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Discussion of “inventory policy, accruals quality and information risk”

Review of Accounting Studies volume 13, pages 411–417 (2008)Cite this article

Abstract

Krishnan et al. (Review of Accouting Studies, 2008) investigate how the choice of LIFO versus FIFO affects firms’ accruals quality and cost of capital. The authors show that LIFO firms have better accruals quality and lower cost of capital than FIFO firms and that the cost of capital effect associated with the inventory valuation method is not subsumed by differences either in fundamental risk or accruals quality between LIFO and FIFO firms. This discussion is focused on key design choices and underlying assumptions.

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Notes

  1. Lambert et al. (2007a) model the relation between information risk and expected return in a CAPM-consistent world, in which the effect of information risk on expected return goes through the unobservable, forward-looking beta, for which information risk measures can be partial determinants.

  2. Core et al. estimated a two-stage test, in which accruals quality (their proxy for information risk) is insignificant. The same holds for beta and the Fama-French size factor. KSS replicate the Core et al. test and find that accruals quality as well as the LIFO–FIFO factor are significant in their sample.

  3. While I view AQ as a good choice of earnings quality metric for KSS’ research questions, other research questions may make other quality metrics equally or more preferable. Indeed, other measures have been used in prior LIFO–FIFO studies. For example, Jennings et al. (1996) document that LIFO income statements and LIFO balance sheets have higher statistical associations with equity values (what some researchers refer to as value relevance) than non-LIFO financial statements.

  4. While there is a portion of profitability that has an effect on expected return over and above what can be explained by the book-to-market ratio, more profitable firms have higher expected returns after controlling for book-to-market and growth (Fama and French 2006). If anything, that would work against KSS’ result that LIFO firms (which are more profitable) have a lower expected return.

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  1. The Fuqua School of Business, Duke University, 1 Towerview Drive, Box 90120, Durham, NC, 27708, USA

    Per Olsson

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Olsson, P. Discussion of “inventory policy, accruals quality and information risk”. Rev Acc Stud 13, 411–417 (2008). https://doi.org/10.1007/s11142-008-9075-2

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Keywords

  • Inventory
  • Accruals quality
  • Information risk
  • Cost of capital
  • Asset pricing

JEL Classifications

  • M41
  • G12