Factors Associated with the Year-End Decline in Working Capital

Abstract

W orking capital is an important indicator of firm operational efficiency. All else being equal, lower levels signal greater efficiency. Managers are thus likely to be motivated to report lower levels of working capital at times of greater external attention. We find that working capital levels decrease in the fourth fiscal quarter significantly more than expected, conditional on seasonal changes in economic activity. The decrease subsequently reverses in the following first fiscal quarter. Evidence indicates that firms manage down year-end working capital through transactions that increase year-end operating cash flow and that firms spread this activity over all working capital accounts. Finally, the temporary decrease in year-end working capital is correlated with compensation benchmarks and analysts' annual cash flow forecasts. The temporary drop is also more pronounced for firms with industry dominance.

Conditional conservatism and disaggregated bad news indicators in accrual models

“…However, cash flow fluctuates predictably due to seasonal factors (e.g.,Frankel et al 2016). Furthermore, a temporary seasonal decrease in the market price does not require an inventory write-down (ASC 330-10-55-2).…”

Executive compensation and cash contributions to defined benefit pension plans

“…8 Thus examining cash contributions to DB plans presents a unique opportunity to test managers' incentives to report higher cash flows from operations in the current period, without the confounding effect of earnings management. Cash flows from operations is an important performance metric used by the capital markets, and as a result, we have seen an increase in analysts' forecasts of cash flows from operations (i.e., DeFond & Hung, 2003;Givoly et al, 2009;Wasley & Wu, 2006) and the use of cash flow information in compensation contracts (Frankel et al, 2016;Nwaeze et al, 2006). Given the importance of cash flows from operations, managers likely have incentives to delay contributions to report higher cash flows from operations for personal gains.…”

“…They document that CEO cash compensation is positively correlated with contemporaneous cash flows from operations, particularly when the informativeness of earnings is low. Frankel et al (2016) further document that executive compensation in the form of cash bonuses motivates companies to reduce non-cash working capital in the fourth fiscal quarter in order to report higher cash flows from operations. While not tabulated, we confirm the positive association between cash compensation and cash flows from operations.…”

“…We provide evidence that firms delay contributions to report higher cash flows from operations when reported cash flows from operations are important in influencing CEO compensation. Our paper is related to, but different from, two recent studies that examine managers’ incentives to report higher cash flows from operations (Frankel, Levy, & Shalev, ; Lee, ). They find that managers report higher operating cash flows by reducing non‐cash working capital in the fourth quarter.…”

“…Therefore, our study suggests a different type of cash flow management. In addition, Frankel et al (2016) and Lee (2012) find that working capital increases significantly in the first quarter following a decrease in the previous fourth quarter. Because working capital includes assets and liabilities needed for operating purposes, this finding suggests a temporary delay in operating cash flow.…”