The Moderating Role of Establishing the Audit Committee and Auditor's Expertise in the Industry on the Relationship between Free Cash Flow and Real Earnings Management

Previous research has shown that managers invest free cash flow in projects with the negative current value and use earnings management to hide the negative effects of such investments, especially when management oversight is weak manipulates real accounting-related processes to increase profits. The results of this study offer beneficial information for the investors with a similar institutional environment because the study promotes the application of applying audit committee and auditor's expertise as efficient tools to constrain management behavior towards manipulation of the accruals. Thus the purpose of this study is to investigate the moderating role of establishing the audit committee and auditor's expertise in the industry on the relationship between free cash flow and real earnings management with a sample of 133 firms for the years 2009-2018.  

The research hypotheses have been tested whit using multivariate linear regression models and with the help of combined data. Chen, et al., (2016) model has been used to measure free cash flow, and Cohen and Zarvin's (2010) model has been used to test real earnings management criteria. Also, the numbers zero and one have been used to measure the moderating variables of the establishment of the audit committee and the auditor's expertise in the industry.

The findings indicate a relationship between free cash flow and real earnings management through abnormal production costs and abnormal operating cash flow but were not observed a significant relationship between free cash flow and actual earnings management through abnormal discretionary expenses. Therefore, the moderating variables were tested with two criteria of abnormal production costs and abnormal operating cash flow which were specified establishment audit committee and auditor's expertise in the industry, weakening the relationship between free cash flow and real earnings management through abnormal production costs and abnormal operating cash flow.  

The existence of an effective audit committee as an intra-agency supervisor can limit management's ability to manipulate financial statements and control its opportunistic behavior to use free cash flow for earnings management through operational decision-making. Also, the auditor's expertise in the industry as external-agency supervisors by overseeing the financial reporting process, both through the audit of financial statements and through the interplay of internal corporate governance mechanisms, can limit the inefficient use of free cash flow by management. Therefore, investors, general assemblies, and the board of directors of joint-stock companies, when choosing an auditing firm, should pay serious attention to the selection of an auditor's expertise in the industry as an effective monitoring mechanism for the work of managers. Besides, decision-makers of companies with significant free cash flow can effectively control the negative effects of free cash flow by hiring an auditor's expertise in the industry. It is also necessary that the board of directors of joint-stock companies have more oversight over the activities of the members of the audit committee so that this committee can do its job properly and accurately.