Ebook Incentives to Inflate Reported Cash from Operations Using Classification and Timing
Cash from operations (CFO) and earnings are complementary measures of firm performance. Investors advocate the use of CFO to gauge the credibility of earnings on the basis that CFO is more “real” than earnings.
However, cases of cash flow misreporting have raised concerns that managers exercise discretion in financial reporting and in the timing of transactions to alter reported CFO (hereafter referred to as CFO management). Despite the concerns about misreporting of CFO, there is limited research about when, why and how firms manage reported CFO.
This paper examines the following questions: (1) What are the incentives to manage reported CFO? (2) What are the mechanisms through which CFO is managed? In this paper, CFO management is distinct from earnings management. Particularly, CFO management stems from incentives to alter reported CFO and not earnings. To the extent that investors focus solely on earnings, CFO management would be pointless. However, depending on the firm characteristics, CFO and earnings have different information content for future earnings and, correspondingly, for investors. For example, executives rank earnings as the most important financial metric to external constituents in general but consider CFO to be more important than earnings when the firm is under distress (Graham, Harvey, and Rajgopal 2005).
Empirically, the multitude of transactions that increase both reported CFO and earnings simultaneously poses a challenge to distinguish between CFO management and earnings management. For example, reducing discretionary expenses increases both earnings and CFO (Dechow and Sloan 1991; Bushee 1998; Roychowdhury 2006). To investigate CFO management as a separate phenomenon from earnings management, I examine how reported CFO can be managed using classification and timing.
Classification refers to the shifting of items between the statement of cash flows categories, namely operating, financing, and investing, holding earnings and aggregate cash flows constant. Timing refers to the adjustment of working capital to alter reported CFO, holding earnings constant. The choice to investigate CFO management holding earnings constant possibly understates the economic prevalence of the behavior but offers a clean setting to examine CFO management net of the confounding effects of earnings management.
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