We introduce uncertainty in the classic inventory costing choice problem to investigate the underlying partitions imposed by two accounting inquiries (processes of generating information):variable costing and absorption costing. In a contemporaneous reporting environment, we show that absorption costing provides a finer partition of the state space compared to variable costing when a firm arbitrarily increases the production level (opportunistic overproduction), and the predetermined fixed overhead rate is adjusted. Grounded in an information economics perspective, the intent of the article is to propose an approach to detect real earnings management by extracting information from financial statements. The resulting managerial biases arising from earnings management are also discussed.
| INTRODUCTIONHow accounting as an information system can convey information is the focus of accounting research in information economics. More specifically, attempts to understand how much and what information is conveyed are the prime objective. In this regard, ranking of information systems is an important topic within information economics. The design of accounting information systems is a complex task. Nevertheless, in this article, we consider a specific subproblem, the classic inventory costing choice problem of absorption costing verses variable costing to understand how the choice of an accounting method changes the characteristic of the accounting system. The overarching theme of the article is to raise awareness that accounting is an information science.Fellingham (2015) adopts the view that accounting is an information science, and he uses carefully crafted information theorems to show that double entry systems are distinct and a valuable contribution to information science. He refers to the mutual information theorem as the fundamental theorem of accounting and shows that it establishes the operational equivalence of accounting and information science. Consequently, as Fellingham (2015) illustrates, accounting appears on the dollar side of the theorem's equality, and probabilities and information science appear on the other side. Within an information science paradigm, Arya, Fellingham, Glover, and Sivaramakrishnan (2000) explore the connection between information system design and the level of managerial slack during capital project implementation.More specifically, in line with Fellingham (2015) and Arya et al. (2000), the objective of this article is the inference of economic truth of economic transactions from financial statements. Hence, we propose the following research question. Is there a way to detect real earnings management by extracting information from financial statements? More specifically, if one is able to compare two accounting inquiries (the process of generating information) such as variable costing (VC) and absorption costing (AC) from an information economics perspective, which accounting inquiry would reveal a manager engaging in opportunistic production to boost earnings?
