Neerav Nagar

How Does Regulation Affect the Relation between Family Control and Reported Cash Flows? Comparative Evidence from India and the United States

Manuscript Type. Empirical. Research Question/Issue. We conduct a two‐country study to understand (i) how family and non‐family firms engage in classification shifting to manage reported operating cash flows in each country; (ii) how this behavior varies between the two countries; and (iii) how corporate governance regulation introduced independently in each country moderates the observed behavior. Research Findings/Insights. We find that family ownership has different effects on quality of cash flow reporting in the two countries. Furthermore, country‐level regulation moderates these effects differently. In particular, (i) firms in both countries engage in manipulating operating cash flows, but the evidence is stronger in the United States; (ii) family firms in India engage in more shifting than non‐family firms, but this is not observed in the United States; and (iii) family (non‐family) firms in India increase (reduce) shifting, whereas only non‐family firms in the United States increase shifting after regulation. Since non‐family firms in India raise more external capital than family firms after regulation, we infer that family firms in India reacted to this competition for capital and resorted to shifting. Theoretical/Academic Implications. Most studies assume that the incentives for family firm behavior are the same in different market settings. However, factors such as efficiency of public capital markets, enforcement of corporate laws and regulations, and other institutional practices can cause differences in family firm behavior across different market settings. We investigate the behavior of family and non‐family firms in each of these markets and study how a feature of the national governance system, regulatory design, moderates this behavior. Practitioner/Policy Implications. Our findings should be useful to global investors and regulators in both emerging and developed markets. The results indicate how similar regulation in the two different settings can trigger differences in the behavior of firms.

Do financially distressed firms misclassify core expenses

Purpose - This paper aims to examine whether financially distressed firms manipulate core or operating income through the misclassification of operating expenses as income-decreasing special items. Design/methodology/approach - This sample comprises firms in the USA with data from 1989 to 2010. The authors used the methodology given in Findings - Managers of financially distressed firms are more likely to inflate core or operating income as compared to the healthy firms to meet or beat earnings benchmarks. They do so by misclassifying core or operating expenses as income-decreasing special items. Specifically, core expenses are shifted to income-decreasing special items like goodwill impairments, settlement costs, restructuring costs and write downs. Practical implications - The paper sheds light on an important firm characteristic, financial distress that intensifies classification shifting – an earnings management tool which auditors, investors and regulators find tough to detect. The findings have implications for investors, as they fail to comprehend such shifting ( Originality/value - The authors extend the literature on accruals and real earnings management by the financially troubled firms and present first evidence that the managers of such firms also manipulate core or operating income through classification shifting.

Firm Life Cycle and Real-Activity Based Earnings Management

We examine real-activity based earnings management, i.e., cuts in discretionary innovation/marketing spending and overproduction for meeting the earnings benchmark of avoiding losses across firms’ life cycle. We use the cash flow components to classify a firm’s life cycle. We hypothesize and find that firms in the growth and mature stages exhibit real-activity based earnings management to meet earnings target of avoiding losses; but firms in the introductory stage do not. We also hypothesize and find that such real-activity based earnings management to meet the earnings benchmark of avoiding losses is associated with future performance for mature firms, but not so for growth firms. Collectively, our evidence shows the importance of considering firm’s life cycle when examining real-activity based earnings management.

Classification shifting: impact of firm life cycle

Purpose - This paper examines whether firms in the decline stage of life cycle manipulate core or operating income through misclassification of operating expenses as income-decreasing special items. Design/methodology/approach - Our sample comprises of firms from an emerging market, India with data from 1996-2011. We use the methodology given in McVay (2006) and multiple regressions. Findings - Managers of Indian firms also engage in classification shifting, primary incentive being desire to avoid reporting of operating losses. Further, the use of classification shifting is dependent upon the stage of life cycle in which firm is in. Specifically, firms in the decline stage of life cycle are more likely to use classification shifting to avoid reporting of operating losses. Practical implications - The paper sheds light on a critical phase of the firm life cycle – decline, which increases the possibility of use of classification shifting – an earnings management technique which auditors, investors and regulators find tough to detect. Originality/value - We extend the literature on classification shifting, and present first evidence that such shifting is more likely to take place during the decline phase of firm life cycle.

Does Good Corporate Governance Constrain Cash Flow Manipulation? Evidence from India

Accounting frauds like Enron in the United States and Satyam in India are likely to have occurred due to the failure of firm-level corporate governance mechanisms in constraining unethical financial reporting practices. In this paper, we examine whether such corporate governance measures and regulatory reforms constrain the manipulation of operating cash flows, an important firm performance indicator. We focus on an emerging market, India where corporate governance and regulations are weak, and business groups and founding owners dominate the corporate landscape. We find that cash flow manipulation is likely to increase with an increase in the promoters’ shareholding. Further, board diligence and better audit fail to curb such manipulation. Our findings suggest that managers seem to move from earnings management towards cash flow manipulation. However, we do find that such manipulation has gone down in the recent years, and diligent boards constrain it, possibly due to the recent steps taken by the Indian Government for improving the corporate governance environment in India.

Classification Shifting in the Cash Flow Statement: Evidence from India

We present first evidence that the manipulation of operating cash flows through misclassification is likely to be more common in the countries with weak investor protection and governance. We also show that managers manipulate operating cash flows using different misclassification strategies. Specifically, they shift operating cash outflows to investing and financing cash outflows, and investing and financing cash inflows to operating cash inflows. We focus on an emerging market, India, which is characterized by weak corporate governance and investor protection, and the United States and present evidence that the magnitude of such misclassification is higher for the firms in India. Further, Indian firms in financial distress are more likely to manipulate operating cash flows as compared to the financially distressed firms in the United States by engaging in the misclassification of cash flows. Thus, we link weak governance and investor protection with the magnitude of cash flow misclassification.