Earnings management, surplus free cash flow, and external monitoring

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. © 2003 Elsevier Inc.All rights reserved.