Agency costs of free cash flow and conditional conservatism

Abstract

Scope and Method of Study: This dissertation investigates whether agency costs in the context of Jensen's free cash flow theory will generate demand for conservative financial reporting from shareholders. Jensen (1986) argues that shareholders' difficulty in monitoring managerial opportunistic behavior creates the potential for managers to spend internally generated cash flow for their own benefit, rather than for maximizing firm value. Recent evidence suggests that accounting conservatism has evolved as part of an efficient contracting mechanism that facilitates reducing agency costs for both shareholders and bondholders. Based on high free cash flow and limited growth opportunities within industries, I select firms that are prone to overinvestment (J-type firms), and test the differences in reporting conservatism between J-type firms and non J-type firms.

Findings and Conclusions: I find that firms with greater agency costs of free cash flow incorporate losses in a more timely manner relative to gains than firms with less agency costs of free cash flow. I also find that debt issuance and dividend payments as well as good corporate governance reduce the relative importance of conservatism in mitigating the agency costs of free cash flow by reducing the cash reserves within the firm or by improving the use of excess cash. Also, J-type firms with greater conservatism are less likely to overinvest in the future. These results are robust to several regression specifications, several proxies for agency costs of free cash flow with different estimation techniques and an alternative measure of conservatism, even after controlling for other sources of conservatism. Overall, the results suggest that firms with more potential agency costs of free cash flow adopt more conservative accounting to mitigate agency conflicts between shareholders and managers.