Date: March 27, 2015
From: Danilo; Gustavo Bueno; Jacob Broberger; Joep Laureijs; José Adriano Machado
Subject: Group 2’s analysis of Managing Earnings by Manipulating Inventory: The Effects of Cost Structure and Valuation Method
Introduction
In this memo, we intend to analyze and breakdown Managing Earnings by Manipulating Inventory: The Effects of Cost Structure and Valuation Method by Kirsten A. Cook, Ryan Houston & Michael R. Kinney’s major faults and weak-points. The article examines how production cost structure and inventory valuation affect a company’s earning management through inventory manipulation. Its two main findings are the following: i. Firms with high fixed-cost ratios are more likely to manipulate production but make smaller abnormal inventory changes than companies with low fixed-costs ratios; ii. LIFO firms are less likely than other companies to manage earnings by using the production lever (i.e. shifting fixed costs between COGS and inventory) because they may also manage earnings by liquidating LIFO layers and releasing the LIFO reserve.
Before we begin our analysis, we put together a brief rundown of the essential concepts the article’s authors go through to form their conclusions.
Cost Structure
Cost structure refers to the types and relative proportions of fixed and variable costs that a business incurs. Valuation methods
A company can value its inventory using several methods. The two most important methods are LIFO (“last in first out”) and FIFO (“first in, first out”).
Under FIFO, the cost of goods sold (COGS) is based upon the cost of material bought earliest in the period. During periods of inflation, the use of FIFO will result in a lower estimate of COGS and a larger net income.
Under LIFO, the COGS is based upon the cost of material bought towards the end of the period, resulting in costs that closely