Firm Financial Policies Research Articles

Impact of Covid-19 on Earnings Management in Financial Reporting - Concept Paper

The outbreak of the COVID-19 pandemic in 2020 brought severe impacts on economies around the world. The market situation worsened and became uncertain due to the shock of the sudden virus outbreak. This has created issues for almost all industries globally as they must cater to the sudden changes in economies to stay competitive. Companies have taken the initiative by undertaking earnings management strategies in their accounting functions to present a strong performance in their financial reports. Due to this, the reliability and quality of financial reporting have been questioned. This paper explains the impacts of COVID-19 on earnings management in financial reporting. Three impacts are discussed: the enormous financial pressure on enterprises, the uncertainty due to the pandemic impacts on firm financial policies, and the increased information asymmetry between corporate outsiders and insiders. With these insights, suggestions are proposed on the control companies can implement to ensure the reliability and quality of the financial report.

Venture Capital and Private Equity-backed firms at the beginning: Effect on firm financial policies

Venture Capital and Private Equity-backed firms at the beginning: Effect on firm financial policies

Does too much liquidity generate instability?

Corporate demand for cash is related to a number of firm-specific characteristics, like the presence of transaction costs, information asymmetry in credit markets, uncertainty and risk aversion. The purpose of this paper is to build a dynamic model that describes the potential chaotic effects of the accumulation of cash by firms over a prolonged period of time. By exploring the theoretical connections between firm financial policies and investment decisions, we show that too much liquidity might generate economic instability. When firm increases the share of cash devoted to risky investment, and reduces the share of cash distributed to shareholders as dividends, the fixed point of the system changes from being stable to being unstable. Moreover, the impact of such a policy on the stability of the system is larger the greater the investment risk. The chaotic behavior is mainly observable in the dynamics of cash, which in turn may affect all investment decisions.

CEO facial masculinity and firm financial outcomes

In this paper, we explore relationships between CEO facial width, a proxy for testosterone levels during adolescence, and financial management decisions. Using methodology from prior research, we collect a sample of 968 S&P 500 CEO profiles and analyze them to determine the facial width-to-height ratio (fWHR). We expect that greater CEO facial width will be associated with riskier, more aggressive financial policies. We find that higher CEO facial width-to-height ratio (fWHR) is associated with more aggressive financial management decisions. Specifically, we find a positive relationship between CEO fWHR and firm leverage and a negative relationship between CEO fWHR and firm cash holdings. These relationships are also observed among subsamples where CEOs are likely to wield substantial influence over financial management policies, such as long-tenured CEOs. We do not find evidence that CEO selection process explains the observed relationship between fWHR and financial policies. Thus, it appears that the relationships documented between CEO fWHR and firm financial policies are likely consistent with managerial preference and that high testosterone levels may induce CEOs to pursue aggressive financial policies. We show that high-fWHR CEOs tend to own a smaller fraction of their firms. This suggests an increased priority for more masculine CEOs on pursuing their own best interests (diversification in their personal portfolios) ahead of signaling alignment with shareholders, while the reverse is true for CEOs with lower fWHRs. The results are robust to the inclusion of industry and year fixed effects and firm-year controls. This paper adds to the literature that shows individual differences in CEOs, in this case, CEO masculinity, can predict differences in the financial managerial characteristics of firms and financial policies.

An empirical analysis of accounting conservatism surrounding share repurchases

This study examines the change of the demand for accounting conservatism surrounding share repurchases for a sample of US listed firms between 2003 and 2013. We find that the extent of accounting conservatism decreases significantly post share repurchase, consistent with the view that share repurchases reduce excess cash and information asymmetry, and consequently the agency-cost demand for conservative accounting decreases. Further analysis finds this result holds only for financially unconstrained firms and firms with low or no financial distress risk, but there is no significant decrease in accounting conservatism for financially constrained firms or for firms with high financial distress risk. This suggests that share repurchases in these firms might result from other motives such as manager hubris, earnings management, or false signals to mislead investors, and thus cannot reduce the agency-based demand for accounting conservatism. Our results add further evidences to the literature on accounting conservatism and firm financial policies.

Economic policy uncertainty: A literature review

The significance of uncertainty in policies related to economic decisions is higher than ever before in today’s interconnected world. This study contributes to existing research by reviewing the literature on the impact of economic policy uncertainty on corporations and economies worldwide. We show the importance of measuring and tracking uncertainty by highlighting its influence on financial decisions. We examine the growing number of studies that use the economic policy uncertainty index (EPU) of Baker, Bloom, and Davis (2016) as a key factor in measuring uncertainty. We then review the impact of EPU on financial markets, macro and micro level, stock markets, corporate behavior, and risk management. Then, we document the asymmetric policy responses of economic uncertainty. Overall, policy uncertainty has a significant impact on firm financial policies as well as on consumer spending. Specifically, corporations act more conservatively during times of high uncertainty, thereby slowing investments in production and employment. In addition to the local effect of EPU, it spills over to other countries.

The Impact of Financial Education of Managers on Medium and Large Enterprises – A Randomized Controlled Trial in Mozambique

This paper studies the impact of a course in Finance for top managers of medium and large enterprises in Mozambique through a randomized controlled trial (RCT). Survey data and accounting data provide consistent evidence that managers change firm financial policies in response to finance education. The largest treatment ef- fect is on short-term financial policies related to working capital. Reductions in accounts receivable and inventories generate an increase in cash flows used to finance long-term investments. Those policy changes also improve the performance of the treated firms. Overall, our results suggest that relatively small and low-cost interventions, such as a standard executive education program in finance, can help firms to mitigate financial constraints and potentially affect economic development.

Financial constraints and the interdependence of corporate financial decisions

Purpose This paper aims to examine the interdependence of financial decisions (investment, financing, dividends and cash-holding) under financial constraints. Design/methodology/approach The authors specify and estimate a system of simultaneous equations with panel data and firm fixed effects by three-stage least squares in a sample of firms from 62 countries from 1996 to 2010. Findings The main findings largely corroborate previous studies regarding the interdependence of financial decisions. The authors also find evidence suggesting that financial constraints have a major impact on firms’ financial decisions. The results also suggest that financial constraints manifest themselves in virtually all firms, indicating that such constraints are a matter of degree and not of kind. Research limitations/implications Implications regarding the impact of cash flows on investment and cash-holding decisions are only partially confirmed. Practical implications The results are consistent with the hypothesis that financial constraints distort the financial policies of firms. For the purpose of formulating policies that reduce these distortions, the authors emphasize the role of the availability of internal funds and the recoverable fraction of assets in easing financial constraints, thus allowing for greater investment on the part of firms. Social implications The results suggest that regulators should promote policies that reduce the dependence of corporate investment on internally generated cash flows. Originality/value Unlike previous studies, the authors account for the direct impact endogenous variables could have on each other. In addition, they explore the impact of each country’s particular legal environment on the pledgeability of assets at the company level.

The Impact of Media Sentiment on Firm Risk, Corporate Investment and Financial Policies

This study investigates the association between media sentiment and a comprehensive set of corporate decision making measures that capture firm, corporate investment, and financial policy risk. This study predicts that CEOs who achieve greater media coverage are more risk-seeking. We find a positive association between media sentiment and the volatility of future firm stock returns, research and development expenditures and cash holdings. CEOs are more overconfident when estimating returns and risk when media sentiment is strong and positive. CEOs are more risk-seeking when sentiment is negative in an attempt to salvage firm reputation and increase personal wealth. Liquidity is used to hedge risk when firms and CEOs face increased media coverage. Our findings support the role of media sentiment as an external mechanism monitoring firm risk and policies.

Credit supply constraints and financial policies of listed companies during the 2007–2009 financial crisis

This study examines the effects of lending constraints on the financial policies of UK publicly listed companies during the 2007–2009 financial crisis. Using a sample of 2039 publicly listed firms, the results of our analysis indicate that financial policies of firms are sensitive to variations in the supply of external finance and credit, suggesting that liquidity-constraint firms with low cash reserves suffered more at the time of the credit crunch. While managing through the potential negative effects of the financial crisis, majority of the sample companies increased the use of internal finance and deferred the payments of dividends which helped them apply effective financial policies during the crisis period. The findings of this study also document that during the crisis period, financial policies of firms were exposed to variations in the supply of finance and credit, which, by implication, posed a threat to their operations, sustainability and growth. Our findings produce awareness about the negative effects of the non-availability of external finance and credit supply to listed companies, and signify the role of different financing channels and credit system in the operations and growth of listed companies. These findings have implications for financial regulation and policy making in the UK.

Common Ownership, Competition and Firm Financial Policy

Common Ownership, Competition and Firm Financial Policy

Tax avoidance and earnings management of firms in Ghana: does the funding strategy matter?

The agency perspective of tax avoidance suggests a complementary relationship between tax avoidance and earnings management. Thus, this paper seeks to evaluate how the firm's financial policy affects the relationship between corporate tax avoidance (CTA) and earnings management (EM) using a sample of 119 firms from emerging and developing countries over a four-year period 2010-2013. We employ system methods of moments (GMM) and find that the financing structure of a firm plays little role on the firm's incentives to engage in avoidance activities and/or manage their earnings. The results imply that monitoring managerial diversionary behaviour by relying on external monitoring mechanism provided by debt holders does not lead to a reduction in EM associated with increased tax avoidance activities.

Common Ownership, Competition and Firm Financial Policy

I use data on all public firms in the U.S. and their owners to construct a modified Herfindahl-Hirschman Index (MHHID) of market concentration that is based on the network of institutional ownership between rival firms. The new feature of my measure is that it uses a locally defined industry around each firm to calculate firm-level market concentration. I find that increases in MHHID lead to lower firm cash holdings. I also show that these results are driven by constrained firms. Such firms have bigger incentives to accumulate precautionary buffers, since they cannot access external funds. I further show that increases in MHHID lead to decreases in textual based measures of financial constraints and uncertainty. These findings are supportive of theories of intertemporal management of financial flexibility as an insurance against adverse future events. To address potential endogeneity concerns, I build on the literature of liquidity induced mutual fund outflows and identify funds that are exposed to underperforming industries and are likely to face outflows. Then, I use the proportion of the MHHID such exposed funds are responsible for in unaffected industries as an instrument. I further confirm that the results are robust to using a shock to common ownership stemming from outflows associated with a large mutual fund scandal in 2003.

US political corruption and firm financial policies

Using US Department of Justice data on local political corruption, I find that firms in more corrupt areas hold less cash and have greater leverage than firms in less corrupt areas. The results are robust to including a range of controls and to using an instrumental variable approach, two alternative survey measures of corruption, and propensity score matching. Further, the association between corruption and leverage is largest among firms that operate primarily around their headquarters. Overall, the evidence is consistent with the hypothesis that firms manage liquidity downward and debt obligations upward to limit expropriation by corrupt local officials.

CEO Facial Width Predicts Firm Financial Policies

Facial width-to-height ratio (fWHR) is a proxy for testosterone levels and has been linked to aggressive behavior and increased risk tolerance. This study is the first to examine the relationship between a proxy for CEO testosterone levels and firm financial policies. Using data hand-collected from images of 968 male CEOs of S&P 500 firms, I find that CEO facial width is positively correlated with leverage and negatively correlated with cash holdings during the 20022013 period. The relationship between CEO fWHR and financial policies is also observed for CEOs who go on to attain longer tenures with their firms, as well as when post-turnover firm-year observations are removed from the sample. Overall, it appears that CEO testosterone levels have a significant impact on corporate financial management decisions, as higher testosterone levels may induce CEOs to pursue more aggressive financial policies.

Business Networks, Firm Connectivity, and Firm Policies

I examine firm financial policies under a network structure of customer-supplier relationships. In this network, negative economic shocks that occur to one firm can affect other firms' profitability through their relationship-specific connections, leading to a contagion effect. I demonstrate theoretically that when external financing is costly, firms connected to the distressed firms will find it optimal to extend financing in order to preserve their relationship-specific synergies. Empirically, I show that firms strongly connected in the network will choose more conservative financial policies. Using firms' closeness centrality in the network as a proxy for the strength of their connections, I find that central firms choose lower leverage, higher cash holdings, and lower payout. To alleviate potential endogeneity concerns, I use mergers of firms' secondary neighbors to instrument for network structure changes. Compared to withdrawn mergers, the secondary neighbors of mergers experience increases in closeness, which lead them to adopt more conservative financial policies following the mergers.Finally, to validate the channels behind my results, I use several exogenous shocks including 9/11 and show that firms closely related to the distressed firms increase their trade credit demand and reduce their investment following negative shocks.

Optimal dividend policy with random interest rates

Several recent papers have studied the impact of macroeconomic shocks on the financial policies of firms. However, they only consider the case where these macroeconomic shocks affect the profitability of firms but not the financial markets conditions. We study the polar case where the profitability of firms is stationary, but interest rates and issuance costs are governed by an exogenous Markov chain. We characterize the optimal dividend policy and show that these two macroeconomic factors have opposing effects: all things being equal, firms distribute more dividends when interest rates are high and less when issuing costs are high.

Corporate financial policies in emerging markets: the role of financial market development

Purpose – The paper aims to study the importance of financial market development and financial structure in explaining the financial policies of firms in emerging market countries. Design/methodology/approach – The paper uses a panel data of 32 countries and the system generalized method of moments approach. Findings – The analysis shows that stock market development is associated with higher use of external finance relative to internal finance, while bond market development is associated with lower use of external finance relative to internal finance. The findings of this study also indicate that stock market development tends to shift the policies of firms towards less debt and more equity, and bond market development is associated with higher debt and less equity in emerging economies. Originality/value – The value of this study is in respect of its contribution to the extant literature on corporate financial policies in emerging market economies.

Optimal Dividend Policy with Random Interest Rates

Several recent papers have studied the impact of macroeconomic shocks on the financial policies of firms. However they only consider the case where these macroeconomic shocks affect the profitability of firms but not the financial markets conditions. We study the polar case where the profitability of firms is stationary, but interest rates and issuance costs are governed by an exogenous Markov chain. We characterize the optimal dividend policy and show that these two macroeconomic factors have opposing effects: all things being equal, firms distribute more dividends when interest rates are high and less when issuing costs are high.

In Sickness and in Health: Firm Performance and Managerial Health

This paper examines the importance of CEO characteristics for firm valuation and policies using the insight that managerial effort depends in part on the health of the manager and health is part of human capital. We use CEO health shocks as a time-varying and physical managerial attribute that can change the degree of managerial effort. Using hand-collected data on CEO deaths and medical leaves to identify large health shocks, we find that firm value is considerably lower and corporate financial policies are largely less precarious (lower cash holdings, leverage, and return volatility) in the years preceding the death of the manager compared to a matched sample of firms. Chronic health conditions and weak governance environments primarily produce these effects. Stock prices also decline by about 2% when top managers take medical leaves. Overall, our results suggest that CEO health has important consequences for the performance and financial policies of firms.