The Relationship Between the Quality of Financial Information in Industrial Companies and Discretionary Inventory Management

The Relationship Between the Quality of Financial Information in Industrial Companies and Discretionary Inventory Management

Maria Filipa Nogueira (Instituto Politécnico de Santarém, Portugal)
DOI: 10.4018/978-1-5225-7817-8.ch008
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Inventories are the base element for the manufacturing (industrial) companies. The inclusion of discretionary in the inventory management processes of production leads to changes in the value of the companies. The accounting system produces information used in predictions and for management decision. The usefulness and opportunity of information are considered indispensable. If managers use their discretionarily, in the accounting system and in real activities, to achieve the firm value and earnings forecast, they will influence and modify the financial information quality. Ferrer and Ferrer said that a simple decision can enrich one company from one moment to another, and a small accounting change allows a great loss of results. The question arises: Do managers use their discretionarily and modify the financial information quality? Using adjusted models to capture discretionary accounting management and real activity management, it is possible to conclude that there is a strong evidence of discretionary management of the inventory in manufacturing Portuguese SME.
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Inventories are the base element for the production. Inventory management causes changes in the company's patrimonial and economic value, through its processing, acquisition and sale. The inclusion of discretionary in the management processes that include inventories leads to changes of the company’s value. The possibility of the occurrence of discretionary management is the motivation for the development of this article. The focus will be inventories because manufacturing companies are one of the more inventory-dependent activity sectors (e.g. Bernard & Noel, 1991; Cannon, 2008; Aaker & Gjesdal, 2010; Cook, Huston, & Kinney, 2012; Nissim, 2017; Pustylnick, Temchenko, & Gubarkov, 2017).

All management acts are reflected in the financial statements of the companies (Ferrer & Ferrer, 2016). The preparation of financial information must be based on existing regulations to provide objective and reliable financial statements. However, the ambiguity of some norms allows subjective judgments and the exercise of discretion in the accounting of operations. This discretion results in accruals change of the financial statements (changing assets and liabilities as well as items of the income statement). There are several econometric models to study accruals (e.g. Jones, 1991; Dechow, Sloan, & Sweeney, 1995). The information provided by the accounting system is one of the focus of research in accounting to study the quality of information provided (Herath & Lu, 2017).

Accounting is a system that produces information. It is used to register and quantify the facts or events that occurred during a period, to inform about the company economic and financial situation and about the results achieved. This information is useful to make predictions and to base decision-making management. The financial information can be managed by using the flexibility of the accounting normative (Stolowy & Breton, 2003).

Manufacturing companies have, in the inventories, one of their preponderant items for the introduction management discretion in accounting and in real activities. For this reason, the quality of information will be studied based on accruals and on real activities.

All management acts cause change in the financial statements, but decisions related to the volume and time of purchase and sale (timing) are used in the discretion included in real earning management (Roychowdhury, 2006). One method of managing discretionarily results is to take decisions about the operational process, that is, about activities. Changing operational practices can lead to goals on the financial information, influencing the judgment of users and it can be studied using accrual models.

For those countries where there is a big dependence between accounting and taxation, i.e. between the accounting result and the fiscal result, taxes arise as an incentive to manage the results. In the countries of continental Europe, such as Portugal, managers have a strong incentive to manage the accounting results in the downward direction, with the objective of reducing the amount of tax payable (Eilifsen, Knivsflå, & Sættem, 2010). One of the main incentives for managing results as the decrease of the tax payable (Moreira, 2008).

This study involved 12.181 Portuguese manufacturing SME. The first part is about discricionarity of accounting practices and its link with inventory management. The second part is about the discritionarity of real activities and its link with inventory management. There is an evidence that both kinds of management are used in the companies of the sample. For the study were regressed adaptations of the models used in several studies corroborating their results (Dechow, Sloan, & Sweeney, 1995; Ferrer & Ferrer, 2016; Gao, Gao, & Wang, 2017; Gunny, Jacob, & Jorgensen, 2013; Roychowdhury, 2006; Roychowdhury, Kothari, & Mizik, 2012).

Key Terms in this Chapter

Accounting: Financial accounting is the process of recording, summarizing and reporting the transactions resulting from business operations over a period. The transactions are shown in financial statements, including the balance sheet, income statement and cash flow statement. Financial reporting occurs using financial statements. The financial statements present the classifications of financial data: revenues, expenses, assets, liabilities, and equity.

Inventory Management: Is the management of inventory and stock. As an element of supply chain management, inventory management includes aspects such as controlling and overseeing ordering inventory, storage of inventory, and controlling the amount of product for sale.

Real Activities Discretionary Management: Alteration of normal course operational practices, motivated by managers’ desire to mislead some stakeholders to achieve financial reporting goals.

Real Activity: All the normal operational activities of a company.

Inventory: Is an asset that is intended to be sold in the ordinary course of business. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale. Inventory items can fall into one of the following three categories: held for sale in the ordinary course of business; or in the process of being produced for sale; or for consumption in the production process. Inventory is typically classified as a short-term asset, since it is usually liquidated within one year.

Quality of Accounting Information: The usefulness of accounting for decision-making, which depends on qualitative characteristics as the relevance (predictive value and confirmatory value) and reliability (free from errors and prejudices).

Accruals: Change of the financial statements (changing assets and liabilities as well as items of the income statement); all the associated accounting specialization of the economic year, which do not involve financial flows, and where the discretionary action of the manager is decisive for the recognition of an expense or income.

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