The Influence of a Firms’ Business Strategy on the Downside Risk of Earnings, Accruals and Cash Flow

Abstract

This study examines whether a firm’s business strategy is an underlying determinant of downside risk in accounting earnings and its components. Based on organizational theory we predict that firms following an innovative “prospector” strategy exhibit lower profitability tendencies than firms following a cost-oriented “defender” strategy. Further, we anticipate that these strategies are asymmetrically positioned towards environmental uncertainty, with defenders focusing their efforts to efficiency, cost control, and minimizing exposure to downside risk, whereas prospectors direct their resources to flexibility, innovation, and maximizing the growth potential through aggressive expansion to new product markets. We find that prospectors are indeed less profitable than defenders. We also demonstrate that prospectors have greater total and downside earnings risk. Finally, we decompose earnings into accruals and cash flow and show that the higher exposure of prospectors to earnings downside risk is driven by the cash flow component rather than the accrual component. Collectively, our results suggest that considering how strategy interacts with financial reporting attributes is a useful way for evaluating a firms’ risk profile.

Keywords: Earnings downside risk, Business strategy, Accruals risk, Cash flow risk

JEL Classification: M41, M21