Review of Accounting Studies, 7, 189–193, 2002


C 2002 Kluwer Academic Publishers. Manufactured in The Netherlands.

Discussion of “Inventory Changes

and Future Returns”
PAUL HRIBAR sph24@cornell.edu
Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853

The pricing of accruals has generated a substantial amount of research since Sloan (1996)
first provided evidence that accounting accruals are mispriced by the market, and that
forming a hedge portfolio on the basis of the accrued portion of net income could earn
abnormal returns of over ten percent in the following year. This striking result has survived
numerous robustness tests using different time periods, different measures of accruals,
different risk adjustments, and examining whether the accrual mispricing is subsumed by
other market anomalies. The result has always been the same—the market overprices the
accrual component of net income.
The fact that accruals are the life-blood of accounting makes this anomaly particularly
intriguing to accounting academics. More recent studies have measured the reaction of var-
ious intermediaries and market participants (e.g., analysts, auditors, institutional investors,
etc.), and decomposed total accruals into finer partitions in order to learn more about the
economic construct driving the anomaly. The Thomas and Zhang (2002) paper falls squarely
into the latter category.
Thomas and Zhang focus on the somewhat curious result that when total accruals are
decomposed into account-level line items, the change in inventory appears to explain the
majority of the accrual anomaly. In fact, a hedge portfolio formed on the basis of changes
in inventory earns approximately the same abnormal return as a hedge portfolio formed on
the basis of total accruals. After demonstrating that the mispricing of inventory is not due
to a correlated omitted variable (primarily changes in long-term assets), they proceed to
document a set of empirical regularities related to inventory changes that may provide the
basis for the development of a coherent theory. The purpose of this discussion is to try to
place the Thomas and Zhang findings in a broader context, point out the consistencies and
inconsistencies with existing explanations for the accrual anomaly, and hopefully provide
some perspective on what future research in the area should address.

Explanations for the Accrual Anomaly

Two general explanations have been advanced for why the accrual component of earnings is
less persistent than the cash component, though they do not explain why the market system-
atically ignores this difference. The first explanation suggests that purposeful intervention
on the part of management reduces the persistence of accruals. The general argument is that
management uses accruals to opportunistically inflate or deflate earnings. Because oppor-
tunistic earnings management represents an intertemporal shifting of income, this behavior
190 HRIBAR

reduces the persistence of the accrual component of net income. To the extent that the
market fails to detect earnings management activities, prices will appear to overreact to the
accrual component of earnings.
The second class of explanations requires no intent to deceive on the part of management.
Abnormally high or low accruals might arise out of the natural course of operations of a
firm, and need not indicate earnings management behavior by the firm. These abnormally
high or low accruals, however, provide fundamental signals about the future performance
of the firm (e.g., bloated inventory levels, decreased receivables turnover, etc). To the extent
the market ignores the fact that these signals predict lower future profitability (e.g., Lev
and Thiagarajan, 1993), the market will appear to overreact to the accrual component
of net income (e.g., Abarbanell and Bushee, 1998). These explanations relate to business
management, as opposed to earnings management, since they relate to mangers’ operation of
the firm, without assuming any conscious intent to move earnings in an intended direction.1
While both explanations imply market inefficiency, they have markedly different policy
implications. If the accrual anomaly is related to business management and investors ignor-
ing fundamental signals, then there are no obvious policy implications, and the remedy may
simply be to better educate investors. If, on the other hand, the accrual anomaly could be re-
liably linked to earnings management, it would provide evidence of a direct and significant
economic consequence of this discretionary managerial behavior. Attempts to alleviate the
source of the mispricing might then be directed at curbing earnings management activities
at a firm level, rather than focusing at the investor level.
On the surface, Thomas and Zhang’s main finding that inventory changes are most re-
sponsible for the accrual mispricing immediately casts doubt on the validity of the earn-
ings management explanation. In particular, inventory purchases do not directly impact
net income, but rather decrease the cash from operations, thereby increasing the accrual
component of earnings.2 Therefore, if the change in inventory is reflective of earnings man-
agement, there must be a shifting of expenses between the balance sheet (inventory account)
and the income statement (COGS). Although inventory-related earnings management could
be accomplished through avenues such as over/under production, inventory write-downs,
or reserves for obsolescence, these are generally not the first transactions that come to
mind when one thinks about earnings management.3 More widely publicized techniques
for managing earnings include accelerating revenue recognition, timing asset sales, adjust-
ing depreciation schedules and rates, and the use of special purpose entities, none of which
manifest themselves as a change in inventory.
In an attempt to shed additional light on the issue, Thomas and Zhang include a num-
ber of empirical tests that are intended to check the validity of the earnings management
explanation. Among these tests, the demonstrated relationship between COGS and changes
in inventory is most supportive of earnings management. In particular, the earnings man-
agement story requires that increases in inventory be associated with decreases in COGS
(i.e., increasing margins), because managers are shifting expenses from the income state-
ment to the balance sheet. Thomas and Zhang provide evidence that this does indeed
occur—namely that margins are increasing at the same time that inventory balances are
increasing. While this result is consistent with earnings management, other explanations
are possible that would predict similar results without requiring earnings management. For
example, if firms with growing margins are most likely to overestimate future demand
DISCUSSION OF “INVENTORY CHANGES AND FUTURE RETURNS” 191

(perhaps due to extrapolating current abnormally high demand) and invest heavily in in-
ventory, then it is possible that we would see increasing margins concurrent with build-ups
in inventory, both of which presage a reversal in the following year. Consequently, this
evidence does not rule out non-earnings management based explanations.
Another concern with the earnings management explanation is that we are presented with
no evidence as to how this earnings management occurs. For example, if firms managed
earnings through over/under production, we would expect to see greater mispricing among
the manufacturers. However, Thomas and Zhang show that the inventory changes of retail-
ers are equally mispriced. Thus, if earnings management is responsible for the inventory
mispricing, then retailers must be accomplishing this through some other means. Since no
additional evidence is provided on this issue, the reader is left with only a vague notion that
the earnings management involves shifting of expenses between the income statement and
balance sheet, with no empirical data to show how it is actually accomplished.
Given the uncertainty about the validity of the earnings management based explanations,
is there any evidence that a business-management type explanation might be more appro-
priate? For example, Thomas and Zhang recognize that prior research has documented that
capital expenditures and changes in other non-current assets are mispriced similar to accru-
als (e.g., Fairfield et al., 2001; Titman et al., 2001). The similarities between the mispricing
of changes in inventory, capital expenditures, and changes in other non-current assets are
unmistakable, and unlikely to be a coincidence. All three of these accounts relate to in-
vestments of capital, albeit on different scales, and these investment decisions do not flow
directly to net income. Thus, there may be a single explanation that accounts for all of these
separately identified anomalies.
Thomas and Zhang consider the relationship between inventory mispricing and these other
anomalies only to the extent that they include proxies for capital expenditures and changes
in other non-current assets into their regression analysis to ensure that these anomalies do
not subsume the mispricing of inventory changes. Although this analysis demonstrates that
all three variables are predictive of abnormal return in the presence of each other, it does not
rule out possibility that the same phenomenon underlies the mispricing of all three accounts.
Indeed, Thomas and Zhang’s result showing that these three accounts generate the greatest
abnormal returns suggests that we should be looking for an explanation that applies to all
of these accounts.
At least two possible explanations are suggested in earlier papers that might account
for the mispricing of all three accounts. First, Fairfield et al. (2001) argue that investors’
over-extrapolation of the firm’s past growth (or contraction) could manifest itself as a
negative relation between changes in assets and future returns (e.g., Lakonishok, Shleifer
and Vishny, 1994). Thus, rather than earnings management, a general mispricing of growth
in net operating assets is proposed to be the cause. Although this explanation encompasses
changes in inventory as well as other non-current assets, it ignores the fact that changes in
accounts receivable are empirically as large as changes in inventory, and that sales growth
and receivables are more highly correlated than sales growth and inventory. Therefore, if
over-extrapolating growth is the explanation, we would expect accounts receivable to be
equally predictive of future returns, which is not what Thomas and Zhang find.
A second explanation that could account for the mispricing of both changes in inven-
tory and changes in non-current assets is related to the over-investment problem.
192 HRIBAR

Titman et al. (2001) argue that managers over-invest when faced with a surplus of cash,
and that this phenomenon explains the negative relation between changes in non-current
assets (i.e., capital expenditures) and future returns. While this explanation is more obvi-
ously related to changes in non-current assets such as PP&E and goodwill, it could also
apply to inventory, the one component of accruals that involves an investment of capital
by management. Although this explanation is not directly tested in Thomas and Zhang,
some of their evidence is consistent with it. For example, they show that firms with the
largest inventory increases have stock returns in excess of market returns, increasing ROAs,
and increasing capital expenditures prior to the year of the large inventory increase. These
factors suggest strong prior performance and might be related to excess cash, which could
lead to overinvestment in inventory and/or long-term assets.

Implications for Future Research

Overall, the results of Thomas and Zhang do not clearly point to either the earnings
management-related explanation or a general business management-related explanation
as the likely cause of the mispricing of changes in inventory. Their empirical results are not
conclusive, and do not provide the reader with an obviously superior explanation for the
mispricing of inventory. However, the weight of the combined evidence described above
makes earnings management less plausible as the primary explanation for the inventory
mispricing and, perhaps, by inference the accrual anomaly. Additional tests could provide
evidence on this issue.
First, the current sample focuses exclusively on firms that carry inventory. Between 10
and 20 percent of the firms listed on Compustat, however, report no significant inventory
balance. Assuming that the set of no-inventory firms have the same incentives to manage
earning, one relatively straightforward extension would examine which accounts (if any)
drive the accrual mispricing for these firms. If earnings management is the cause of accrual
mispricing, then accruals should still be mispriced within this set of firms, and the observed
mispricing should shift from changes in inventory to other accruals. If, on the other hand,
an overinvestment-type explanation is more accurate, then the mispricing should be only
concentrated in the accounts that involve investments of capital, such as PP&E and goodwill.
Second, one of the greatest obstacles to the earnings management explanation is that there
is no documented research that shows inventory is a popular method for firms to manage
earnings.4 An extension that address this concern would involve examining samples of firms
with strong (e.g., seasoned equity offerings, avoiding losses, voluntary disclosures, etc.) ver-
sus weak incentives to manage earnings, and identifying the composition of accruals within
these firms. If, in fact, inventory changes reflect earnings management, then we would ex-
pect the subsample of firms with greater incentives to manage earnings to have unusually
large changes in inventory. If, on the other hand, firms with greater earnings management
incentives do not have unusual changes in inventory, then it is less likely that inventory
represents a common account through which earnings are managed. Consequently, attribut-
ing the mispricing of inventory changes to earnings management would seem unwarranted.
Since most prior earnings management studies examine aggregate discretionary accruals,
there is currently little evidence that can shed light on this issue.
DISCUSSION OF “INVENTORY CHANGES AND FUTURE RETURNS” 193

In summary, the paper by Thomas and Zhang (2001) provides an additional piece of the
accrual anomaly puzzle. In particular, the authors demonstrate that of the accrual compo-
nents, inventory changes are the most predictive of future returns in both univariate and
multivariate settings. This finding, however, raises another set of questions related to why
changes in inventory should be mispriced by the market. Although the paper presents a large
amount of evidence aimed at answering these questions, there is no single explanation that is
consistent with all of the data presented. This leaves the reader in the somewhat unsatisfying
position of knowing more about the accrual anomaly after reading the paper, but facing a
new set of questions that remain unanswered. When considered jointly with other papers
that have examined this issue, however, the Thomas and Zhang paper gives some clues that
provide a direction for future research in the area. Some of the more fruitful approaches to
future research in this area will use the mounting number of empirical regularities as the
basis for an explanation of the cause of the accrual anomaly. Ideally, these papers will be
able to integrate the findings from the seemingly related anomalies, design critical tests,
and provide evidence that helps distinguish between the competing explanations.

Acknowledgments

I appreciate the helpful comments of Michael Cipriano, Charles Lee, and Bob Libby.

Notes

1. Of course, business management activities are typically undertaken with the hope of ultimately affecting
earnings, but they are different in that they are not simply accounting maneuvers intended to temporarily
distort current earnings.
2. Obviously, purchases on account have no net impact on cash from operations, as the increase in accounts
payable will offset the increase in inventory on the statement of cash flows. Nevertheless, these transactions
still do not impact net income.
3. An extreme inventory-based earnings management explanation would be that firms consciously over/understate
the inventory balance and, therefore, under/overstate the COGS. Since this would fall outside of GAAP, it is
not considered as a plausible earnings management technique.
4. Additionally, there is no evidence that earnings management through inventory accounts is less identifiable by
investors, which could also explain why inventory changes are mispriced and other accruals are not.

References

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