Overhead Cost Allocation and Earnings Manipulation between Quarters

• In Event: Earnings Management, Investments & Corporate Fraud

Abstract

Overhead is an integral part of cost of goods sold. Prior managerial accounting research has found that overhead rates are manipulated for internal reporting purposes by management to obtain personal benefits. To the extent that overhead rates impact cost of goods sold and therefore gross profit and income reported to external users, we investigate whether or not overhead rate manipulation is used to manage reported earnings. Our study adds to the existing literature on earnings management by: (1) providing evidence of earnings manipulation using a specific accounting metric, overhead allocation, rather than aggregate accruals, (2) identifying conditions under which earnings manipulation between quarters is likely to occur, rather than on an annual basis, (3) presenting preliminary evidence on how a metric that is manipulated for managerial reporting purposes, and used by management for their personal gain, can directly affect external financial reports used by capital markets participants thereby reducing earnings quality for stock pricing. In summary, we provide new evidence on how management’s selection of assumptions used in allocating overhead to cost of goods sold can lead to manipulation of gross profit margins and reduce quality of reported earnings. In all four quarters, it appears that management decreases the applied the overhead rate to increase the gross profit margin. On average, this then allows management to turn a negative earnings surprise to a positive earnings surprise in quarters one and two and reduce negative earnings surprises in quarters three and four. It appears that manipulation is more likely to occur for smaller firms and for firms with weaker associations between cogs and sales. However, the market is not able to detect presence of such manipulation in earnings. Finally, by combining the perspectives of managerial and financial accounting, our study extends this line of research that benefits both disciplines.

Authors

• Carl S Smith, University of Hartford

• Karen Tucker Teitel, College of the Holy Cross

• Susan Wahab, University of Hartford