Inventory overproduction and managerial ability

• Published date: 01 July 2023
• Author: Haihong He
• Date: 01 July 2023
• DOI: http://doi.org/10.1002/jcaf.22624

Received: 6 January 2 023Accepted: 18 February 2023

DOI: 10.1002/jcaf.22624

RESEARCH ARTICLE

Inventory overproduction and managerial ability

Haihong He

California State University, Los Angeles,

California, USA

Correspondence

Haihong He, College of Business and

Economics, California State University,

Los Angeles, 5151 State University Drive,

Los Angeles, CA 90032, USA.

Email: hhe@calstatela.edu

Abstract

This study examines a sample of manufacturing firms in order to assess the

relationship between overproduction levels with different levels of managerial

ability. Using the managerial ability measure developed by Demerjian et al.

(2012), this paper shows that firms with high levels of managerial ability have

smaller size of overproduction. Furthermore, when overproduction occurs in

firms with high levels of managerial ability,it is less likely to reverse in the follow-

ing year and is more likely to be associated with future sales increases. Overall,

the results suggest that high managerial ability firms generally avoid overproduc-

tion. High-ability managers having fewer overproduction reversals suggest that

they are less likely to use overproduction to manage earnings; instead, they are

more likely to overproduce to build up inventory to expect higher futuresales.

KEYWORDS

earnings management, managerial ability, overproduction

1 INTRODUCTION

Overproduction per se is an undesirable but sometimes

unavoidable outcome in business management and opera-

tions. Optimal business decision-making and control pre-

fer lean production to eliminate excess inventory because

overproduction is detrimental to firms as it causes higher

inventory stocking costs and wasted resources. Thus, from

a firm strategic management perspective, overproduction

is an undesirable result of resource management in the

operational process. Overproduction, however, appears

as a deliberate accounting choice to manage earnings

according to real-economic earnings management (REM)

literature (e.g., Roychowdhury, 2006). In many accounting

studies on earnings management (e.g., Cohen & Zarowin,

2010; Gunny, 2010; Roychowdhury, 2006), overproduc-

tion is considered one of several real-economic activities

that can be employed opportunistically in the absorption

accounting process to report higher earnings. Thus, it is

intriguing that firms deliberately alter business operations

suboptimally to influence accounting outcomes.

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© 2023 The Authors. Journal of CorporateAccounting & Finance published by Wiley Periodicals LLC.

Different from the REM literature on overproduction,

some accounting studies (Bruggen et al., 2011; Gupta et al.,

2010; Jiambalvo et al., 1997; Lev & Thiagarajan, 1993)

attempt to link overproduction to business operations and

the results are inconclusive. For example, Jiambalvo et al.

(1997) find that the stock market generally reacts posi-

tively to overproduction and suggest that overproduction

is a leading indicator of high future sales and is unre-

lated to the manipulation of earnings; Gupta et al. (2010)

examine whether overproduction is driven by internal

decision making’s inability to respond to the negative

demand shock instead of opportunistic external finan-

cial reporting, but their results do not support it. In sum,

prior accounting research has provided limited evidence of

linking overproduction to operations.

Based on the previous accounting research on over-

production as an opportunistic outcome or overproduc-

tion as an operational outcome, this study incorporates

managerial ability as a moderating variable to examine

overproduction. Specifically, we propose that overproduc-

tion will be avoided more effectively in firms with better

J Corp Account Finance. 2023;34:265–281. wileyonlinelibrary.com/journal/jcaf 265

266 HE

management skills. Further, we explore whether differ-

ent managerial ability affects the likelihood of different

incentives for overproduction to occur. We expect that, if

overproduction occurs, more (less) able managers would be

less (more) likely to overproduce opportunistically for the

external financial reporting purpose, whereas more (less)

able managers would be more (less) likely to “overproduce”

(i.e., adjust production flexibly) to meet operational needs

such as preparing for future customer demand.

We use the managerial ability measure developed by

Demerjian et al. (2012) to proxy for the firm’s management

ability to optimally schedule production and control inven-

tory levels to maximize the firm value. Managerial ability

is vital for both directing businesses and choosing a finan-

cial reporting strategy. High-ability managers have superb

knowledge of the production process and a clear under-

standing of the value-declining consequences of overpro-

duction to business. They hence are unlikely to produce

excess inventory in operational decision-making. In the

meantime, high-ability managers are also less likely to face

financial reporting pressure to choose income-increasing

accounting methods and are more capable of finding

alternative accounting methods than the value-decreasing

overproduction to meet the earnings benchmarks (Huang

& Sun, 2017). Using a sample of manufacturing firms from

1990 to 2018, we first find that firms with high levels of

managerial ability have smaller sizes of overproduction, or,

stated alternatively, low-ability managers havelarger sizes

of overproduction.

We next examine the dubious existence of overpro-

duction in firms by assessing the future overproduction

reversals and the association of future sales and current

period overproduction in high-ability firms compared to

low-ability firms. We find that overproductions in firms

with high levels of managerial ability are less likely to

reverse in the following year,and we infer that high-ability

managersareprobablylesslikelytomanageearningsusing

overproduction since the future reversal of overproduction

is a sign of using overproduction to manage earnings. We

further find weak evidence1that overproduction in firms

with high managerial ability is associated with future sales,

suggesting that overproduction in high managerial ability

firms might reflect firms’ inventory build-ups in expecta-

tion of higher future sales. Taken together, these results

suggest that high managerial ability firms generally avoid

earnings management overproduction and may increase

production flexibly to meet future demand in business

management.

Further, we do not find the managerial ability’s effect

on the overproduction reversal in firms with a backlog. In

contrast, we find that the association between future sales

and more able managers’ use of overproduction is more

robust in firms with a backlog. With backlog signaling

inventory shortage in the production supply process, such

results provide additional evidence to support that more

able managers would only deviate from lean production

for justifiable reasons. It is also worth noting that in unt-

abulated analyses, we do not find that overproduction in

high-ability firms is positively associated with future ROA

and future cash flow. Thus, high-ability managers appear

to increase production in direct response to sales, which

may not translate into higher earnings.

This research contributes to prior research on overpro-

duction by providing evidence of an operational explana-

tion and contrasting it with the REM explanation. The

majority of previous research often emphasizes overpro-

duction being utilized as an earnings management tool

due to financial reporting pressure and overlooks to a cer-

tain degree the fact that overproduction is not desired in

the business management process. Weighing between the

benefits of short-term gains from boosting the earnings

and the potential long-term detriments to the business

performance, reasonable and rational managers would

not choose overproduction for the opportunistic report-

ing purpose. In fact, good and effective management

should give priority to the reduction of wasted resources

and may increase production only when the operational

needs call for more supply. Our research adds to the prior

accounting research (Bruggen et al., 2011; Jiambalvo et al.,

1997) that argues that operating decisions explain over-

production.

Our paper adds to the stream of research that employs

managerial ability to explain business performance and

accounting qualities. This research adopts the manage-

rial ability measure developed by Demerjian et al. (2012)

and extends that this ability measure can capture whether

firms are able to use resources effectively to avoid overpro-

duction. Demerjian et al. (2013) conclude that “earnings

quality is positively associated with managerial ability.

Specifically, more able managers areassociated with fewer

subsequent restatements, higher earnings and accruals

persistence, lower errors in the bad debt provision, and

higher quality accruals estimations. The results are con-

sistent with the premise that managers can and do impact

the quality of the judgments and estimates used to form

earnings.” This study furthers prior research by offering

additional evidence that suggests this measure effectively

captures the quality of business management.

The remainder of this paper is organized as follows. Sec-

tion 2 reviews related studies and presents the hypotheses

development. Section 3 presents the research design, of

which includes the measurement of primary variables and

the empirical specification. Section 4 discusses the results.

Section 5 concludes the paper.