Misclassification of Cash Flows in India: Impact of Weak Governance

Abstract

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.