TY - JOUR
T1 - Effect of cash flow risk on corporate failures, and the moderating role of earnings management and abnormal compensation
AU - Li, Xia
AU - Gupta, Jairaj
AU - Bu, Ziwen
AU - Kannothra, Chacko George
PY - 2023/6/29
Y1 - 2023/6/29
N2 - In this study, we find that United States firms’ average cash flow risk (CFR) shows a significantly increasing trend over the past four decades. This does not portend well considering the significance of cash flows in maintaining a firm’s financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm’s failure. Empirically, we find that CFR has a strong positive effect on a firm’s financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm’s failure. Our findings are also robust to alternative definitions of a firm’s failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.
AB - In this study, we find that United States firms’ average cash flow risk (CFR) shows a significantly increasing trend over the past four decades. This does not portend well considering the significance of cash flows in maintaining a firm’s financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm’s failure. Empirically, we find that CFR has a strong positive effect on a firm’s financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm’s failure. Our findings are also robust to alternative definitions of a firm’s failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.
KW - Financial distress
KW - Cash flow risk
KW - Bankruptcy
KW - Earnings management
KW - Abnormal compensation
UR - http://www.open-access.bcu.ac.uk/15062/
U2 - 10.1016/j.irfa.2023.102762
DO - 10.1016/j.irfa.2023.102762
M3 - Article
SN - 1057-5219
VL - 89
JO - International Review of Financial Analysis
JF - International Review of Financial Analysis
ER -