Free Cash Flow and Earnings Management

Abstract

This study draws on Jensen's free cash flow hypothesis to evaluate the relationship between free cash flow and earnings management. This study also examines whether the level of leverage moderate the relationship between free cash flow and earnings management. This study uses a fixed effects regression model to examine the effect of free cash flow on earnings management and to test whether leverage levels moderate that relationship for an unbalanced panel of 13,850 firms' year observations from 2011 to 2018 across five European countries. Consistent with the free cash flow hypothesis of Jensen, this study suggests that firms with high free cash flow are more likely to manage earnings. Further, the results also suggest that the positive impact of free cash flow on earnings management is attenuated in firms with high leverage levels. This study contributes to the literature by examining how free cash flow affects the extent of earnings management and by shedding light on the mediating effect of leverage on the relationship between free cash flow and earnings management.