Investor protection and cash flow misclassification

Abstract

Research Question/Issue: We analyze whether cash flow misclassification is likely to be higher in the countries with weak investor protection. We also test whether managers use different strategies to misclassify cash flows. Research Findings/Insights: 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 cash flow 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 such misclassification. Managers manipulate operating cash flows by shifting operating cash outflows to investing and financing cash outflows, and investing and financing cash inflows to operating cash inflows. Theoretical/Academic Implications: We present first evidence that the magnitude of cash flow manipulation through misclassification is associated with weak investor protection and governance. We also present an improved methodology to capture the strategies for such misclassification. Practitioner/Policy Implications: Our results indicate that cash flows are as prone to manipulation and misclassification as the earnings. These may be useful to regulators and auditors in India and other countries with weak investor protection, where they need to monitor the cash flow reporting closely.