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Journal of Business Research xx (2004) xxx – xxx

Earnings management, surplus free cash flow, and
external monitoring
Richard Chung, Michael Firth*, Jeong-Bon Kim
School of Accounting and Finance, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong, China

Managers engage in earnings management for various reasons. We argue that low-growth companies with high free cash flow (SFCF) will
use income-increasing discretionary accruals (DAC) to offset the low or negative earnings that inevitably accompany investments with
negative net present values (NPVs). Our results, using 22,576 company year observations over the period 1984 – 1996, confirm our
hypothesis. We also examine the role of high-quality auditors and institutional shareholders in mitigating the SFCF – DAC relation. Our
results show that Big 6 auditors and institutional investors with substantial shareholdings moderate the SFCF – DAC relation, which suggests
that external monitoring by these two outside stakeholders is effective in deterring managers’ opportunistic earnings management.
D 2004 Elsevier Science Inc. All rights reserved.
Keywords: External monitoring; Surplus free cash flow; Earnings management; Audit quality; Institutional shareholdings

Free cash flow allied to low-growth opportunities has
been identified as a major agency problem where managers
make expenditures that reduce shareholder wealth. To
camouflage the effects of the non-wealth-maximizing
investments, managers can use accounting discretion to
increase reported earnings. This opportunistic behavior is
restricted if external monitoring by outside stakeholders is
effective. In this paper, we argue that high-quality auditors
are more effective in limiting managers’ ability to make
opportunistic accounting choices than low-quality auditors.
We also argue that financial institutions with substantial
equity stakes in a company have the incentive, time, and
expertise to monitor the opportunistic actions and earnings
management of corporate executives.
This paper has three objectives. First, we investigate
whether managers of low-growth companies with high free
cash flows have incentives to boost reported earnings by
choosing income-increasing discretionary accruals (DAC).
In so doing, our analysis focuses on whether the level of
DAC is positively related to free cash flow in low-growth
firms. To ease exposition, we use the term surplus free cash
flow (SFCF) for free cash flow in low-growth firms.

* Corresponding author. Tel.: +852-2766-7062. fax: +852-2330-9845.
E-mail address: (M. Firth).

Second, we examine whether external monitoring by
high-quality auditors and institutional investors with substantial shareholdings are effective in deterring opportunistic earnings management. Our measures of audit quality
include the traditional classification of Big 6 and the more
recent emphasis on the length of auditor tenure. Thus, we
use a more comprehensive approach to identify audit
quality. If external monitoring is effective, managers’ abilities to make opportunistic accounting choices will be more
constrained than otherwise. As a result, the level of DAC
should be lower for companies with more effective monitoring than for those with less effective monitoring. Finally,
we investigate whether and how the incentive effect of
SFCF on DAC (i.e., the positive relation between DAC and
SFCF) is constrained or moderated by external monitoring
by high-quality auditors and substantial institutional shareholders. If external monitoring effectively mitigates managerial opportunism, the adverse effects of SFCF will be
reduced, and the positive relation between DAC and SFCF
will be weakened.
To our knowledge, this paper is the first attempt to
examine the SFCF agency problem in the context of
managers’ opportunistic accounting choices. This study
also sheds light on the interaction between incentive
effects and monitoring effects on managers’ DAC
choices. While previous research documented that the level of DAC is lower for Big-6-audited companies (Becker

0148-2963/$ – see front matter D 2004 Elsevier Science Inc. All rights reserved.
JBR-05976; No of Pages 11

These projects and activities may be self-gratifying to the managers and may bring them pecuniary benefits or other personal rewards. 1998. Chung et al. Long tenure is associated with higher accruals except when SFCF is high. then the auditor will try to persuade the client to revise the financial statements. This will result in lower stock prices and may trigger shareholder actions to remove directors and senior executives. Section 2 describes the data sources and research method. Non-value-maximizing investments eventually reduce earnings.ARTICLE IN PRESS 2 R. will reveal themselves in the future profits of the company. Past evidence suggests that auditors tend to be conservative (Basu et al. Managers do not disclose to investors an investment’s cash flow projections and the assumptions behind them. it has paid little attention to examining how the incentive effect on DAC interacts with the monitoring effect. Kim et al. 1981. Becker et al. The results are consistent with our hypothesis that management use positive accruals to camouflage the earnings impact of investments in negative NPV projects and other self-serving activities. Financial institutions with high investment stakes in a company also appear to restrain management from using positive accruals if SFCF is high. these managers may believe the investments will at least ‘break even’ for investors. the audit report can be qualified. 1983).. and if they do not do so. In the absence of effective monitoring or disciplinary actions by outside stakeholders and their agents. 1. we find that companies with high SFCF use income-increasing DAC to boost reported earnings. institutional investors do not constrain DAC. Traditionally.. High-quality auditors are more likely to restrict income-increasing DAC (Becker et al. although the fact that they ‘hide’ or give little disclosure to the activities suggests that they do not believe that the activities will withstand scrutiny by investors. managers may employ accounting procedures that increase reported income. however. Krishnan and Krishnan (1997) and Francis and Krishnan (1999). It is now widely accepted that there are quality differences among audit firms (DeAngelo. We therefore argue that auditors will restrain managers’ abilities to choose incomeincreasing DAC for companies with high SFCF. 2003). High-quality auditors want to avoid shareholder litigation and the bad publicity associated with a client company that aggressively uses inappropriate positive DAC. quality auditors and institutional shareholders monitor management actions and deter aggressive income-increasing earnings management. Poor investments. 2002). Francis et al.. The audit function reduces agency costs created by information asymmetry and reduces the control problems caused by the separation of ownership and management (Watts and Zimmerman. Identifying high-quality audits is problematic. 1999) and for companies with high institutional shareholdings (Rajgopal et al. The auditor examines the accounting procedures used by clients to see if they are appropriate. Chung et al. The results for auditor tenure are somewhat ambiguous. Francis et al. 1999). Identifying the agency cost of free cash flow (investments in negative NPV projects) is very difficult. / Journal of Business Research xx (2004) xxx–xxx et al. These ‘inflated’ profit numbers may help assuage investors and lead to higher market valuation than would otherwise have been the case (this assumes investors cannot completely unravel the earnings management).. 1998.. and so they may not agree with aggressive income-increasing DAC.. If the procedures are considered inappropriate. 1998). Big 6 firms have been used as a proxy for high-quality auditors (DeAngelo. Francis et al. This result suggests that Big 6 auditors inhibit companies with high SFCF from using income-increasing accruals. 1981. Managers may not even internally project cash flows for some investments. Our first and primary hypothesis is H1: Companies with high SFCF are more likely to choose income-increasing DAC than otherwise.. 1998. the biases managers have for some ‘pet’ activities or personal perquisites may make them ignore cash and profit planning.. in which case the accruals are lower. Big 6 . Finally. This argument is predicated on high-quality auditors having a lot of reputation at stake. and creditors that the income statement and balance sheet accurately or conservatively reflect the state of the client’s activities and net assets. some managers may choose to invest in marginal or negative NPV projects and activities. 1987. while Section 3 presents and discusses the results. 1999). Our results indicate that when SFCF is high.576 company year observations over the period 1984 – 1996. This verification gives assurance to shareholders. We hypothesize that auditors and institutional shareholders will reduce the SFCF –DAC relation. Our results also show that Big 6 auditors are associated with less positive accruals. To camouflage the impact of negative or marginal NPV investments on earnings. Appealing to commercial secrecy provides a cloak for bad investment decisions. The next section sets up our hypotheses on the DAC and SFCF relationship.. potential investors. In contrast. Using a large sample of 22.. provide evidence suggesting that auditors are more likely to issue a qualified audit opinion when they believe that failure to do so increases litigation risk beyond an acceptable level. Simunic and Stein. Firms with low-growth opportunities are more likely to invest free cash flow in unprofitable projects. and this is especially so when SFCF is high. 2003. among others. An important role of the external independent auditor is to attest to the financial statements of client companies. Background and hypotheses Jensen (1986) defined the agency cost of free cash flow as cash flows that are invested in negative net present value (NPV) projects. Section 4 summarizes our findings. In many cases. when surplus free cash is low.

Thus. Institutional shareholders have the expertise to analyze company performance. Johnson et al. Francis et al. We hypothesize that the monitoring activities of institutional shareholders will inhibit management from opportunistically using incomeincreasing DAC (Chung et al.. The findings from these studies have generally concluded that long tenure does not harm independence and may in fact improve audit quality (Sainty et al. computer. will restrict the income-increasing DAC of clients when compared to non-Big 6 auditors. it becomes difficult for them to sell shares immediately at the prevailing price. there is little or no evidence of auditors being sued if reported profits are less than the ‘true’ earnings. In this circumstance. Based on this evidence. One particular dimension of an auditor – client relationship is the length of audit tenure. Pierre and Anderson (1984) and Palmrose (1988) show that auditors are more likely to be sued if reported profits are alleged to exceed the ‘true’ earnings. 2003). / Journal of Business Research xx (2004) xxx–xxx auditors have a substantial market share of listed company clients in the United States as well as in many other countries. Big 6 auditors will restrict the use of DAC more than when SFCF is low. Institutional investors also have the wherewithal to remove managers if they believe the managers are using DAC to camouflage the earnings impact of their opportunistic actions. 2002. There are arguments that a long tenure will dull an auditor’s independence and make them more willing to accept management’s interpretations of accounting for business transactions (Sainty et al. We argue that institutional shareholders will more closely monitor management and management’s accounting choices if there are high agency costs. Models To test our hypothesis that companies with high levels of SFCF will adopt income-increasing DAC. 2002). Davis et al. 2002).ARTICLE IN PRESS R. 1999. and they have the power to affect or change corporate actions and decisions. 2002. conclude.1. Because of the conflicting arguments on the impact of audit firm tenure on independence and audit quality. managers may find it easier to indulge in earnings management. They also have very large consultancy. using a variety of approaches. Myers et al. These models include . 2002). when SFCF is high. This leads to our second hypothesis: H2: Big 6 auditors moderate the SFCF –DAC relationship. They find that long tenure is associated with increased earnings management. those companies that have substantial institutional shareholders become less able to engage in opportunistic earnings management. St. When institutional investors have substantial shareholdings. (Mandatory rotation is required in some European countries—Arrunada and Paz-Ares. research has looked beyond the traditional dichotomy of Big 6 and non-Big 6 as a proxy for audit quality. the Big 6 auditors deploy significant resources to auditing (recruitment. Management ownership is also a variable that may reduce agency costs as the motivation of managers with relatively large share stakes are more closely aligned to the motivations of [other] shareholders. Davis et al. have examined the relationship between audit quality and audit tenure. We argue that our proxy for audit quality. 2. the Big 6 auditors. This lack of liquidity means investment institutions have incentives to closely monitor companies with high SFCFs. they will be more conservative and will restrain clients from using positive DAC (Francis et al. we include audit tenure as a main effect and as an interaction term in our regression models. short auditor –client tenure (less than 5 years) is differentiated from long auditor– client tenure (5 years or more). Institutional shareholders will therefore impose more monitoring when free cash flow is high. that there is no systematic relationship between management ownership and accounting accruals... Pierre and Anderson (1984) report a lower level of litigation among Big 6 auditors compared with non-Big 6-auditors (after controlling for the relative sizes of the auditors). Research method 2. However. 1999). If the institutions own a large percentage of a company’s shares. 1997.. then they have the incentive and motivation to monitor management’s actions. Geiger and Raghunandan. 2002.. One way of inhibiting the actions of management is the threat of legal action against managers taken by institutional investors. and systems). we do not incorporate a management ownership variable in the regression model. Recently. This leads to our third hypothesis: H3: Large institutional shareholders moderate the SFCF – DAC relationship. (2003) reach an opposite conclusion.) In contrast... however. and tax departments that use the same brand name as the audit firm. Because Big 6 auditors stand to lose more from litigation than non-Big-6 auditors. A number of empirical studies. the accounting profession argues that auditor rotation will reduce audit effectiveness as new auditors face steep learning curves in understanding clients’ businesses (Geiger and Raghunandan. In particular.. Other things being equal. training. 2003. and they have the independence to insist that clients make necessary changes to their financial statements or else they will issue qualified audit reports. St. we estimate cross-sectional regression models. We hypothesize that a Big 6 auditor will be even more cautious when a client company’s agency costs are high. This view has led to calls for mandatory auditor rotation in the United States. In contrast. we do not specify directional signs on the tenure variables. Chung et al. To protect their hard-won reputations. 3 In light of the conflicting arguments and the somewhat mixed empirical evidence discussed above.

B6 is a dummy variable coded 1 if the auditor is a member of the Big 6. 1993). PSDIV is the preferred stock dividends. 2).ARTICLE IN PRESS 4 R. and TA is the total assets at the beginning of the fiscal year. Companies that retain substantial cash flows and that have low-growth prospects are more likely to invest the cash flows in marginal or negative NPV projects..t1  þ a2 ðPPEit =TAi. (2002). and e denotes unspecified random factors. High PBs indicate that the stock market is expecting high growth (Holthausen and Larcker.t1 Þ þ eit ð2Þ where TAC/TA is the total accruals divided by lagged total assets. SFCFIS is the interaction of SFCF and IS.. 4) is above the sample median for the year and the price-to-book ratio (PB) is below the sample median for the year. For very high levels of debt. One reason for this relationship is that companies with high debt levels face increased monitoring by bankers and creditors. CSDIV is the common stock dividends. with company (i) and time (t) subscripts. D denotes change from year t  1 to year t.t1 Þ þ a1 ½ðDREVit  DARit Þ=TAi. otherwise SFCF is coded 0. Chung et al. SIZE. DAR is the change in accounts receivables. Companies with above-median RCF and below-median PB are our proxy for firms with potential free cash flow agency problems. Skinner. companies may wish to increase write-offs to the income statement (the socalled ‘Big Bath’—DeAngelo et al.. is: DACit ¼ b0 þ b1 SFCFit þ b2 B6it þ b3 LTit þ b4 SFCF  B6it þ b5 SFCF  LTit þ b6 ISit þ b7 SFCF  ISit þ b8 DEBTit þ b9 RELCFit þ b10 SIZEit þ b11 ACit ð1Þ where DAC is the discretionary accounting accruals derived from the modified Jones (1991) model (see Eq. #REV is the change in sales revenues. The cutoff point of 5 years or more for long tenure (LT = 1) is similar to the criterion used by Knapp (1991) and Sainty et al. (2).t1 ð4Þ where RCF is the retained cash flow. PPE denotes property.. / Journal of Business Research xx (2004) xxx–xxx two proxy measure for high-quality auditors and a measure for institutional shareholders. DEBT is the total debt divided by total assets. RELCF is the relative cash flow measured by the difference between cash flow for the year divided by lagged total assets (year t  1) and the industry median for the year. 1995). DAC are estimated cross-sectionally for each year and for each industry using the modified Jones (1991) model (Dechow et al. 1994). 5. from Eq. RCF for each company is calculated as RCFit ¼ ðINCit  TAXit  INTEXPit  PSDIVit  CSDIVit Þ=TAi. 2003). otherwise IS is coded 0. SFCFB6 is the interaction of SFCF and B6. TAC/TA is made up of non-DAC (NDAC) that arise from the normal operations of the business. and equipment. Consistent with other studies. 1998). eit. TACit =TAi. NDAC) is used as the dependent variable in Eq.Thus. TA is the lagged total assets. The basic model. or 7 years as the point at which rotation should take place has also been advocated in various SEC or congressional reports (Davis et al. The model. The residual term (difference between TAC and the fitted value. DEBT. and AC is the absolute value of total accruals divided by lagged total assets (year t  1). while DAC are defined as the residual. SIZE is the log of market value of equity at fiscal year end. INC is the operating income before depreciation..t1 ¼ NDACit þ DACit ð3Þ NDAC are defined as the fitted values from Eq. The model is estimated cross-sectionally each year for each industry (based on two-digit SIC codes). Total accruals (TAC) is calculated as TAC=(Dcurrent assets  Dcash)  (Dcurrent liabilities  Dshort-term debt  Dtaxes payable)  depreciation. SFCFLT is the interaction of SFCF and LT. Geiger and Raghunandan (2002) found that the auditor tenure effect in their study tapered off after 5 years. LT is a dummy variable coded 1 if a firm has had the same auditor for 5 years or more. while DAC are choices made by a firm’s managers. RELCF. We proxy the existence of an SFCF agency problem by examining the RCF and growth prospects of a company. Myers et al. otherwise B6 is coded 0. We contend that high RCF in and of itself does not imply that it will be invested in wealth-decreasing projects. is TACit =TAi. see Eq. (2). 1. with company (i) and time (t) subscripts. INTEXP is the interest expense. TAX is the total taxes. plant. and this will . otherwise LT is coded 0. and this inhibits the use of positive discretionary accounting accruals. Growth is proxied by the price to book ratio (PB). Companies with high RCF and low-growth prospects are much more likely to make ‘unwise’ investments. 2003. IS is a dummy variable taking the value 1 if the sum of institutional shareholdings and blockholdings (ownership above 5%) is above the sample median for a year. SFCF is a dummy variable set equal to 1 if retained cash flow (RCF. and AC are added as control variables in Eq. Previous studies have documented a negative and significant coefficient for DEBT in regressions explaining DAC (Becker et al. 1992. 1. We hypothesize that these factors will have an effect on DAC and that they will modify the SFCF – DAC relationship. The use of 4.t1 ¼ a0 ð1=TAi. DAC is assumed to be the outcome of managers’ opportunistic choices of accounting methods.

The differences in DAC across the two groups of ownership level are not statistically significant.455 0 3. Companies with high SFCF tend to use income-increasing DAC to boost reported earnings. Summary statistics for the sample are reported in Table 1. This database has observations beginning in 1988. and the cash flow to total assets for the sample companies is slightly below their industry averages. 3. About 48% of companies have been audited by the same auditor for 5 years or more.500  0.1978. (2003).892 0.515 0. we require there to be at least 20 companies per two-digit industry code. Nineteen percent of observations are classified as having potential SFCF agency problems. although we find that the significance of the mean difference is marginal. Companies with high cash flows (and hence high profits) may adopt income-decreasing DAC so as to smooth earnings.. however.189 0.9% (mean) and 7% (median). Approximately 57% of the sample companies have substantial ( > 5%) institutional shareholders. Big 6 auditors appear to constrain managers’ discretion in choosing income-increasing DAC. The institutional shareholder data are obtained from the COMPACT D/ SEC Disclosure database. The Big 6 audit 82% of the sample companies.576 company year observations for 1984 –1996 and 11.ARTICLE IN PRESS R.. the SFCF finding is consistent across observations with Big 6 and non-Big 6 auditors. audit tenure. Univariate results Table 2 shows the test results for differences in DAC across subsamples formed on the basis of SFCF. The final sample size is 22. As we need 5 years of data to construct our tenure variable (LT). Note.457  0.547 1 5 ables indicate that most companies are audited by highquality firms and are monitored by institutional investors. 1988.7%. auditor. Winsorization reduces the impact of outlier observations on the results.328 6. The evidence suggests that high SFCF leads to high DAC. Chung et al.055  0.385 0.391 0. Panel C shows that firms with longer audit tenures have lower DAC. Results 3.003 0.596 0. We winsorize observations that fall in the top 1% and bottom 1% for each variable. 1980 to 1996.D. / Journal of Business Research xx (2004) xxx–xxx reduce positive accruals.2. The mean and median DACs are close to zero. This finding is inconsistent with the results of Rajgopal et al. The Big 6 finding is consistent across observations with low and high free cash flow..070 0  0.100 0.1.387 1 1 1 0. Big-6-audited firms have lower DAC (significant at the . Panel F reports .570 0. 2003. for a discussion of procedures to identify and adjust for outliers). 1998).310 0. Panel B reports DAC across Big 6 and non-Big 6 partitions. High institutional share ownership does not appear to constrain managers’ accounting choices.01 level for the Wilcoxon Z test). (2002). Consistent with our expectations.944 0. Debt to total assets averages 45. The differences are significant at the . This finding is consistent with our hypothesis. The Big 6 and IS vari- Table 1 Descriptive statistics for variables Variable DAC SFCF B6 IS DEBT RELCF SIZE AC LT 22576 22576 22576 11686 22576 22576 22576 22576 22576 Mean S.888 0. To operationalize the Jones (1991) model. Median Minimum Maximum  0. see Barnett and Lewis. Observations with high SFCF have higher DAC. Variables that fall in the top 1% and bottom 1% are recoded to the nearest permitted value (the value just below the top 1% and the value just above the bottom 1%.113 0.005 0 1 0. 1998. In panel A.686 company year observations for 1988 – 1996 (that have the relevant institutional shareholding data).. Absolute total accruals to total assets average 9.188 1. average (mean and median) DAC are reported for observations with high and low SFCF. per year.819 0.213 0. The magnitudes of the correlations between the independent variables is small enough that multicollinearity is not a major problem in interpreting the regression coefficients (Judge et al. 2. and a Big 6 auditor leads to low DAC.313 0 0 0 0. Company year observations with negative book values and missing values are excluded.05 level using the one-tail t test and at the . Francis et al. and the mean difference is highly significant.816 0.653 0. Becker et al.01 level (t test for means) and the .10 level (one-tail Wilcoxon Z test for distributions). Likewise.032 3.483 0. This evidence is consistent with studies that examined Big 6 and accounting accruals in other contexts (Becker et al. 868). that the lowest DAC occurs in the low SFCF/Big 6 quadrant. Data The sample is drawn from all companies included in the 1998 COMPUSTAT PC-Plus Active and Research files during the 17-year period. The division of the sample into high and low institutional shareholdings appears to have no impact on DAC (Panel D).. Previous studies have also documented a positive coefficient for SIZE and a negative coefficient for AC (Becker et al.528 0. and institutional share ownership.099 0. p. The results are directionally consistent with Myers et al. (1998) report that cash flow had a negative relationship to DAC. 1999). Panel E shows a four-way partitioning of DAC on the basis of SFCF and B6. Kim et al.001 0 0. We measure the cash flow of a company relative to its industry median. our test results are from 1984 to 1996.

94 (  2.002 (  0.001 (  0. / Journal of Business Research xx (2004) xxx–xxx the four-way partitioning of DAC based on SFCF and audit tenure.31) t (Z) Statistics refer to t test (nonparametric Wilcoxon median test) for differences in means (distribution). and short-term and longterm audit tenure subsamples SFCF = 0 SFCF = 1 Mean DAC (median) N Mean DAC (median) N t (Z) Short term Long term t (Z) 0.005) 2321  2. but they are especially influential when clients have SFCF. although not all the LT coefficients are significant.2.68) with a long auditor association have lower DAC.004 (  0.003 (  0. Chung et al. and low (IS = 0) and high (IS = 1) institutional ownership subsamples SFCF = 0 Mean DAC (median) N IS = 0 IS = 1 t (Z)  0.003 (  0.004) 4256  3.003 (  0. (B) Big 6 and non-Big 6 subsamples Mean DAC (median) N Non-Big 6 Big 6 t (Z) 0.25 (  1.68) 4. B6.006) 10913 5. although we make no prediction on the sign.32) 3.004 (  0.000 (  0.006) 8592  0.005) 4573  0. A consistent finding across all the columns is that SFCF is positively and significantly related to DAC.40 (  1.03 (  0. Multivariate results The regression results for various specifications of Eq. the increase in reported profits may reduce the pressure on management such that they can more easily engage in non-value-maximizing expenditures.67) (D) Low (IS = 0) and high (IS = 1) institutional ownership subsamples Mean DAC (median) N IS = 0 IS = 1 t (Z)  0.000) 4089  0.29 (  1.88) (G) Low (SFCF = 0) and high (SFCF = 1) SFCF. has a negative sign in all model specifications and is statistically significant in most of them. The length of audit tenure (LT) is also a variable of interest. Thus. Big 6 auditors act to reduce DAC in general. B.89 (3.001 (  0. This suggests that a Big 6 auditor forces or coerces client companies to reduce income-increasing DAC.004 (  0.008 (  0. IS remains nonsignificant. Columns A through E use the full sample data from 1984 to 1996.57 (3.36) Mean DAC (median) N t (Z) IS = 0 IS = 1 t (Z) 0. G.64) 1.62)  0.001) 3407 0. The smallest DAC occurs in the low SFCF/long tenure quadrant.002) 1207  2. The regression result is opposite to the univariate .27) 3.006) 18487 1.16 (1. 1998.. The evidence is consistent with the univariate results reported in Table 2 as well as in prior research (Becker et al.36 (1.002 (  0. The major variables of interest are SFCF. and SFCFIS.41) (E) Low (SFCF = 0) and high (SFCF = 1) SFCF and Big 6 and non-Big 6 subsamples SFCF = 0 SFCF = 1 Mean DAC (median) N Mean DAC (median) N t (Z) Non-Big 6 Big 6 t (Z)  0.001) 1935  3. a period for which we have data on institutional shareholders.60) 2. Here. and low (IS = 0) and high (IS = 1) institutional ownership subsamples SFCF = 1 (A) Low (SFCF = 0) and high (SFCF = 1) SFCF subsamples Mean DAC (median) N SFCF = 0 SFCF = 1 t (Z)  0.003 (  0. The findings from the four-way partitioning used in Panels D and E corroborate the findings in Panels A.62 (  0.. Kim et al.13) 0.005) 5906  0.006) 3574  2.004) 11663  0.84 (  0.007 (  0.003) 1192  2. This result is consistent with our hypothesis (H1). (1) are shown in Table 3.10 (2. SFCFB6. We report t statistics using the Newey and West (1987) procedure to avoid problems of residual autocorrelation.005 (  0.02)  0. High SFCF is associated with high DAC. Panel G examines the four-way partitioning of the sample data on the basis of SFCF and IS. IS.47 (  0. B6. The interaction term. Companies with a longer term auditor relationship have higher DAC.013 (0.34) (F) Low (SFCF = 0) and high (SFCF = 1) SFCF.005) 9728 0.006) 4714  0. and H use data from 1988 to 1996. and C. The evidence is consistent with the prediction from H2.83 (  1.005) 682  2. and firms Table 2 Univariate test differences in DAC between subsamples Table 2 (continued) (G) Low (SFCF = 0) and high (SFCF = 1) SFCF.44 (0.005) 5780 0.57 (1. The auditor variable. (C) Short-term and long-term tenure subsamples Mean DAC (median) N Short term Long term t (Z) 0.009 (  0.ARTICLE IN PRESS 6 R.002 (  0.006) 18320 0.001 (0.003 (  0.23) 0.007) 14913 0. while Columns F. 2003). The evidence is consistent with Panels A and C. has negative and significant coefficients. SFCF is a significant factor in explaining DAC across low and high institutional shareholding groups. Companies with high SFCF use income-increasing DAC. SFCFB6.

019 (13.58)  0.028 (12.79)  0.000 (  0.044 (10.033 (  13.002 (1.18)  0.015 (  5.16) 0. In both columns.64) 0.035 (  13.008 (0.085 (  24.316 (  30.83) 0.52) 0. 1994).42)  0. / Journal of Business Research xx (2004) xxx–xxx 7 Table 3 Regression estimates (t statistics) on DAC model Variable Predicted sign A B C D E F G H Intercept (?) SFCF (+)  0.015 (28.008 (0.20)  0.008 (0.98) 0.013 (  0.35)  0. 1995).14) 0. The control variables. that Becker et al.86) 0.008 (0. whereas we use ‘excess’ cash flow divided by lagged total assets (where the industry median cash flow divided by lagged total assets are deducted from the company’s cash flow). These results are consistent with prior research (Becker et al.014 (29. (1998) use cash flow of the company. is negative and significant at the . (1998). SFCFIS.307 (  44.012 (15.30)  0.008 (0.83) B6  0.03)  0. Chung et al.01 level.013 (  0.238  0.012 (  3.242  0.240  0.021 (  4.89) 0.004 (1.015 (29. in contrast.001 (0.83)  0.241  0. 1998.085 (  24. These companies .015 (  4.27) SFCFIS () DEBT () RELCF () SIZE (+) AC () 0. have the anticipated negative signs. DEBT and RELCF. 1994.032 (  11. In Columns G and H.92)  0.019 (  4..06) 0.240 N Adjusted r-square  0.30)  0. institutional shareholding (IS) is nonsignificant while the interaction term. This is defined as the ratio of the market value of assets to the replacement cost of assets.86) 0. The results show that the institutional shareholder variable is not significant.64) 22576 . The evidence is consistent with Davis et al. institutional shareholders do not constrain the use of positive DAC.003 (1. we carry out two additional analyses.00) 0. 3. DeAngelo et al. However.017 (  2. The first disaggregates the results on the basis of the company’s performance.ARTICLE IN PRESS R. G.009 (  4.016 (  5.37) 0. when there is no free cash flow agency problem.68) 22576 . The evidence in Columns G and H is consistent with H3.63) 11686 .74) LT (?) 0. (2003).37) 0.076 (  16.076 (  16.64)  0.34) ()  0.241  0.68) 22576 .22)  0.23)  0.44) 0.3.242  0.317 (  30. Robustness checks To examine the robustness of our results.037 (9.237 t Statistics are estimated based on the Newey – West adjustment for heteroskedasticity..63) SFCFB6 () SFCFLT (?)  0.34)  0.27)  0.004 (  1.22)  0. long-tenure auditors become much more vigilant in constraining managers’ use of income-increasing DAC. results reported in Table 2. Note. The signs and magnitudes of the coefficients on LT and SFCFLT suggest that long-tenure auditors have a net negative impact on DAC when clients have high SFCFs.31)  0.085 (  24.047 (8. and the second extension examines yearly regression results.019 (13.318 (  30. who report a negative and statistically significant coefficient on their measure of accruals.02) 0.79)  0. we incorporate an additional variable reflecting the interaction of SFCF and institutional shareholdings (SFCFIS).011 (15.077 (  16.77) 0.20)  0. Finally.74) 0.004 (2.307 (  45. (2002).19)  0.308 (  44.012 (15. Companies with Q < 1 are said to be performing poorly as the market value is less than the replacement cost of assets. One interpretation of these results is that long-term auditors are less vigilant in constraining managers’ use of income-increasing DAC because they are more complacent.023 (  6.84)  0.36)  0.029 (  10.014 (29. Columns F. Dechow et al.83) 0. The coefficient on SIZE is positive and significant.033 (  11.015 (29.005 (  2.69) 11686 .32) IS () 0.004 (2. and so our results differ from those of Rajgopal et al.025 (9.024 (  6.77) 0.26) 0.011 (  0.91)  0.307 (  44.085 (  24. however.88)  0. AC is not significantly associated with DAC. this result contrasts with Becker et al.56) 0. and H use sample data for 1988 to 1996 and include a variable reflecting institutional shareholdings.005 (  2.085 (  24.50)  0.. and the coefficients are significant at the .018 (10.90) 0.56)  0. Our interpretation of this result is that institutional shareholders act to deter positive DAC when SFCF is high. when clients have high SFCF.71) 11686 .26)  0. A common measure of company performance is Tobin’s Q (Chung and Pruitt.308 (  45.01 level.69) 22576 .022 (  6.15) 0.95) 0.67) 22576 .014 (  4.31) 0.

006 0.086  0.003 0.012 0.012  0.009 0.193 (  23.047  0.530 (  51.076  0.030  0.006 0.024 0.066  0.101  0.095 0.40  0.046  0.393  0.385  0.001  0.003  0.019  0.047  0.108  0.000  0.177 t Statistics are estimated based on the Newey – West adjustment for heteroskedasticity.011 0.016 (  0.98) (2.015  0.019  0.056  0.015 0.031 0.058 0.015  0.252 0.017 0.400  0.026  0.396  0.020  0.058 0.019 0.023  0.016 0.79) (  6.023  0.15) (  9.03 IS ()  0.012  0.007 0.004 0.012 0.93)  0.088  17.009  0.050 0.085  13.409  0.028 0.020 (  7.038 0.030 0.003 0.98)  0.055  0.447  0.030  0.005 0.013 0.36  0.108  0.096  0.381  0.238  0.89) (  3.016 0.202 (  16.006  0.097  0.056 0.002 0.006  1.007  0.016  3.002 0.031  0. / Journal of Business Research xx (2004) xxx–xxx Table 4 Regression estimates (t statistics) on DAC for Q < 1 and Q>1 subsamples Variable Predicted sign Intercept SFCF B6 LT SFCFB6 SFCFLT IS SFCFIS DEBT RELCF SIZE AC N Adjusted r-square (?) (+) () (?) () (?) () () () () (+) () Q<1 Q>1 A Q<1 B  0.019 0.009  0.483  0.005 0.57) (  1.263  0.04  0.001 0.001  0.004  0.024 0.003  0.008  0.005 0.156 (  12.040 (2.096  0.016 0.145 (5.078 0.87) 0.68 SFCFIS DEBT RELCF () ()  0.181 0.099  0.065  0.006  0.006  0.059  0.014 0.005 0.15) (  0.279  0.007 0.053  0.009  0.299  0.97) (  0.009  0.014  0.011 0.007 0.012  0.004 0.314  0.ARTICLE IN PRESS 8 R.53)  0.001  0.05 0.39 (B) Subsample with nonmissing IS variable Year Intercept SFCF B6 LT SFCFB6 SFCFLT (Predicted sign) 88 89 90 91 92 93 94 95 96 Average t (?) (+) () (?) () (?)  0. We therefore rerun Eq.014  0.54) 0.013  0.014  0.005  0.61  0.012  0.001  0.048 0.60) (  1.17) (  2.006 0.019  1.002  0.024  0.004  0.011  0.017 (19.046 8.077  0.120  0.98) (  1.001  0.189 (  2.055  0.018 0.075  0.004  0.099  0.115 (  18.005  0.031  0.094 0.002 0.89) 8795 .016  0.011 0.013  3.11)  0.071  0.015 (11.34)  0.333  0.46 0.006  0.144  0.55 SIZE AC () (+) ()  0.68  0.005 (  0.002 0.033 0.010 0.44 0.005 0.013 7.014  0.003 (0.014  1.408  0.015  4.085  0.002 (  0.010  0.12) (  4.008  4.083 0.035 (  5.068  0.001 0.100 (  11.086 0.035  0.007 0.010  0.08) 0.015 16.075  0.76  0.481  0.05 0.014 0.072  0.019 0.86) (6.007 0.008  0.012  0.424 Q>1 (  7.033  0.009 (16.003  0.005 0.357  12.047 0.002 0.053  0.013 0.012 0.088 0.104  0.022 0.012  0.009 (  1.01) D  0.003  0.027  3.004 0.011  0.70  0.163 (8.101  0.026  0.03) (4.009  0.007  0.209  0.007  0.82 0.007  0.017 0.015 0. may be more prone to using positive DAC in an attempt to increase their ratings.041 0.016 0.245  0.013 0.019  0.001  0.094  0.84) (0.085  0.033 0.53)  0.041 0.060  0.004  0.04) (13.010  0.45) (  0.011 0.176 7054 .021  0.041  0.52) 0.019 0.056  0.015  0.019 0.057 (  14.003 (  0.312  0.113  0.90) C  0.015 0.77  0.068 0.003  0.54)  0.111  0.005  0.002 0.002  0. may also have higher agency costs as the poor performance may reflect willful acts by the managers. as evidenced by low Q scores.49) (9.020  0.013  0.025  0.030 0.008 0.043 0.58 0.007  0.028  0.010  0.070 0.86)  0.024  0.013  3.398  0.015  0.87  0.004 0.057  0.008  0.037 6.49) 0.016  0.230  0.016 0.036  0. (1) but segregate observations into those where Q < 1 and those Table 5 Annual regression estimates (t statistics) on DAC model (A) Full sample Year Intercept SFCF B6 LT SFCFB6 SFCFLT DEBT RELCF SIZE AC (Predicted sign) (?) (+) () (?) () (?) () () (+) () 84 85 86 87 88 89 90 91 92 93 94 95 96 Average t 0.004 2.09) 13781 .010  0.001  0.043  0.010  0.03)  0.87) (  11.059 0.030 0.029  0.122  0.28) 4632 .016  0.76)  0.003  0.011  0.015 0.080  0.001 0.64) 0.69) 0.557 0.026 0.015  4.304  0.398  0.010  0. Companies with poor stock market performance.338  17.002  0.022  0.73 0.002 0.003  0.029 0.034 0.024  0.027  0.005 0.051 0.17 0.43) (  2.52)  0.44) (9.06) (  41.263  0.263  0.82 . Chung et al.006  0.

481 N Adjusted r-square  0. The results of partitioning on the basis of high Q and low Q are shown in Table 4. All variables are measured at the year’s end.64) 0.053 (7.062 (  5. DEBT.93) 0. monitoring by Big 6 auditors and institutional investors is much more acute when companies have low stock values as measured by the Q ratio.000 (0. plus book value of long-term debt.22)  0. We Table 6 Regression estimates (t statistics) on change in DAC (DDAC) model Variable Predicted sign A B C D E F G H Intercept (?) SFCF (+)  0.06) B6  0.004 (  1.006 (  1.059 (  3.36)  0.008 (  1.02) IS ()  0. Chung and Pruitt (1994) find that this relatively simple calculation compares very well with (gives very similar results to) the more complex procedures used by Lindenberg and Ross (1981).003 (1.225 (  19.008 (1.30) 0.14)  0. The interactions of Big 6 auditors and institutional shareholders with SFCF reduce DAC when companies have poor stock market ratings ( Q < 1).70) 10540 .224 (  19.001 (0.21)  0.43) ()  0. Big 6 firms and institutional investors are more vigilant when a company’s SFCF is high and stock market valuation is low.85)  0.566 (  65.566 (  65. Thus. We also report the regression results estimated separately for each year.473 t Statistics are estimated based on the Newey – West adjustment for heteroskedasticity.63)  0.002 (  1.46) 0.73) 10540 . SFCF has significantly positive coefficients in all columns.003 (  1.006 (  3.481 .92)  0.004 (2. as follows: Qit ¼ ðMVEit þ PSit þ DEBTit Þ=TAit ð5Þ where MVE is the market value of common stock.72) 0.14) 0.566 (  65. In the annual regressions.003 (  1. The evidence from Table 4 confirms that high SFCFs are associated with positive DAC. when companies have poor stock market ratings.051 (10.580 (  45.002 (  0. / Journal of Business Research xx (2004) xxx–xxx where Q>1.30) 0.006 (1.  0.00)  0.33) 19743 .217 (  13.66) 0. When we partition by Q. We estimate Q.10) 0. RELCF. and TA denotes the total assets.89) 0. When companies 9 have poor stock market performance ( Q < 1). SFCF has a much stronger influence on income-increasing DAC.051 (10.005 (0.217 (  13.004 (  0.66) 0.003 (  2.062 (  5.062 (  5.62)  0.062 (  5.50) SFCFIS () DDEBT () DRELCF () DSIZE (+) DAC ()  0. SFCFB6.20)  0.218 (  13.51)  0.059 (  3.51) SFCFB6 () SFCFLT (?)  0.473  0.60) LT (?)  0. PS is the liquidating value of preferred stock.10)  0.22)  0.000 (  0. This reduces the potential effect of any serial correlation in the regression error terms.32) 19743 .05 level.10) 0. Long audit tenure is associated with higher DAC when Q < 1.ARTICLE IN PRESS R. although this is cancelled out if SFCF is high. Thus. the presence of a Big 6 auditor reduces the magnitude of the association between SFCF and DAC.005 (1.02)  0. an individual company appears just once.003 (  1.91)  0.004 (  1. SFCFIS is significant in Column C and has the expected negative sign. The Big 6 variable has the expected negative sign in all the partitions.57)  0.001 (  0.006 (  0.007 (  1.34) 0. but these auditors become more vigilant when SFCF is high.96) 0.82) 0.473  0.051 (10.68)  0. is especially strong when Q < 1.580 (  45. When Q < 1.580 (  45.34) 19743 .67) 0.566 (  65.88)  0.225 (  19.224 (  19.36)  0.008 (2. companies with long-term associations with their auditors have higher DAC.60) 0.004 (  0.61)  0.566 (  65. and so DAC is reduced.062 (  5.16)  0.23)  0. This approach to computing Q follows Chung and Pruitt (1994). AC becomes highly significant but with negative signs when Q < 1 and positive signs when Q>1.13)  0.003 (2.67) 0.473  0. but only one of the coefficients is significant at the .003 (  1.89)  0.91) 0.002 (  0. with company (i) and time (t) subscripts.85)  0. one-tail test (this occurs when Q < 1).007 (0.34) 19743 .002 (0. The interaction term.70) 10540 .053 (7. and SIZE are significant in all columns.007 (1. In summary.001 (0.88)  0.473  0. Chung et al.17)  0.225 (  19.005 (  3.91)  0. and so the evidence is similar to that in Table 3.005 (  1.45) 0.97) 0. The magnitudes of the coefficients are much higher when Q < 1.053 (7.98)  0. DEBT is the value of a company’s short-term liabilities net of its short-term assets.20)  0.051 (10.33) 19743 .43) 0.059 (  3.99)  0.481  0.051 (10.

Companies with a long-term auditor relationship have higher DAC. 15:1 – 24. when SFCF is high. Pruitt SW. are statistically significant and have the expected signs. Firth M. Auditor conservatism and reported earnings. 2003. 1998. Account Bus Res 2003. Panel B of Table 5 reports the annual regression results using data from 1988 to 1996. The results show SFCF to be highly significant as is the case with all the previous analyses. References Arrunada B. This behavior is especially strong when SFCF is high. A growing body of research has examined managers’ motives for using DAC and has used these motives to predict earnings. Big 6 auditors constrain management from making incomeincreasing DAC. 4. Detecting earnings management. acting as agents for stockholders.8:29 – 48. this sample incorporates a variable reflecting institutional shareholdings. Boston College. The effect of audit quality on earnings management.33:19 – 32. Sweeney A. Becker CL. 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Accounting choice in troubled companies. Firth M. Hwang L. Auditor conservatism and fourth quarter earnings. This result again suggests that institutional shareholders effectively constrain the management’s use of income-increasing DAC when SFCF is high. J Corp Finance 2002. Acknowledgements We are very grateful to the editors and reviewers whose helpful and insightful comments and suggestions greatly improved the paper. SFCF. Skinner DJ.70:193 – 225. and size are also significantly related to discretionary accounting accruals. Due to their conservatism and their desire to avoid litigation. and SFCFB6. LT. New York: Wiley. SFCFLT is positive and significant in Columns D and E. Davis LR. although there are two factors at work. . Big 6 auditors moderate the SFCF – DAC relationship. but there is considerable disagreement as to the sign of the association. Basu S. Baruch College. Our findings add to the expanding literature that addresses discretionary accounting choice. However. The Big 6 (B6) and Big 6 interaction term (SFCFB6) and the tenure interaction term (SFCFLT) have negative coefficients and are significant at the . SFCF has positive signs in seven specifications of the model. Soo B. thus suggesting that more leeway is given by the auditors. We extend this line of research by investigating the relationship between SFCF and DAC and the moderating effect of monitoring variables on the SFCF –DAC relationship. Our empirical results using data from 1984 to 1996 confirm our hypothesis of a positive relationship between SFCF and DAC. 1978. Financ Manage 1994. while the interaction term (SFCFIS) is significant at the . J Account Econ 1981. J Account Econ 1994. Summary Discretionary accounting accruals provide mechanisms for managers to adjust earnings towards some preferred level. These results can be used to support auditor rotation (the LT results) or to support long tenure (the SFCFLT results). B6. although significance levels vary. Paz-Ares C. relative cash flows. auditor independence and earnings management.17:31 – 61. The results corroborate the evidence from Table 3. Chung R. SFCF represents non-wealth-maximizing expenditures and thus signals a significant agency cost to shareholders.) The results are shown in Table 6. This paper has also benefited from comments made by workshop participants at the Hong Kong Polytechnic University. However. Outliers in statistical data. This paper argues that companies with high SFCF use income-increasing DAC to camouflage the earnings impact of non-value-maximizing investments and other expenditures. The variables LT and SFCFLT are also significant and have the same signs as in Table 3. (We thank a reviewer for suggesting this analysis. The monitoring variables. Management uses DAC to camouflage the poor returns from the negative NPV expenditures funded from RCF. Jan C-L.23:70 – 4. 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Panel A. and the interaction terms are generally not significant in the analyses. Debt. IS.

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