Financing policy, executive stock options and cash flow forecasts

Abstract

This article investigates the relationship between management voluntary disclosures of cash flow forecasts and external financing policy, earnings management, earnings forecasts and executive stock option compensation. We find that management is more likely to issue cash flow forecasts when a firm has external financing needs or when a firm has more executive stock option compensation. However, management is less likely to disclose cash flow forecasts when a firm has more earnings management. Consistent with the prior research, we document that a firm with high dividend payout, large asset value and high profitability tends to disclose cash flow information to convey good news. Further, if analysts have released earning forecasts, management is likely to issue cash flow forecasts to complement those analyst earnings forecasts. If analysts release cash flow forecasts, management is less likely to disclose cash flow forecasts to avoid issuing repeat forecasts. Our results, therefore, suggest that different incentives drive management disclosure decisions regarding cash flow forecasts in actual practice.

Keywords:

• external financing
• executive stock options
• cash flow forecasts
• earnings forecasts
• earnings management

JEL Classification:

• G32
• G30

Notes

¹ Securities and Exchange Commission (SEC) Regulation Fair Disclosure (FD) requires firms that disclose material nonpublic information to securities market professionals disclose the same information simultaneously or promptly to the public, depending on whether the initial disclosure was intentional or neglectful. FD clearly regulates the content of speech since it refers only to statements that are ‘material’ to reasonable investors. The rule plainly does not just require more disclosure, but rather burdens and thereby restricts these disclosure statements to analysts that trigger the disclosure duty.

² Wasley and Wu (2006) indicate that the firms with issuing cash flow forecasts since 2000 have more than tripled from pre-2000 levels.

³ Cheng and Warfield (2005) find that managers with higher equity incentives are likely to sell stock in the future and unlikely to report higher abnormal earnings in the current period. This result indicates that manager wealth is more sensitive to future stock performance and also explains why higher earnings may be reported in future periods and then to increase the value of their equity holdings.

⁴ The data of cash flow and earnings forecasts by analysts are from I/B/E/S database.

⁵ Khurana et al. (2006) adopt the rank of the total disclosure score (obtained from the annual volumes of the report of the Financial Analysts Federation Corporate Information Committee) based on a within industry/year ranking in order to measure the overall level of disclosure of a firm. Lang and Lundholm (1996) provide evidence that firms with more informative disclosure policies have a larger analyst following, more accurate analyst earnings forecasts, less dispersion among individual analyst forecasts and less volatility in forecast revisions. They measure corporate disclosure by using the annual corporate disclosure ratings on FAF (Financial Analysts Federation Corporate Information Committee) report. Hope (2003) uses CIFAR (Center for International Financial Analysis and Research) evaluations of annual report disclosure levels to measure the accounting policy disclosures, and finds that the level of accounting policy disclosure negatively relates to forecast dispersion and forecast error, and further, accounting policy disclosures are incrementally useful to analysts over and above all other annual report disclosures. These findings suggest that accounting policy disclosures reduce uncertainty about forecasted earnings. Bhat et al. (2006) documented that governance transparency is positively associated with analyst forecast accuracy using country-level proxies for corporate governance transparency. Hence, we use earnings forecast errors of analysts to measure the overall level of disclosure of a firm.

⁶ Demirguc-Kunt and Maksimovic (1998) point out that internally financed growth rate increases in a firm's return on assets, implying that greater profitability from assets in place also supports higher growth rate.

⁷ Demirguc-Kunt and Maksimovic (1998) indicate that short-term financed growth rate is the maximum growth rate that can be obtained if the firm reinvests all its earnings and obtains enough short-term external resources to maintain the ratio of its short-term liabilities to assets.

⁸ The return on assets (ROA) is an indicator of firm performance that is measured by net income divided by total assets. We expect ROA to be positively related to market reactions to IFG.

⁹ Al-Akra et al. (2010) measure the Voluntary Disclosure Index (VDI), where the annual report for each firm is awarded a score of 1 if a voluntary item is disclosed and 0 if it failed to disclose. The VDI for a firm is measured as the ratio of the actual score awarded to the maximum possible score.

¹⁰ Net cash flow from operations, OCF, is a measure of the operating performance of the firm. We expect that there is a positive relationship between OCF and MCFF.

¹¹ When the volatility of earnings of the firm (EPV) or the volatility of stock returns of the firm (SREV) is larger, it implies that operation performance is unstable. Hence, the management may voluntarily disclose cash flow forecasts to establish the confidence of investors in the firm. On the other hand, managers are more likely to disclose cash flow forecasts to increase the value of executive stock options (CEOSO) in their compensation by announcing good news. Hence, we use EPV, SREV and CEOSO as the control variables in the empirical model.

¹² The CEO tenure data were taken from DEF14a disclosures. If the CEO accepts an offer before the mid-year, he or she is regarded as assuming that position at the beginning of the year. Allgood and Farrell (2000) conclude that longer tenure of an executive is positively related to operating performance because longer tenure can promote internal integration and control within the company.