Incentives to Inflate Reported Cash from Operations Using Classification and Timing

Abstract

This study examines when firms inflate reported cash from operations in the statement of cash flows (CFO) and the mechanisms through which firms manage CFO. CFO management is distinct from earnings management. Unlike the manipulation of accruals, firms cannot manage CFO with biased estimates, but must resort to classification and timing. I identify four firm characteristics associated with incentives to inflate reported CFO: (1) financial distress, (2) a long-term credit rating near the investment/non-investment grade cutoff, (3) the existence of analyst cash flow forecasts, and (4) higher associations between stock returns and CFO. Results indicate that, even after controlling for the level of earnings, firms upward manage reported CFO when the incentives to do so are particularly high. Specifically, firms manage CFO by shifting items between the statement of cash flows categories both within and outside the boundaries of Generally Accepted Accounting Principles (GAAP), and by timing certain transactions such as delaying payments to suppliers or accelerating collections from customers.

Keywords: classification shifting, real activities manipulation, cash flow