Accounting for inventory costs and real earnings management behavior

Abstract

Prior research finds that managers engage in inventory overproduction to inflate current earnings despite the fact that overproduction is associated with significant economic costs. Additionally, Statement of Financial Accounting Standards No. 151 (SFAS 151) limited the fixed costs that can be capitalized to inventory in periods of low production, thereby introducing a penalty for underproduction by requiring firms to expense unallocated overhead in the current period. Because periods of underproduction often follow periods of overproduction, and because SFAS 151's emphasis on the subjective determination of normal capacity can erroneously categorize overproducing firms as underproducers in subsequent years, we posit that SFAS 151 makes overproduction less desirable than before. Therefore, we posit that management's propensity to use overproduction to meet earnings benchmarks should decrease after the adoption of SFAS 151. Consistent with expectations, we find a lower propensity to use overproduction to meet benchmarks following SFAS 151. These results challenge the view that SFAS 151 inadvertently encouraged overproduction.