Market Reaction to Abnormal Inventory Growth: Evidence for Managerial Decision-Making

Prior research demonstrates that manufacturing firms increase production (relative to sales) to transfer fixed costs from cost of goods sold (COGS) to inventory accounts, thereby increasing income to reach or surpass earnings thresholds. We examine how the market reacts to this earnings management strategy. We find that investors respond positively to inventory growth based on an expectation of increased future sales; however, this signal is weaker for inventory manipulators. Further, the market premium from meeting or beating analyst earnings forecasts by manipulating inventory is smaller than the premium for achieving this threshold absent inventory manipulation or through accrual manipulation. Finally, we examine firms considered to be “serial” inventory manipulators, finding that the market consistently discounts earnings beats for these firms, suggesting that inventory manipulation erodes investor confidence in firms’ earnings. Collectively, our results provide new insights into a challenge facing operations managers and finance managers in manufacturing firms.

Private lenders' use of analyst earnings forecasts when establishing debt covenant thresholds

We examine whether lenders use analyst forecasts of the borrower's earnings as inputs when establishing covenant thresholds in private debt contracts. We find that, among debt contracts that include an earnings covenant, earnings thresholds are set closer to analyst forecasts when analysts have historically issued more accurate earnings forecasts. These results are robust to firm fixed effects and an instrumental variable approach. Further, we find that, following a plausibly exogenous decline in the availability of analyst earnings forecasts, debt contracts are less likely to include earnings covenants. Our evidence is consistent with lenders using analyst earnings forecasts as an input when establishing debt covenant thresholds and suggests sell-side analysts play a role in debt contracting.