Market Reaction To Abnormal Inventory Growth Evidence For Managerial Decision-Making

JOURNAL OF MANAGEMENT ACCOUNTING RESEARCH American Accounting Association
Vol. 34, No. 1 DOI: 10.2308/JMAR-2020-058

Spring 2022
pp. 31–50
Market Reaction to Abnormal Inventory Growth: Evidence

for Managerial Decision-Making
Kirsten A. Cook
G. Ryan Huston
Texas Tech University
Michael R. Kinney
Texas A&M University
Jeffery S. Smith
Virginia Commonwealth University
ABSTRACT: Prior research demonstrates that manufacturing firms increase production (relative to sales) to transfer
fixed costs from cost of goods sold (COGS) to inventory accounts, thereby increasing income to reach or surpass
earnings thresholds. We examine how the market reacts to this earnings management strategy. We find that
investors respond positively to inventory growth based on an expectation of increased future sales; however, this
signal is weaker for inventory manipulators. Further, the market premium from meeting or beating analyst earnings
forecasts by manipulating inventory is smaller than the premium for achieving this threshold absent inventory
manipulation or through accrual manipulation. Finally, we examine firms considered to be ‘‘serial’’ inventory
manipulators, finding that the market consistently discounts earnings beats for these firms, suggesting that inventory
manipulation erodes investor confidence in firms’ earnings. Collectively, our results provide new insights into a
challenge facing operations managers and finance managers in manufacturing firms.
Keywords: abnormal inventory growth; earnings management; managerial manipulation; market reaction;
manufacturing.
I. INTRODUCTION
I
n corporations, the top management team is ‘‘a group of senior managers that makes decisions that are important to the
firm’s future’’ (Simsek, Veiga, Lubatkin, and Dino 2005). These managers must simultaneously supervise their individual
divisions within the firm to achieve local goals and coordinate their efforts to achieve the overarching firm goal of
maximizing value for shareholders, a concept Hambrick (1994) refers to as ‘‘behavioral integration.’’ Specifically, behavioral
integration involves information sharing, collaboration, and joint decision-making among top management team members to
enhance firm performance (Hambrick 1994; Carmeli 2008). In this study, we examine an obstacle to behavioral integration in
manufacturing firms that may arise between operations managers and finance managers: determining the firm’s appropriate
inventory level in the context of earnings management incentives. Specifically, we examine investors’ perceptions of inventory
overproduction strategies used to meet accounting earnings targets.
Prior literature documents that manufacturing firms use the tenets of absorption costing to manage earnings by
overproducing inventory relative to sales (Roychowdhury 2006; Gunny 2010; Gupta, Pevzner, and Seethamraju 2010; Cook,
We thank Anwer Ahmed, Joseph Gerakos, Wenli Huang, Uday Murthy, Linda Myers, Karen Nelson, Tom Omer, Sue Porter, Bob Trezevant, Senyo Tse,
Connie Weaver, Bill Wempe, and workshop participants at Florida State University and the University of South Florida. We also thank I/B/E/S
International, Inc. for sharing forecasted and actual earnings data. Michael R. Kinney thanks PricewaterhouseCoopers and KPMG for financial support.
Kirsten A. Cook and G. Ryan Huston, Texas Tech University, Rawls College of Business, School of Accounting, Lubbock, TX, USA; Michael R. Kinney,
Texas A&M University, Mays Business School, Department of Accounting, College Station, TX, USA; Jeffery S. Smith, Virginia Commonwealth
University, School of Business, Department of Supply Chain Management and Analytics, Richmond, VA, USA.
Editor’s note: Accepted by Isabella Grabner, under the Senior Editorship of Eva Labro.
Submitted: September 2020
Accepted: August 2021
Published Online: September 2021
31
32 Cook, Huston, Kinney, and Smith
Huston, Kinney, and Smith 2021). We study the market implications of this form of real activities management. First, we
examine whether inventory manipulation impacts the market view of inventory increases as a signal of future performance;
second, we examine whether investors value earnings derived from inventory manipulation. We argue that understanding the
market reaction to inventory manipulation provides relevant information to firm decision makers, most notably on the interplay
between operations managers attempting to maximize performance and enhance operational efficiency and financial managers
seeking to maximize profits and meet earnings benchmarks.
Abnormal or excess inventory buildup is a major issue for operations/inventory managers as it can negatively affect firm
performance. Research on abnormal inventory levels has produced mixed results in terms of the nature and magnitude of the
effect on performance because inventory increases can indicate positive news (e.g., increased anticipated sales) or potential
problems (e.g., inventory obsolescence) (Lev and Thiagarajan 1993). Likewise, decreases in inventory potentially indicate
strong current demand (a positive development) or pending inventory backlogs (a negative situation).
Separately, developing streams of research in both accounting and operations management focus on firms’ use of near-term
inventory manipulation as signals to the market about performance. The accounting literature focuses more on the earnings
impact of inventory overproduction through absorption costing (e.g., Roychowdhury 2006; Cook et al. 2021). By
overproducing inventory, manufacturing firms move fixed production costs out of cost of goods sold (COGS) into inventory
accounts to increase earnings. Inventory overproduction with the intent to meet accounting earnings targets exacerbates the
problems found in prior operations literature regarding excess inventory. However, a primary tenet in the accounting literature
suggests that meeting earnings targets and creating a smooth earnings stream are primary goals of management and are viewed
positively by the market (Graham, Harvey, and Rajgopal 2005; Burgstahler and Dichev 1997; Degeorge, Patel, and Zeckhauser
1999; Burgstahler and Eames 2006; Brown and Caylor 2005). Operations management notes this as a problem for operational
efficiency, considering both the cost of overproduction (e.g., warehousing and obsolescence) and the impact on operational
goals like inventory turnover ratios and just-in-time (JIT) manufacturing (e.g., Lai, Debo, and Nan 2011; Lai and Xiao 2018).
As such, top management teams face a tradeoff between manipulating inventory or not, and this decision depends on the
expected return to meeting or beating earnings targets using this strategy.
Whether the market can recognize a firm’s inventory overproduction strategy is an empirical question that is important to
both financial and operations managers. Thus, we examine the market’s reaction to inventory manipulation, parsing inventory
changes into a justified component associated with customer demand and a manipulative component associated with
managerial discretion to determine if the market responds differently to these two components. Specifically, we develop a
prediction model for total inventory changes and use this model to partition total inventory changes into these two components.
Empirically, we regress total inventory changes on contemporaneous and future sales changes and beginning inventory levels,
using the residuals from this model as a proxy for manipulative inventory changes. Then, we examine how the market reacts to
inventory increases that are justified as well as those that are manipulative. Further, we perform subsample analyses examining
firms that manipulate earnings on multiple occasions during our sample period (‘‘serial’’ manipulators) to determine both what
kinds of firms repeatedly use inventory manipulation and whether the market reacts differently to inventory manipulation by
these firms.
Our first test examines the market response to inventory changes; Lev and Thiagarajan (1993) note that inventory increases
(decreases) may be positive based on the expectation of increased sales (strong current demand) or negative based on inventory
obsolescence (order backlogs). However, they do not consider the impact of inventory manipulation inherent in the potential
signal associated with inventory changes. We demonstrate that the market responds favorably to inventory increases, but this
favorable reaction is decreasing in the degree of manipulation inherent in the increase. In sensitivity analyses, we find that the
favorable view of inventory changes diminishes for ‘‘serial’’ manipulators. We believe this finding indicates that the market
views inventory increases to be of lower quality when they may derive from managerial manipulation, based on the potential
costs of overproduction (e.g., additional storage costs and potential obsolescence).
Next, we examine the earnings effect of manipulative inventory changes. Here, we decompose analyst forecast errors into a
manipulative inventory change component and an unmanaged ( justified) component and regress cumulative abnormal returns
surrounding quarterly earnings announcements on these two components. We find the coefficient for the managed (unmanaged)
component of the forecast error is negative (positive) and statistically significant, signifying that the market discounts earnings
derived from inventory manipulation. This finding also provides evidence to top management teams that the expected return to
manipulating inventory is lower than previously believed.
We then analyze whether the market reacts differently to earnings announcements depending on the manner in which firms
meet or exceed analyst expectations. Among firms that meet (or beat) analysts’ expectations, cumulative abnormal returns
surrounding earnings announcement dates are positive, regardless of whether these firms reach these targets through inventory
management. However, companies that are able to match, or even exceed, the consensus analyst prediction absent any earnings
manipulation experience a greater market premium than firms that manipulate inventory. Further, we see a discount for ‘‘serial’’
inventory manipulators, both for meeting or beating generally and also through inventory manipulation, suggesting that
Journal of Management Accounting Research

Volume 34, Number 1, 2022
Market Reaction to Abnormal Inventory Growth: Evidence for Managerial Decision-Making 33
manipulating inventory once for the sake of beating a target is more acceptable to investors than becoming a ‘‘serial
manipulator’’ by repeatedly manipulating inventory, as repeated inventory manipulation appears to erode confidence in firms’
earnings in the long run. Finally, we compare the market reaction of earnings derived from inventory manipulation to another
common earnings management technique, discretionary accruals. The outcomes of our analyses generally show that the market
reacts less favorably to inventory manipulation relative to accrual manipulation, consistent with the additional costs of
inventory manipulation. While inventory management has largely been considered a substitute for accrual management during
the Sarbanes-Oxley era, we shed light on the relative benefits of each strategy from a market perspective.
Our study merges and extends four streams of literature. First, controlling for managerial discretion in production
decisions, we investigate how the market interprets the signals contained in firms’ total inventory changes, finding that the
market responds favorably to inventory increases, but this relation diminishes with additional discretionary inventory change.
Second, we extend the real activities management literature by examining market reaction to earnings generated by inventory
manipulation. Third, we build on studies of market reaction to reaching earnings targets by managing earnings (e.g., Gleason
and Mills 2008), demonstrating that while the market does not react as positively to meeting earnings targets through inventory
manipulation, it is more positive than missing an earnings target. Further, our results suggest that the market views inventory
manipulation differently depending on how often firms use this strategy to meet earnings targets. Finally, our results provide
additional context regarding the pecking order of earnings management, demonstrating that the market views inventory
manipulation less favorably than accrual manipulation, consistent with the additional costs of inventory manipulation.
We believe these findings provide a relatively independent (market-oriented) perspective on the struggle between
operations managers seeking greater operational efficiency and financial managers seeking to meet earnings benchmarks. By
understanding the market reaction to this earnings management strategy, we are better able to understand the decision-making
process and the interplay between operations managers such as the chief operating officer (COO) and financial managers such
as the chief financial officer (CFO).1 Specifically, if investors discount the value of earnings generated by manipulative
overproduction, the relative benefits of this strategy (higher stock price) are unlikely to justify its costs (inventory holding costs,
obsolescence, etc.), giving the COO leverage on the top management team to maintain an inventory level that is justified by
customer demand. The top management team, and ultimately the chief executive officer (CEO), must decide whether the
financial reporting benefits of overproducing inventory exceed the costs of this earnings management strategy, especially in
light of our findings that the market significantly discounts the value of these inventory-managed earnings.
We also build on the management control systems literature in accounting. Specifically, Otley (1999) developed a
framework for evaluating management control systems based around five questions, and our study addresses the last of these
five questions: ‘‘What are the information flows (feedback and feed-forward loops) that are necessary to enable the organization
to learn from its experience, and to adapt its current behavior in the light of that experience?’’ That is, the evidence that we
provide in this study regarding investors’ valuation of earnings generated by inventory overproduction is an ‘‘information flow’’
to members of the top management team about whether this earnings management strategy is effective and whether they should
adapt this behavior going forward. We believe that our evidence will revise top management teams’ prior beliefs about
investors’ valuation of earnings generated by inventory manipulation relative to the value of earnings generated by justified
customer demand. Thus, holding steady the costs of overproducing inventory, providing evidence that the benefits of this
strategy are lower than previously assumed may result in firms reconsidering (and abandoning) this strategy.
II. LITERATURE REVIEW AND DEVELOPMENT OF HYPOTHESES

Lev and Thiagarajan (1993) find that changes in inventory levels may signal either positive or negative news about current
and expected future firm performance. Inventory increases convey positive news when firms stockpile inventory in anticipation
of higher future sales; however, inventory buildup signals bad news when such increases are associated with slow-moving
merchandise or obsolete inventory. Similarly, the market interprets inventory decreases as either good or bad news depending
on firm circumstances. Inventory decreases signal that current demand is strong (good news) or that stock outages and order
backlogs loom (bad news). However, Lev and Thiagarajan (1993) do not consider that, in the manufacturing sector, firms may
modify production relative to sales to manage earnings via the mechanics of absorption costing.
Jiambalvo, Noreen, and Shevlin (1997) argue that the market may view income realized from inventory increases as being
of lower quality than other earnings because such earnings may derive from managerial manipulations. The authors find a
positive association between market returns and inventory increases of manufacturing firms; thus, on average, the market views
inventory expansion positively. In supplemental tests, the authors find some evidence that managers manipulate production to
1
We also contacted three operations managers at manufacturing firms to better understand these top management team interactions from a practical
standpoint.

manage earnings. However, like Lev and Thiagarajan (1993), Jiambalvo et al. (1997) provide no direct tests of a systematic
association between financial reporting objectives and inventory changes.
Empirical research in operations also investigates the association between specific levels of company inventories and
economic performance. Earlier studies focus on how to improve common metrics such as days of supply or inventory turns
(Cheng, Cantor, Dresner, and Grimm 2012; Eroglu and Hofer 2011; Kesavan, Kushwaha, and Gaur 2016; Jain 2018; Rekik,
Syntetos, and Glock 2019). Prior work explores how effectively managing inventory can affect financial performance (e.g., Qi,
Boyer, and Zhao 2009; C. Hofer, Eroglu, and A. Hofer 2012; Alan, Gao, and Gaur 2014). In general, this research stream
denotes the positive impact proper inventory management has on financial performance, with rare exceptions (Cannon 2008;
Eroglu and Hofer 2011). The conclusion across this literature stream is that matching inventory levels to customer demand is a
key component that ultimately leads to enhanced outcomes (Hendricks and Singhal 2009; Ullrich and Transchel 2017). Further
research investigates the impact of ‘‘abnormal’’ inventory growth (AIG), noting that excess inventories drive weaker long-term
market returns (Chen, Frank, and Wu 2005, 2007).
A separate stream of earnings management literature demonstrates that income-increasing discretionary accruals
exaggerate the magnitude of positive earnings surprises, whereas income-decreasing discretionary accruals suppress the
magnitude of positive earnings surprises. DeFond and Park (2001) hypothesize and find that firms with positive earnings
surprises and income-increasing abnormal working capital accruals have lower earnings response coefficients (ERCs) than
firms with positive earnings surprises and income-decreasing abnormal working capital accruals. Balsam, Bartov, and
Marquardt (2002) examine a sample of firms likely managing earnings (i.e., firms with earnings that reach or narrowly exceed
the consensus analyst forecast and with total earnings comprised of large discretionary components) and find a negative
association between the discretionary earnings component and the cumulative abnormal return in a short window surrounding
the Form 10-Q filing date. Baber, Chen, and Kang (2006) report that the market reacts negatively to evidence of earnings
management, and this negative reaction is stronger when firms disclose supplementary balance sheet/cash flow information
along with earnings news.
Extensive evidence exists in accounting that managers manipulate both accruals (e.g., Healy and Wahlen 1999; Payne and
Robb 2000) and real activities (e.g., Roychowdhury 2006) to inflate their earnings. In addition, evidence exists that investors
are aware of managers’ manipulative actions and react to accrual management negatively (e.g., DeFond and Park 2001; Bartov,
Givoly, and Hayn 2002). For example, in a tax context, Dhaliwal, Gleason, and Mills (2004) document that firms reduce their
reported tax expense from quarter three to quarter four to inflate earnings and reach or exceed analysts’ consensus earnings
forecasts, and Gleason and Mills (2008) document that investors discount the market value of earnings generated by this
manipulative managerial action.
We posit that the market views inventory increases demonstrated in the financial statements positively when they relate to
anticipated customer demand (i.e., justified), as opposed to earnings management incentives (i.e., manipulative). This presumes
that investors (1) examine firms’ disclosures of inventory in their financial statements, and (2) have the ability to distinguish
between justified and manipulative inventory changes. While we do not suggest that every investor properly interprets the
signals inherent in firms’ inventory disclosures, prior literature in accounting (Lev and Thiagarajan 1993; Jiambalvo et al.
1997) and a host of practitioner articles (e.g., Kim 2019; Novet 2019; Schultz 2019) suggest that inventory signals are valued
by investors. To the extent that either of our presuppositions is incorrect, we will find no support for our hypotheses. As the
degree of discretion inherent in the positive inventory change increases, we expect that the market’s valuation of this positive
inventory change decreases. Lai and Xiao (2018) suggest that a one-size-fits-all approach to assessing inventory levels is not
necessarily appropriate, stating that ‘‘interpreting the inventory level requires firm segregation based on operational
characteristics . . . a higher inventory level does not necessarily imply that the firm is more or less efficient.’’ Lai (2006) takes a
similar stance, suggesting that when the market observes high inventory, it cannot tell whether the inventory level is due to
incompetence or is linked to a specific strategic decision where the goal is to either meet tangible demand or to purposefully
alter inventory levels as an earnings management mechanism.
Thus, we offer the following set of hypotheses:
H1a: The market exhibits a positive response to inventory growth related to customer demand.
H1b: The market exhibits a less positive response to inventory growth related to managerial manipulation.
An expanding stream of accounting research addresses the use of real activities, and more specifically inventory
overproduction, to manage earnings (e.g., Graham et al. 2005; Roychowdhury 2006; Gunny 2010; Gupta et al. 2010; Cook et
al. 2021). By overproducing inventory, firms may use absorption costing to transfer fixed production costs out of COGS and
into inventory accounts to increase net income. As an example of absorption costing, consider a firm that has $1 million in fixed
manufacturing costs, produces 1,000 units in a given year, and expects to sell all of these units in the current period. In this
case, COGS includes all $1 million of fixed costs along with any per-unit variable costs because the fixed costs attach to the

1,000 units at a cost per unit of $1,000. Alternatively, if the firm were able to produce 2,000 units in the year, selling only the
expected 1,000 units, the fixed cost per unit decreases from $1,000 per unit to only $500. In this case, COGS includes the same
variable costs for the 1,000 units sold, but it includes only $500,000 of fixed costs, with the remaining $500,000 attaching to the
1,000 unsold units that are included in ending inventory on the firm’s balance sheet.2 By reducing COGS by $500,000, the
firm’s net income before taxes has now increased by $500,000; the earnings impact of this strategy is a function of the firm’s
relative amount of fixed costs and the extent of overproduction. Specifically, if fixed costs were greater than $1 million and/or
the firm produced more than 2,000 units in the period, net income would increase by more than $500,000 in this example.
Obviously, overproduction to meet target earnings exacerbates problems found in prior literature regarding excess
inventory (e.g., obsolescence, storage costs). However, little evidence exists concerning the market response to earnings when
firms use real activities management. A survey of CFOs reported that 80 percent of respondents suggested they would reduce or
delay research and development (R&D) spending, while an addition 55 percent indicated they would delay new projects to
increase income (Graham et al. 2005). Although the extant literature provides evidence of real activities management
(Roychowdhury 2006; Badertscher 2011; Zang 2012; Gupta et al. 2010; Cook et al. 2021), none of these studies explores if or
how the market reacts to these strategies, nor do they investigate how this market reaction influences decision-making by the
top management team regarding the appropriate inventory level to maximize firm value.
While the market generally views increased income news positively, we predict a negative market reaction to components
of earnings resulting from manipulative inventory changes because (1) this income is likely transitory in nature, and (2) the
market anticipates the negative future impact of excess inventory. How the market ‘‘prices’’ accounting earnings is the subject
of a significant accounting and finance literature stream, but generally one can break down pricing strategies based on persistent
and transitory components of earnings. Given that the market price of a share is theoretically calculated as the present value of
the sum of expected dividends (earnings), earnings persistence is an important piece of the calculation. A subset of this
literature stream demonstrates that accounting accruals are valued less relative to other earnings because they are considered
transitory. We investigate the same question with earnings that come from inventory overproduction, because we assert that
these earnings are also transitory and therefore should be valued less than other earnings.
Hence, we propose our second group of hypotheses:
H2a: The market responds positively to unmanaged earnings.
H2b: The market responds less positively to earnings derived from inventory manipulation.
A final consideration for firms that can manipulate inventory levels is how this manipulation could affect the ability to
meet/beat the consensus analyst earnings forecast. We consider various possibilities for meeting/beating the forecast, including
meeting/beating without any managerial manipulation relative to meeting/beating through manipulative inventory changes. The
accounting literature has noted the importance of meeting/beating the forecasts, so it stands to reason that the conscious
decision to alter inventory levels is of importance.
Several studies have found that firms meeting/beating analyst forecasts are rewarded by the market (DeFond and Park
2001; Bartov et al. 2002; Bhojraj, Hribar, Picconi, and McInnis 2009), while others are penalized for missing these targets
(Skinner and Sloan 2002). This reward structure has led to an increase in the frequency of firms achieving their income targets
(Brown 2001; Brown and Caylor 2005). However, past research suggests that the market reaction differs when firms manage
earnings through accounting accruals and estimates to meet/beat targets (DeFond and Park 2001; Bartov et al. 2002; Hribar,
Jenkins, and Johnson 2006; Baber et al. 2006; Gleason and Mills 2008). Specifically, Balsam et al. (2002) examine firms likely
managing earnings (i.e., instances where firms have earnings that reach or narrowly exceed the consensus analyst forecast and
with total earnings comprised of large manipulative components) and find a negative association between the manipulative
earnings component and the cumulative abnormal return in a short window surrounding the Form 10-Q filing date. Generally,
while these studies find that the market reaction is diminished for meeting/beating through earnings manipulations, there is still
a positive reaction for meeting/beating relative to missing earnings targets.
None of these earnings management techniques demonstrated in the preceding literature (accruals, stock buybacks,
accounting estimates, etc.) have the negative impact on future returns associated with inventory overproduction (warehousing,
obsolescence, etc.). Given these costs, we suggest that the market should not reward the manipulation of inventory by firms for
the purpose of meeting/beating earnings targets. However, it is important to note that inventory manipulation, unlike
accounting accruals, is not a violation of Generally Accepted Accounting Principles (GAAP), meaning that executives
manipulating inventory do not run the risk of penalties associated with the Sarbanes-Oxley Act of 2002. To the extent that (1)
lower market valuations for accrual manipulations found in prior literature are based largely on the possibility of restatements
2
Firms need only to begin production of inventory rather than complete the production process in order to shift fixed costs from COGS to inventory
accounts, as fixed costs may attach to either work-in-process or finished-goods inventory.

or other accounting-oriented penalties, or (2) the market is unable to discover inventory manipulation, it is an empirical
question as to whether there will be a similar valuation for inventory manipulation as to that of accrual manipulation.
Our third set of hypotheses presents this expectation:
H3a: The market reaction is less positive for meeting/beating earnings targets through inventory manipulation than
meeting/beating without manipulation.
H3b: The market reaction is less positive for meeting/beating earnings targets through inventory manipulation than
through accrual manipulation.
Our ultimate goal in examining how the market perceives earnings generated by inventory manipulation is to speak to the
tension between (1) operations managers, who strive to maintain inventory levels that correspond with customer demand and
thus contribute to operational efficiency, and (2) financial managers, who strive to maximize profits to reach or exceed earnings
benchmarks. If investors fail to distinguish between unmanaged earnings and inventory-manipulated earnings when assessing
firm value, inventory overproduction may benefit the firm as a whole (as well as its managers who are compensated with
earnings-based bonuses and/or firm equity) despite its disruption to the inventory-management system established by the
operations manager. However, if investors recognize the disruptiveness associated with overproducing inventory to inflate
earnings and accordingly discount inventory-managed earnings when assessing firm value, our evidence would suggest that
firms should allow operations managers to maintain optimal inventory levels without interference from financial managers.
III. SAMPLE
Only manufacturing firms have the opportunity to impact earnings through the use of inventory manipulation; thus, we begin
with all quarterly observations from manufacturing industries (SIC codes between 2000 and 3999) in the Compustat Industrial
Quarterly database between 1988 and 2014.3 We limit the sample to firms that utilize the first-in, first-out (FIFO) method to value
inventory. We eliminate observations listing multiple valuation methods because we cannot determine how alternate inventory
valuation methods influence companies’ motivations for managing earnings through manipulative inventory changes. Further, we
eliminate last-in, first-out (LIFO) firms because these firms face may manage earnings upward using either overproduction or by
liquidating LIFO layers (Cook et al. 2021). Importantly, we note that LIFO firms represent a very small proportion of the sample of
manufacturing firms, suggesting that their removal from the sample should not negatively impact the generalizability of our findings.
Our initial sample consists of 61,324 observations. We remove 19,389 observations missing financial statement data from
Compustat, 1,311 observations lacking CRSP stock return data, and 25,149 observations missing forecasted and actual earnings data
from the Institutional Brokers’ Estimate System (I/B/E/S). Our final sample includes 15,475 observations from 1,457 distinct firms.
IV. EMPIRICAL METHODOLOGY

To measure the portion of earnings resulting from inventory manipulation, we employ a two-stage regression method. The
first-stage model regresses firms’ inventory changes on current and future sales demand, lagged inventory level, fixed-cost
ratio, and firm size. Further, we include firm, year, and quarter fixed effects to capture seasonality of production and demand.4
The first-stage model residuals then proxy for firms’ manipulative inventory changes. We recognize that any noise inherent to
this model, or factors for which we do not control, are classified as manipulative inventory changes in our research design;
however, we have no reason to believe that these factors are systematically correlated with market returns in our second-stage
models. Compustat Industrial variable names appear in parentheses:
Inv chq ¼ a þ b1 Hi Invq1 þ b2 Hi FCRq þ b3 Sal chq þ b4 Fut demqþ1 þ b5 Fut demqþ2 þ b6 Fut demqþ3 þ b7 Sizeq1
þ Firm Indicators þ Year Indicators þ Quarter Indicators þ e
ð1Þ
where:
Inv_chq ¼ inventoriesq (invtq) – inventoriesq1;
Hi_Invq1 ¼ 1 if Invq1 is greater than the sample median, and 0 otherwise;
3
In sensitivity analyses (unreported), we utilize different partitions of our sample (i.e., into the decade of the 1990s and the early 2000s) to control for the
differences in the market surge and the ‘‘market bubble’’ burst. We also break our sample into pre- and post-Sarbanes-Oxley to control for differences in
regulatory conditions. We find no significant differences in our results across these partitions.
4
In sensitivity analyses (unreported), we omit the lagged inventory level and fixed-cost ratio indicator variables (Hi_Inv and Hi_FCR) from the model;
our inferences are unchanged under these specifications.

Invq1 ¼ inventoriesq1;
Hi_FCRq ¼ 1 if FCR is greater than the sample median, and 0 otherwise;
FCRq ¼ property, plant, and equipmentq (ppentq)/assetsq (atq);
Sal_chq ¼ salesq (saleq) – salesq1;
Fut_demqþ1 ¼ salesqþ1 – salesq;
Fut_demqþ2 ¼ salesqþ2 – salesqþ1;
Fut_demqþ3 ¼ salesqþ3 – salesqþ2; and
Sizeq1 ¼ natural logarithm of total assetsq1 (atq).
Inv_ch measures total quarterly inventory changes. Hi_Inv is an indicator variable capturing firms with relatively high
levels of inventory on hand at the beginning of the quarter; these firms may be less likely to overproduce inventory in the
current quarter than those with relatively low levels. Hi_FCR is an indicator variable capturing firms with relatively high fixed-
cost ratios; Cook et al. (2021) demonstrate that these firms are more likely to overproduce inventory but report relatively
smaller inventory increases than firms with lower fixed-cost ratios. Sal_ch measures changes in sales for the current period,
whereas Fut_dem measures changes in sales for the three following quarters. We use actual sales changes as proxies for
managers’ expectations of future sales; we argue that while anticipated future demand will not equal actual demand, there is no
systematic bias inherent in our proxy.5 If companies attempt to preserve a consistent inventory-to-sales ratio, we should find a
positive coefficient for Sal_ch. However, if sales either increase or decrease unexpectedly such that management does not
modify production accordingly, we would find a negative coefficient for Sal_ch. Thus, we do not make a prediction for Sal_ch.
In contrast, to the extent that managers accurately forecast future changes in customer demand and adjust production
accordingly, we anticipate a positive coefficient for Fut_dem. Conversely, to the extent that firms engage in channel stuffing
behavior, we expect the association between Inv_ch and Fut_dem to be less positive. Model (1) includes proxies for future
demand measured one, two, and three quarters out because companies’ current production decisions likely relate to expected
future sales in the coming year. Table 1 provides all variable definitions and calculations.
We winsorize all variables at the 1st and 99th percentiles to mitigate the impact of outlying observations. We use Man_
inv_ch, the residuals from Model (1), as a measure of firms’ abnormal or manipulative inventory changes. For our market tests,
we begin by regressing earnings announcement returns on analyst forecast errors (computed using actual earnings rather than
earnings per share) to reconcile with prior research and create a baseline for our hypothesis tests. We use the market-adjusted
cumulative abnormal return over the five-day period centered on the announcement day (2, þ2), consistent with Gleason and
Mills (2008).6 We estimate all models in the paper using quarterly data.7 Model (2) is as follows:
CARt ¼ a þ b1 AFEq þ b2 BMq1 þ b3 Sizeq1 þ b4 Momentumq þ e ð2Þ
where:
CARq ¼ five-day cumulative abnormal return centered around the earnings announcement day (2, þ2);
AFEq ¼ Actualq Forecastq;
Actualq ¼ I/B/E/S actual EPSq (value) 3 common shares used to calculate EPSq (cshprq);
Forecastq ¼ the last I/B/E/S consensus forecast estimateq (meanest) 3 common shares used to calculate EPSt (cshprq);
BMq1 ¼ book-to-market ratio: [assetsq1 (atq) – liabilitiesq1 (ltq)]/[common shares outstandingq1 (cshoq) 3 closing
priceq1 (prccq)];
Sizeq1 ¼ natural logarithm of total assetsq1 (atq); and
Momentumq ¼ cumulative size-adjusted returns for the six months preceding the earnings announcement.
Analyst forecast error (AFE) is the difference between firms’ actual I/B/E/S earnings and the last consensus I/B/E/S
forecast before the earnings announcement. We use unadjusted I/B/E/S earnings to avoid miscalculations caused by stock
splits (Baber and Kang 2002; Payne and Thomas 2003; Gleason and Mills 2008). Consistent with prior research showing
5
In sensitivity analyses (unreported), we re-estimate this model omitting the future demand variables, and our inferences are generally unchanged.
However, the explanatory power of the model decreases from an Adjusted R2 of 0.257 to 0.178 upon the exclusion of these variables. We believe the
benefit of increased explanatory power in the first-stage model outweighs the potential noise associated with differences between expected and actual
demand.
6
In addition to five-day return windows, we also examine other return windows, including (1, þ1), (0, þ3), and (3, þ3). Additionally, we calculate
alternative market-adjusted returns (Eventus MAR and MM). In sensitivity analyses (unreported), we find that neither the choice of return window nor
method of market adjustment yields any significant differences in the results.
7
In supplemental analyses (unreported), we construct and examine a sample of annual observations to determine whether firms manipulate inventory to
reach annual earnings targets (either in addition to or in lieu of quarterly thresholds). Our results for this annual sample are generally consistent with
those that we subsequently tabulate for our quarterly sample.

TABLE 1
Variable Definitions
Variable Definition
CAR Five-day cumulative abnormal returns centered around the announcement date (2, þ2).
AFE Actual Forecast.
Actual I/B/E/S actual EPSq (value) 3 common shares used to calculate EPSq (cshprq).
Forecast The last I/B/E/S consensus forecast estimateq (meanest) 3 common shares used to calculate EPSq (cshprq).
BM Book-to-market ratio: [assetsq (atq) liabilitiesq (ltq)]/[common shares outstandingq (cshoq) 3 closing priceq
(prccq)].
Size Natural logarithm of total assetsq (atq).
Momentum Cumulative size-adjusted returns for the six months preceding the earnings announcement.
Inv_Man_FE Man_inv_ch 3 FCR.
Unmanaged_FE Preman Forecast.
Preman Pre-managed earnings: Actual Inv_Man_FE.
Man_inv_ch Residual from Model (1).
Inv_ch Inventoriesq (invtq) inventoriesq1.
Pos_inv_ch 1 if inventory change (Inv_ch) is positive, and 0 otherwise.
Manipulation Abs (Man_inv_ch)/Abs (Inv_ch), censored at 1 if manipulative inventory change is greater than inventory
change.
Accruals The residual from the regression of total accruals on the change in revenue and lagged return on assets,
consistent with Kothari, Leone, and Wasley (2005).
Beat w/IM Only 1 if AFEq 0, Inv_Man_FEq AFEq and Acc_Man_FEq , AFEq, and 0 otherwise.
Beat w/Acc Only 1 if AFEq 0, Inv_Man_FEq , AFEq and Acc_Man_FEq AFEq, and 0 otherwise.
Beat w/Either 1 if AFEq 0, Inv_Man_FEq AFEq and Acc_Man_FEq AFEq, and 0 otherwise.
Beat w/o Mgmt 1 if AFEq 0, Inv_Man_FEq , AFEq, Acc_Man_FEq , AFEq, and (4) (Inv_Man_FEq þ Acc_Man_FEq ) ,
AFEq, and 0 otherwise.
Beat w/Both 1 if AFEq 0, Inv_Man_FEq , AFEq, Acc_Man_FEq , AFEq, and (4) (Inv_Man_FEq þ Acc_Man_FEq )
AFEq, and 0 otherwise.
Miss 1 if AFEq , 0, and 0 otherwise.
FCR Fixed-cost ratio: gross property, plant, and equipmentq (ppentq)/assetsq (atq).
Hi_FCR 1 if actual FCR . median FCR, and 0 otherwise.
Fut_dem Future demand one quarter ahead: salesqþ1 (saleq) salesq.
Sal_ch Sales change: salesq (saleq) salesq1.
Beat w/o IM 1 if Actual . Forecast and Preman Forecast, and 0 otherwise.
Beat w/IM 1 if Actual . Forecast and Preman , Forecast, and 0 otherwise.
positive returns are associated with positive earnings surprises and negative returns are associated with negative surprises,
we anticipate that AFE has a positive coefficient. Three control variables are included based on models from other returns
studies (Fama and French 1992; Jegadeesh and Titman 1993; Gleason and Mills 2008): the lagged book-to-market ratio
(BM), the natural logarithm of lagged total assets (Size), and the cumulative size-adjusted return for the six months
preceding the earnings announcement (Momentum). All tabulated regression models are measured using a GMM
estimator.8
Signals Inherent in Inventory Changes

To test H1, we examine investors’ interpretations of the signals inherent in firms’ total inventory changes, conditioned on
whether these changes derive more from changes in contemporaneous and anticipated future sales or managerial opportunism.
To this end, we scale the absolute value of the residuals from Model (1), Man_inv_ch, by the absolute value of total inventory
changes, Inv_ch, censoring the ratio at 2 if manipulative changes are more than two times greater than total inventory changes.
We label the resulting variable Manipulation. Manipulative inventory changes are the differences between actual and predicted
inventory changes; thus, for firms with near-zero total inventory changes, manipulative inventory changes could exceed total
8
In sensitivity analyses (unreported), we find qualitatively similar results using OLS, correcting for both heteroscedasticity and autocorrelation, as well
as using standard errors clustered by firm, year, and quarter. Results are consistent across each specification.

inventory changes. Censoring the ratio at 2 is admittedly arbitrary; in sensitivity tests, we use different ratios, but results are not
sensitive to the ratio used.9
In Model (3), consistent with Jiambalvo et al. (1997), we examine the stock market’s reaction to inventory increases (Pos_
inv_ch) and then interact Pos_inv_ch with Manipulation to determine if market reaction to firms’ inventory increases differs
when these changes derive from business fundamentals relative to perceived manipulation. We predict the coefficient for Pos_
inv_ch to be positive, as per the H1a expectation that for firms with low manipulation, the market views inventory increases
positively. Alternatively, we predict a negative coefficient on the interaction of Manipulation with Pos_inv_ch based on H1b,
suggesting that the market places a lower valuation on inventory increases based on managerial manipulation. Model (3) is as
follows:
CARq ¼ a þ b1 Manipulationq þ b2 Pos inv chq þ b3 Manipulationq 3 Pos inv chq þ b4 AFEq þ b5 BMq1 þ b6 Sizeq1
þ b7 Momentumq þ e
ð3Þ
where:
Manipulationq ¼ Abs (Man_inv_chq )/Abs (Inv_chq ), censored at 2 if Abs (Man_inv_chq ) . 2 3 Abs (Inv_chq );
Man_inv_chq ¼ the residual from the estimation of Model (1); and
Pos_inv_chq ¼ 1 if inventory change (Inv_chq ) is positive, and 0 otherwise.
Tests of Earnings Manipulations

Next, we estimate the earnings effect of manipulative inventory changes. The earnings effect is different from manipulative
inventory change because it requires the inclusion of firms’ fixed costs. Under absorption costing, the earnings effect of an
overproduction strategy is a function of the relative amount of fixed costs and the level of overproduction in the period as
described above. Specifically, as fixed costs increase, the firm can transfer more fixed costs from COGS into inventory accounts
for each unit of overproduction. Thus, the effect on net income of overproducing inventory (which we label the inventory-
managed forecast error, Inv_Man_FE) is the product of the manipulative inventory change and the fixed-cost ratio, as
demonstrated in Equation (4) below:
Inv Man FEq ¼ Man inv chq 3 FCRq ð4Þ
where FCRq ¼ property, plant, and equipmentq (ppentq)/assetsq (atq).
While firms’ fixed costs ratios (FCR) cannot be observed directly, the ratio of property, plant, and equipment (PPE) to
assets is used to measure FCR due to its correlation with the major elements of fixed manufacturing costs, including
maintenance costs, property taxes and insurance, and depreciation expense (Gupta et al. 2010).
To test H2a and H2b, we compare the earnings response coefficients for the inventory-managed and unmanaged
components of forecast error. We also deflate forecast errors (AFE, Inv_Man_FE, and Unmanaged_FE) by either total assets or
market value of equity in sensitivity analyses (unreported), and our results are robust to an additional control for firm size. We
expect the coefficient of Unmanaged_FE (b2) to be positive, consistent with H2a. As stated in H2b, the coefficient of Inv_
Man_FE (b1) is expected to be negative, suggesting the market views inventory-managed earnings as being of lower quality
than unmanaged earnings given the potential negative future implications of overproduced inventory. Model (5) is as follows:
CARq ¼ a þ b1 Inv Man FEq þ b2 Unmanaged FEq þ b3 BMq1 þ b4 Sizeq1 þ b5 Momentumq þ e ð5Þ
where:
Unmanaged_FEq ¼ Premanq – Forecastq; and
Premanq ¼ Actualq – Inv_Man_FEq.
Meeting or Beating Earnings Targets

To test H3a, we create two indicator variables identifying whether firms that meet/beat their consensus analyst forecast do
so with or without manipulative inventory increases (Beat w/IM and Beat w/o IM, respectively), similar to Gleason and Mills
(2008):
9
In addition to interacting the continuous Manipulation variable with the categorical Pos_inv_ch, we also interact a categorical Manipulation variable,
calculated based on whether the value of manipulative inventory change is greater than or less than the sample median, with a continuous measure of
Pos_inv_ch. Results (unreported) are not sensitive to this change.

CARq ¼ a þ b1 Beat w=o IMq þ b2 Beat w= IMq þ b3 AFEq þ b4 BMq1 þ b5 Sizeq1 þ b6 Momentumq þ e ð6Þ
where:
Beat w/o IMq ¼ 1 if Actualq Forecastq and Premanq Forecastq, and 0 otherwise; and
Beat w/IMq ¼ 1 if Actualq Forecastq and Premanq , Forecastq, and 0 otherwise.
The intercept measures the average stock price reaction for firms that miss their consensus EPS forecast; thus, we expect a
negative coefficient for a. We expect positive coefficients for both Beat w/o IM and Beat w/IM if the market return is positive
when firms meet/beat their forecasts; however, as stated in H3a, we expect that the market will differentiate between firms that
meet/beat with and without inventory manipulation, meaning the coefficient on Beat w/o IM (b1) will be greater than the
coefficient for Beat w/IM (b2).
In addition to inventory, firms may manipulate accruals to manage earnings (Healy and Wahlen 1999; Payne and Robb
2000). To reconcile our findings regarding inventory manipulation with prior studies of accrual manipulation, we next test
market reactions to inventory management while controlling for accrual management. Specifically, we examine whether the
market reacts to firms’ use of an inventory-management strategy differently than to generic accruals management. We compare
the market reaction to firms’ use of both inventory management and accrual management to meet/beat earnings targets. To do
so, we create four separate indicator variables to categorize firms’ management techniques to meet/beat benchmarks; all miss
firms are accounted for in the intercept. First, Beat w/o Mgmt represents firms whose pre-accrual and pre-inventory
management earnings exceed the forecast. Beat w/IM Only and Beat w/Acc Only represent observations for which the firm met/
beat its target through only inventory manipulation or only accrual manipulation, respectively. Finally, Beat w/Either represents
observations for which both the magnitude of the accrual manipulation and the magnitude of the inventory manipulation are
sufficiently large to meet/beat the earnings target.10 We expect coefficients of all four variables to be positive because meeting/
beating in any fashion is perceived as better than missing the earnings target. Additionally, we expect a larger coefficient for
meeting/beating without management relative to beating with either inventory or accrual manipulation, and we expect a larger
coefficient for meeting/beating with accrual manipulation relative to inventory manipulation, consistent with H3b. Model (7) is
as follows:
CARq ¼ a þ b1 Beat w=o Mgmtq þ b2 Beat w= IM Onlyq þ b3 Beat w= Acc Only þ b4 Beat w= Eitherq þ b5 AFEq
þ b6 BMq1 þ b7 Sizeq1 þ b8 Momentumq þ e ð7Þ
where:
Beat w/o Mgmtq ¼ 1 if AFEq 0, Inv_Man_FEq , AFEq, Acc_Man_FEq , AFEq, and (Inv_Man_FEq þ Acc_Man_FEq )
, AFEq, and 0 otherwise;
Beat w/IM Onlyq ¼ 1 if AFEq 0, Inv_Man_FEq AFEq and Acc_Man_FEq , AFEq, and 0 otherwise;
Beat w/Acc Onlyq ¼ 1 if AFEq 0, Inv_Man_FEq , AFEq and Acc_Man_FEq AFEq, and 0 otherwise; and
Beat w/Eitherq ¼ 1 if AFEq 0, Inv_Man_FEq AFEq and Acc_Man_FEq AFEq, and 0 otherwise.
V. RESULTS
Descriptive Statistics
Sample descriptive statistics appear in Table 2, Panel A. Mean and median cumulative abnormal returns (CAR) are positive
for the entire sample; further, mean and median forecast errors (AFE) are also positive, consistent with a stock price reward for
meeting or beating earnings expectations. The mean and median for Inv_Man_FE are both near zero (mean ¼0.002; median ¼
0.001), which is to be expected because the manipulative inventory change variable is the residual from the first-stage
regression model. Of our 15,475 sample observations, 45.2 percent of firms meet/beat earnings targets absent inventory
manipulation (Beat w/o IM); however, 39.5 percent meet/beat their earnings targets through the earnings effect associated with
manipulative inventory increases (Beat w/IM).11 Only 15.3 percent of sample observations miss earnings targets (Miss).
10
In addition, 149 observations required companies to employ both inventory and accrual management to meet/beat the earnings forecast. For
multivariate analyses, these observations are dropped; however, these observations are separately shown in univariate statistics. Results (unreported) are
qualitatively unchanged when we include these observations as a separate variable in the model.
11
While this 39.5 percent statistic appears high, our sample consists entirely of manufacturing firms, and cost of goods sold is the largest expense on these
firms’ income statements. Thus, overproduction has an outsized effect on these firms’ reported earnings. We examine these categories of observations
in greater depth in Table 8.

TABLE 2
Descriptive Statistics
Panel A: Descriptive Statistics

Variable n Mean Std. Dev. Q1 Median Q3
CAR 15,475 0.008 0.079 0.032 0.006 0.047
AFE 15,475 0.179 0.270 0.010 0.090 0.280
Man_inv_ch 15,475 0.002 2.776 0.006 0.0001 0.006
Inv_Man_FE 15,475 0.002 1.494 0.062 0.001 0.058
Unmanaged_FE 15,475 0.163 8.063 1.166 0.076 1.491
BM 15,475 0.420 0.235 0.249 0.377 0.539
Size 15,475 6.293 1.739 4.936 6.202 7.478
Momentum 15,475 0.013 0.235 0.133 0.007 0.114
Inv_ch 15,475 5.884 37.272 1.378 0.909 6.375
FCR 15,475 0.276 0.156 0.158 0.252 0.365
Panel B: Bivariate Correlations

Variable CAR AFE Inv_Man_FE Unmanaged_FE BM Size Momentum
CAR 0.063 0.020 0.018 0.063 0.021 0.011
(, 0.001) (0.013) (0.026) (, 0.001) (0.011) (0.186)
AFE 0.121 0.053 0.044 0.074 0.294 0.047
(, 0.001) (, 0.001) (, 0.001) (, 0.001) (, 0.001) (, 0.001)
Inv_Man_FE 0.016 0.009 0.111 0.003 0.157 0.005
(0.046) (0.265) (, 0.001) (0.701) (, 0.001) (0.526)
Unmanaged_FE 0.033 0.082 0.863 0.003 0.017 0.010
(, 0.001) (, 0.001) (, 0.001) (0.724) (0.035) (0.227)
BM 0.045 0.109 0.0002 0.006 0.167 0.022
(, 0.001) (, 0.001) (0.790) (0.456) (, 0.001) (0.007)
Size 0.009 0.222 0.048 0.064 0.159 0.007
(0.244) (, 0.001) (, 0.001) (, 0.001) (, 0.001) (0.369)
Momentum 0.002 0.064 0.021 0.020 0.020 0.006
(0.791) (, 0.001) (0.008) (0.013) (0.014) (0.488)
Table 2, Panel B, Pearson and Spearman correlation coefficients appear above and below the diagonal, respectively.
p-values appear in parentheses.
All variables are defined in Table 1.
Panel B in Table 2 denotes Pearson and Spearman correlation coefficients for the continuous variables used in the
regression models. CAR has a positive correlation with both AFE and Unmanaged_FE, but a negative correlation with Inv_
Man_FE. These correlations provide some support for H2a and H2b: the market places a lower valuation on opportunistic
inventory manipulation, but more definitive results require controls for other factors in regression analyses.
Regression Analyses
The results of Model (1) are presented in Table 3. We find that high lagged inventory levels and high fixed-cost ratios are
associated with inventory decreases. We further find that anticipated demand in the following quarter is strongly associated
with inventory increases, suggesting that firms stockpile in advance of greater demand. However, the association decreases as
the future demand window lengthens. The Adjusted R2 for Model (1) is 25.7 percent, suggesting that the model reasonably
incorporates the anticipated effects on inventory changes; however, we are again careful not to imply that all unexplained
inventory changes are associated with manipulation, given that there is likely significant noise in the first-stage model.
The results of estimating Models (2) and (3) are presented in Table 4. Model (2) creates a baseline for comparison and
shows that, per our expectation, the coefficient b1 on AFE is significant and positive (0.036, t ¼ 11.84), consistent with prior
research. The coefficients for the control variables (BM, Size, and Momentum) are generally consistent with what has been
reported in earlier work (e.g., Gleason and Mills 2008). BM is positive and significant throughout the models, Size is negative
and significant, and Momentum is nonsignificant. In Model (3), we examine the market reaction to firms’ inventory increases,

TABLE 3
Regression Results for Model (1)
Variable Model (1)
Hi_Invq1 4.485
(3.05)***
Hi_FCR 0.321***
(0.26)
Sal_ch 0.004
(1.26)
Fut_demqþ1 0.098***
(32.50)
Fut_demqþ2 0.007**
(2.44)
Fut_demqþ3 0.002
(0.83)
Size 0.007***
(6.70)
Observations 15,475
Adjusted R2 0.257
*, **, *** Indicate statistical significance at the 0.1, 0.05, or 0.01 level, respectively.
t-values are in parentheses below each coefficient.
TABLE 4
Regression Results for Models (2) and (3)
Variable Prediction Model (2) Model (3)
Intercept ? 0.005 0.019***
(1.59) (4.74)
Manipulation ? 0.005*
(1.51)
Pos_inv_ch þ 0.005*
(1.50)
Manipulation 3 Pos_inv_ch 0.001**
(2.28)
AFE þ 0.036*** 0.020***
(11.84) (9.42)
BM þ 0.039*** 0.022***
(11.23) (9.15)
Size ? 0.003** 0.001**
(4.57) (2.18)
Momentum 0.001 0.002
(0.02) (0.69)
No. Observations 15,475 15,475
Adjusted R2 0.017 0.016

TABLE 5
Variable Prediction Model (5)
Intercept ? 0.002
(0.53)
Inv_Man_FE ? 0.0001*
(1.88)
Unmanaged_FE þ 0.0002**
(2.10)
BM þ 0.037***
(10.56)
Size ? 0.001*
(1.78)
Momentum 0.001
(0.50)
No. Observations 15,475
Adjusted R2 0.010
Model (5) F-test of Unmanaged_FE . Inv_Man_FE: F ¼ 5.01 (p ¼ 0.025).
conditioned on the level of manipulation inherent in these increases (Manipulation). The main effect for Pos_inv_ch is positive
and marginally significant (0.005, t ¼ 1.51), consistent with H1a and Jiambalvo et al. (1997). However, the negative interaction
between Manipulation and Pos_inv_ch (0.001, t ¼ 2.28) suggests that additional context is required in determining the
signal for inventory increases, as the market views inventory increases less positively for firms that are more likely to be
managing inventory, consistent with H1b.
The results of estimating Model (5) are presented in Table 5, which tests H2 by disaggregating AFE into two components,
Inv_Man_FE and Unmanaged_FE. The positive and significant coefficient for Unmanaged_FE (0.0002, t ¼ 2.10) suggests that
the market has a strong, positive reaction to the unmanaged earnings surprise; the coefficient b1 on Inv_Man_FE, however, is
negative and significant (0.0001, t ¼ 1.88). Additionally, the F-test suggests that the coefficient for Unmanaged_FE is
significantly greater than the coefficient for Inv_Man_FE (F ¼ 5.01; p ¼ 0.025). The market appears to place lower valuation on
earnings associated with inventory manipulation relative to the unmanaged earnings component. Overall, Table 5 results
suggest the market is capable of disentangling firms’ use of inventory management, diminishing the rewards for this component
of earnings, consistent with H2.
In Table 6, we examine the market reaction to firms using inventory manipulation to meet/beat earnings targets. In Model
(6), the intercept, a captures stock price reaction for the subsample of firms that miss their earnings targets and is negative and
highly significant, which is congruous with prior studies (e.g., Skinner and Sloan 2002). The coefficient for Beat w/o IM is
positive and significant (b1 ¼ 0.038, t ¼ 18.26), as is the coefficient for Beat w/IM (b2 ¼ 0.033, t ¼ 16.04). An F-test reveals that
the coefficient for Beat w/o IM is significantly greater than the coefficient for Beat w/IM (F ¼ 11.55; p , 0.01). Collectively, our
results support H3a.
Panel A of Table 7 displays the breakdown of CARs for various categories of quarterly observations. The mean (median)
CAR for firms missing their earnings target (Miss) is 0.02 (0.014). We parse our sample of firms meeting/beating the earnings
target into two categories. First, we examine meet/beat firms only in the context of inventory manipulation with no calculation of
discretionary accruals and find that firms meeting/beating with inventory management (Beat w/IM) have mean (median) CARs
that are approximately 63 (73) percent (mean CAR ¼ 0.010; median CAR ¼ 0.008) of the CAR for firms that meet/beat without
inventory management (Beat w/o IM) (mean CAR ¼ 0.016; median CAR ¼ 0.012). This result is consistent with H3a.
Panel B of Table 7 presents regression results for Model (7). We find a significantly positive coefficient for firms that meet/
beat without either form of management (Beat w/o Mgmt ¼ 0.037, t ¼ 17.43). Further, there is a significantly positive market
reaction to meeting/beating with manipulation. However, consistent with the univariate analyses, F-tests suggest that meeting/
beating without any form of management has more positive CARs than meeting/beating through any form of management
(Beat w/Acc Only: F ¼ 8.58; Beat w/IM Only: F ¼ 15.08; Beat w/Either: F ¼ 21.43). Additionally, consistent with H3b, CARs
for meeting/beating using accruals alone (Beat w/Acc Only) are significantly greater than meeting/beating through inventory

TABLE 6
Intercept 0.030***
(6.54)
Beat w/o IM þ 0.038***
(18.26)
Beat w/IM ? 0.033***
(16.04)
AFE þ 0.015***
(4.83)
BM þ 0.046***
(13.27)
Size ? 0.002***
(3.98)
Momentum 0.004*
(1.49)
Observations 15,475
Adjusted R2 0.038
Model (6) F-test of Beat w/o IM . Beat w/IM: F ¼ 11.55 (p ¼ 0.0007).
management alone (Beat w/IM Only) (F ¼ 3.70; p ¼ 0.055).12 Taken together, our results demonstrate that there is a greater
negative reaction by the market to inventory manipulation relative to accrual manipulation, consistent with an understanding of
the future costs of inventory manipulation. Further, the market appears to view inventory manipulation less negatively for firms
with higher fixed-cost ratios, consistent with the arguments of Cook et al. (2021). However, the market still rewards firms for
meeting or beating earnings targets, even if inventory manipulation is required to get to the target. We believe these findings
shed light on the relative benefits and drawbacks of inventory manipulation strategies, aiding the decision-making process
between financial and operations managers.
Sensitivity Analyses
Generally, our main analyses suggest that the market discounts the earnings associated with inventory manipulation, and
inventory manipulation appears to diminish the ability of positive inventory changes to signal future customer demand. These
findings lead to two additional research questions: (1) What types of firms repeatedly use inventory manipulation? And (2)
Does the market treats these firms differently when evaluating inventory-managed earnings?13 To attempt to answer these
questions, we focus specifically on a subsample of manufacturing firms that we label ‘‘serial’’ inventory manipulators.
Specifically, we define ‘‘serial’’ manipulators based on the frequency with which they meet or beat earnings targets with
inventory manipulation (i.e., Beat w/IM). Because we have variation in the number of firm-quarter observations for each
sample firm, we use a two-step process whereby a serial manipulator (1) must have more than one instance of beating with IM,
and (2) must have a percentage likelihood of beating with IM that is greater than the sample median.14
12
In sensitivity analyses (unreported), we break out the managed forecast error component from Model (5) into inventory and accrual management
components. Our results continue to demonstrate a positive and significant coefficient for the unmanaged component of earnings. In addition, the
coefficient for the accrual component is significantly positive; however, the coefficient for the inventory-managed component is not significantly
different from zero. We believe that this finding demonstrates that the market can effectively differentiate between earnings management through
inventory management relative to accruals, discounting inventory-managed earnings more severely based on the additional costs associated with this
strategy.
13
We thank an anonymous reviewer for suggesting these analyses.
14
Admittedly, this measure of how serial manipulators are categorized is arbitrary. However, in sensitivity analyses, we measure serial manipulators
based on only using a threshold of how many periods they beat with IM, varying the number of periods (i.e., if Beat w/IM is greater than 1, 2, etc.).
While our results become statistically weaker as we increase the number of periods, the results are consistently statistically significant at least at a 10
percent level, giving us additional comfort regarding the method.

TABLE 7
Sensitivity Analyses for Accruals
Panel A: CARs for Categories of Interest

Variable n Mean Std. Dev. Q1 Median Q3
Miss 2,366 0.020 0.079 0.058 0.014 0.023
Beat w/o IM 6,996 0.016 0.077 0.024 0.012 0.053
Beat w/IM 6,113 0.010 0.078 0.031 0.008 0.049
Beat w/o Mgmt 6,959 0.016 0.076 0.025 0.011 0.052
Beat w/IM Only 1,259 0.009 0.082 0.034 0.006 0.052
Beat w/Acc Only 3,462 0.013 0.079 0.029 0.010 0.051
Beat w/Either 1,280 0.006 0.080 0.036 0.005 0.049
Beat w/Both 149 0.011 0.077 0.030 0.007 0.047
Panel B: Regression Results for Model (7)

Intercept 0.02***
(5.43)
Beat w/IM Only 0.027***
(8.90)
Beat w/Acc Only 0.032***
(14.23)
Beat w/Either 0.025***
(8.49)
Beat w/o Mgmt 0.037***
(17.43)
AFE þ 0.012***
(3.85)
BM þ 0.042***
(12.60)
Size ? 0.003***
(4.73)
Momentum 0.004*
(1.50)
Observations 15,326
Adjusted R2 0.035
Model (7) F-test of Beat w/o Mgmt . Beat w/Acc Only: F ¼ 8.58 (p ¼ 0.003).
Model (7) F-test of Beat w/o Mgmt . Beat w/IM Only: F ¼ 15.08 (p , 0.0001).
Model (7) F-test of Beat w/o Mgmt . Beat w/Either: F ¼ 21.43 (p , 0.0001).
Model (7) F-test of Beat w/Acc Only . Beat w/IM Only: F ¼ 3.70 (p ¼ 0.055).
To determine what kinds of firms still engage in inventory manipulation, we first compare these firms on a number of
characteristics to better understand whether there are specific differences between serial manipulators and other sample firms.
Panel A of Table 8 demonstrates that serial manipulators are generally larger (in terms of total assets, sales, and market
capitalization), more mature (e.g., lower market-to-book ratio and higher profitability), and firms with greater inventory levels
and higher fixed-cost ratios. However, non-serial firms tend to have greater abnormal accruals but better inventory turnover
ratios (untabulated). Generally, these results suggest that larger, higher fixed-cost ratio firms have greater ability to use
inventory manipulation, whereas smaller, lower fixed-cost ratio firms appear more inclined to use accrual manipulation to meet
earnings targets.
Further, we examine whether the market reacts differently to serial manipulators relative to non-serial firms. Panel B of
Table 8 demonstrates that the market discounts AFE and Beat/w IM for serial firms relative to non-serial firms, but beating the

TABLE 8
Sensitivity Analyses for Non-Serial and Serial Firms
Panel A: Comparisons of Non-Serial and Serial Firms

Non-Serial n ¼ 6,530 Firms ¼ 852 Serial n ¼ 8,945 Firms ¼ 605
Variable Mean Median Std. Dev. Mean Median Std. Dev
AFE 0.132 0.040 0.254 0.213 0.130 0.275
BM 0.446 0.395 0.249 0.400 0.363 0.222
Size 6.015 5.922 1.601 6.496 6.437 1.808
Inv_ch 4.314 0.717 30.498 7.090 1.043 42.020
FCR 0.257 0.239 0.147 0.289 0.263 0.162
CAR 0.006 0.003 0.080 0.010 0.008 0.078
Inv 215.267 59.345 650.138 359.270 86.029 830.186
Sales 17.520 1.786 34.748 23.900 2.747 28.329
ROA 0.025 0.022 0.019 0.026 0.023 0.018
MVE 3,079.900 525.866 11,197.000 7,113.570 909.510 23,977.230
Accruals 0.003 0.002 0.062 0.001 0.004 0.058
Note: Values in bold type indicate statistically larger means (p , 0.01).
Panel B: Regression Results for Non-Serial and Serial Firms

Variable Model (2) Model (8)
Intercept 0.001 0.04***
(0.20) (8.15)
Beat w/IM 0.036***
(13.20)
Beat w/o IM 0.039***
(15.41)
Serial 0.004
(1.18)
Serial 3 Beat w/IM 0.007*
(1.77)
Serial 3 Beat w/o IM 0.003
(0.080)
AFE 0.032*** 0.004
(8.31) (1.37)
Serial 3 AFE 0.017***
(3.43)
BM 0.023*** 0.028***
(8.28) (10.34)
Size 0.001*** 0.001***
(3.74) (3.27)
Momentum 0.002 0.001
(0.069) (0.55)
Observations 15,475 15,475
Adjusted R2 0.011 0.032
earnings target yields positive market returns even when serial manipulators use inventory manipulation to meet the target. In
untabulated analyses, we are unable to find a statistically significant difference between serial and non-serial firms for the
inventory-managed component of earnings. Last, when examining the signal associated with positive inventory changes, we
find that there is generally a less favorable view of inventory increases for serial manipulators relative to non-serial firms.
Generally, it appears that the market recognizes specific firms that are inclined to use an inventory manipulation strategy to
meet earnings targets, and it places less value on beating earnings targets for these firms, suggesting that investors can

distinguish between justified and manipulative inventory changes and punish firms more for habitual inventory manipulation
than for a single occurrence. That being said, we are not ever able to find a negative reaction to meeting or beating earnings
targets, suggesting that this strategy continues to generate positive returns relative to missing the earnings target.
Further, we compare the market reaction to the managed component for firms with greater costs associated with inventory
manipulation. Cook et al. (2021) demonstrate that firms with higher fixed-cost structure get more ‘‘bang for their buck’’ for each
unit of inventory overproduced based on absorption costing principles. Thus, we examine the market reaction to the managed
forecast error for high fixed-cost ratio firms relative to low fixed-cost ratio firms. If the market is able to discern this earnings
management strategy, there should be a more positive coefficient for the managed forecast error of high fixed-cost firms relative
to low fixed-cost ratio firms. However, as in our analyses comparing the managed forecast error for serial manipulators and
non-serial firms, we are unable to discern a statistically significant difference between high and low fixed-cost firms.
Discussion with Operations Managers

While our results suggest that the market at least partially sees through firms’ inventory manipulation strategies, it is not
necessarily clear whether firms would change behavior based on such findings. Thus, we contacted three operations managers
at manufacturing firms to better understand these questions from a practical standpoint. While these questions and responses are
informal and clearly not generalizable to the entire population of manufacturing firms, it appears that inventory manipulation
strategies create tension between operations and finance-oriented managers; further, it appears that our results might inform the
internal debate. Our key takeaways are as follows:
Both (1) meeting earnings targets, and (2) operating efficiency are important goals in these managers’ firms.
While the market’s reaction to their firms’ earnings is very important overall, it is less important to them in their roles in
operations.
None of these managers has discussed the impact of absorption costing and how shifting fixed costs can raise their firms’
net income.
When deciding on production/inventory levels, two managers indicated that they had not overproduced inventory to
meet an earnings target, while the third indicated that their team had engaged in this behavior.
All three managers indicated that a disconnect exists between incentives for the CFO and the COO, with the CFO being
too focused on short-term numbers and sacrificing long-term value.
Two of the three managers indicated that there is a level of inventory at which an overproduction strategy is no longer
feasible due to the costs associated with warehousing, obsolescence, etc. One manager stated that the incentives needed
to sell the overproduced inventory as well as the ability to store the overproduced inventory are important
considerations.
There was disagreement among the three managers about whether analysts and investors can recognize an
overproduction strategy, with one saying yes, one saying no, and one believing that analysts could discern this strategy
but not the market in general. However, two of the three managers indicated that, if investors can see through this
strategy (evidence we provide in our study), knowing this information would influence their firms’ behavior.
VI. CONCLUSION
This paper explores how the market responds to firm inventory changes. Specifically, we examine the impact of both
manipulative (i.e., purposeful managerial actions) and justified (i.e., tied to customer demand) inventory fluctuations for
manufacturing companies. Our empirical results indicate that the market responds positively to abnormal inventory growth if
the increase is tied to legitimate drivers. In other words, when a firm increases inventory in response to customer demand, the
market views this in a positive light and values the firm accordingly. In contrast, our results show a negative market reaction to
firms that have earnings derived from managerial inventory manipulation.
The results also demonstrate that it is imperative to meet, or even beat, analyst forecasts, even if it is done via managerial
manipulation. In this case, the market has a positive reaction to firms that hit the forecast regardless of whether it was done via
manipulative actions or in response to customer demand. The reaction is more positive for instances where the latter situation
was the case, but it still holds that manipulating inventory can be a positive tool for firms to wield when the need exists to match
analyst projections. Further, we compare inventory and accrual management techniques used to reach analyst goals. Here, we
show a more negative market reaction when firms use inventory manipulation relative to accruals management, noting that the
market rewards firms for meeting/beating projections regardless of how that goal is achieved. Finally, we provide evidence that
serial manipulators suffer larger discounts from the market when they overproduce inventory to manage earnings than other
sample firms, suggesting that the market can discern manipulative from justified inventory changes and reduces the premium
for meeting/beating the earnings target more for repeated inventory manipulators.

This paper contributes to the managerial decision-making audience as well. A great deal of prior literature demonstrates the
pressures to meet earnings expectations of financial markets and outlines many of the techniques used by managers to meet
these expectations, including inventory manipulation. However, we suggest that the discounted market reaction to meeting
earnings targets through inventory manipulation found in this study gives operations/inventory managers a case to stand up to
the pressure of manipulating inventory to help meet earnings goals. In this respect, we also build on the management control
systems literature in accounting. Specifically, Otley (1999) developed a framework for evaluating management control systems
based around five questions, and our study addresses the last of these five questions: ‘‘What are the information flows (feedback
and feed-forward loops) that are necessary to enable the organization to learn from its experience, and to adapt its current
behavior in the light of that experience?’’ That is, the evidence that we provide in this study regarding investors’ valuation of
earnings generated by inventory overproduction is an ‘‘information flow’’ to members of the top management team about
whether this earnings management strategy is effective and whether they should adapt this behavior going forward.
Our findings may serve as a springboard for future research into top management teams’ decision-making regarding
inventory manipulation. Specifically, two potentially fruitful research questions that could be addressed by future inquiry are:
(1) How do COOs and CFOs incentive plans impact the decision to manipulate inventory?
(2) What factors drive CFOs to ask COOs to aid them in meeting earnings targets by manipulating inventory?
The interviews that we conducted offer some preliminary insights into these questions, but further investigation is certainly
merited. Specifically, our interviewees indicated that, while the market’s reaction to their firms’ earnings is very important
overall, it is less important to them in their roles in operations, suggesting that their compensation contracts do not incentivize
inventory manipulation. However, they also indicated that a disconnect exists between incentives for the CFO and the COO,
with the CFO being too focused on short-term numbers and sacrificing long-term value. Our results suggest that directors
(specifically, board compensation committees) should modify CFOs’ compensation contracts to better align with COOs’
operational goals.
Finally, our results offer a cautionary tale of the suboptimal overproduction of inventory. As we note, even if manipulating
inventory to satisfy managerial pressures to meet/beat analyst forecasts is beneficial to the firm’s stock price in the short run, it
does potentially result in devoting resources to activities that are not best for the long-term viability of the firm.
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JOURNAL OF MANAGEMENT ACCOUNTING RESEARCH American Accounting Association

Vol. 34, No. 1 DOI: 10.2308/JMAR-2020-058

Market Reaction to Abnormal Inventory Growth: Evidence

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II. LITERATURE REVIEW AND DEVELOPMENT OF HYPOTHESES

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IV. EMPIRICAL METHODOLOGY

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Signals Inherent in Inventory Changes

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Tests of Earnings Manipulations

Meeting or Beating Earnings Targets

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Panel A: Descriptive Statistics

Panel B: Bivariate Correlations

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Panel A: CARs for Categories of Interest

Panel B: Regression Results for Model (7)

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Panel A: Comparisons of Non-Serial and Serial Firms

Panel B: Regression Results for Non-Serial and Serial Firms

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Discussion with Operations Managers

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