Investigation of the Relationship between Surplus Free Cash Flows and Earnings Management, with an Emphasis on the Moderating Role of Audit Quality (Evidence from Tehran Stock Exchange)

Document Type : Research Paper

Authors

Abstract

  Introduction
       In Agency theory of free cash flows, companies with high free cash flows but low-growth opportunities possibly experience high earnings management. High quality auditors are more likely to detect the practices of earnings management; one way to reduce surplus free cash flow is through earnings management. The purpose of this paper is to scrutinize the effect of audit quality factors, namely audit size, audit change and audit opinion, on the relationship between surplus free cash flows and earnings management. Past studies have examined the relationship between surplus free cash flows and earnings management and found that low-growth companies with high free cash flow use income-increasing discretionary accruals to offset the low or negative earnings.
 
Hypothesis
       This study is aimed at examining the effect of audit quality on the relationship between surplus free cash flows and earnings management. To investigate this, one main and three subsidiary hypotheses were designed as follows:
H. Audit quality moderates the SFCF-earnings management relationship
H1. Audit size moderates the SFCF-earnings management relationship
H2. Audit change moderates the SFCF-earnings management relationship
H3. Audit opinion moderates the SFCF-earnings management relationship
 
Method
       The data required for the research were gathered from 97 companies listed on Tehran Stock Exchange during a 10-year period from 2005 to 2014. Multiple regressions are implemented to test those hypotheses. The cross-sectional modified version of Jones (1991) model was used to measure discretionary accruals (DACs) (the proxy for earnings management). SFCF is an indicator variable with firm j scored 1 if their retained cash flow is above the sample median and their price to book ratio is below the sample median in fiscal year t; otherwise is scored 0. Audit quality refers to the quality of the auditor. It is examined with three factors.
       The Eviews statistical package are utilized to run the analysis.
 
Results
       The first and second hypotheses are supported. Audit size and change moderate the SFCF-earnings management relationship. The relationship between surplus free cash flow and earnings management was positive and the arrival of a moderating variable (the audit size and change) caused a negative relationship between surplus free cash flow and earnings management and reversed the relationship.
       Research data do not support the third hypothesis. It is suggested that audit opinion does not moderate the SFCF-earnings management relationship.
Conclusion
       The most important index measuring audit quality is the reputation of the auditor and the audit firm's size. For example, Becker et al. (1998), Gul (2003) and Lin and Hawang (2010), argue that auditors with high quality are more likely to identify ways of earnings management. The greater the audit quality is, the less able management is to manipulate the earnings. The use of Community of external monitoring such as an audit firm (audit organization) with high-quality and reputation tends to moderate the earnings management from surplus free cash flow. This finding is similar to that found by Chung (2005), Rusmin et al. (2014) in Malaysian case and in contrast with Nekhili et al. (2016).
       Audit change must be done rotationally in companies so that the independence of auditing firms is maintained. Moreover, many lawmakers contend that a prolonged relationship between the auditor and employer may negatively impact the monitoring ability as well as the quality of the audit. As a result, reducing the period an auditor works with an employer can help increase the independence of the auditor and, in turn, the independence of auditing firms tends to increase the quality of the auditing practices. The results of the study showed that compulsory rotation of the auditor increased the independence of the auditor and the quality of the audit, which was in agreement with the findings of Carcello and Nagy (2004), Jafari (2014) but contradicting those by Yegane et al. (2010).
        Finally, there are interest conflicts between management and shareholders and as managers seek to maximize their rewards and benefits, there are enough incentive in managers to manipulate and distort the accounting figures. The use of community of external monitoring such as a big audit firm (audit organization) of high-quality and reputation tends to moderate the earnings Management from surplus free cash flow. Therefore, this would result in the effectiveness of the company’ investment decisions.
 
Keywords: Surplus Free Cash Flows, Audit Quality, Audit Size, Audit Change, Earnings Management.

Keywords

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References

 
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History

  • Receive Date: 30 October 2016
  • Revise Date: 18 January 2017
  • Accept Date: 15 April 2017

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