The role of audit quality and culture influence on earnings management in companies with excessive free cash flow

Abstract

PurposeThe purpose of this paper is to examine the effect of culture and audit quality on managers’ decisions regarding accounting accruals. It focuses on companies experiencing excessive free cash flow, as these companies have been associated with an agency problem.Design/methodology/approachThis study measures the magnitude of discretionary accruals as a proxy for earnings management using the cross-sectional modified Jones model. Excessive free cash flow is scrutinized by the method used by Chung et al. (2005). Listed companies in nine countries in the Asia-Pacific region are represented in this study. The statistical analyses are used to examine the influence of cultural aspect, the role of external monitoring by high-quality auditors and the earnings management practice in the companies with excessive free-cash-flow.FindingsThe empirical results presented in this paper provide support for the proposition that managers of companies with excessive free-cash-flow will make investment decisions that are not always in the best interest of the shareholders and use accounting discretion to increase reported earnings. This study provides empirical evidence that these companies have been associated with an agency problem and the role of external auditor persists in a setting, where cultural differences prevail in across countries.Practical implicationsIn cross-border trade and investment, the findings provide the opportunity to exploit a setting, where cultural differences prevail, whereas other potentially influential variables, including the role of external monitoring by high-quality auditors, are relatively constant across countries.Originality/valuePrevious studies (Leuz et al., 2003; and Enomoto et al., 2015) examine factors influencing earnings management internationally have concentrated on legal institutions and investor protection. Han et al. (2010) completed a cross-country study on the effects of national culture on earnings management. This study focuses on companies across countries experiencing with excessive free cash flow and examines the cultural aspect and the effectiveness of external monitoring by high-quality auditors operating in different countries in mitigating managerial opportunism.