Does the board of directors and their stock ownership mitigate interest payment classification shifting? UK evidence

Abstract

We investigate whether the independence of the board of directors and stock ownership by outside directors and executives may limit interest payment classification shifting within the statement of cash flows. We find that such classification shifting is less prevalent in United Kingdom (UK) firms with high-quality internal governance, demonstrating that effective internal governance may serve as a substitute for rules-based accounting standards. While we find that governance mechanisms play a crucial role in mitigating this practice in both distressed and non-distressed firms, our findings are more pronounced in non-distressed firms. We also find that there is an inverted U-shaped relationship between board independence, stock ownership by managers and independent directors, and the classification shifting of interest payment. Thus, it is premature to propose that board independence and stock ownership can mitigate managerial opportunism in all cases. Indeed, our findings suggest that there are optimal independent director and ownership thresholds below which caution is required to ensure that managers remain focused on maximizing shareholder value.

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