Evidence of Accruals Management: A Test of the Free Cash Flow and Debt Monitoring Hypotheses
Posted: 6 May 1998
Date Written: Undated
This study tests the hypotheses that there is a positive association between Free Cash Flow (FCF), as defined by Jensen, and accruals and that debt moderates this relationship. Jensen argues that managers of low growth firms with high FCF pursue non-value maximizing activities by investing in negative NPV projects instead of paying dividends to shareholders. This management behavior results in lower market values for the firms. We hypothesize that managers of these firms will attempt to mitigate this situation by reporting higher earnings through accrual activities to protect their interests. This expectation suggests a positive relationship between FCF and accruals for firms with low growth opportunities. Jensen also argues that debt can provide a monitoring mechanism to mitigate the FCF problem. This argument leads us to expect that firms with high FCF and high debt will have lower levels of discretionary accruals than firms with high FCF and low debt because the FCF problem will be partially mitigated through higher debt. The results of this study provide evidence that supports both hypotheses.
JEL Classification: G32, G35, M41, M43
Suggested Citation: Suggested Citation