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

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