Just How Much Does the Tail Wag the Dog? Altering Inventory to Manage Earnings

Abstract

ABSTRACTUsing absorption costing, manufacturing firms can alter production (relative to sales) to shift fixed costs between cost of goods sold and inventory accounts, thereby managing earnings either upward or downward. The accounting‐oriented benefits of such a strategy are met with operations‐oriented costs (e.g., carrying costs, inventory obsolescence, and/or stock outages), creating business frictions between accounting and operations. We use a large sample of manufacturing firms to study how production cost structure and inventory valuation method affect this strategy. Thus, the goal of this investigation is less about whether firms manage earnings in general and more about examining the impact of firm characteristics on the likelihood of altering inventory to manage earnings. Our results indicate that firms with high fixed‐cost ratios (FCRs) are more likely to alter inventory but make smaller abnormal inventory changes than companies with low FCRs. Because Last‐In‐First‐Out (LIFO) firms in the manufacturing sector also may manage earnings by liquidating LIFO layers and releasing the LIFO reserve into earnings, these firms are less likely than other companies to manage earnings by shifting fixed costs between COGS and inventory. Finally, we examine our findings in a multi‐period context, determining that when firms have greater abnormal inventory changes in period t, they are less inclined to alter inventory in period t + 1. These results suggest that manufacturing firms alter inventory levels to reach accounting earnings targets, but they tend to do so when the strategy is relatively less costly.