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Inventory Policy, Accruals Quality and Information Risk

In this paper, we show that the market requires less return from LIFO firms than from FIFO firms, implying a higher valuation of LIFO firms. Francis et al. (2005) show a similar effect with accruals quality, i.e., that the market requires less return from firms with better accruals quality than from firms with poorer accruals quality.

We test whether the effect of inventory policy is subsumed by accruals quality and show that even after controlling for accruals quality, inventory policy is incrementally priced by the market. This finding suggests that the investors use a firm’s accounting policies in addition to its accruals quality measure in estimating the firm’s systematic information risk.

The stock price effect of inventory policy has been extensively investigated for over thirty years (For example, see Sunder 1973, 1975; Abdel-khalik and McKeown 1978; Brown 1980; Ricks 1982, 1986; Johnson and Dhaliwal 1988; Biddle and Ricks 1988; Leong et al. 1991; Jennings et al. 1992; Kang 1993; Guenther and Trombley 1994). However, most of these papers have focused on the market pricing of incremental tax-based cash flow effects of LIFO inventory policy. In contrast, we focus on a different issue, namely the effect of inventory policy on accruals quality and systematic information risk that is priced by the market.

We measure accruals quality similar to Francis et al. (2005) by the unexplained variation in current accruals after controlling for cash flows in the preceding, current and subsequent years, change in sales and property, plant and equipment [we denote the standard deviation of the residual in that regression as Accruals Estimation Error, AEE]. Francis et al. (2005) find that the market demands higher market return for firms with poorer accruals quality and attribute this effect to systematic information risk. We provide evidence supporting three findings: (i) the market requires lower return from LIFO firms compared to FIFO firms ceteris paribus; (ii) LIFO firms have systematically better accruals quality than FIFO firms and (ii) the market effect of inventory policy persists even after controlling for accruals quality.

Inventory Policy, Accruals Quality and Information Risk