Overhead Cost Measurement: Evidence from Danish Firms’ Switch from Variable to Absorption Costing

Abstract

While both U.S. GAAP and IFRS require inventory to be valued using absorption costing, prior to IFRS convergence, Danish GAAP permitted, but did not require, variable costing for financial reporting. Upon convergence, firms that had initially reported using variable costing were required to retrospectively adopt absorption costing. As a result, these firms were required to restate inventory under absorption costing for the prior year. Danish firms thus produced audited financial statements under both variable and absorption costing for the year prior to adoption of absorption costing. This unique setting allows us to observe the amount of fixed manufacturing overhead included in inventory in the pre-adoption year. In our setting, since the financial statements were initially prepared using variable costing, we have an opportunity to examine financial statements prepared using absorption costing, where management had no incentive to overproduce in order to manage earnings. In addition to documenting the extent of overhead in inventory in the absence of incentives to overproduce, we study the incremental and relative information content of earnings under each of the inventory valuation methods and compare earnings quality between the two methods. We find that variable costing is incrementally informative over variable costing, and weak evidence that the reverse holds as well. We find no evidence of a difference in relative information content. Finally, we find that absorption costing results in smoother earnings than does variable costing, which is consistent with higher earnings quality under absorption costing.