An Evaluation of The Relationships Between The Corporate Governance Mechanisms, The Free Cash Flow, and Earnings Management in Tehran Stock Exchange Listed Companies

Special Issue INTERNATIONAL JOURNAL OF HUMANITIES AND
March 2016 CULTURAL STUDIES ISSN 2356-5926
An Evaluation of the Relationships between the Corporate Governance

Mechanisms, the Free Cash Flow, and Earnings Management in Tehran Stock
Exchange Listed Companies
Amin Raeisi
MSc Student of Accounting, Islamic Azad University, Ahvaz Branch, Iran
Seyed Ali Vaez

Assistant Professor of Shahid Chamran University of Ahvaz, Iran
Abstract
The accruals on one hand enable the managers to calculate the earnings in a way indicative of
the actual value of the financial firm and on the other hand, let them abuse the flexibility of the
methods and the accepted principles of accounting besides distorting the informative content of
the earnings. One of the duties of the corporate governance is to decrease the conflicts of
interest between shareholders and managers. The corporate governance reduces the chances of
earnings management and probably improves the investors knowledge of corporate
performance credit. On the other hand, when the financial units managers face the free cash
flow, initially it is important that they can invest the mentioned flows in convenient and efficient
projects, so they can create value for their shareholders through this approach. In this regard,
the current study aimed at evaluating the relationships between the corporate governance
mechanisms, the free cash flow, and earnings management in Tehran Stock Exchange listed
companies. The research hypotheses were tested through the integrated data statistical
procedure, during the beginning of 2009 to the end of 2015, using the information of 170
companies chosen by systematic elimination sampling. The results of the study indicated that
according to Jensens Theory (1986), the corporate governance features reduce the earnings
management and the free cash flow.
Keywords: the earnings management, the free cash flow, the board of directors size,
institutional ownership.
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1. Introduction
The free cash flow is the cash that the company has in its disposal after spending necessary costs
for maintenance or development of assets. Firstly, when the financial units managers face the
free cash flow, initially it is important that they can invest the mentioned flows in convenient and
efficient projects, so they can create value for their shareholders through this approach. In fact,
each companys value is not only related to its ability for creation of free cash flow, but also
significantly to the utilization of these flows. The proper use of these free cash flows by the
managers of the companies with convenient opportunities for investment development leads
positive reaction of the market to these flows and consequently, the stock prices increases
(Habib, 2011). On the other hand, Jensen (1986), regarding the theory of interests conflict,
argues that the companies with high free cash flows and low development opportunities, have an
irrational tendency to invest in projects with zero or negative net present value in order to
preserve of their personal interests (which are in conflict with the interests of shareholders) in the
short run. The above mentioned items indicate that valuation of the free cash flow of a company
can be affected by that companys future development opportunities in a way the stock exchange
values more the free cash flow of the companies with higher development opportunities (Penman
& Jahuda, 2009).
The previous studies indicate that the ownership structure limits opportunistic behaviors of the
managers (Jensen & McLing, 1974). The ownership structures typology includes managerial,
governmental, and institutional ownerships. The owners have the required motivation and power
for controlling the proper use of the assets. The capital ownership through adjusting the
relationship between the free cash flows and using the properties are able to control the
opportunistic behaviors of the managers. Moreover, regarding the duty of ownership rights
governance, the representative costs of information asymmetry and the separation of ownership
from management are reduced (Watts & Zimmerman, 1983). The shareholders governance based
on their abilities in reducing the capital costs for the companies that face representation issues
due to the existence of free cash flows, is significantly higher (Chen et al, 2011).
The institutional ownership is defined as the stake percentage of the corporate investors which
has a significant role in governance of the managers activities. They state that the existence of
the institutional owners leads to completion of the governance duty in the firm and neutralize the
management decisions for insufficient use of the property. The institutional owners have higher
controlling abilities that the companies managers in the countries with firm authority and lawful
mechanisms (Benfratello, 2006).
It is expected the institutional ownership reduces the information asymmetry and consequently,
the representation problems, since it can effectively direct and control the managers efforts for
manipulating the accounts. The institutional owners try their to do their duty in the best possible
way and create a reasonable assurance with respect to financial reporting quality, protecting the
interests of shareholders and increasing the benefits of investing (Yoo, 2005). Thus, the
probability of opportunistic behaviors such as earnings management in the companies whose
stakes are kept by the institutional owners is reduced. With the increase in institutional
ownership, the managerial decisions of the company are well governed and actions for assuring
the efficiency and effectiveness of the free cash flows use are taken.
The institutional owners help the companies to achieve the highest efficiency using their
knowledge and expertise in production technologies. The institutional owners who own higher
percentage of the companys ownership are more motivated to govern and control the
management activities, as the with increase in institutional ownership percentage, the
relationship between the free cash flows and using the property gets more significant (Qiang,
2003).
The managerial ownership leads in active participation of the managers in governance of free
cash flows to ensure investing in the projects with added value (Warfield et al, 1995). The
managerial ownership has an important role in assuring the proper use of free cash flows for
investing in long-term lucrative projects and maximizing the interests of the shareholders.
According to the theory of representation, the managerial ownership helps preserve the interests
of both the managers and owners. In other words, the managers goal is to maximize the
stakeholders yield through proper use of free cash flows. It can be said the managerial
ownership limits the improper use of free cash flows and decrease the opportunistic earnings
management.
Regarding the theoretical framework and what was mentioned above, the basic objective of the
current study is to evaluate the modifying relationship between the corporate governance
structure, the free cash flow, and the earnings management in Tehran Stock Exchange listed
companies.
2. The Theoretical Framework of the Study
2.1.The Free Cash Flow and the Representation Problems Associated with it
On existence of the free cash flows, the free cash obtained from the operational activities is
indicative of the companys ability in creating the cash flows. Kimmel et al believe that the cash
obtained from the operational activities not only should be invested in the new fixed properties in
order for the company to maintain the current level of its operational activities, but also a portion
of this cash should be distributed among the stakeholders as the share interest or its redemption
in order to satisfy the stakeholders. Thus, the cash obtained from the operational activities cannot
be solely perceived as the ability of the financial firm for creating the cash flows. Therefore, it is
required for evaluation of the business unit to calculate its free cash flows as well as the cash
obtained from the operational activities (Martin & Petty, 2000). Also, in Martin and Pettys
opinion, the old criteria of accounting such as each shares profit and the properties yield cannot
solely be indicative of the business units performance. These criteria should be used besides
criteria such as the free cash flows, since while the profit is repeatedly manipulated by the
managers, the denial and manipulation of the cash flows is very difficult. The investigation of the
related literature is indicative of different approaches on free cash flows and their calculation.
Jensen was among the first who determined and defined the free cash flows.
2.2.Earnings Management
Perhaps the best way to think about the earnings management is that the initial aim of the
financial statements is to solve the problem of asymmetry of information. The information

asymmetry points that the managers of the commercial units have a greater access to the actual
information of the company than the outsiders. In fact, the financial reports provide the manager
with an instrument to transfer the companys performance information to the users of financial
statements. The managers of the companies with increasing profit trends over years utilize some
ways for continuing this manner. One of these ways is to reduce the profit when it is raised and
increase it when it is decreased.
Generally, the earnings management is defined as an effective factor on the companys profit in a
way the interests and demands of the company and its managers are met. Wild (2001) has
defined the earnings management as ways for desirable companies status informing. The
earnings management is the purposeful intervention of the management in profit determination
process in line with the desirable purposes of the management. The earnings management is
intentional intervention in external financial reporting process with the aim of yielding profit.
Healy and Wahlen (1999) define the earnings management as follows: the earnings management
happens when the managers use judgments on financial reporting and transactions structure to
manipulate the financial statements and mislead some beneficiary stakeholders on the companys
business or affecting the results of the contracts based on the reported accounting amounts.
3. Research hypotheses
According to the theoretical framework, the following hypotheses are suggested:
1st hypothesis: there is significant relationship between the free cash flows and earnings
management.
2nd hypothesis: the size of board of directors has a significant effect on the relationship between
the free cash flows and earnings management.
3rd hypothesis: the board of directors independence has a significant effect on the relationship
between the free cash flows and earnings management.
4th hypothesis: the duality of the directors task has a significant effect on the relationship
between the free cash flows and earnings management.
5th hypothesis: the quality of audit has a significant effect on the relationship between the free
cash flows and earnings management.
6th hypothesis: the institutional ownership has a significant effect on the relationship between the
free cash flows and earnings management.
7th hypothesis: the managerial ownership has a significant effect on the relationship between the

4. Methodology
The current study is of applied type in terms of objective and of correlation type in terms of
method and the nature. In terms of the subject and scientific range, it is classified in financial
management category and stock exchange, more specifically in the area of the information
related to corporate governance, free cash flow, earnings management, and the ownership
structure of the companies. It deals with the interactive relationship between the corporate
governance structure, the free cash flow, and earnings management in Tehran Stock Exchange
listed companies. The data collection method is library-based besides credited articles and TSE
website. The data collection instrument are the databases and document exploration which
include the information on institutional and managerial ownership and the board of directors
features extracted from the appendices of financial statements and the boards reports besides
other financial information given in audit financial statements. All these data can be extracted
from the Rahavard Novin Software, and the internet and E-archives of the stock exchange
website. The statistical population of the current study includes the Tehran Stock Exchange listed
companies from the beginning of 2009 to the end of 2015 which remained in the stock exchange
market during this 7-year period. In order to assure the reliability, the companies which entered
the stock exchange market after 2009 and/or were out of the market during this period, were
excluded. The selection procedure of the statistical population is provided in table 1.
Table 1: the selection procedure for the statistical population
Description Quantity Quantity

The number of the companies listed in Tehran Stock Exchange 755
until the end of 2015
Number of the companies entering the Stock Exchange during 537
the time range of the study
Number of the companies whose financial year dos not end in 551
12/29
The number of the companies which are investing and brokerage 57
The numbers of the companies whose information are not 555
accessible or complete for calculation of the variables
total 515
The number of the companies chosen as the statistical 071
population
The research variables measurement method depends on the division of dependent and
independent variables. In this section, these variables will be measured.
Dependent Variable: Earnings Management
According to Dechaw et al (1995), the Modified Jones Model (1986) is the strongest model for
measuring earnings management. In this regard, the mentioned model was used in the current

study to measure discretionary accruals. In the modified Jones model, firstly the total
discretionary accruals are calculated through the following model:
Equation1: TAt E it CFO
In which:
TA: is the total companys discretionary accrual in the year t
E: is the profit before extraordinary items for company i in year t
CFO: the free cash flows obtained from the operations for company I in year t.
After calculation of total discretionary accruals, the parameters 1 , 2 , 3 are estimated through
the following formula in order to determine the discretionary accruals:
TAit 1 REV PPE t

Equation 2: 1 2 3
Ait 1 Ait 1 Ait 1 Ait 1
In which:
TAit is the company is total discretionary accruals in the year t
Ai ,t 1 is the book value of the total properties of the company i from year t to t-1
REVit is the changes in the company i's sales revenue between years t and t-1
PPE it are the company is properties, machinery, and equipment in the year t
it is the unclear effects of the random factors
1 , 2 , 3 are the estimated parameters of the company i
After the calculation of the parameters 1 , 2 , 3 through the least squares model, the
discretionary accruals are calculated through the following equation:
1 REVit REC it PPE it

Equation 3: NDACit 1 2 3
Ait 1 Ait 1 Ait 1
In which:
NDAit is the company is non-discretionary accruals in the year t
REC is the change in the accounts receivables of the company i from year t to t-1

Eventually, the discretionary accruals (DAC) are calculated as follows after determination of
NDAC.
TA
Equation 4: DAC NDA
Ait 1
The Dependent Variables:

The Size of the Board of Directors
The number of the managers of the board of directors: The board of directors size is one of
corporate governance mechanisms which has been evaluated in several studies. Most of
researchers have concluded that the size of the board can improve the companys performance in
two manners: a) the higher need of the company for connecting to the outside, and b) higher
executive responsibility in the company (Krivogorsky, 2006).
The Board of Directors Independence
The percentage of non-executive directors is obtained by dividing the number of non-executive
board members to the total board directors.
Duality of The CEOs Responsibility
According to the representation theory, if the CEO and the chairman of the board is the same
person (the sameness of the CEOs responsibilities), the supervision will face serious problems.
One of the ways for separating the decision management and the decision control is to divide the
responsibilities of the CEO and the chairman of the board.
The duality of the CEOs responsibility is the dummy variables zero and one. If the CEO is also
the chairman of the board, this value is zero and otherwise, it is one.
Institutional Ownership
The institutional investors can be effective controllers since they have the needed resources and
ability for properly supervising the managerial decisions. It is claimed that the companys
performance is improved in line with the improvement of institutional ownership equals the
shares of the governmental and public companies. These companies include insurance
companies, the banks, financial institutions, governmental companies, and other components of
the government. This variable has been also defined this way in the works of Kumar (2003),
Earnheart and Lizel (2006), and Namazi and Kermani (2009).
Managerial Ownership
It is indicative of the shares kept by the board of the directors members. According to the
representation theory, the managers increase their position, fame, credit, welfare, and respect
through the companys costs. This theory that analyzes the conflict between the managers and
stakeholders will result in the same entrepreneurship theory though from a different view. The
entrepreneurship talks about the advantages of the managerial ownership while the
representation theory suggests the decrease in the costs of representation in case the managers
become the owners (Jensen & Meckling, 1976).
Audit quality
One of the most common definitions about the audit is the one provided by Di Angelo (1981).
He puts it as the market evaluation (presumption) from the probability that the auditor firstly
discovers the significant distortions in the financial statements or accounting system and
secondly he reports the important discovered distortion.
Free Cash Flows
The calculation of the free cash flows based on the Jensen model is very difficult, since all the
projects with the current positive net value as expected by the financial firm cannot be
determined quickly. Moreover, usually, the information for determination of the reliable capital
costs rate are not accessible. Thus, it was intended other models for calculation of the free cash
flows of the financial firms which can replace the Jensen model in a way or another be used. The
model of Lehn and Poulsen (1989) has been used in the current study for calculation of the free
cash flows of the financial firms.
Based on the above mentioned model, the free cash flows are calculated by the following
formula:
Equation 5: FCFit ( INCit TAX it INTEPit PSDIVit CSDIVit ) / Ai ,t 1

In which:
FCFit
: the free cash flows of the company i in the year t
INCit
: the operating profit before depreciation for the company i in the year t
TAX it
: the total taxes paid by the company i in the year t
INTEPit
: interest expense paid by the company i in the year t
PSDIVit : Preferred shareholders dividends paid by the company i in year t
CSDIVit : Ordinary shareholders profit dividends paid by company i in year t
Ai ,t 1
: the total book value of the company is properties in the year t-1
Controlling Variables
Return of the Assets
The assets return ration is a criterion indicating how much yield the company has made from his
assets or in other words return from the invested resources. The return of the assets is a ratio that
enables us know the companys assets are to what extent useable and to what extent the manager
has been able to optimally use the limited resources. The higher this ratio, the higher the
companys performance is (Shanazarian, 1389). This ratio is obtained by dividing the net profit
to total assets:
Equation 6:
Q TOBIN IT 0 1BIND it 2CEO it 3BSIZE it 4RB it 5AUDQit 6lev 7size it
E is the net profit and Assets is the total assets.

The Firms Size
For determination of the companys size, several criteria such as Logarithm of the value of total
assets, total sales, number of employees, market value of equity are being used (Frankel, 2002).
The logarithm is used to remove the non-linearity of the firm size data. This non-linearity is due
to the distribution of the companys assets value and using the logarithm facilitates the
evaluation. The logarithm of total value of the assets at the end of the year was used in the
current study for comparing it to previous study:
Pit 0 1EPS it 2VD it 3EPS it *VD it 4LOSS it *VD it 5SIZEit *V
Financial Leverage
This ratio is achieved by dividing the total debt to total assets. It indicates that how much assets
have been supplied by loans and how much was supplied through the firms invest and it is
achieved from the sum of total corporate debt divided by the total assets.
Debt it
LEVE
Assets it
Debt is total debt and Assets is total asset.

The variables used in the study and their symbols are provided in table 2.
Table 2: the utilized variables in the study and their symbols

Row symbol The research variables and their type
Dependent
5 DAC Earnings management
variable
Independent
2 FCF Free cash flow
variable
Independent
3 Board size
SIZEBORD variable
Independent
5 BIND Board independence
variable
Duality of CEO Independent
7 DUAL
responsibility variable

Independent
6 AQ Audit quality
variable
Independent
5 MANOWN Managerial ownership
variable
Independent
8 INSOWN Institutional ownership
variable
Controlling
9 SIZE Firm size
variable
Controlling
51 LEVE Financial leverage
variable
Controlling
55 ROA Return of assets
variable
Finally, for testing the hypotheses, the multi-variable regression between the dependent and
independent variables alongside the combined data analysis were used. Using the combined data
requires determination and selection of various models of this method including fixed effects
models, random effects model, or the pooled data. For determination of the model used for
combined data, tests such as Chow test, Hausman, and ALM test were used.
5- Findings
5-1- Analysis of the Data Using the Combined Data
Actually, there are two criteria for approving/rejecting the research hypotheses:
1- The significance level (p-value or sig) is lower than 0.05.
2- The absolute value of t-student statistic at 95% significance level is greater than 2.
In any of the above situations, the obtained test statistic will lead in rejection of H0 and
consequently approving the H1.
For testing the hypothesis H0, the t-student statistic is used. In this regard, if the obtained
significant coefficient is lower than 0.05, the null hypothesis will be rejected and as a result, its
opposite hypothesis will be approved. Approve of the opposite hypothesis means that there is a
significant linear relationship between the independent variables of the study and the tested item
dependent variable in the model designed for testing the research variables.
The statistical hypotheses of the study are as follows:
H0: there is no correlation between the dependent and independent variables.
H1: there is no correlation between the dependent and independent variables.
Thus, if sig<0.05, the H0 is rejected and the H1 is approved. According to the mentioned multi-
variable model, if the coefficient of each independent variable (i) is positive, the mentioned
independent variables have a direct relationship with the dependent variable, and if this
coefficient is negative, there is a reverse relationship. Generally, the f-statistic is used for
investigating the significance of the whole model, and the t-statistic is used for the relationship
between each dependent and independent variables. The Durbin-Watson test was also used for
investigating the correlation between the residuals of the regression error. In case the statistic of
this test is close to 2, it means that there is no correlation between the residuals.
5-2- The Research Model Test Results
The results of testing the first model of the study are provided in table 3:
Table 3: the results of testing the first research model in the level of combined data
F-static Durbin-
Coeffici
Description T student p-value p.v Watson
ent
Intercept 0 1331 3381 1311 5138 5361
13111
FCF 1356 6315 1311
SIZE 1311 1357 1313
LEVE 1311 1331 1315
ROA 1315 1357 1313
The modified coefficient of determination( R2) 13311
As it is indicated in table 3, the F-statistic is significant in 95% significance level. Thus, the
studys model is generally significant and the independent and the controlling variables can
explain the dependent variable. In addition, the modified coefficient of determination obtained
from the research model was 0.32. This number indicates that almost 0.32% of the dependent
variable i.e. the accruals profit achieved from the independent and controlling variables available
in the model and the remaining 0.68 of its differences are due to other factors.
Also the Durbin-Watson numbers indicate that there is no self-correlation between the Model
disturbing elements, since these numbers are from 1.5 to 2.5.
Hypothesis 1:
There is significant relationship between the free cash flows and earnings management.
In this hypothesis, the dependent variable is earning management and the independent variable is
the free cash flow. According to the results in table 5-4, the t-statistic of the independent variable
Free Cash Flow (FCF) and its significance level are 6.04 and 0.01, respectively. Since the error
level in the current study is 0.05, the CFC variable has a significant level on the earning
management and the first hypothesis of the study is approved with 95% accuracy level. The FCF
variable coefficient is positive. As a result, the relationship between the CFC and earning

management is positive and direct. In other words, with the increase in CFC, the earning
management also increases.
The results of the second hypothesis testing at the combined data levels were analyzed in order to
investigate the interactive effect of the corporate governance mechanisms on the relationship
between the CFC and the earning management. The results are provided in table 4.
Table 4: the results of testing the second research model in the level of combined data
F-static Durbin-
Coeffici
Description T student p-value p.v Watson
ent
Interception 0 1331 3385 1311
FCF 1359 1316 1313

BOARDSIZE - 1311 - 1311 1315
BORAIND - 1313 - 1359 1311
DUAL 1315 1368 1359
AUDQ - 1317 - 1351 1311
INSTOWN - 1355 - 1338 1315
MANOWN 13111 1363 1311 535
5365
BOARDSIZE*FCF - 1311 - 1315 1313 13111
BORAIND*FCF -1315 - 3353 1311
DUAL*FCF 13113 1317 139
AUDQ*FCF - 1316 - 1333 1311
INSTOWN*FCF - 1316 -3355 1311
MANOWN*FCF 1313 135 1313
SIZE 1311 1351 1313
LEVE 1311 1355 1311
ROA 1315 1338 1311
The modified coefficient of determination ( R )
2
13655
As indicated in table 4, the F-statistics is significant with 95% accuracy level. Thus, the research
model is generally significant and the independent and controlling variables are able to explain
the dependent variable. In addition, the modified coefficient of determination obtained from the
test is 0.67. This number indicates that almost 0.67% of the dependent variable i.e. the earning
management is achieved from the independent and controlling variables available in the model
and the remaining 0.33 of its differences are due to other factors. Also the Durbin-Watson

numbers indicate that there is no self-correlation between the Model disturbing elements, since
these numbers are from 1.5 to 2.5.
Hypothesis 2:
The board size has a significant effect on the relationship between the free cash flows and
earnings management.
According to the results of table 4, the t-statistic of the board size interactive variable in the Free
Cash Flow (FCF) and its significance level (p-value) are -2.07 and 0.04, respectively. Since the
error level in the current study is 0.05, the CFC variable has a significant level on the earning
management and the first hypothesis of the study is approved with 95% accuracy level. The
coefficient of the variable BOARDSIZE*FCF is negative. It means that by the increase in board
size, the positive relationship between the CFC and earning management is reduced. This result
indicates that regarding the regulatory role of the members of the board of directors, the more the
number of the members, there will be less earning management due to the conflict between the
benefits of the members and beneficiaries and the board members do not let the managers be
opportunistic about the CFC.
Hypothesis 3:
The board independence has a significant effect on the relationship between the free cash flows
and earnings management.
According to the results of table 4, the t-statistic of the board independence interactive variable
in the Free Cash Flow (FCF) (BORADIND*FCF) and its significance level (p-value) are -3.13
and 0.00, respectively. Since the error level in the current study is 0.05, the board independence
variable has a significant level on the earning management and the second hypothesis of the
study is approved with 95% accuracy level. The coefficient of the variable BOARDIND*FCF is
negative. It means that by the increase in board independence, the positive relationship between
the CFC and earning management is reduced and prevent the manger from abusing the CFC and
controls him. It means that the role of non-executive directors is according to the representation
theory and it is a powerful supervision instrument in reducing the earning management.
According to the representation theory, the existence of independent non-executive directors in
the companys board of managers and their supervising function as independent individuals
helps to the reduction of the conflicts between the interests of the stakeholders and the managers.
Hypothesis 4:
The duality of the CEOs responsibility has a significant effect on the relationship between the
According to the results of table 4, the t-statistic of the board independence interactive variable
in the Free Cash Flow (FCF) (BORADIND*FCF) and its significance level (p-value) are -3.13
and 0.00, respectively. Since the error level in the current study is 0.05, thus the duality of the
CEOs responsibility does not have any significant effects on the relationship between the free

cash flows and earnings management and the third hypothesis cannot be approved by 95%
accuracy level.
Hypothesis 5:
The quality of audit has a significant effect on the relationship between the free cash flows and
earnings management.
According to the results of table 4, the t-statistic of the quality of audit interactive variable in the
Free Cash Flow (FCF) (AUDQ*FCF) and its significance level (p-value) are -2.33 and 0.02,
respectively. Since the error level in the current study is 0.05, the quality of audit variable has a
significant level on the earning management and the fourth hypothesis of the study is approved
with 95% accuracy level. The coefficient of the variable AUDQ*FCF is negative. It means that
by the increase in quality of audit, the positive relationship between the CFC and earning
management is reduced and the auditors by their following and the high quality of audit, prevent
the managers from being opportunistic about the CFC and abuse it. Generally, the auditors goal
is to protect the stakeholders interests from the significant distortions and errors present in the
financial statements. The auditors for maintaining the credit of the profession, their professional
fame, and avoiding the litigation against them, tend to improve the quality of the audit.
Meanwhile, the mangers intentions for applying the personal interests in earning management
prevent the auditors from achieving their goals. On the other hand, the auditors can discover the
earning management done by the managers and make them trouble by increasing the quality of
audit.
Hypothesis 6:
The institutional ownership has a significant effect on the relationship between the free cash
flows and earnings management.
According to the results of table 4, the t-statistic of the institutional ownership interactive
variable in the Free Cash Flow (FCF) (INSTOWN*FCF) and its significance level (p-value) are -
3.11 and 0.00, respectively. Since the error level in the current study is 0.05, the institutional
ownership variable has a significant level on the earning management and the fifth hypothesis of
the study is approved with 95% accuracy level. The coefficient of the variable INSTOWN*FCF
is negative. It means that by the increase in institutional ownership, the positive relationship
between the CFC and earning management is reduced. It means that the institutional ownership
has an active supervising role on the companys decision in earning management and by the
increase in the percentage of institutional ownership, the flexibility of the company for earning
management of the accruals is reduced. In other words, the increase in the ownership of the
institutional ownership leads to reduction in earnings management and we can interpret that the
more the percentage of ownership of the institutional investors, their supervision will be more
and finally the earnings management is reduced.
Hypothesis 6:
The managerial ownership has a significant effect on the relationship between the free cash
flows and earnings management.

According to the results of table 4, the t-statistic of the managerial ownership interactive variable
in the Free Cash Flow (FCF) (MANOWN*FCF) and its significance level (p-value) are 2.11 and
0.00, respectively. Since the error level in the current study is 0.05, the managerial ownership
variable has a significant level on the earning management and the sixth hypothesis of the study
is approved with 95% accuracy level. The coefficient of the variable MANOWN*FCF is
negative. It means that by the increase in managerial ownership, the positive relationship
between the CFC and earning management is reduced.
6- Conclusion and Suggestions

The current study aimed at the evaluation of the interactive effect of the corporate governance
features on the relationship between the free cash flows and the earnings management in Tehran
Stock Exchange listed companies and the following results were obtained:
1- There is positive and direct relationship between the FCF variable and the earnings
management at the 95% accuracy level. In fact, the results indicated that the companies
that manage their earnings also have higher FCF and in other words by applying the
earnings management, pave the way for opportunistic decisions.
2- The size and the independence of the board of directors lead to modification of the
relationship between the FCF and earnings management and reduce this relationship. In
other words, by the increase in the size of the board and especially the independent
members, the opportunistic behavior of the managers and the use of FCF will be reduced.
It means that the role of the non-executive managers in Iran are in accordance with the
representation theory and it is a powerful instrument for reduction of the earnings
management, since the executive members due to intervention in the executive processes
have the needed intention and the will for the earnings management, while the non-
executive members due to their supervising role in major management of the company
has less intentions for earnings management.
3- The institutional ownership has a modification effect on the relationship between the FCF
and earnings management and reduces this relationship. It means that the institutional
stakeholders have an active supervisory role in the companys decisions on earnings
management and by the increase in the ownership percentage of the institutional
ownership, the flexibility of the company for earning management of the accruals will be
reduced. In other words, the increase in the ownership of the institutional ownership leads
to reduction in earnings management and we can interpret that the more the percentage
of ownership of the institutional investors, their supervision will be more and finally the
earnings management is reduced.
4- The results indicated that managerial ownership leads to the increase in the relationship
between the FCF and earnings management. It means by the increase in the ownership
of the shareholders who are themselves managers; the earnings management is
increased. In fact, this relationship indicates that companies, in which a portion of their
shares belong to the board of directors and the managers, apply higher earnings
management.
5- The quality of audit also modifies the relationship between the FCF and earnings
management. The auditors for maintaining the credit of the profession, their professional

fame, and avoiding the litigation against them, tend to improve the quality of the audit.
Meanwhile, the mangers intentions for applying the personal interests in earning
management prevent the auditors from achieving their goals. On the other hand, the
auditors can discover the earning management done by the managers and make them
trouble by increasing the quality of audit.
6- There is a positive and direct relationship between the firms size and the assets yield,
and earnings management. It indicates that the bigger firms apply higher earnings
management. The first reason is that the relatively bigger companies are more sensitive in
terms political terms compared to smaller companies. The significant positive swings in
the profit in the bigger companies may lead to uncertainty about the monopoly profits. In
other words, the higher cash in the profits of the big companies may lead to this question
that these companies have increased their profit using their monopoly power. On the
other hand, the significant negative swings in the profit leads to the doubts on probable
bankruptcy and distort the companys image in the business environment. Also the
significant swings in the big companies profit increase the probability of unwanted
political costs. Thus, the bigger companies have higher intentions for earnings
management. The second reason is that by the companies getting bigger, the mangers
responsibility for responding to the beneficiaries is increased.
7- There is positive and direct relationship between the financial leverage and earnings
management since the companies managers have higher intentions for satisfying the
creditors though the earnings management. In other words, the companies manage the
earnings in order to reduce the risk. The companies with higher ratio of debt to total
assets use earnings management for assuring the creditors on the ability to pay back the
received loans alongside with their interests. Lack of significant swings in the profits
assures the creditors that the business firm will be able to pay back the loans in future.
Finally, some suggestions are provided:
1- According to the obtained results, the increase in the number of the board directors and
their independence has a negative effect on the companies earnings management. It is
indicative of the ability of this supervisory instrument for decreasing the earnings
management and familiarity of the market with the role of non-executive board members
besides their efforts for the corporate governance of the companies in which they are the
non-executive board members. Thus, it is suggested that as mentioned in the corporate
governance regulations of the companies, most of the board members be non-executive
and this ratio should be increased and also these non-executive members fulfill their
duties for creating the related committees (such as the audit committee, appointments
committee,) and give the specific reports of the related committees such as the stability
reports of the companies, and etc.
2- The investors when using the financial statements for decision-making in investing the
companies shares or selling the shares should consider the earnings management.
Relying on the profit of each share without considering the probable effects of earnings
management can lead to undesirable results. The recognition of the earnings
management by the investors can lead to better understanding of the concept of
accounting profit, and help with the recognition of its features and limitations.

3- Regarding the positive relationship between the managerial ownership and earnings
management, it is suggested for the investors to consider the extent of the managerial
ownership.
4- Regarding the positive relationship between the firms size and earnings management, it
is suggested to account for the firms size for investing decisions.

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An Evaluation of The Relationships Between The Corporate Governance Mechanisms, The Free Cash Flow, and Earnings Management in Tehran Stock Exchange Listed Companies

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Special Issue INTERNATIONAL JOURNAL OF HUMANITIES AND

March 2016 CULTURAL STUDIES ISSN 2356-5926

An Evaluation of the Relationships between the Corporate Governance

Seyed Ali Vaez

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2. The Theoretical Framework of the Study

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Table 1: the selection procedure for the statistical population

Description Quantity Quantity

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Equation1: TAt E it CFO

TAit 1 REV PPE t

TAit is the company is total discretionary accruals in the year t

it is the unclear effects of the random factors

1 , 2 , 3 are the estimated parameters of the company i

1 REVit REC it PPE it

NDAit is the company is non-discretionary accruals in the year t

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The Dependent Variables:

Equation 5: FCFit ( INCit TAX it INTEPit PSDIVit CSDIVit ) / Ai ,t 1

E is the net profit and Assets is the total assets.

Pit 0 1EPS it 2VD it 3EPS it *VD it 4LOSS it *VD it 5SIZEit *V

Debt is total debt and Assets is total asset.

Table 2: the utilized variables in the study and their symbols

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FCF 1359 1316 1313

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6- Conclusion and Suggestions

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Habib Ahsan. 2004. impact of Earnings Management on Value-Relevance of Accounting Information.

Hermalin, B. E., Weisbach, M. S. (2010). "Information Disclosure and Corporate Governance."

http://www.ijhcs.com/index.php/ijhcs/index Page 139

Saghafi, Ali; Safarzadeh, Mohammad Hossein.(2012) Empirical investigation of the profit

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Pit 0 1EPS it 2VD it 3EPS it VD it 4LOSS it VD it 5SIZEit *V