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

Xia Li, Jairaj Gupta, Ziwen Bu and Chacko George Kannothra

International Review of Financial Analysis, 2023, vol. 89, issue C

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 or so. 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.

Keywords: Financial distress; Cash flow risk; Bankruptcy; Earnings management; Abnormal compensation (search for similar items in EconPapers)
JEL-codes: G32 G33 M12 M41 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:89:y:2023:i:c:s1057521923002788

DOI: 10.1016/j.irfa.2023.102762

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