Review of Accounting Studies, 7, 163–187, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
Inventory Changes and Future Returns
JACOB K. THOMAS
620 Uris Hall, Columbia Business School, New York, NY 10027
University of Illinois at Chicago, Chicago, IL 60607
Abstract. We ﬁnd that the negative relation between accruals and future abnormal returns documented by Sloan
(1996) is due mainly to inventory changes. We propose three explanations for this result, derived from the prior
literature, but ﬁnd evidence inconsistent with all three explanations. To assist future investigations in formulating
additional explanations, we document several empirical regularities for extreme inventory change deciles. We
speculate that demand shifts explain our results, and examine the feasibility of alternative reasons for the stock
market’s apparent inability to recognize the impending proﬁtability reversals. Our evidence is consistent with
earnings management masking the implications of demand shifts.
Keywords: inventory changes, market efﬁciency, earnings management
JEL Classiﬁcation: G14, M41
Sloan (1996) documents a startling ﬁnding: investing long/short in ﬁrms in the bottom/top
decile of accruals (scaled by average beginning and ending total assets) generates a hedge
portfolio return of about 10 percent in the following year, and about 5 percent and 3 percent
in the two years after that. He concludes that the stock market fails to recognize that accruals
and cash ﬂows, the two components of reported earnings, have different persistence. As
a result, ﬁrms with high (low) accruals, or low (high) cash ﬂows, report earnings in the
following year that are predictably lower (higher) than market expectations, and stock prices
move accordingly. This result has been investigated extensively in the recent literature, and
the collective evidence suggests that while managers recognize the implications of accruals
(e.g., Beneish and Vargus, 2001), stock prices and relatively sophisticated stock market
participants do not (e.g., Bradshaw, Richardson and Sloan, 2001).
Our ﬁrst objective is to identify the components of Sloan’s accrual measure that are pri-
marily responsible for this apparent market inefﬁciency. We ﬁnd that inventory changes
represent the one component that exhibits a consistent and substantial relation with future
returns. Our second objective is to understand how inventory changes, a seemingly innocu-
ous item (since in many instances, such as inventory acquisitions, there is no direct link
between this accrual component and earnings), are linked to subsequent abnormal returns.
We ﬁrst propose three explanations with testable predictions, which are derived from results
documented in the prior literature, but ﬁnd evidence inconsistent with all three explanations.
We then switch to documenting empirical regularities and fashioning an explanation that
is potentially consistent with our evidence. Since limitations of available data hamper our