Managing Earnings by Manipulating Inventory: The Effects of Cost Structure and Valuation Method

50 Pages Posted: 2 Jul 2007 Last revised: 30 Jun 2012

See all articles by Kirsten A. Cook

Kirsten A. Cook

Texas Tech University - Area of Accounting

George Ryan Huston

Arizona State University (ASU) - School of Accountancy

Michael Kinney

Texas A&M University - Department of Accounting

Date Written: May 31, 2012

Abstract

Using absorption costing, manufacturing firms can manipulate production (relative to sales) to shift fixed costs between cost of goods sold and inventory accounts, thereby managing earnings either upward or downward. Considering two earnings targets (avoiding losses and consensus analyst forecasts), we use a large sample of manufacturing firms to study how production cost structure and inventory valuation method affect this strategy. We report the following results: Firms with high fixed-cost ratios are more likely to manipulate inventory but make smaller abnormal inventory changes than companies with low fixed-cost ratios. Because LIFO firms in the manufacturing sector may also manage earnings by liquidating LIFO layers and releasing the LIFO reserve, LIFO firms are less likely than other companies to manage earnings by shifting fixed costs between COGS and inventory.

Keywords: earnings management, inventory, production, real activities management

JEL Classification: L21, L60, M41, M43, M46

Suggested Citation

Cook, Kirsten A. and Huston, George Ryan and Kinney, Michael R., Managing Earnings by Manipulating Inventory: The Effects of Cost Structure and Valuation Method (May 31, 2012). Available at SSRN: https://ssrn.com/abstract=997437 or http://dx.doi.org/10.2139/ssrn.997437

Kirsten A. Cook

Texas Tech University - Area of Accounting ( email )

P.O. Box 42101
Lubbock, TX 79409
United States

George Ryan Huston

Arizona State University (ASU) - School of Accountancy ( email )

Tempe, AZ 85287
United States

Michael R. Kinney (Contact Author)

Texas A&M University - Department of Accounting ( email )

430 Wehner
College Station, TX 77843-4353
United States
979-862-2078 (Phone)
979-845-0028 (Fax)

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