Review of Accounting Studies, 7, 189–193, 2002
C
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discussion of “Inventory Changes
and Future Returns”
PAUL HRIBAR
sph24@cornell.edu
Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853
The pricing of accruals has generated a substantial amount of research since Sloan (1996)
first provided evidence that accounting accruals are mispriced by the market, and that
forming a hedge portfolio on the basis of the accrued portion of net income could earn
abnormal returns of over ten percent in the following year. This striking result has survived
numerous robustness tests using different time periods, different measures of accruals,
different risk adjustments, and examining whether the accrual mispricing is subsumed by
other market anomalies. The result has always been the same—the market overprices the
accrual component of net income.
The fact that accruals are the life-blood of accounting makes this anomaly particularly
intriguing to accounting academics. More recent studies have measured the reaction of var-
ious intermediaries and market participants (e.g., analysts, auditors, institutional investors,
etc.), and decomposed total accruals into finer partitions in order to learn more about the
economic construct driving the anomaly. The Thomas and Zhang (2002) paper falls squarely
into the latter category.
Thomas and Zhang focus on the somewhat curious result that when total accruals are
decomposed into account-level line items, the change in inventory appears to explain the
majority of the accrual anomaly. In fact, a hedge portfolio formed on the basis of changes
in inventory earns approximately the same abnormal return as a hedge portfolio formed on
the basis of total accruals. After demonstrating that the mispricing of inventory is not due
to a correlated omitted variable (primarily changes in long-term assets), they proceed to
document a set of empirical regularities related to inventory changes that may provide the
basis for the development of a coherent theory. The purpose of this discussion is to try to
place the Thomas and Zhang findings in a broader context, point out the consistencies and
inconsistencies with existing explanations for the accrual anomaly, and hopefully provide
some perspective on what future research in the area should address.
Explanations for the Accrual Anomaly
Two general explanations have been advanced for why the accrual component of earnings is
less persistent than the cash component, though they do not explain why the market system-
atically ignores this difference. The first explanation suggests that purposeful intervention
on the part of management reduces the persistence of accruals. The general argument is that
management uses accruals to opportunistically inflate or deflate earnings. Because oppor-
tunistic earnings management represents an intertemporal shifting of income, this behavior
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