The Role of Cash Holdings in Corporate Misconduct

Abstract

We test the role of cash holdings in corporate misconduct. Consistent with the agency costs of equity overvaluation, before misconduct, investors overvalue firms’ cash holdings, and firms that commit misconduct accumulate excess cash holdings. Furthermore, consistent with the free cash flow hypothesis, the accumulated excess cash holdings at the beginning of misconduct positively predict firms’ simultaneous misconduct actions, including overinvestment decisions, the delay of bad news disclosures, and insider selling. The association of excess cash holdings with the degree of withholding bad news and insider trading occurs mainly in firms with higher managerial equity-based incentives or firms with internal control weakness. The results suggest that cash holdings are one important mechanism by which equity overvaluation leads to corporate misconduct and emphasize the importance of internal control over financial reporting in safeguarding corporate resources.