Corporate Governance Mechanisms And Cash Flow Forecasts Disclosure

The Association between Corporate Governance Mechanisms and Cash Flow Forecasts Disclosure
Research Proposal

1. Introduction

Corporate disclosure and the institutions which facilitate credible disclosure between managers and investors play an important role in mitigating the asymmetries that impede the efficient allocation of resources in a capital market economy. Two main asymmetries arise in capital markets. First, investors face an information problem because managers have better information than savers about the value of business investment opportunities and have incentives to exaggerate their value. Second, when savers have invested in a business, self interested managers have incentives to expropriate their funds creating an agency problem. Both information and agency problems may have a solution through optimal contracts, regulation that requires managers to disclose their private information, and board of directors, whose role is monitor managers on behalf of external owners. Also, because of information asymmetries, there is a demand for information intermediaries, such as financial analysts, who produce private information to uncover manager’s superior information and any manager misuse of investors’ resources (Healy, Palepu, 2001).
Current accounting literature shows a marked increase in the number of firms and analysts that disseminate cash flow forecasts and estimates in recent years. Wasley and Wu (2005) show that management cash flow forecasts expressed as a percentage of all the firms on Compustat increased from 0.3% in 1996 to 4% in 2002. Zhang (2007) shows that in 1993, less than 1% of the public companies were covered by analysts’ cash flow forecasts, but in 2005 almost 30% of public firms were covered. These studies find that managers provide cash flow forecasts to meet investors’ demand and try to influence market’s perceptions, reinforcing good news and trying to reduce the influence of bad news. Moreover, they find that analysts issue cash flow forecasts when earnings appear to be less informative and to meet investors demand for more value relevant information.
On the other hand, prior studies investigate the association between a set of corporate governance mechanisms and voluntary disclosure, represented by the properties of management earnings forecasts (Ajinaya et.al 2004, Karamanou et. al 2005). They find that firms with effective governance mechanisms are more likely to make a management earnings forecast, especially when that involves bad news. This evidence suggests that better governance in public corporations is associated with less information asymmetry between managers and shareholders, especially when shareholders are more likely to be at risk of suffering wealth losses. Moreover, these studies find that better governance is associated with a grater level of precision in earnings forecasts. Therefore, effective governance is associated with high-quality information flowing from managers to investors.
Other studies investigate the association between corporate governance and the quality of information available to financial analysts (Byard et.al, 2006). They find that the quality of financial analysts’ information about upcoming earnings increases with the quality of corporate governance.
My study addresses the following specific questions: How is the firm’s governance structure related to the likelihood that managers issues a cash flow forecast? How is the governance structure related to the level of precision in a management cash flow forecast? How is the firm’s governance structure related to the level of accuracy in an analysts’ cash flow estimates? I expect better governance be associated with a larger amount and more accuracy of cash flow forecast.
I am interested in cash flow forecasts because it seems that investors and analysts are paying more attention to cash flow than before since the recent accounting scandals might have increased the markets concern about earnings manipulation. Moreover, in general, cash flows help market participants evaluate firm viability by providing additional information about solvency and liquidity.
This study, linking corporate governance mechanisms to voluntary disclosure and the quality of financial analysts’ information, may be relevant given the current scrutiny of corporate governance mechanisms and the state of the financial reporting system. These have become under siege in the wake of a series of financial scandals including Enron and WorldCom. These scandals have led to a greater focus on the need for stronger corporate and more transparent disclosure. I try to find whether these are related.

2. Literature Review and Hypothesis Development

2.1 Voluntary disclosure and Management Cash Flow Forecast
Most of the literature in voluntary disclosure focuses on the motivation and consequences of disclosure. Six forces are identified as motivations for disclosure: capital market transactions, corporate control contest, stock compensation, litigation, proprietary cost and management talent signaling. Healy and Palepu (1993) point out that managers expecting to issue public debt or equity pay much attention to investors’ perception of a firm. Then, managers who think about making capital market transactions have incentives to provide voluntary disclosure and reduce information asymmetry. Managers also use voluntary disclosure to reduce the likelihood of undervaluation, to explain poor earnings performance and to reduce the risk of litigation. Verrecchia (2001) hypothesizes that a firm’s decision to disclose information to investors is influenced by concerns that such disclosures can damage their competitive position in the market, even if it makes more costly to raise additional equity. Trueman (1986) argues that talented managers have an incentive to make voluntary disclosure to reveal their type.
Several studies examine the consequences of voluntary disclosure in the capital markets. They find that firms that make extensive voluntary disclosure improve liquidity, reduce capital cost, and increase the number of financial analysts following the firm. Healy (1999) finds that firms that expand disclosure experience significant increases in stock prices that are unrelated to current earnings performance. They also find that firms with increased rating of disclosure have a significant higher bid-ask spread than their industries peers after the disclosure changes. Walker (1995) finds a significant negative relation between analysts’ rating of firms’ disclosures and their bid-ask spreads. Botosan and Plumlee (2002) find a negative cross sectional relation between cost of capital and analysts ranking of annual reports. Lang and Lundholm (1993) find that firms with more informative disclosure have larger analysts following, less dispersion in analyst forecast, and less volatility in forecast revisions.
Recently, managers are issuing voluntarily cash flow forecasts more often. Wasley and Wu, (2006) argue that a potential explanation for this recent trend is investors and analysts paying more attention to cash flow than before because the recent scandals might have increased the investors concern about earnings manipulation. Also the sharp decline in the stock market in early 2000 may have increased investors demand for cash flow information. Analyzing 2,090 cash flow forecast from 1980 to 2003, they find that the likelihood that management issues a cash flow forecast increases in periods when there is a large increase in operating cash flow, when analysts are forecasting earnings loss, when management reveals in their press releases that earnings will be either below or above expectations, and when the firm is young, and decreases in periods with extreme positive discretionary accruals.
Adheji and Duru (2006) find that firms whose managers voluntarily disclose free cash flow information are less profitable, more leveraged, have lower credit ratings and pay higher dividends, which is consistent with the idea that managers may release this information to influence markets’ perception of the firm.
This literature concludes that managers provide cash flow forecasts to meet investors’ demand and try to influence market’s perception, reinforcing good news and trying to reduce the influence of bad news.

2.2 Analyst Cash Flow Forecast
DeFond and Hung (2003), examining I/B/E/S database over a period of 1993 to 1999, find that almost 12% of the firms with earnings forecast also include cash flow forecasts. They find that analysts tend to forecast cash flow for firms with larger accruals, more heterogeneous accounting choices relative their industry pears, high earnings volatility, high capital intensity and poor financial health. Therefore, financial analysts respond to market-based incentives to provide market participants with value-relevant information.
They also find that annual earnings have a lower association with 15 month returns among firms with cash flow forecasts, and that stock returns around the annual earnings announcements date for firms with cash flow forecast are positively associated with cash flow forecast errors, but are not associated with earnings forecast errors. All their results are consistent with the idea that market participants demand cash flow forecasts when earnings are less relevant in security valuation.
DeFond and Hung (2007) find that analysts supplement their earnings forecast with cash flow forecast in countries where weak investor protection results in earnings that are less useful in asses the firms’ underlying economic performance. They analyze 70,837 firm-year observations across 36 countries over 1994 through 2002 period, including 31,766 firm-year with cash flow forecast. They find a positive correlation between countries that have weaker investor protection and that have poorer earnings’ value relevance and a greater tendency to manage earnings. They also find a positive correlation between firms with poorer earnings’ value relevance and the tendency for analysts to forecast earnings cash flows.
Luzi Hail (2007) argues that the two main assumptions of DeFond and Huang (2007), that investors’ unsatisfied demand for accounting information and their willingness to rely on cash flow information as valuable information signal, are a priori not obvious in an international context. In an additional analysis, she tests whether changes in investors’ protection or earnings quality relate to changes in the frequency of cash flow forecasts. She finds that analysts supplement their earnings forecasts more frequently with cash flow forecast after a country’s first prosecution under insider trading laws and after non-US firms have cross-listed their shares on a US exchange or voluntarily adopt IFRS or US GAAP. This result contradicts DeFond and Huang prediction.
Most of this literature agrees on the idea that analysts issue cash flow forecasts when earnings appear to be less informative and to meet investors demand for more value relevant information.
When analysts and managers forecast both earnings and cash flow they are implicitly forecasting total operation accruals. This idea is explored by McInnis and Collins, 2006, who find that firms with cash flow forecast exhibit higher accruals quality than firms of similar size and in the same industry without cash flow forecast. Therefore, analysts’ cash flow forecasts serve as an effective earnings management constraint and may help improve the quality of the information provided by managers.
Hodder, Hopkins and Wood, 2006, show in an experiment conducted with 50 second year business graduate students, that the currently required structure of the operating-activities section of the indirect approach statement of cash flow causes lowers levels of learning and higher levels of forecast error and dispersion. Moreover, conducting a quasi experimental analysis of publicly available cash flow forecasts provided by Value Line analysts, they find that forecast errors are higher for companies that report mixed-signed operating cash flow and operating accruals information. This result implies that cognitive limitations that impede information acquisition manifest in a systematic error in a market setting.

2.3 The association between corporate governance structure and voluntary disclosure
Karamanou and Vafeas (2005) study the relation between management earnings forecast made by 275 Fortune 500 firms between 1995 and 2000 and variables proxying for how boards, audit committees, and institutional shareholders monitor management. They find that firms with effective governance mechanisms are more likely to make a management earnings forecast, especially when that involves bad news. They also find that among forecasting firms, forecast precision decreases with better governance, but only when bad news is conveyed. Finally, they find that evidence that market reaction to management earnings forecast announcements is related to board and audit committee characteristics, especially when the forecast releases good news suggesting that investors have greater confidence in good news forecasts that undergo the scrutiny of more effective boards and audit committees.
Ajinkya, Bhojraj and Sengupta, 2004, investigate the relationship of the board of directors and institutional ownership (governance proxies) with the properties of management earnings forecasts. Using a sample of management’s earnings forecast issued from 1997 to 2002, they find that institutional ownership and the proportion of outside directors are positively associated with the likelihood of forecast occurrence and frequency of management earnings forecast issuance. They also find that companies with a greater percentage of outside directors make more accurate and less optimistically biased earnings forecast.
All these literature agree on the idea that better governance mechanisms are associated with more information flowing to the market as voluntary disclosures by firms. Therefore, I expect that more effective boards, more effective audit committees, and institutional ownership are related with managers more likely to issue cash flow forecasts and with more accurate management cash flow forecast.

2.4 The association between corporate governance structure and the quality of analyst information
Corporate governance is related is closely related to the integrity of the financial information and the financial reporting quality is associated is associated with analysts’ forecasts accuracy. Some literature analyzes the relationship between corporate governance and analyst forecasts.
Byard, Li and Weintrop (2006) examine the association between corporate governance and the quality of information available to financial analysts. Using a sample of analyst’s earnings forecasts for 2887 firms-years, representing 1279 firms, between 199 and 2002, they find that analysts’ forecast accuracy is significantly positively related to the independence of the board of directors and significantly negatively associated with the presence of a CEO who is also the chair of the board. They also find evidence that smaller boards of directors are associated with increased analysts’ earnings forecast accuracy.
Using country-level proxies for corporate governance transparency Bhat, Hope and Kamg (2006) find a positive relation between these proxies and forecast accuracy after controlling for financial transparency. They also find that governance transparency is more important in explaining forecast accuracy when financial disclosure is low.
Overall the literature agrees on firms with better governance have better quality of information environments.
Therefore, I expect that more effective boards, more effective audit committees, and institutional ownership are related with to more accurate analysts cash flow forecast.

3. Research design
3.1 Definition of corporate governance variables

In order to find the relation between the likelihood of cash flow forecast, the accuracy of managers, and analysts’ cash flow forecast and the effectiveness of a firm’s corporate governance; I need to define variables that measure effectiveness of boards and audit committees. I capture the effectiveness of boards using the following variables: BOARD_IND measured as the percentage of independent directors on the board; BOARD_SIZE measured as the total number of directors serving on the board of directors; and DUAL_CEO as a dummy variable equal to one if the CEO is also the chair of the board, and zero otherwise.
Core et. al. (1999) indicate that less independent outside directors provide poor monitoring. Moreover, Beasley (1996) finds a negative association between outside directors and the likelihood of financial fraud. Therefore, I expect that managers are more likely to issue cash flow forecasts and that the accuracy of managers and analysts cash flow forecasts are positively related with BOARD_IND. Yermack (1996) find that larger boards are less effective, so I expect that managers are less likely to issue cash flow forecasts and that the accuracy of managers and analysts cash flow forecasts are negatively related to BOARD_SIZE. Jensen (1993) argues that the presence of a dual CEO is an indicator of poor governance, then I expect that managers are less likely to issue cash flow forecasts and that the accuracy of managers and analysts cash flow forecasts are negatively related to DUAL_CEO.
I measure audit committee effectiveness with the variable AUDIT_IND, measured as the percentage of independent directors on the audit committee. Klein (2002) finds that earnings management decreases with the percentage of outside directors on the audit committee, then I expect that managers are more likely to issue cash flow forecasts and that the accuracy of managers and analysts cash flow forecasts are positively related with AUDIT_IND.
Institutions demand more disclosure. I define INST_OWN as the percentage of a firm’s stock that is owned by institutional investors. I expect that managers are more likely to issue cash flow forecasts and that the accuracy of managers and analysts cash flow forecasts are positively related with INST_OWN.

3.2 The relation between corporate governance and management cash flow forecast

In order to find a relation between corporate governance and the probability of occurrence of managers’ cask flow forecast, I run the following regression:

MGMT_CFF = α0 + α1 BOARD_IND + α2 BOARD_SIZE + α3 DUAL_CEO
4 AUDIT_IND + α5 INST_OWN + α6 AGE + α7 LMVAL (1)
+ α8 NEG_EARN + α9 Post_Reg_FD + ε

Where, MGMT_CFF is 1 if the firm issued a cash flow forecast and o otherwise.
BOARD_IND, BOARD_SIZE, DUAL_CEO, AUDIT_IND and INST_OWN are defined in the previous section.
I also include the following control variables: AGE (in years) measured as the current year minus the first year that stock price information become available on the CRSP database; Chen et. al. (2002) argue that investors’ demand for financial information in addition to earnings can be particularly strong for young firms because there is a greater uncertainty about these firm’s earnings and their production activities. LMVAL is the log of the market value of a firm’s common equity at the beginning of the fiscal period. Following Wasley and Wu (2006), I include NEG_EARN which equals on if the firm reported negative earnings in the period and 0 otherwise. Post_Reg_FD equals 1 if the observation is related to the post RegFD period (after October 2000) and 0 Otherwise. Heflin, Subramanyam, and Zhang (2003) find that the number of forecast issuance has increased after RegFD .
Since MGMT_CFF is a binary variable I will estimate equation (1) with a probit model. I expect that α1, α4, α5 be positive, and α2 and α3 be negative.

3.3 The relation between corporate governance and the accuracy of management cash flow forecast
In order to find a relation between corporate governance and the accuracy of managers’ cask flow forecast, I run the following regression using Ordinary Least Squares method:

ACCURACY_MGMT = β0 + β1 BOARD_IND + β2 BOARD_SIZE
+ β3 DUAL_CE +β4 AUDIT_IND + β5 INST_OWN (2)
+ β6 LMVAL + β7 NEG_EARN + β8 Post_Reg_FD + ε

Where ACCURACY_MGMT is defined as the absolute value of the difference between the management cash flow forecast per share and the actual cash flow per share divided by cash flow per share at the beginning of the fiscal period. BOARD_IND, BOARD_SIZE, DUAL_CEO, AUDIT_IND and INST_OWN, LMAV, NEG_EARN and Post_Reg_FD are defined previously.
I expect that β 1, β4, and β5 be positive and β 2 and β 3 be negative.

3.4 The relation between corporate governance and the accuracy of analyst cash flow forecast
In order to find a relation between corporate governance and the accuracy of analysts’ cask flow forecast, I run the following regression using OLS method:

ACCURACY_AN = δ0 + δ1 BOARD_IND + δ2 BOARD_SIZE + δ3 DUAL_CEO
+ δ4 AUDIT_IND + δ5 INST_OWN + δ6 LMVAL (3)
+ δ7 NEG_EARN + δ8 Post_Reg_FD + ε

Where ACCURACY_AN is defined as the absolute value of the difference between the analyst cash flow forecast per share and the actual cash flow per share divided by cash flow per share at the beginning of the fiscal period. BOARD_IND, BOARD_SIZE, DUAL_CEO, AUDIT_IND and INST_OWN, LMAV, NEG_EARN and Post_Reg_FD are defined previously.
I expect that δ1, δ 4, and δ 5 be positive and δ 2 and δ 3 be negative.

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