indicatingwhether the company was owner-controlled or manager-controlled {OM),and a switch or no switch firm {EC). A 10% ownership of voting stockby insiders was used as the cutoff for the OM variable. The percentageof insider ownership was obtained from the companies' filings with theSEC, as summarized by the Value Line Investment Survey.

4.4 INVESTIGATION PERIOD

The analysis was carried out for a period of four years covering thetwo years before the change, the year of the change to LIFO, and theyear following the change. As in other studies (e.g., Ciscel and Carroll[1980] and Lewellen and Huntsman [1970]) a regression equation wasseparately estimated for each year.

4.5 THE SAMPLE

The sample consisted of 176 firms, 88 which switched to LIFO and 88which retained FIFO over the four-year investigation period. The switchfirms were selected first from the list reported by Forbes in 1974, theyear in which most of the LIFO changes took place.® The following data

*In this paper, "pay" includes salary, cash bonus, and bonus in unrestricted stock.Another definition of pay adds fringe benefits and deferred performance payments (seeAppendix A), However, both definitions exclude stock options granted, termination clauses,golden parachutes, personal tax situation, etc, and other changes in managers vrealth forwhich no adequate measurements can readily be developed. I might emphasize, however,that the measurements of pay used in this paper are the same used by managerial economists(e,g., Boyes and Schlagenhauf [1979], Ciscel and Carroll [1980], and Hirschey and Pappas[1981]), I wish to express my appreciation to the anonymous reviewer who requested Iinvestigate this issue, which led to several corrections reported in the paper and in theappendixes.

^This is the same source used by Boyes and Schlagenhauf [1979], Ciscel and Carroll[1980], and Hirschey and Pappas [1981] in their studies concerning executives' pay andthe managerial theory of the firm. The data compiled by Forbes were obtained from proxyfilings with the SEC and correspond directly to the classifications presented in thosereports.


requirements were imposed on the selection process for these 88 switchfirms: (1) each company was currently (in 1982) listed on Compustat inorder to obtain sales and assets data; (2) none was a financial institution,insurance company, or utility; and (3) executives' pay data were availablefor each company for at least three of the four years of the investigationperiod. The final sample of switch firms represented 51 industries (usingthree digits of the standard CUSIP industrial classification).

The other 88 nonswitch (FIFO) firms were also selected from the sameForbes list. In addition to satisfying the three data requirements for theswitch firms, each nonswitch firm maintained its inventory valuationmethod during the entire investigation period. Since the investigationperiod was determined by the switch year for the LIFO sample, the FIFOsample was constrained to represent the same composition of fiscal years.Once the selection was made, the two samples were then combined foreach separate year. The FIFO sample was composed of companies from57 industries (also using the three-digit CUSIP industrial classification).

Since the selection process centered on the calendar year of the switchto LIFO, some variation in sample size occurred from one year to anotherbecause of missing data. Companies were excluded from the sample inthe years of missing data.^"

5. Estimation and Results

5.1 MODEL ESTIMATION

The basic model (Ml) was estimated for each year separately with twoseparate regressions estimated for the year of the change: one for incomeas reported (LIFO), and the other using the pro forma, as if (FIFO)income. The results for model (Ml) are reported in table 1. As shown,heteroscedasticity in the residuals was observed in all regressions, exceptfor the year before the change (year —1). Nevertheless, the functionsbehaved as expected. That is, the coefficients of income were consistentlysignificant (atp < 0.01), positive, and less than one; the functions werestatistically significant (p < 0.01); and the levels of adjusted R^ werereasonable for cross-sectional analysis.

5.2 CORRECTING FOR HETEROSCEDASTICITY ASSUMINGTHAT MODEL ( M l ) IS THE TRUE MODEL

The test for heteroscedasticity I used is the Glejser test (Johnston[1972, p. 220]) in which the absolute value of the residuals is regressedon some form of the independent variable, LnlNC. A significant coeffi-cient indicates that the variance of the error terms is proportional to theindependent variable, LnlNC.

A weighted least squares is recommended to correct this problem.

° The smallest sample size consisted of 132 companies for the fiscal period of two yearsbefore the change; for the remaining periods, the sample size was 149 or larger.


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Deflating all the variables in {Ml) by the independent variable (LnINC)and then applying OLS is equivalent to using a weighted least squares(see Commons [1976, pp. 459-62] and Neter and Wasserman [1974, pp.131-36]). This leads to model

LnPiil/LnINC,) = boH/LnlNd) + bi + b^{l/LnINCi)*OMi

+ bsil/LnINCi)*ECi + b^OMi + hEd (Mlw)

where all terms are as defined in Ml. The estimated coefficients in{Mlw) correspond to those of {Ml), but {Mlw) has the additionaleconometric property of reducing the problem of heteroscedasticity.

Since the estimated regression of year —1 was not heteroscedastic inthe initial estimation (as shown in table 1), technically, there was noneed to use weighted least squares for that year's data. However, doingso should provide a check on the validity of the estimated functionreported in table 1 for year —1.

The results from estimating {Mlw) are presented in table 2. As shown,adjusted R^ values were significantly higher than those reported in table1 for the years in which corrections for heteroscedasticity were required,(—2, 0, -1-1), but not so for year —1. Nevertheless, the variables foundsignificant in year —1 are the same as those reported in table 1. Giventhese results, the best linear unbiased estimators are those reported intable 2 for years —2, 0, and -1-1 and table 1 for year —1 (for which atransformation was not required).

5.3 RESULTS

5.3.1. The period before the change. The question of interest in thisperiod concerns the differences in pay structure between those firms thatretained FIFO and those that subsequently changed to LIFO. Based onthe results of best linear unbiased estimators for the periods precedingthe accounting change (from table 1 for year —1 and from table 2 foryear —2), there is some evidence of differences in pay structure betweenthe two groups of firms. In particular, the significance of coefficient a^for the interaction term {OM*EC*LnINC) suggests that the manager-controlled firms which retained FIFO {OM = 1 and EC = 1) had a higherincome-based bonus than those that subsequently changed to LIFO.

"The (Mlw) model in the text was the result of applying the weight (l/LnlNC) tomodel (Ml). Let (l/LnlNCi) = Ki, then model Mlw is as follows:

ao(Ki) + aiLnlNCi(Ki) + a^OMiiKi) +

(See Commons [1976] for discussion.)


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Thus, the null hypothesis Hi^ is rejected in favor of the alternativehypothesis Hi^ for manager-controlled firms that did not subsequentlychange to LIFO.^^

5.3.2. The year of the change. These hypotheses relate to the adapta-bility of pay structure as a result of making the switch to LIFO. Theresults presented below are taken from the regression estimates reportedin table 2 (for Mlw), after deleting variables with insignificant coeffi-cients and estimates of coefficients from truncated models which con-tained only significant variables. ^

For the switch firms (both owner- and manager-controlled):

+ e;

i = 3.12 + 0.222 LnlNCi + e,- (Full Model)

i = 3.31 -I- 0.20 LnINC + e;. (Truncated Model)

For the FIFO firms (owner-controlled):

+ az) + (ai -I- a5)LnINCi + e,

i = 4.46 -I- 0.072 LnlNd -\- e, (Full Model)

i = 4.71 -I- 0.049 LnlNd + e;. (Truncated Model)

For the FIFO firms (manager-controlled):

i = {ao + as) + (oi + as + ae)LnINCi + e,

' A chi-square test on (a contingency table) 2 x 2 classification by firm ownership(manager-controlled versus owner-controlled) and the accounting method {FIFO—LIFO)was not statistically significant (atp < 0,05). This test might be construed as a direct testof the propensity of either group to switch to LIFO. However, it is limited to this sampleof firms and, given the sample selection, cannot be used as a basis for inference.

" The use of only the significant coefficients from the full model could present problemsif the explanatory variables in the model were correlated. Although bivariate correlationcoefficients were not statistically significant (p < 0.05), I reestimated the model afteromitting the insignificant variables. The sum-of-the-squares and the R^s of the full modelversus the truncated model are shown below.

Two years beforeOne year beforeYear of switch , ,Year after switch

Sum-of-Squares

Full Model(Mlw)

0,1360,1260,1720,141

Truncated(Mlw)

0,1440,1270,1730,149

Adjusted R'^

Full Model(Mlw)

0,660.300.800.82

Truncated(Mlw)

0.650,320,810,82

As shown, the values of these measures are so close that computing i^-ratios for testingthe significance of differences between them is not necessary.


i = 4.46 -I- 0.108 LnlNQ + e,- (Full Model)

i = 4.71 + 0.086 LnlNQ + e,. (Truncated Model)

These relationships suggest four observations, (i) The pay structurefor the executives of the switch firms was the same for both manager-controlled and owner-controlled firms and was characterized by a higherelasticity of pay to income than for those firms that retained FIFO, (ii)The pay structure of those retaining FIFO differed in that manager-controlled firms had a higher coefficient (resulting from the significantinteraction term measured by Oe) than did owner-controlled firms. Thisrelationship is consistent with the structural differences that apparentlyexisted prior to the change to LIFO. (iii) The significance of the coeffi-cient 05 indicates that the bonus component of the switch firms washigher than the bonus component of the FIFO firms in compeirison toprior years, (iv) These three observations are common to both regressionsestimated for year 0 using income as reported and using income as if nochange took place.

Overall, the results for the year of the switch indicate that, instead ofpenalizing executives for lowering income, the switch firms, on average,adapted to the effects of the change by allowing a larger income-basedcomponent of compensation. Further, the similarity of results betweenthe reported and the as if regressions suggests that the adaptation mighthave taken the form of basing the bonus on the FIFO (as if) income.Hence, the results do not lead to a rejection of the null hypotheses H2^and Ha^; that is, no adverse effects of the choice of LIFO on executives'bonus are presented by these findings, even for those firms that weremanager-controlled.

5.3.3. The year after the change. Based on the regression estimates foryear -1-1 shown in table 2, the statistical significance of coefficients a^and 06 (at p < 0.01) leads to the following relationships using onlyvariables with significant coefficients. As before, the truncated forms ofthe models were obtained by reestimating the relationship after omittinginsignificant coefficients.

For the switch firms (both owner- and manager-controlled):

i = 00 + aiLnlNCi + et

i = 3.97 -I- 0.15 LnlNQ + ei (Full Model)

i - 4.88 + 0.066 LnlNCi + e,. (Truncated Model)

For the FIFO firms (owner-controlled):

i = 3.97 -I- 0.04 LnlNCi + ei (Full Model)

i = 4.88 + 0.043 LnlNCi + e,. (Truncated Model)


For the FIFO firms (manager-controlled):

ao(ai -I- a5 -h a(i)LnINCi 4- ei

i = 3.97 -1- 0.074 LnlNd + ei (Full Model)

i = 4.88 + 0.049 LnlNd + et. (Truncated Model)

5.4 FIRM SIZE

I used three approaches to correct for the effects of variation in firmsizes. The first consisted of estimating the basic model using standardizedfirst differences {MID) in the continuous variables—firm income {INC)and executives' pay (P)—as follows:

it = {Pit - Pit-i)/Pit-i

INd^ - INCu-i)/INCu-i,

and took the following form:

it == do + diMNCu + dzOMi -f- dsEd + d^OM.^

dt + deOMi*Ed*MNdt + e^, {MID)

where t is the year, A is the change, and other terms are as before.Estimates of the difference model are reported in table 3. The onlysignificant variable was the change in the firms' income over time. Thecoefficient of the accounting change variable {EC) was not significantlydifferent from zero, nor were the coefficients of the interaction terms.These results, in addition to obtaining increased values of the coefficientof MNC over time (from 0.0036, to 0.177, to 0.21), suggest the absenceof a significant effect of the accounting switch to LIFO on the changesin executives' compensation from one year to the next during the inves-tigation period.

The second approach consisted of estimating the basic model with firmincome and executives' pay being expressed as a ratio of the square rootof total assets {Ml/TA), a scaling used unsuccessfully by others (e.g.,Lewellen and Huntsman [1970] and Ciscel and Carroll [1980]). Theresults are reported in table 4. As in previous studies, this transformationprovided a much better fit (adjusted R^ values vary from 0.77 to 0.96).Except for obtaining an insignificant intercept, however, all of the othervariables portrayed the same overall picture generated from estimatingthe basic model {Ml). The coefficient a^ of the interaction termEC*LnINC was negative and significant in both the change year and theyear after the change. Since 05 is a slope-shift and the switch firms werecoded zero, this result again indicates a higher elasticity of executivecompensation for the switch firms relative to FIFO firms, a conclusionthat is consistent with the assertion that these firms adapted their bonuscontracts after the switch to LIFO. Differences in the results of estimating{Mlw) in table 2 and {Ml/TA) in table 4 do not provide evidence thatcan be construed as inconsistent with this implication.


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6. Summary and Conclusions

This study attempted to determine whether the bonuses paid to exec-utives of the firms which switched to LIFO (mostly in 1974) wereadversely affected by the switch. The analyses lead to two observations.First, the results indicated that the switch to LIFO did not, on average,adversely affect the income-based performance bonus awards for thoseexecutives who elected to make the switch. The switch companies usedin this sample apparently adapted their bonus pay to refiect the effect ofthe LIFO change on income by renegotiating their bonus contracts.Second, the results suggest that executives of the manager-controlledfirms that retained FIFO had a relatively higher income-based bonuscompared to the other firms.

There are several limitations to the study which should be noted. Dueto self-selection bias, the results cannot be generalized beyond the sampleused here without further replication. Another limitation stems from themethod used to measure executives' pay. The variable was measured bythe sum of salary, cash bonus, and performance bonus granted in unre-stricted stock. Although adding other components of compensation whichare typically reported in proxy statements did not materially alter thefindings (see Appendix A), the exclusion of stock options and changes inthe market values of executives' stock holdings limit the generalizabilityof these results. Furthermore, bonus payments in any given year mightbe related to performance in prior years, especially when "total pay" isused. The one-period model used here does not capture these features.Although I do not know how to disentangle these components, a multi-period methodology might be appropriate to address this problem. I findsome comfort in the fact that estimation of alternative models did notmaterially alter the results.

APPENDIX A

Results Using Total Pay as Defined in Proxy StatementsThe analysis in the text examined the effects of the switch to LIFO on CEOs'

annual salary plus bonus. In addition to the data on salary plus bonus, proxystatements include data on "total pay." These data must be used with carebecause of frequent changes in definitions and the varying composition of thenumbers. For example, the 1981 proxy statements include data on stock gains by

" The direct objective of this study was to assess the effects of switching to LIFO.However, by implication, the results also provide evidence on one possible consequencethat FIFO firms tried to avoid. Nevertheless, the direct motivation for retaining FIFOneeds to be examined further.


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CEOs. Such data were not included earlier. In 1974, the year in which most ofthe LIFO changes were made, total pay of CEOs included (a) salary plus bonus,(b) fringe benefits, (c) contingent payments, and (d) incentive bonuses hased onlong-term performance measures. Regression estimates that used total pay as themeasure of compensation did not produce different results from those presentedabove. For example, table 5 presents a brief comparison of the regression esti-mates of two models, {Ml) and {Ml/TA), for the year of the change to LIFO.As shown, the substantive results are essentially similar for the two data bases.

APPENDIX B

Model {Ml) was augmented to account for sales. Two approaches were usedin estimating this model: the first included sales as a full variable, while the otherused the residuals from regressing sales on income {RS). Although the goodnessof fit of both functions was exactly the same, orthogonalization of sales andincome influences estimates of the coefficients. Given the objective of this study,it is more sensible to orthogonalize sales and income in the manner done here.(For other approaches to orthogonalization of the two variables see Lewellen andHuntsman [1970] and Ciscel and Carroll [1980]).

The results of estimating model (Ml) augmented with RS are presented intable 6. These results indicate the following.

(0 No differences in pay structure were detected before the change betweenthe FIFO firms and those that subsequently changed to LIFO. This is inconsistentwith the results from estimating (MI), which indicated a difference betweenmanager-controlled FIFO firms and all others in the two years before the change.

{ii) During and after the year of the change, other than the coefficients ofincome and sales, the coefficient Oe of the interaction term {OM*EC*LnINC)was statistically significant at (p < 0.01) and positive. This finding is consistentwith the results obtained from estimating (Mi). Moreover, none of the othercoefficients was statistically significant. Such a result implies the inability toreject the null hypothesis H2^ as was the case with {Ml). However, the alterationin the significance of the coefficient Oe from the preswitch to the switch periodimplies a rejection of Hs^ for this subset of firms (the manager-controlled firmsthat retained FIFO).

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the effect of lifo-switching and firm ownership on executives' pay

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