Research

High Free Cash Flow Means Auditors Must Delve Deeper

Companies that generate high levels of cash flow might appear to be a solid market investment. However, finance researchers have shown that when companies build up more cash flow than they need, errant managers tend to spend the excess unwisely, which can actually drain shareholder value.

Professor Paul Griffin has teamed up with David Lont of the Department of Accountancy and Business Law at University of Otago, New Zealand, and Yuan Sun of UC Berkeley’s Haas School of Business to analyze the impact this “free cash flow hypothesis” has on auditing fees. Griffin presented their research findings at the July 2009 Accounting and Finance Association of Australia and New Zealand.

Griffin and his co-authors concluded that auditors monitoring firms with high free cash flow and low growth prospects increase their fees due to the work involved in checking on managers. The rise in audit fees is due to the additional work load and auditing effort, not from additional risk associated with the questionable audit. Griffin et al. argue that the auditors are fulfilling an important governance or monitoring role that is critical to the well being of the company boards and their investors. Companies that generate high levels of cash flow might appear to be a solid market investment. However, finance researchers have shown that when companies build up more cash flow than they need, errant managers tend to spend the excess unwisely, which can actually drain shareholder value.

Griffin has been invited to lead the inaugural Quantitative Accounting Research Ph.D. consortium to be held November 26 at the University of Auckland in New Zealand. As an internationally recognized scholar in accounting, financial valuation and security markets, Griffin will provide his insights on research methodology and critical feedback to select Ph.D. students. The following day, Griffin will be the Distinguished Keynote Speaker at the 2009 Auckland Region Accounting Conference at the University of Auckland Business School, where he will present a talk on “Evolution and Application of Research in Accounting and Auditing.”