Skip to main content

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

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.

This is a preview of subscription content, access via your institution.

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.

References

  • Aboody, D., Hughes, J., & Liu, J. (2005). Earnings quality, insider trading, and cost of capital. Journal of Accounting Research, 43, 651–673.

    Article  Google Scholar 

  • Allayannis, G., Rountree, B., & Weston, J. (2006). Earnings volatility, cash flow volatility, and firm value. University of Virginia and Rice University working paper.

  • Barone, G. (2003). Perceptions of earnings quality and their association with the cost of equity capital. University of Texas working paper.

  • Barth, M., Konchitchki, Y., & Landsman, W. (2006). Cost of capital and financial statement transparency. Stanford University, University of Southern California and University of North Carolina working paper.

  • Berger, P., Chen, H., & Li, F. (2006). Firm specific information and the cost of equity capital. University of Chicago, University of British Columbia, and University of Michigan working paper.

  • Bhattacharya, U., Daouk, H., & Welker, M. (2003). The world pricing of earnings opacity. The Accounting Review, 78, 641–678.

    Article  Google Scholar 

  • Bhattacharya, N., & Ecker, F., Olsson, P., & Schipper, K. (2007). Direct and mediated associations among earnings quality, information asymmetry and the cost of equity. Southern Methodist University and Duke University working paper.

  • Botosan, C., & Plumlee, M. (2005). Assessing alternative proxies for the expected risk premium. The Accounting Review, 81, 21–53.

    Article  Google Scholar 

  • Botosan, C., & Plumlee, M. (2007). Are information attributes priced? University of Utah working paper.

  • Botosan, C., Plumlee, M., & Xie, Y. (2004). The role of information precision in determining cost of equity capital. Review of Accounting Studies, 9, 233–259.

    Article  Google Scholar 

  • Chaney, P., Cooil, B., & Jeter, D. (2007). A latent class model of earnings attributes. Vanderbilt University working paper.

  • Chen, L., Dhaliwal D., & Trombley, M. (2007). The effect of fundamental risk on the market pricing of accruals quality. University of Arizona working paper.

  • Claus, J., & Thomas, J. (2001). Equity premia as low as three percent? Evidence from analysts’ earnings forecasts for domestic and international stock markets. Journal of Finance, 56, 1629–1666.

    Article  Google Scholar 

  • Cohen, D. (2006). Does information risk really matter? An analysis of the determinants and economic consequences of financial reporting quality. NYU working paper.

  • Core, J., Guay, W., & Verdi, R. (2007). Is accruals quality a priced risk factor? Journal of Accounting and Economics, forthcoming.

  • Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(Supplement), 35–59.

    Article  Google Scholar 

  • Easley, D., & O’Hara, M. (2004). Information and the cost of capital. Journal of Finance, 59, 1553–1583.

    Article  Google Scholar 

  • Easton, P. (2004) PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review, 79, 73–95.

    Article  Google Scholar 

  • Ecker, F., Francis, J., Kim, I., Olsson P., & Schipper, K. (2006). A returns-based representation of earnings quality. The Accounting Review, 81, 749–780.

    Article  Google Scholar 

  • Fama, E., & French, K. (1992). The cross-section of expected stock returns. Journal of Finance, 47, 427–465.

    Article  Google Scholar 

  • Fama, E., & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33, 3–56.

    Article  Google Scholar 

  • Fama, E., & French, K. (2006). Profitability, investment and average returns. Journal of Financial Economics, 82, 491–518.

    Article  Google Scholar 

  • Fields, T., Lys, T., & Vincent, L. (2001). Empirical research on accounting choice. Journal of Accounting and Economics, 31, 255–307.

    Article  Google Scholar 

  • Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2004). Costs of equity and earnings attributes. The Accounting Review, 79, 967–1010.

    Article  Google Scholar 

  • Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of accruals quality. Journal of Accounting and Economics, 39, 295–327.

    Article  Google Scholar 

  • Gebhardt, W., Lee, C., & Swaminathan, B. (2001). Toward an implied cost of capital. Journal of Accounting Research, 39, 135–176.

    Article  Google Scholar 

  • Gray, P., Koh, P.-S., & Tong, Y. (2007). Accruals quality, information risk and cost of capital: Evidence from Australia. University of Queensland, Hong Kong University of Science and Technology and Nanyang Technological University working paper.

  • Hughes, J., Liu, J., & Liu, J. (2007). Information asymmetry, diversification and cost of capital. The Accounting Review, 82, 705–729.

    Article  Google Scholar 

  • Hughes, P., & Schwartz, E. (1988). The LIFO/FIFO choice: An asymmetric information approach. Journal of Accounting Research, 26, 41–58.

    Article  Google Scholar 

  • Jennings, R., Simko, P., & Thompson, R. (1996). Does LIFO inventory accounting improve the income statement at the expense of the balance sheet? Journal of Accounting Research, 34, 85–109.

    Article  Google Scholar 

  • Krishnan, G., Srinidhi, B., & Su, L. (2008). Inventory policy, accruals quality and information risk. Review of Accouting Studies (current issue).

  • Lambert, R., Leuz, C., & Verrecchia, R. (2007a). Accounting information, disclosure, and the cost of capital. Journal of Accounting Research, 45(Supplement), 385–420.

    Article  Google Scholar 

  • Lambert, R., Leuz, C., & Verrecchia, R. (2007b). Information asymmetry, information precision, and the cost of capital. University of Pennsylvania and University of Chicago working paper.

  • Liu, M., & Wysocki, P. (2007). Cross-sectional determinants of information quality proxies and cost of capital measures. Pennsylvania State University and MIT working paper (version: July 2007).

  • McNichols, M. (2002). Discussion of ‘The quality of accruals and earnings: The role of accrual estimation errors’. The Accounting Review, 77(Supplement), 61–69.

    Article  Google Scholar 

  • Nichols, C. (2006). Fundamental or information risk? An analysis of the residual accrual volatility factor. Cornell University working paper.

  • Ogneva, M. (2007). Accrual quality and expected returns: The importance of controlling for cash flow shocks. University of Southern California and Stanford University working paper.

  • Ohlson, J., & Jüttner-Nauroth, B. (2005). Expected EPS and EPS growth as determinants of value. Review of Accounting Studies 10, 349–365.

    Article  Google Scholar 

  • Penman, S. (1991). An Evaluation of accounting rate-of-return. Journal of Accounting, Auditing & Finance, 6, 233.

    Google Scholar 

  • Penman, S. (1996). The articulation of price-earnings ratios and market-to-book ratios and the evaluation of growth. Journal of Accounting Research, 34, 235–259.

    Article  Google Scholar 

  • Sunder, S. (1973). Relationship between accounting changes and stock prices: problems of measurement and some empirical measurement. Journal of Accounting Research, 11(Supplement), 1–45.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to Per Olsson.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

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

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11142-008-9075-2

Keywords

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

JEL Classifications

  • M41
  • G12