Effect of cash flow risk on corporate failures, and the moderating role of earnings management and abnormal compensation

Li, Xia and Gupta, Jairaj and Bu, Ziwen and Kannothra, Chacko George (2023) Effect of cash flow risk on corporate failures, and the moderating role of earnings management and abnormal compensation. International Review of Financial Analysis, 89. ISSN 1057-5219

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Abstract

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.

Item Type:	Article
Identification Number:	https://doi.org/10.1016/j.irfa.2023.102762
Dates:	Date Event 27 June 2023 Accepted 29 June 2023 Published Online
Uncontrolled Keywords:	Financial distress, Cash flow risk, Bankruptcy, Earnings management, Abnormal compensation
Subjects:	CAH17 - business and management > CAH17-01 - business and management > CAH17-01-07 - finance CAH17 - business and management > CAH17-01 - business and management > CAH17-01-08 - accounting
Divisions:	Faculty of Business, Law and Social Sciences > Birmingham City Business School > Centre for Accountancy Finance and Economics
Depositing User:	Xia Li
Date Deposited:	14 Feb 2024 15:04
Last Modified:	14 Feb 2024 15:06
URI:	https://www.open-access.bcu.ac.uk/id/eprint/15062

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