Effect of Cash Flow Risk on Corporate Failures, and the Moderating Role of Earnings Management and Abnormal Compensation

In this study, we find that the average cash flow risk (CFR) of United States firms 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 the important role it plays 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. Suggesting that managers use earnings management successfully to reduce the impact of high CFR on firms’ failure likelihood. While a negative moderating effect of abnormal compensation suggests that executive compensation packages that incentivize superior risk management help firms in reducing their failure likelihood. Our findings are also robust to alternative definitions of a firm’s failure, namely financial constraints, presumed debt covenant violation and legal bankruptcy filings