Academic journal article Academy of Accounting and Financial Studies Journal

CEO Overconfidence and Cash Flow Management

Academic journal article Academy of Accounting and Financial Studies Journal

CEO Overconfidence and Cash Flow Management

Article excerpt


There is a growing body of relatively recent literature on the misclassification of items in financial statements. Many managers have been found to inflate core or operating earnings by shifting operating expenses to income-reducing special items in the income statement (Mcvay, 2006; Fan et al., 2010; Cain et al., 2012). Managers use various methods to inflate core earning or operating earnings, depending on the costs, constraints, and timing relating to each strategy. Additionally, managers have also been found to manipulate operating cash flows. Zhang (2006) finds that cash flow manipulation is more likely when the magnitude of accruals is high, firms are capital-intensive, and firms consider cash dividend targets important. Lee (2012) suggests that firms overstate operating cash flows by shifting classifications in the cash flow statement when they are in financial distress, or when the company has a long-term credit rating approaching the investment/noninvestment grade cut-off; firms also consider analysts' cash flow forecasts. Additionally, shifting can occur whenever there is stronger correlation between a firm's stock returns and its Cash Flow from Operations (CFO).

Cash from operations and earnings are complementary measures of firm performance. Cash Flow from Operating (CFO) indicates the amount of money a firms brings in from the ongoing regular business activities, such as manufacturing and selling goods or providing a service. That is, CFO focuses on the core business. Therefore, cash flows from operations are considered sustainable and have related to valuation of business. Recent studies document that a growing and economically significant proportion of firms' analysts and managers issue cash flow forecasts (Defond & Hung, 2003; Wasley & Wu, 2006; Call, 2008). As greater numbers of firms and analysts are now issuing cash flow forecasts, the probability that operating cash flow figures will be manipulated has increased. For this reason, investors have started to pay more attention to the CFO. Emerging cases of cash flow misreporting have raised concerns about whether managers exercise discretion in financial reporting and in the timing of transactions, in order to inflate reported CFO (Lee, 2012).

According to the results of earlier research, overconfidence could impact financial reporting, as overconfident Chief Executive Officers (CEOs) would tend to overestimate the predicted future cash flow of projects but underestimate the likelihood and impact of adverse events (Heaton, 2002; Malmendier & Tate, 2005; Lin et al., 2005). Overconfident CEOs are likely to be less conservative in accounting (Ahmed & Duellman, 2013), they are also more likely to exhibit an optimism that leads to intentional financial misstatement (Schrand & Zechman, 2012), issue a financial restatement (Presley & Abbott, 2013), and engage in real earnings management (Hsieh et al., 2014; Dechow et al., 1995).

Overconfident CEOs are more likely to undertake hubristic takeovers and to spend more resources internally. However, if internal funds are not sufficient, they do not issue new equity to increase investment in new projects. Overconfident CEOs consider external financing costly, and they tend to create financial slack for future investment by reducing dividends (Deshmukh et al., 2013). Additional cash flow provides an opportunity for overconfident CEOs to invest at levels more in line with their desired levels (Malmendier & Tate, 2008).

Overconfident CEOs have incentives to manipulate firm earnings (e.g., to meet shareholder requirements and attract the attention of market investors) (Graham et al., 2005). Overconfidence about future earnings can create the anticipation of greater financial slack, and may lead to borrowing from future earnings for use in the current period something that also suggests a greater likelihood of current earning management (Schrand & Zechman, 2012). …

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