ARTICLE IN PRESS

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

Abstract
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: afmaf@inet.polyu.edu.hk (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.
doi:10.1016/j.jbusres.2003.12.002
JBR-05976; No of Pages 11

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R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

et al., 1998; Francis et al., 1999) and for companies with

high institutional shareholdings (Rajgopal et al., 2002), it has
paid little attention to examining how the incentive effect on
DAC interacts with the monitoring effect.
Using a large sample of 22,576 company year observations over the period 1984 1996, we find that companies
with high SFCF use income-increasing DAC to boost
reported earnings. 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. Our results
also show that Big 6 auditors are associated with less
positive accruals, and this is especially so when SFCF is
high. This result suggests that Big 6 auditors inhibit
companies with high SFCF from using income-increasing
accruals. The results for auditor tenure are somewhat
ambiguous. Long tenure is associated with higher accruals
except when SFCF is high, in which case the accruals are
lower. Financial institutions with high investment stakes in
a company also appear to restrain management from using
positive accruals if SFCF is high. In contrast, when surplus
free cash is low, institutional investors do not constrain
DAC. Our results indicate that when SFCF is high, quality
auditors and institutional shareholders monitor management
actions and deter aggressive income-increasing earnings
management.
The next section sets up our hypotheses on the DAC
and SFCF relationship. Section 2 describes the data sources
and research method, while Section 3 presents and discusses the results. Finally, Section 4 summarizes our
findings.

1. 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. Firms with low-growth opportunities are
more likely to invest free cash flow in unprofitable projects. In the absence of effective monitoring or disciplinary
actions by outside stakeholders and their agents, some
managers may choose to invest in marginal or negative
NPV projects and activities. These projects and activities
may be self-gratifying to the managers and may bring them
pecuniary benefits or other personal rewards. In many
cases, these managers may believe the investments will at
least break even for investors, 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.
Identifying the agency cost of free cash flow (investments in negative NPV projects) is very difficult. Managers
do not disclose to investors an investments cash flow
projections and the assumptions behind them. Appealing
to commercial secrecy provides a cloak for bad investment
decisions. Managers may not even internally project cash

flows for some investments; the biases managers have for

some pet activities or personal perquisites may make them
ignore cash and profit planning. Poor investments, however,
will reveal themselves in the future profits of the company.
Non-value-maximizing investments eventually reduce earnings. This will result in lower stock prices and may trigger
shareholder actions to remove directors and senior executives. To camouflage the impact of negative or marginal
NPV investments on earnings, managers may employ accounting procedures that increase reported income. 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). Our first and primary
hypothesis is
H1: Companies with high SFCF are more likely to choose
income-increasing DAC than otherwise.
We hypothesize that auditors and institutional shareholders will reduce the SFCF DAC relation. An important role
of the external independent auditor is to attest to the financial
statements of client companies. This verification gives assurance to shareholders, potential investors, and creditors
that the income statement and balance sheet accurately or
conservatively reflect the state of the clients activities and
net assets. 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, 1983). The auditor examines the
accounting procedures used by clients to see if they are
appropriate. If the procedures are considered inappropriate,
then the auditor will try to persuade the client to revise the
financial statements, and if they do not do so, the audit report
can be qualified. Krishnan and Krishnan (1997) and Francis
and Krishnan (1999), among others, 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. Past evidence
suggests that auditors tend to be conservative (Basu et al.,
1998; Chung et al., 2003), and so they may not agree with
aggressive income-increasing DAC. We therefore argue that
auditors will restrain managers abilities to choose incomeincreasing DAC for companies with high SFCF.
It is now widely accepted that there are quality differences
among audit firms (DeAngelo, 1981; Simunic and Stein,
1987; Francis et al., 1999). High-quality auditors are more
likely to restrict income-increasing DAC (Becker et al.,
1998; Kim et al., 2003; Francis et al., 1999). This argument
is predicated on high-quality auditors having a lot of reputation at stake. High-quality auditors want to avoid shareholder litigation and the bad publicity associated with a client
company that aggressively uses inappropriate positive DAC.
Identifying high-quality audits is problematic. Traditionally,
Big 6 firms have been used as a proxy for high-quality
auditors (DeAngelo, 1981; Becker et al., 1998). Big 6

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auditors have a substantial market share of listed company

clients in the United States as well as in many other
countries. They also have very large consultancy, computer,
and tax departments that use the same brand name as the
audit firm. To protect their hard-won reputations, the Big 6
auditors deploy significant resources to auditing (recruitment, training, and systems), and they have the independence to insist that clients make necessary changes to their
financial statements or else they will issue qualified audit
reports. We argue that our proxy for audit quality, the Big 6
auditors, will restrict the income-increasing DAC of clients
when compared to non-Big 6 auditors. St. 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. In contrast, there is little or no
evidence of auditors being sued if reported profits are less
than the true earnings. Because Big 6 auditors stand to lose
more from litigation than non-Big-6 auditors, they will be
more conservative and will restrain clients from using
positive DAC (Francis et al., 1999). St. 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). We hypothesize that a Big 6
auditor will be even more cautious when a client companys
agency costs are high. Thus, when SFCF is high, Big 6
auditors will restrict the use of DAC more than when SFCF
is low. This leads to our second hypothesis:
H2: Big 6 auditors moderate the SFCF DAC relationship.
Recently, research has looked beyond the traditional
dichotomy of Big 6 and non-Big 6 as a proxy for audit
quality. One particular dimension of an auditor client
relationship is the length of audit tenure. There are arguments that a long tenure will dull an auditors independence
and make them more willing to accept managements
interpretations of accounting for business transactions
(Sainty et al., 2002; Davis et al., 2003). This view has led
to calls for mandatory auditor rotation in the United States.
(Mandatory rotation is required in some European
countriesArrunada and Paz-Ares, 1997.) In contrast, 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, 2002). In this circumstance, managers may
find it easier to indulge in earnings management. A number
of empirical studies, using a variety of approaches, have
examined the relationship between audit quality and audit
tenure. 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., 2002;
Geiger and Raghunandan, 2002; Myers et al., 2003; Johnson
et al., 2002). However, Davis et al. (2003) reach an opposite
conclusion. They find that long tenure is associated with
increased earnings management.

In light of the conflicting arguments and the somewhat

mixed empirical evidence discussed above, we include audit
tenure as a main effect and as an interaction term in our
regression models. In particular, short auditor client tenure
(less than 5 years) is differentiated from long auditor client
tenure (5 years or more). Because of the conflicting arguments on the impact of audit firm tenure on independence
and audit quality, we do not specify directional signs on the
tenure variables.
Institutional shareholders have the expertise to analyze
company performance. If the institutions own a large
percentage of a companys shares, then they have the
incentive and motivation to monitor managements actions,
and they have the power to affect or change corporate
actions and decisions. When institutional investors have
substantial shareholdings, it becomes difficult for them to
sell shares immediately at the prevailing price. This lack of
liquidity means investment institutions have incentives to
closely monitor companies with high SFCFs. Other things
being equal, those companies that have substantial institutional shareholders become less able to engage in opportunistic earnings management. We hypothesize that the
monitoring activities of institutional shareholders will inhibit management from opportunistically using incomeincreasing DAC (Chung et al., 2002). One way of inhibiting
the actions of management is the threat of legal action
against managers taken by institutional investors. 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. We argue that institutional shareholders will more
closely monitor management and managements accounting
choices if there are high agency costs. Institutional shareholders will therefore impose more monitoring when free
cash flow is high. This leads to our third hypothesis:
H3: Large institutional shareholders moderate the SFCF
DAC relationship.
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. Francis et al., 1999,
conclude, however, that there is no systematic relationship
between management ownership and accounting accruals.
Based on this evidence, we do not incorporate a management ownership variable in the regression model.

2. Research method
2.1. Models
To test our hypothesis that companies with high levels
of SFCF will adopt income-increasing DAC, we estimate
cross-sectional regression models. These models include

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R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

two proxy measure for high-quality auditors and a

measure for institutional shareholders. We hypothesize
that these factors will have an effect on DAC and that
they will modify the SFCF DAC relationship. The basic
model, with company (i) and time (t) subscripts, is:
DACit b0 b1 SFCFit b2 B6it b3 LTit
b4 SFCF  B6it b5 SFCF  LTit b6 ISit
b7 SFCF  ISit b8 DEBTit b9 RELCFit
b10 SIZEit b11 ACit

where DAC is the discretionary accounting accruals

derived from the modified Jones (1991) model (see Eq.
2); SFCF is a dummy variable set equal to 1 if retained
cash flow (RCF, see Eq. 4) is above the sample median
for the year and the price-to-book ratio (PB) is below the
sample median for the year, otherwise SFCF is coded 0;
B6 is a dummy variable coded 1 if the auditor is a
member of the Big 6, otherwise B6 is coded 0; LT is a
dummy variable coded 1 if a firm has had the same
auditor for 5 years or more, otherwise LT is coded 0;
SFCFB6 is the interaction of SFCF and B6; SFCFLT is
the interaction of SFCF and LT; 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, otherwise IS is coded 0;
SFCFIS is the interaction of SFCF and IS; 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; SIZE is the log of
market value of equity at fiscal year end; and AC is the
absolute value of total accruals divided by lagged total
assets (year t  1).
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. (2002). Geiger and Raghunandan (2002)
found that the auditor tenure effect in their study tapered off
after 5 years. The use of 4, 5, 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., 2003; Myers et
al., 2003).
DAC are estimated cross-sectionally for each year and
for each industry using the modified Jones (1991) model
(Dechow et al., 1995). The model, with company (i) and
time (t) subscripts, is
TACit =TAi;t1 a0 1=TAi;t1
a1 DREVit  DARit =TAi;t1 
a2 PPEit =TAi;t1 eit

where TAC/TA is the total accruals divided by lagged total

assets. Total accruals (TAC) is calculated as TAC=(Dcurrent

assets  Dcash)  (Dcurrent liabilities  Dshort-term debt  Dtaxes payable)  depreciation. D denotes change from
year t  1 to year t; TA is the lagged total assets; #REV is
the change in sales revenues; DAR is the change in accounts
receivables; PPE denotes property, plant, and equipment;
and e denotes unspecified random factors.
The model is estimated cross-sectionally each year for
each industry (based on two-digit SIC codes). TAC/TA is
made up of non-DAC (NDAC) that arise from the normal
operations of the business, while DAC are choices made by
a firms managers.Thus,
TACit =TAi;t1 NDACit DACit

NDAC are defined as the fitted values from Eq. (2),

while DAC are defined as the residual, eit, from Eq. (2). The
residual term (difference between TAC and the fitted value,
NDAC) is used as the dependent variable in Eq. 1.
Consistent with other studies, DAC is assumed to be the
outcome of managers opportunistic choices of accounting
methods.
We proxy the existence of an SFCF agency problem by
examining the RCF and growth prospects of a company.
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. We contend
that high RCF in and of itself does not imply that it will be
invested in wealth-decreasing projects. Companies with
high RCF and low-growth prospects are much more likely
to make unwise investments. RCF for each company is
calculated as
RCFit INCit  TAXit  INTEXPit  PSDIVit
 CSDIVit =TAi;t1

where RCF is the retained cash flow; INC is the operating

income before depreciation; TAX is the total taxes; INTEXP
is the interest expense; PSDIV is the preferred stock
dividends; CSDIV is the common stock dividends; and
TA is the total assets at the beginning of the fiscal year.
Growth is proxied by the price to book ratio (PB). High
PBs indicate that the stock market is expecting high growth
(Holthausen and Larcker, 1992; Skinner, 1993). Companies
with above-median RCF and below-median PB are our proxy
for firms with potential free cash flow agency problems.
DEBT, RELCF, SIZE, and AC are added as control
variables in Eq. 1. Previous studies have documented a
negative and significant coefficient for DEBT in regressions explaining DAC (Becker et al., 1998). One reason
for this relationship is that companies with high debt levels
face increased monitoring by bankers and creditors, and
this inhibits the use of positive discretionary accounting
accruals. For very high levels of debt, companies may
wish to increase write-offs to the income statement (the socalled Big BathDeAngelo et al., 1994), and this will

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reduce positive accruals. Becker et al. (1998) report that

cash flow had a negative relationship to DAC. Companies
with high cash flows (and hence high profits) may adopt
income-decreasing DAC so as to smooth earnings. We
measure the cash flow of a company relative to its industry
median. Previous studies have also documented a positive
coefficient for SIZE and a negative coefficient for AC
(Becker et al., 1998).
2.2. Data
The sample is drawn from all companies included in
the 1998 COMPUSTAT PC-Plus Active and Research
files during the 17-year period, 1980 to 1996. As we
need 5 years of data to construct our tenure variable (LT),
our test results are from 1984 to 1996. The institutional
shareholder data are obtained from the COMPACT D/
SEC Disclosure database. This database has observations
beginning in 1988. Company year observations with
negative book values and missing values are excluded.
We winsorize observations that fall in the top 1% and
bottom 1% for each variable. Winsorization reduces the
impact of outlier observations on the results. 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%; see Barnett and
Lewis,1978, for a discussion of procedures to identify
and adjust for outliers). To operationalize the Jones
(1991) model, we require there to be at least 20 companies per two-digit industry code, per year. The final
sample size is 22,576 company year observations for
1984 1996 and 11,686 company year observations for
1988 1996 (that have the relevant institutional shareholding data).
Summary statistics for the sample are reported in Table
1. The mean and median DACs are close to zero. Nineteen
percent of observations are classified as having potential
SFCF agency problems. The Big 6 audit 82% of the
sample companies. About 48% of companies have been
audited by the same auditor for 5 years or more. Approximately 57% of the sample companies have substantial
( > 5%) institutional shareholders. 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.D.

Median

Minimum

Maximum

 0.003
0.189
0.819
0.570
0.457
 0.032
3.816
0.099
0.483

0.113
0.391
0.385
0.310
0.213
0.188
1.528
0.100
0.500

 0.005
0
1
0.596
0.455
0
3.892
0.070
0

 0.313
0
0
0
0.055
 0.888
0.515
0.001
0

0.387
1
1
1
0.944
0.328
6.653
0.547
1

ables indicate that most companies are audited by highquality firms and are monitored by institutional investors.
Debt to total assets averages 45.7%, and the cash flow to
total assets for the sample companies is slightly below their
industry averages. Absolute total accruals to total assets
average 9.9% (mean) and 7% (median). 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., 1988,
p. 868).

3. Results
3.1. Univariate results
Table 2 shows the test results for differences in DAC
across subsamples formed on the basis of SFCF, auditor,
audit tenure, and institutional share ownership. In panel
A, average (mean and median) DAC are reported for
observations with high and low SFCF. Observations with
high SFCF have higher DAC. The differences are significant at the .01 level (t test for means) and the .10 level
(one-tail Wilcoxon Z test for distributions). This finding is
consistent with our hypothesis. Companies with high
SFCF tend to use income-increasing DAC to boost
reported earnings.
Panel B reports DAC across Big 6 and non-Big 6
partitions. Big-6-audited firms have lower DAC (significant at the .05 level using the one-tail t test and at the .01
level for the Wilcoxon Z test). Consistent with our expectations, Big 6 auditors appear to constrain managers
discretion in choosing income-increasing DAC. This evidence is consistent with studies that examined Big 6 and
accounting accruals in other contexts (Becker et al., 1998;
Kim et al., 2003; Francis et al., 1999), although we find
that the significance of the mean difference is marginal.
Panel C shows that firms with longer audit tenures have
lower DAC, and the mean difference is highly significant.
The results are directionally consistent with Myers et al.
(2003).
The division of the sample into high and low institutional
shareholdings appears to have no impact on DAC (Panel D).
The differences in DAC across the two groups of ownership
level are not statistically significant. High institutional share
ownership does not appear to constrain managers accounting choices. This finding is inconsistent with the results of
Rajgopal et al. (2002).
Panel E shows a four-way partitioning of DAC on the
basis of SFCF and B6. The evidence suggests that high
SFCF leads to high DAC, and a Big 6 auditor leads to low
DAC. The Big 6 finding is consistent across observations
with low and high free cash flow. Likewise, the SFCF
finding is consistent across observations with Big 6 and
non-Big 6 auditors. Note, however, that the lowest DAC
occurs in the low SFCF/Big 6 quadrant. Panel F reports

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R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

the four-way partitioning of DAC based on SFCF and

audit tenure. The evidence is consistent with Panels A and
C. High SFCF is associated with high DAC, and firms
Table 2
Univariate test differences in DAC between subsamples

Table 2 (continued)
(G) Low (SFCF = 0) and high (SFCF = 1) SFCF, 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)

 0.004
(  0.006)
18320

0.003
(  0.004)
4256

 3.83
(  1.36)

Mean DAC
(median)
N

t (Z)

IS = 0

IS = 1

t (Z)

0.003
(  0.003)
1192
 2.40
(  1.23)

0.003
(  0.002)
1207
 2.25
(  1.13)

0.03
(  0.31)

t (Z) Statistics refer to t test (nonparametric Wilcoxon median test) for

differences in means (distribution).

(B) Big 6 and non-Big 6 subsamples

Mean DAC
(median)
N

Non-Big 6

Big 6

t (Z)

0.001
(0.000)
4089

 0.003
(  0.006)
18487

1.89
(3.68)

with a long auditor association have lower DAC. The

smallest DAC occurs in the low SFCF/long tenure quadrant. Panel G examines the four-way partitioning of the
sample data on the basis of SFCF and IS. SFCF is a
significant factor in explaining DAC across low and high
institutional shareholding groups. IS remains nonsignificant. The findings from the four-way partitioning used in
Panels D and E corroborate the findings in Panels A, B,
and C.

(C) Short-term and long-term tenure subsamples

Mean DAC
(median)
N

Short term

Long term

t (Z)

0.001
(  0.004)
11663

 0.007
(  0.006)
10913

5.16
(1.67)

(D) Low (IS = 0) and high (IS = 1) institutional ownership subsamples

Mean DAC
(median)
N

IS = 0

IS = 1

t (Z)

 0.003
(  0.005)
5906

 0.002
(  0.005)
5780

0.44
(0.41)

(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)

 0.002
(  0.001)
3407
0.013
(0.005)
682
 2.94
(  2.02)

 0.004
(  0.007)
14913
0.001
(  0.006)
3574
 2.84
(  0.64)

1.10
(2.60)
2.57
(3.34)

(F) Low (SFCF = 0) and high (SFCF = 1) SFCF, 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)

0.000
(  0.005)
9728
0.009
(  0.001)
1935
 3.29
(  1.62)

 0.008
(  0.006)
8592
 0.002
(  0.005)
2321
 2.62
(  0.68)

4.36
(1.27)
3.57
(1.88)

(G) Low (SFCF = 0) and high (SFCF = 1) SFCF, and low (IS = 0) and high
(IS = 1) institutional ownership subsamples

SFCF = 0

Mean DAC
(median)
N

IS = 0

IS = 1

t (Z)

 0.005
(  0.006)
4714

 0.004
(  0.005)
4573

 0.47
(  0.32)

3.2. Multivariate results

The regression results for various specifications of Eq.
(1) are shown in Table 3. We report t statistics using the
Newey and West (1987) procedure to avoid problems of
residual autocorrelation. The major variables of interest are
SFCF, B6, SFCFB6, IS, and SFCFIS. The length of audit
tenure (LT) is also a variable of interest, although we make
no prediction on the sign. Columns A through E use the full
sample data from 1984 to 1996, while Columns F, G, and H
use data from 1988 to 1996, a period for which we have data
on institutional shareholders.
A consistent finding across all the columns is that SFCF
is positively and significantly related to DAC. This result is
consistent with our hypothesis (H1). Companies with high
SFCF use income-increasing DAC. Here, the increase in
reported profits may reduce the pressure on management
such that they can more easily engage in non-value-maximizing expenditures.
The auditor variable, B6, has a negative sign in all model
specifications and is statistically significant in most of them.
This suggests that a Big 6 auditor forces or coerces client
companies to reduce income-increasing DAC. The evidence
is consistent with the univariate results reported in Table 2
as well as in prior research (Becker et al., 1998; Kim et al.,
2003). The interaction term, SFCFB6, has negative and
significant coefficients. Thus, Big 6 auditors act to reduce
DAC in general, but they are especially influential when
clients have SFCF. The evidence is consistent with the
prediction from H2.
Companies with a longer term auditor relationship have
higher DAC, although not all the LT coefficients are significant. The regression result is opposite to the univariate

ARTICLE IN PRESS
R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

Table 3
Regression estimates (t statistics) on DAC model
Variable

Predicted
sign

Intercept

(?)

SFCF

(+)

 0.035
(  13.52)
0.028
(12.56)

 0.023
(  6.77)
0.025
(9.74)

LT

(?)

0.001
(0.64)

0.004
(2.63)

SFCFB6

()

SFCFLT

(?)

 0.033
(  11.56)
0.044
(10.36)
 0.005
(  2.37)
0.004
(2.50)
 0.019
(  4.58)
 0.015
(  5.30)

 0.022
(  6.44)
0.018
(10.34)

()

 0.032
(  11.31)
0.037
(9.30)
 0.005
(  2.26)

 0.033
(  13.15)
0.019
(13.83)

B6

 0.029
(  10.74)
0.019
(13.88)
 0.009
(  4.32)

IS

()

0.000
(  0.27)

SFCFIS

()

DEBT

()

RELCF

()

SIZE

(+)

AC

()

0.003
(1.22)
 0.014
(  4.03)
 0.076
(  16.18)
 0.317
(  30.86)
0.011
(15.79)
 0.013
(  0.69)
11686
.238

 0.024
(  6.00)
0.047
(8.27)
 0.004
(  1.37)
0.004
(1.79)
 0.017
(  2.92)
 0.015
(  4.16)
0.002
(1.19)
 0.012
(  3.42)
 0.077
(  16.22)
 0.318
(  30.89)
0.012
(15.83)
 0.011
(  0.63)
11686
.240

N
Adjusted
r-square

 0.021
(  4.91)
 0.016
(  5.64)

 0.085
(  24.34)
 0.307
(  44.95)
0.015
(29.83)
0.008
(0.67)
22576
.241

 0.085
(  24.35)
 0.307
(  45.02)
0.015
(29.77)
0.008
(0.64)
22576
.242

 0.085
(  24.23)
 0.307
(  44.86)
0.014
(29.26)
0.008
(0.68)
22576
.240

 0.085
(  24.20)
 0.308
(  44.98)
0.014
(29.14)
0.008
(0.69)
22576
.241

 0.085
(  24.31)
 0.308
(  45.06)
0.015
(28.90)
0.008
(0.68)
22576
.242

 0.076
(  16.20)
 0.316
(  30.83)
0.012
(15.84)
 0.013
(  0.71)
11686
.237

t Statistics are estimated based on the Newey West adjustment for heteroskedasticity.

results reported in Table 2. 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. The evidence is consistent with Davis et al.
(2003). However, when clients have high SFCF, long-tenure
auditors become much more vigilant in constraining managers use of income-increasing DAC. 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.
Columns F, G, and H use sample data for 1988 to 1996
and include a variable reflecting institutional shareholdings.
The results show that the institutional shareholder variable is
not significant, and so our results differ from those of
Rajgopal et al. (2002). In Columns G and H, we incorporate an additional variable reflecting the interaction of
SFCF and institutional shareholdings (SFCFIS). In both
columns, institutional shareholding (IS) is nonsignificant
while the interaction term, SFCFIS, is negative and
significant at the .01 level. Our interpretation of this
result is that institutional shareholders act to deter
positive DAC when SFCF is high; in contrast, when
there is no free cash flow agency problem, institutional
shareholders do not constrain the use of positive DAC.
The evidence in Columns G and H is consistent with
H3.

The control variables, DEBT and RELCF, have the

anticipated negative signs, and the coefficients are significant at the .01 level. These results are consistent with
prior research (Becker et al., 1998; DeAngelo et al.,
1994; Dechow et al., 1995). Note, however, that Becker
et al. (1998) use cash flow of the company, 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 companys cash flow).
The coefficient on SIZE is positive and significant.
Finally, AC is not significantly associated with DAC;
this result contrasts with Becker et al. (1998), who report
a negative and statistically significant coefficient on their
measure of accruals.
3.3. Robustness checks
To examine the robustness of our results, we carry out two
additional analyses. The first disaggregates the results on the
basis of the companys performance, and the second extension examines yearly regression results. A common measure
of company performance is Tobins Q (Chung and Pruitt,
1994). This is defined as the ratio of the market value of
assets to the replacement cost of assets. Companies with
Q < 1 are said to be performing poorly as the market value is
less than the replacement cost of assets. These companies

ARTICLE IN PRESS
8

R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

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

Q<1

 0.024
0.056
 0.005
0.012
 0.016
 0.020

(  7.04)
(13.60)
(  1.86)
(6.89)
(  3.79)
(  6.90)

 0.038
0.027
 0.004
 0.001
 0.007
 0.007

 0.057 (  14.52)
 0.530 (  51.87)
0.009 (16.03)
 0.156 (  12.09)
13781
.424

Q>1

(  7.98)
(2.15)
(  0.97)
(  0.45)
(  0.57)
(  1.01)

 0.012
0.055
 0.004
0.009
 0.012
 0.017
0.001
 0.010
 0.056
 0.557
0.007
 0.176
7054
.447

 0.115 (  18.76)
 0.193 (  23.08)
0.017 (19.52)
0.163 (8.89)
8795
.189

(  2.49)
(9.98)
(  1.03)
(4.17)
(  2.12)
(  4.84)
(0.43)
(  2.87)
(  11.06)
(  41.44)
(9.15)
(  9.34)

 0.035 (  5.64)
0.040 (2.53)
 0.003 (  0.69)
0.003 (0.86)
 0.016 (  0.93)
 0.009 (  1.11)
 0.002 (  0.54)
 0.005 (  0.53)
 0.100 (  11.98)
 0.202 (  16.49)
0.015 (11.54)
0.145 (5.28)
4632
.177

t Statistics are estimated based on the Newey West adjustment for heteroskedasticity.

may also have higher agency costs as the poor performance

may reflect willful acts by the managers. Companies with
poor stock market performance, as evidenced by low Q

scores, may be more prone to using positive DAC in an

attempt to increase their ratings. We therefore rerun Eq. (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

0.003
 0.034
0.004
 0.066
 0.043
 0.035
 0.004
0.019
 0.006
 0.033
 0.046
 0.055
 0.053
 0.027
 3.58

0.002
0.028
0.015
0.013
0.050
0.041
0.043
0.030
0.033
0.041
0.083
0.058
0.051
0.037
6.36

 0.011
 0.005
 0.023
 0.016
 0.010
 0.008
 0.012
 0.006
 0.008
 0.005
0.001
 0.001
 0.003
 0.008
 4.61

 0.007
0.005
0.004
0.005
0.012
 0.006
0.003
0.001
0.007
0.002
0.005
0.006
0.011
0.004
2.40

 0.003
 0.003
 0.002
0.012
 0.026
 0.026
 0.009
 0.030
 0.006
 0.010
 0.047
 0.036
 0.019
 0.016
 3.44

0.008
 0.024
 0.004
 0.014
 0.024
 0.002
 0.022
0.010
 0.022
 0.014
 0.030
 0.012
 0.023
 0.013
 3.68

 0.108
 0.101
 0.072
 0.047
 0.094
 0.096
 0.108
 0.071
 0.085
 0.080
 0.075
 0.101
 0.099
 0.088
 17.76

 0.408
 0.385
 0.398
 0.393
 0.409
 0.381
 0.398
 0.312
 0.304
 0.279
 0.238
 0.263
 0.230
 0.338
 17.73

0.012
0.016
0.012
0.019
0.019
0.019
0.015
0.008
0.011
0.015
0.016
0.018
0.016
0.015
16.05

0.017
0.111
 0.181
0.086
0.056
0.059
 0.113
 0.263
 0.095
0.005
 0.059
0.088
0.120
 0.013
 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

(?)

(+)

()

(?)

()

(?)

 0.057
 0.019
0.013
0.031
0.010
 0.019
 0.031
 0.053
 0.041
 0.019
 1.82

0.068
0.030
0.026
0.030
0.048
0.058
0.070
0.047
0.033
0.046
8.05

0.009
 0.007
 0.015
 0.014
 0.014
0.003
 0.010
0.006
 0.009
 0.006
 1.87

 0.010
 0.002
 0.001
 0.002
0.005
0.002
0.005
0.007
0.009
0.002
0.77

 0.011
 0.015
 0.006
 0.015
 0.009
 0.024
 0.031
 0.020
 0.001
 0.015
 4.70

 0.029
0.000
 0.013
0.003
 0.014
 0.015
 0.028
 0.016
 0.021
 0.015
 4.03

IS
()
 0.006
0.007
 0.002
0.004
0.011
 0.003
0.003
 0.002
 0.001
0.001
0.68

SFCFIS

DEBT

RELCF

()

()
 0.122
 0.104
 0.085
 0.076
 0.075
 0.065
 0.060
 0.086
 0.096
 0.085
 13.04

 0.020
 0.019
0.004
 0.025
 0.029
 0.005
 0.013
 0.010
 0.001
 0.013
 3.55

SIZE

AC

()

(+)

()

 0.400
 0.481
 0.483
 0.396
 0.314
 0.333
 0.263
 0.299
 0.245
 0.357
 12.17

0.024
0.015
0.011
0.007
0.007
0.011
0.014
0.016
0.016
0.013
7.46

0.252
0.068
 0.077
 0.209
 0.144
 0.097
 0.094
0.078
0.099
 0.014
 1.82

ARTICLE IN PRESS
R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

where Q>1. We estimate Q, with company (i) and time (t)

subscripts, as follows:
Qit MVEit PSit DEBTit =TAit

where MVE is the market value of common stock; PS is the

liquidating value of preferred stock; DEBT is the value of a
companys short-term liabilities net of its short-term assets,
plus book value of long-term debt; and TA denotes the total
assets.
All variables are measured at the years end. This approach
to computing Q follows Chung and Pruitt (1994). 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).
The results of partitioning on the basis of high Q and low
Q are shown in Table 4. SFCF has significantly positive
coefficients in all columns. The magnitudes of the coefficients are much higher when Q < 1. Thus, when companies
have poor stock market ratings, SFCF has a much stronger
influence on income-increasing DAC. The Big 6 variable
has the expected negative sign in all the partitions, but only
one of the coefficients is significant at the .05 level, one-tail
test (this occurs when Q < 1). The interaction term,
SFCFB6, is especially strong when Q < 1. When companies

have poor stock market performance ( Q < 1), the presence

of a Big 6 auditor reduces the magnitude of the association
between SFCF and DAC. When Q < 1, companies with
long-term associations with their auditors have higher
DAC, although this is cancelled out if SFCF is high.
SFCFIS is significant in Column C and has the expected
negative sign. DEBT, RELCF, and SIZE are significant in
all columns, and so the evidence is similar to that in Table 3.
When we partition by Q, AC becomes highly significant but
with negative signs when Q < 1 and positive signs when
Q>1. The evidence from Table 4 confirms that high SFCFs
are associated with positive DAC. The interactions of Big 6
auditors and institutional shareholders with SFCF reduce
DAC when companies have poor stock market ratings
( Q < 1). Thus, Big 6 firms and institutional investors are
more vigilant when a companys SFCF is high and stock
market valuation is low. Long audit tenure is associated with
higher DAC when Q < 1, but these auditors become more
vigilant when SFCF is high, and so DAC is reduced. In
summary, monitoring by Big 6 auditors and institutional
investors is much more acute when companies have low
stock values as measured by the Q ratio.
We also report the regression results estimated separately
for each year. This reduces the potential effect of any serial
correlation in the regression error terms. In the annual
regressions, an individual company appears just once. We

Table 6
Regression estimates (t statistics) on change in DAC (DDAC) model
Variable

Predicted
sign

Intercept

(?)

SFCF

(+)

 0.003
(  1.68)
 0.001
(  0.20)

 0.006
(  3.10)
0.005
(1.60)

LT

(?)

 0.002
(  0.92)

 0.003
(  1.51)

SFCFB6

()

SFCFLT

(?)

 0.004
(  1.34)
0.005
(0.89)
0.001
(0.51)
 0.003
(  1.57)
 0.007
(  1.30)
0.008
(2.10)

 0.005
(  3.10)
0.003
(1.43)

()

 0.005
(  1.96)
0.008
(1.72)
0.001
(0.36)

 0.003
(  2.30)
0.004
(2.06)

B6

 0.004
(  1.82)
0.003
(2.00)
 0.000
(  0.02)

IS

()

 0.003
(  1.50)

SFCFIS

()

DDEBT

()

DRELCF

()

DSIZE

(+)

DAC

()

 0.002
(  0.91)
 0.004
(  0.98)
 0.217
(  13.16)
 0.580
(  45.46)
0.053
(7.62)
 0.059
(  3.70)
10540
.481

 0.008
(  1.97)
0.007
(0.93)
0.002
(0.60)
0.000
(0.14)
 0.006
(  0.91)
0.006
(1.36)
 0.002
(  1.02)
 0.004
(  0.85)
 0.217
(  13.13)
 0.580
(  45.43)
0.053
(7.61)
 0.059
(  3.73)
10540
.481

N
Adjusted
r-square

 0.006
(  1.14)
0.007
(1.99)

 0.224
(  19.21)
 0.566
(  65.64)
0.051
(10.91)
 0.062
(  5.34)
19743
.473

 0.224
(  19.20)
 0.566
(  65.66)
0.051
(10.89)
 0.062
(  5.34)
19743
.473

 0.225
(  19.22)
 0.566
(  65.67)
0.051
(10.88)
 0.062
(  5.32)
19743
.473

 0.225
(  19.23)
 0.566
(  65.66)
0.051
(10.88)
 0.062
(  5.33)
19743
.473

t Statistics are estimated based on the Newey West adjustment for heteroskedasticity.

 0.225
(  19.22)
 0.566
(  65.67)
0.051
(10.85)
 0.062
(  5.33)
19743
.473

 0.218
(  13.17)
 0.580
(  45.45)
0.053
(7.63)
 0.059
(  3.70)
10540
.481

ARTICLE IN PRESS
10

R. Chung et al. / Journal of Business Research xx (2004) xxxxxx

use the Fama and MacBeth (1973) approach to form an

average coefficient from the 13 regressions and compute
the t statistics thereon. The results for the full 13 years of
regressions are shown in Table 5, Panel A. The main variables
of interest, SFCF, B6, and SFCFB6, are statistically significant and have the expected signs. The results corroborate the
evidence from Table 3, and they are consistent with our
hypotheses. The variables LT and SFCFLT are also significant and have the same signs as in Table 3.
Panel B of Table 5 reports the annual regression results
using data from 1988 to 1996; this sample incorporates a
variable reflecting institutional shareholdings. The results
show SFCF to be highly significant as is the case with all
the previous analyses. The Big 6 (B6) and Big 6 interaction
term (SFCFB6) and the tenure interaction term (SFCFLT)
have negative coefficients and are significant at the .01 level.
The IS variable itself is not significant, while the interaction
term (SFCFIS) is significant at the .01 level. This result again
suggests that institutional shareholders effectively constrain
the managements use of income-increasing DAC when
SFCF is high.
A final test is to run a regression of changes in DAC on
the independent variables. (We thank a reviewer for suggesting this analysis.) The results are shown in Table 6.
SFCF has positive signs in seven specifications of the
model, although significance levels vary. Companies that
increase DAC do so when they have high SFCF. The
monitoring variables, B6, LT, IS, and the interaction terms
are generally not significant in the analyses. However,
SFCFLT is positive and significant in Columns D and E.

4. Summary
Discretionary accounting accruals provide mechanisms
for managers to adjust earnings towards some preferred
level. A growing body of research has examined managers motives for using DAC and has used these motives to
predict earnings. 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. 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. Our empirical results
using data from 1984 to 1996 confirm our hypothesis of a
positive relationship between SFCF and DAC.
Big 6 auditors moderate the SFCF DAC relationship.
Due to their conservatism and their desire to avoid litigation,
Big 6 auditors constrain management from making incomeincreasing DAC. This behavior is especially strong when
SFCF is high. Institutional shareholders also have a moderating effect on DAC but only when SFCF is high.
Longer term auditor client relationships have been argued to have an impact on audit quality, but there is
considerable disagreement as to the sign of the association.

Our results indicate that auditor tenure has an impact on the

use of DAC, although there are two factors at work. Companies with a long-term auditor relationship have higher DAC,
thus suggesting that more leeway is given by the auditors.
However, when SFCF is high, companies with long-term
auditor relationships have lower DAC. These results can be
used to support auditor rotation (the LT results) or to support
long tenure (the SFCFLT results).
Our main findings still apply when we conduct sensitivity
tests. Companies with poor stock market ratings, as measured
by Tobins Q, show a very strong relationship between SFCF
and DAC. Debt, relative cash flows, and size are also
significantly related to discretionary accounting accruals.
SFCF represents non-wealth-maximizing expenditures and
thus signals a significant agency cost to shareholders. We
show that companies with high SFCF use income-increasing
DAC. Management uses DAC to camouflage the poor returns
from the negative NPV expenditures funded from RCF. Big 6
auditors, acting as agents for stockholders, and institutional
investors with large shareholdings inhibit managers from
engaging in opportunistic earnings management when companies have SFCF. Our findings add to the expanding
literature that addresses discretionary accounting choice.

Acknowledgements
We are very grateful to the editors and reviewers whose
helpful and insightful comments and suggestions greatly
improved the paper. This paper has also benefited from
comments made by workshop participants at the Hong Kong
Polytechnic University. We gratefully acknowledge partial
financial support for this research from Hong Kong
Polytechnic University research grants.
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