Abstract. Review of Literatures. Free Cash Flows (FCF)

Transcription

1 123 A COMPARATIVE STUDY BETWEEN FREE CASH FLOWS AND EARNINGS MANAGEMENT Dr. Amalendu Bhundia Reader in Commerce; Fakir Chad College Under Universiy of Calcua, Diamond Harbour, Souh 24-Parganas, Pin , Wes Bengal, India India [email protected]; de.amalendu@rock .com Absrac This paper examines and compares free cash flows in he firms lised in Indian Sock Exchange wih an emphasis on earning managemen. The main purpose of he sudy is he inquiry of dispariy beween free cash flows in Indian Sock Exchange wih an emphasis on earnings managemen. Daa and saisics of free cash flows and earnings managemen variables are measured by Len and Poulsen (1989) model and Jones model. The resuls of his sudy signify ha here is a posiive significan relaionship beween earnings managemen and free cash flows and confirm ha firm s free cash flows can simulae earnings managemen. Key Words: Free cash flows earnings managemen, discreionary accruals, non-discreionary accruals. Naurally, all individuals have been looking for increasing heir wealh in order o maximize heir benef securiy and so on. This endency escors hem o look for suiable opporuniies in order o maximize heir wealh by he invesmen. Noneheless, here have been individuals who are unable o manage heir own properies o make prof so hey have o employ ohers o do his ask behalf of hem. According o agency heory, firs groups are principals or owners and second ones are agens or managers. Indeed, managers are represenaives for principals o conduc owner s propery accuraely and finally increase heir owner s wealh. I should be noiced ha individuals have endency o maximize heir vesed-ineres and also managers do so. Managers are eager o show a good picure of he firm's financial posiion o shareholders and oher sakeholders o faciliae maximize heir vesed-ineres and social welfare and or o keep heir posiion. Agency problem arises when maximizing agen's or manager s wealh doesn necessarily lead o maximize sockholder and sakeholders wealh. This posiion refers o ineres conflic beween agens and principals. However, aking his ineres conflic ino accoun, agens or managers may have an incenive o manipulae earnings o maximize heir self-ineres. Operaing cash flows on cash flow saemen indicae firm's abiliy o produce cash flows. However, mos of financial analyss argue ha cash flows from operaing aciviies are funds ha no only should be invesed in new fixed asses o enable firms o keep curren level of operaing aciviies, bu also a proporion of ha fund should be disribued as a dividend or share-repurchase o saisfy sockholders. Earning managemen is defined as inenionally aking seps under generally acceped accouning principles (GAAP) o achieve from he repored earnings o he desired earnings. The converging he repored earning o he desired earning is done hrough accouning manipulaion. Therefore, his call for a full diagnosis of he malady, ha is idenificaion, analysis and quanificaion of he inerfering consrains in achieving maximizaion of profis, hus opens a vas field for research and enquiry. In he presen sudy, herefore; an aemp has been made o examine and compare he inquiry of dispariy beween free cash flows in Indian Sock Exchange wih an emphasis on earnings managemen. Review of Lieraures (FCF) Operaing cash flows on cash flow saemen indicae firm's abiliy o produce cash flows. However, mos of financial analyss argue ha cash flows from operaing aciviies are funds ha no only should be invesed in new fixed asses o enable firms o keep curren level of operaing aciviies, bu also a proporion of ha fund should be disribued as a dividend or share-repurchase o saisfy sockholders. Therefore, cash flows from operaing aciviies, on is own, can' be considered as a firm abiliy Bhundia A. - A Comparaive Sudy Beween and Earnings Managemen

2 124 Business Inelligence Journal January o produce he cash flows. Jensen (1989) was among he pioneers who inroduced free cash flows heory and presened a definiion for i. In his view, free cash flows is defined as he cash from operaing aciviies afer deducing he necessiy cash in order o he invesmen in posiive ne presen value projecs. However, projecs should be measured regarding o ne presen value hrough applying a reliable cos of capial; if he resul is posiive, he necessiy cash for he invesmen deduc from firm's available cash, whaever remains will be considered as free cash flows. According o Len and Poulsen (1989) free cash flows is operaing income before depreciaion expense afer ax, ineres expense and preferred and common sockholders' dividends. Also, Copeland (1995) defines free cash flows as he operaing income afer ax plus non-cash expenses afer deducing he invesmens on working capial, propery, plan, equipmen and oher asses. According o Dechow and Ge (2006) free cash flows is he cash flows from operaing aciviies plus he cash flows from invesmen aciviies. Earnings Managemen (EM) One of he aims of financial saemens is o reflec he resuls of managemen sewardship or heir accounabiliy in he face of resources under heir conrol. Since he managemen of rade (business) uni is responsible for preparing he financial saemens, he managers in doing his imporan maer have enjoyed opporuniies o exercise judgmen in heir reporing (Saleh 2009a). Accrual accouning will give significan righ of selecion o deermine earning in he differen ime periods o managers. In deed, under his accouning sysem, he managers have significan conrol ime of disincion over some cos iems such as adverisemen, research and developmen expendiures. Significanly on he oher hand in accrual accouning sysem, he manager will face differen opions abou ime of disincion of income. For example, he mos rapid disincion of income is horough credi sales. This kind of performance by managers is called "earnings managemen" (Moradi and e al., 2011). Earning managemen is defined as inenionally aking seps under generally acceped accouning principles (GAAP) o achieve from he repored earnings o he desired earnings. The converging he repored earning o he desired earning is done hrough accouning manipulaion (Malla-Nazari & Karimi-e-Zand, 2007). Today, earning managemen is one of he mos debaable and ineresing issues in accouning research since invesors pu los of emphasis on he profi digi as a one of he mos imporan facors in he decision-making. Researches sugges ha low earnings variaion and is persisency indicae he qualiy of earnings. However, invesors can inves wih more confidence in he firms wih more persisen earning rend. In his regard, earning managemen would be one of he mehods of he window dressing of financial posiion ha is done by managemen inerfering in earning deerminaion (Noravesh & e al., 2005). On oher hand, Jensen and Meckling (1976) defines he agency relaionship as a conrac under which one or more principals engage he agen o perform some service on heir behalf which involves delegaing some decisionmaking auhoriy o he agens. Wih esablishing agency relaionship, boh sides ry o maximize heir self-ineres. Because principal and agens uiliy funcion aren equal, ineres conflic arises beween hem and drive in agency coss. I should be noiced ha individuals have endency o maximize heir vesed-ineres and also agens do so. Agens are willing o show a good picure of firm's financial posiion o shareholders and oher sockholder in order o maximize heir vesed-ineres and social welfare and or o keep heir posiion. Agency problem arises when maximizing agen's wealh doesn necessarily lead o maximize sockholder and sakeholders wealh. However, wih consideraion of he ineres conflic beween agens and principals, agen will have an incenive o manipulae earnings o maximize heir self-ineres. Because earning managemen is done on various purposes by agens, empirical evidences of he research lieraure abou agency relaionship and earning managemen, in some exen, are mixed and vague. If earning managemen is done on an opporunisic purpose, firms will have more agency coss and agen will show more profi. In oher words, here is posiive relaionship beween earning managemen and ineres conflic momenum. Bu if earning managemen isn in favor of agen's vesed-ineres, i is expeced ha firms wih high agency coss, have low earning managemen because earning managemen isn done in favor of agen's ineres (Porns e al., 2008). Jaggi and Gul (2000) in his research found ha posiive relaionship beween earning managemen and high free cash flows in firms wih low growh. They argue ha according o Jensen heory, in hese firms, agens insead of disribuing hese free cash flows inves i in he projecs wih negaive ne presen value which drops firms marke value (marke reacs). Therefore, hese firms' managers ry o adjus his siuaion by applying discreionary accruals iems ha sep up income and achieve heir vesed-ineres. Business Inelligence Journal - January, 2012 Vol.5 No.1

3 125 In addiion, hey showed ha deb (financial leverage) adjuss he menioned relaionship. Jones and e al. (2001) sudied relaionship beween earning managemen and free cash flows in he firms wih new and old-srucured economy in Ausralia. He observed ha here is posiive relaionship beween discreionary accrual iems and free cash flows in he firms wih an oldsrucured economy (usually have low growh) because hese firms managers ry o compensae heir weak performance hrough discreionary accrual iems, bu he didn find significan relaionship in he firms wih a newsrucured economy (wih high growh). Chung, e al. (2005) invesigaed he relaionship beween earning managemen and free cash flows in firms wih low growh during he period of Their research sample consiss of American firms. Their resuls indicae posiive significan relaionship beween earnings managemen and free cash flows. Addiionally, afer survey on relaionships among insiuional sakeholders, audi firms and high audi qualiy hey found ou ha he menioned variables lead o a decrease in he relaionship beween earnings managemen and free cash flows and preven managers from managing he earnings. Opler and Timen (1993) saed ha firms wih high growh opporuniy are more probabiliy o have low free cash flows, since available cash is invesed on projecs wih posiive NPV. Tsui and Gul (2000) invesigaed audi fee in high free cash flows and low growh firms in Hongkong. Their findings show, in his sor of firms, because of relaed agency problems of high cash flows, audi fee is high. Also, hey explained ha according o Jensen heory, deb facor can have imporan role in he audi fee reducion. According o Jensen heory, Jagi and Gul (2000) highlighed ha deb facor adjuss he relaionship beween earning managemen and free cash flows in low growh firms. In oher words, more deb raio in hese firms cause managers can inves less in negaive NPV projecs. Richardson (2006) found in firms wih high free cash flows, he invesmen is more han opimal level. In his research sample, during , on average 20 percen of non- financial firms invesed heir free cash flows over opimal level. Buki & Iskandar (2009) sudied abou Surplus Free Cash Flow, Earnings Managemen and Audi Commiee and found ha independen audi commiee helps companies wih high surplus free cash flow o reduce income-increasing earnings managemen pracices. Wang and e al (2010) sudied impac of composiions and characerisics of board of direcors and earnings managemen on fraud and concluded ha discreionary working capial accrual has no influence on fraud and he ineracion of insiuional direcor holding and he discreionary working capial accrual has negaive influence on fraud before he ac of he independen direcors and audior, bu he discreionary working capial accrual has negaive influence on fraud aferward. The conclusive sum of his rerospecive review of relevan lieraure produced ill dae on he offered subjec reveals wide room for he validiy and originaes of his work and reflecs some decisive evidences ha affirm is viabiliy, as may be marked here i. Nor has any previous research examined he free cash flows and Earnings managemen and he exisence of free cash flows and Earnings managemen relaionship of firms lised in Indian sock exchange. Objecives of he Sudy The main objec of he presen sudy is o examine he inquiry of dispariy beween free cash flows in Indian Sock Exchange wih an emphasis on earnings managemen. More specifically i seeks o dwells upon mainly he following issues: i. To observe he free cash flows and earnings managemen siuaion under he sudy; ii. To compare he free cash flows and earnings managemen siuaion under he sudy; iii. To explore he free cash flows and earnings managemen associaion; Mehodology of he Sudy Research Hypohesis There is a difference among firms free cash flows lised in Indian Sock Exchange wih an emphasis on earnings managemen. Sub hypoheses H1: There is a difference among firms free cash flows lised in Indian Sock Exchange wih an emphasis on discreionary accrual iems of earning managemen. H2: There is a difference among firms free cash flows lised in Indian Sock Exchange wih an emphasis on nondiscreionary accrual iems of earning managemen. Bhundia A. - A Comparaive Sudy Beween and Earnings Managemen

4 126 Business Inelligence Journal January Research Design Research mehodology which is used in his sudy is he correlaion ype. Since research aimed o invesigae and compare firm's free cash flow wih an emphasis on earning managemen, Correlaion mehod is used for free cash flows and earning managemen variables. Saisical analysis is done by Eviews 6 sofware. Documenal along wih survey-field mehods are used in daa collecion. Survey-field mehod for collecing daa is from he financial saemens of firms lised in Indian Sock Exchange and documenal mehod is for lieraure sudy and research background review. In Survey-field mehod, required daa for research variables measuremen were acquired by using daa bases of Indian Sock Exchange. Research daa sample consiss of he lised firms in Indian Sock Exchange a all sors of indusry during he period of Sysemaic-eliminaion random sampling is used for daa sampling. Taking hese characerisic ino consideraion, daa sample reduced by 215 firms and from his number 142 firms seleced, considering firms homogeneiy and saisical guidance. Research Variables A -1 is oal asses carrying value of firm (i) in year (-1) Adjused Jones model (inroduced by Dechow, e al. 1995) is used for EM measuremen, for is abiliy o solve presen research problem. The model is as follow: NDA = α (1/A ΔREC 1 }/A i 1 i 1 ) + α ) + α ({ REV 3 2 (PPE /A i 1 Where: NDA is discreionary accrual iems a year () Ai-1 is oal asse of firm (i) a year (-1) ΔREV is he difference beween percen years sale o previous year ΔREC is he difference beween presen ne receivables o previous year PPE is gross plan, propery and equipmen in year () α1, α2, α3 are firm's special parameers and calculaed by following equaion: TA / A i 1 + α ( PPE 3 = α (1/ A 1 / A i 1 i 1 ) + ε ) ) + α ( REV / A 2 i 1 ) Research variables are free cash flows as an independen variable and earning managemen as a dependen variable. Len and Pulson model (1989) is applied for measuring free cash flows. According o his model free cash flow is calculaed by deducing oal of axes, ineres cos and dividend from operaing income before depreciaion and sandardized by dividing i o asses as following: FCF PSDIV = ( INC CSDIV TAX ) / A INTEP 1 Where: FCF is FCF of firm (i) a year () INC is operaing income afer depreciaion of firm (i) a year () TAX is oal axes of firm (i) a year () INTEP is ineres expense of firm (i) a year () PSDIV is preferred sock holders dividends of firm (i) in year () CSDIV is common sock holders dividends of firm (i) in year () TA is a proxy for oal accrual iems a year () oal accrual iems is calculaed by following equaion: TA i = NI CFO And discreionary accruals (DA ) is calculaed by he difference beween oal accruals and non- discreionary accruals as following: DA i = TAi / Ai 1 NDA A -1 is oal asses carrying value of firm (i) in year (-1). Empirical Resuls and Analysis Descripive saisic of research variables are shown in Table-1. Free cash flows as he independen variable have he mos co-efficien of variaion and dispersion (400) and vice versa, discreionary and non-discreionary accruals as he dependen variable have fewer coefficien of variaion i Business Inelligence Journal - January, 2012 Vol.5 No.1

5 127 han free cash flows (69.3 and respecively). The low persisence of free cash flows shows ha, o some exen, level of free cash flows is independen from discreionary and non-discreionary accruals and can' explain hese variaions. Variables Crieria Table 1: Descripive Saisics Discreionary Non- Discreionary Mean Median Maximum Minimum Sd. Dev C.V. (%) Table-6. I should be noiced ha, since free cash flows daa isn normal and has posiive skewness, he median is used for dividing daa ino wo groups- high and low free cash flows. Finding of free cash flows effec on discreionary accruals in able 3 show posiive relaion beween hese wo variables; i means ha increasing free cash flows in firm causes increasing discreionary accruals. Also, he relaionship beween free cash flows and discreionary accruals wih aking regression coefficien of free cash flows (0.037) and -saisic (0.684) ino consideraion is no significan and shows ha discreionary accruals is relaively independen from level of free cash flows. Resuls of F-saisic indicae model in whole is significan and considering Durbin-Wason saisic, i hasn auo-correlaion problem. Resuls of coefficien of deerminaion show ha of discreionary accruals variaions is relaed o he firm's free cash flows. Pool uni roo es is used for invesigaion of variables persisency. Resuls from pool uni roo es of Levin, lin and chu saisic and also Im, Pesaran and Shin-W saisic is shown in Table-2. All research variables including dependen and independen variables are persisen in sudied period. Mehod Lev Lin & Chu Breiung -sa Im, Pesaran & Shin W-sa ADF-Fisher Chi-square PP-Fisher Chi-square Discreionary -44/32-2/76-7/85 126/25 289/37 Hadri Z-sa 8/48 Nondiscreionary -27/69-3/25-9/34 279/02 331/26 11/99-114/23-3/82 (0/0001) -26/34 309/53 351/58 14/79 To analysis sub-hypohesis 1 and 2, free cash flows effecs on discreionary and non- discreionary accruals of earning managemen along wih compare means es for discreionary and non-discreionary accruals in firms wih low and high free cash flows are shown in Table-3 and Table-3: Associaions beween Discreionary and Free Cash based on Regression Model Dependen Variable: Discreionary Mehod: Leas Squares Variables Coefficien -Saisic Probabiliy Discreionary R-squared Durbin- Wason Sa F-saisic Prop. (F-saisic) Resuls of free cash flows effec on non-discreionary accruals which is shown on able 4 indicae negaive relaion beween wo variables. The relaionship beween firms free cash flows and non-discreionary accrual wih aking regression coefficien of free cash flows variable (-0.016) is very weak and -saisic (0.771) is no significan which indicaes non-discreionary accruals is independen from firms free cash flows. Resuls of F-saisic show ha model isn significan in whole and here isn auo-correlaion problem considering Durbin-Wason saisic. Resuls of coefficien of deerminaion shows of non-discreionary accruals variaions is reversely relaed o firms free cash flows. Bhundia A. - A Comparaive Sudy Beween and Earnings Managemen

6 128 Business Inelligence Journal January Table-4: Associaions beween Non-discreionary and based on Regression Model Dependen Variable: Discreionary Mehod: Leas Squares Variables Coefficien -Saisic Probabiliy Nondiscreionary R-squared Durbin-Wason Sa F-saisic Prop. (F-saisic) In order o complee research resuls, compare means es is also conduced for discreionary accruals and nondiscreionary accruals in firms wih high and low free cash flows which is shown in Table-5 and Table-6. ANOVA and -saisic which is shown in Table-5 indicaes ha here isn significan difference among discreionary accruals means in firms wih high and low free cash flows. Conclusions of he Sudy To es research hypohesis, wo regression models wih a consan effecs are esimaed which is explained as followings: 1. According o Len and pulson model variaions of discreionary accruals is relaed o firms free cash flows; 2. There is weak and negaive relaion beween nondiscreionary accruals and level of free cash flows according o Len and Pulson model and of nondiscreionary accruals variaions is relaed o free cash flows, reversely; 3. Resuls of Anova and -saisic indicae ha here isn significan difference among discreionary accrual means in firms wih high and low free cash flows; 4. Resuls of Anova and -saisic indicae ha here isn significan difference among non-discreionary accrual means in firms wih high and low free cash flows. Research resuls are consisen wih Jaggi and Gul (2000), Jones (2001) and Chung, e al. (2005). Limiaions of he Sudy Table-5: Compare Means Tes of Discreionary in Firms wih High and Low Mehod df Value Probabiliy -es ANOVA F-saisic Table-6: Compare Means Tes of Non-discreionary in Firms wih High and Low Mehod df Value Probabiliy -es ANOVA F-saisic ANOVA and -saisic which is shown in Table-6 indicaes ha here isn significan difference among nondiscreionary accruals means in firms wih high and low free cash flows. The findings have imporan implicaions for policy makers and praciioners. The resuls reveal an associaion, no a causal link, beween surplus free cash flow condiion and he level of earnings managemen. Also, inferences in his paper are limied by he seleced sample and ime period, and he sample size is relaively small. A larger sample size may be necessary in order o obain a more saisical power for he daa analysis and significan resuls of hypohesis esing. Thus, fuure research may employ a larger sample size in order o also improve he generalizabiliy of resuls. References Buk R. B. & Iskandar, T. M. (2009), Surplus Flow, Earnings Managemen and Audi Commiee", In. Journal of Economics and Managemen, 3(1), Chung, R, Firh, M & Kim, J. (2005), "Earning Managemen, Surplus Flow, and Exernal Monioring", Journal of Business Research, 58, Business Inelligence Journal - January, 2012 Vol.5 No.1

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