Global Journal of Management and Business Research: D Accounting and Auditing Volume 14 Issue 1 Version 1.0 Year 2014 Type: Double Blind Peer Reviewed International Research Journal Publisher: Global Journals Inc. (USA) Online ISSN: 2249-4588 & Print ISSN: 0975-5853 Free Cash Flow and Earnings Management in Brazil: The Negative Side of Financial Slack By Fabricio Terci Cardoso, Antonio Lopo Martinez & Aridelmo J. C. Teixeira F ucape Business School, Brazil Abstract- The article investigates whether Brazilian firms with excess free cash flow (FCF) and low growth perspectives (Jensen. 1986), when there is excess FCF, accompanied by limited growth perspectives, managers have incentives to camouflage the impact of investments in projects with negative net present value (NPV) by presenting inflated profits. The study includes firms listed on the BMF&Bovespa in the period from 2008 to 2012. Discretionary accruals (DA) were estimated by the modified Jones model and then the relationship between FCF and DA was ascertained by multiple regression. The results indicate that firms with low growth perspectives and excess FCF are more likely to manage earnings to increase profits. Shareholding concentration and adoption of IFRS moderate this relationship (FCF x DA), i.e., in practical terms they restrict the propensity to engage in this type of earnings management. This study is relevant by identifying a tendency to manage earnings. Regulators and investors should pay particular attention to the accounting results disclosed in the presence of excess free cash flow and low growth perspectives. Keywords: free cash flow, discretionary accruals, earnings management. GJMBR-D Classification : JEL Code: O16, M19 Free Cash Flow and Earnings Management in Brazil The Negative Side of Financial Slack Strictly as per the compliance and regulations of: © 2014 Fabricio Terci Cardoso, Antonio Lopo Martinez & Aridelmo J. C. Teixeira. This is a research/review paper, distributed under the terms of the Creative Commons Attribution-Noncommercial 3.0 Unported License http://creativecommons.org/licenses/by-nc/3.0/), permitting all non-commercial use, distribution, and reproduction in any medium, provided the original work is properly cited. Free Cash Flow and Earnings Management in Brazil: The Negative Side of Financial Slack α σ ρ Fabricio Terci Cardoso , Antonio Lopo Martinez & Aridelmo J. C. Teixeira Abstract- The article investigates whether Brazilian firms with invested. Identifying the agency cost associated with excess free cash flow (FCF) and low growth perspectives free cash flow (investments made in projects with engage in earnings management by means of income- negative NPV) is difficult. Managers normally do not increasing accruals. According to the agency cost hypothesis disclose the free cash flow projections of investments (Jensen. 1986), when there is excess FCF, accompanied by 2014 and the premises behind them. To avoid this disclosure, limited growth perspectives, managers have incentives to managers invoke the need for business secrecy. camouflage the impact of investments in projects with ear negative net present value (NPV) by presenting inflated profits. According to Jensen (1986), the payment of Y The study includes firms listed on the BMF&Bovespa in the dividends reduces the power of managers by 85 period from 2008 to 2012. Discretionary accruals (DA) were diminishing the amount of resources available to them. estimated by the modified Jones model and then the To prevent resources from leaving the firm, managers relationship between FCF and DA was ascertained by multiple look to invest these funds in projects to maintain regression. The results indicate that firms with low growth responsibility over them, and as a consequence, perspectives and excess FCF are more likely to manage maintain their power in the company. However, to retain earnings to increase profits. Shareholding concentration and these resources, it is necessary to promise higher future adoption of IFRS moderate this relationship (FCF x DA), i.e., in practical terms they restrict the propensity to engage in this returns to the shareholders, since they will only be willing type of earnings management. This study is relevant by to forgo dividends now when there is an outlook for identifying a tendency to manage earnings. Regulators and increased gains in the future. This promise of higher investors should pay particular attention to the accounting returns is not always easy to keep, so earnings results disclosed in the presence of excess free cash flow and management serves as an instrument to mollify the low growth perspectives. shareholders and preserve the positions of the Keywords: free cash flow, discretionary accruals, managers involved. These circumstances cause earnings management. ) companies to grow beyond their optimal size. D However, according to Chung, Firth & Kim ( I. Introduction (2005), bad investments are eventually revealed by the he objective of this study is to verify whether a firm’s future results. Investments that do not maximize relationship exists between free cash flow (FCF) shareholder wealth can reduce the stock price and T and the propensity to manage earnings by trigger efforts by shareholders to dislodge managers. manipulating discretionary accruals (DA) by firms with Therefore, to camouflage the impact of investments with low growth perspectives, a propensity that arises due to negative NPV, managers use accounting procedures to agency conflicts. According to Jensen (1986), the increase earnings. This “increase” soothes investors interests and incentives of managers and stockholders and boosts the firm’s stock price in the short run. are in conflict regarding the optimal size of the firm and Therefore, verifying whether the earnings payment of dividends, especially in firms with excess information disclosed corresponds to the firm’s real free cash flow and low growth perspectives, i.e., firms performance is fundamental. The importance of with more resources than investment opportunities. In earnings as a parameter for judging the performance of this case, managers can either increase dividends or firms and managers has been stated by various authors. invest in projects with low return, wasting these According to Martinez (2008, p. 2), “one of the most resources. important products of accounting for various users of For Chung, Firth & Kim (2005), in the absence financial information is earnings.” For Dechow, Ge & of efficient control by shareholders, managers can Schrand (2010), high-quality earnings supplies more choose to invest in projects that present negative net relevant information on the financial performance of present value (NPV) or that do not satisfy the profit firms, to serve as a base for investment decisions. Many Global Journal of Management and Business Research Volume XIV Issue I Version expectation of investors. The preference for using the authors have tried to identify factors that contribute to firm’s own resources is to avoid the attention of creditors the quality of earnings. interested in guaranteeing the return of the amounts The results of studies such as Dechow & Dichev (2002) and Dechow, Richardson & Tuna (2003) indicate A uthors α σ ρ: Fucape Business School - Vitória - Brazil. that earnings quality is influenced by accruals. In this e-mail: [email protected] ©2014 Global Journals Inc. (US) Free Cash Flow and Earnings Management in Brazil: The Negative Side of Financial Slack respect, Houge & Loughran (2000) state that accruals findings here can serve as the basis for new studies on and cash flows make an incremental contribution to the theme in Brazil. stock returns and the results obtained is the sum of these two contributions. Therefore, understanding the II. Theoretical Framework relationship between accruals and cash flow will enable better determining the performance of firms and their a) Agency Theory managers, especially from the standpoint of the return It is natural to expect human beings to try to on investment realized by the shareholders. maximize their wealth. According to Bhundia (2012), This return can fall short of what is desired and most people are not able to manage their assets in the one of the factors that can contribute to this is the most effective way, making it wise to contract others conflict of interest between firms’ managers and owners. with more expertise to perform this service. For this same author, according to agency theory the first group For Bhundia (2012) and Jensen (1986), this conflict encourages managers to manipulate the results to is composed of owners (proprietors of the means of 2014 maximize their own wealth, or to remain in their production) and the second is formed by agents or positions. For authors such as Schipper (1989) and managers. In reality, the agents are the representatives ear Y Dechow, Sloan & Sweeney (1995), this manipulation can of the owners of companies (the principals), engaged to be achieved by means of accruals. maximize the wealth of the owners. 86 Various models have been developed to study For Jensen & Meckling (1976), if both sides of this manipulation of earnings, such as those of Jones this relationship seek to maximize their own wealth, there is good reason to believe the agent will not always (1991) and Dechow, Sloan & Sweeney, (1995), among others mentioned in the work of Dechow Ge & Schrand act in the best interests of the principal. These authors (2010). According to Martinez (2008, p. 2), “these define the agency relationship as