Signaling Versus Free Cash Flow Theory

Earnings management refers to strategies deliberately applied to the accounting system to manipulate a company’s earning such that the figures reflect a specific target. Earnings management may become fraudulent when the company presents intentionally misstated data in the income statement. The signaling theory implies that most companies apply the earnings management to amplify the earnings before announcements of the dividend initiation. On the contrary, “free cash flow theory argues that companies use earnings management to lower the earning in dividend initiation” Smith & Pennathur 2019, p. 285) . Increased transparency in real activities makes it difficult for companies to manipulate earnings through accruals since there is a high possibility of litigation. According to the research in the case study, the companies initiating dividends manage the production downward to maintain financial flexibility. The evidence presented in table 5 (p. 299) of the findings supports that aberrant production is prevalent in two years before the initiation. Therefore, “the initiators apply downward real earnings management represented by high abnormal cash flows and low production in the period leading to initiating dividend payment” (p. 285). 

According to the results presented in table 6 (p. 301), the positive coefficient for initiators confirms that the companies use upward earnings management. The dividend initiating companies should have a high performance to provide extra earning to pay out as dividends. Earnings are managed upward in periods before the dividend initiation to control future prospects. The companies initiating dividends use downward real activities to uphold their credibility in lowering agency problems while maintaining flexibility in the financial system to pay future dividends. In conclusion, there are agencies effects evident in the free cash flow theory since most of the nonpaying companies seek ostensive contracts to refund the shareholders. Generally, the initiating companies use the earnings management to generate a pool of earnings reserves and maintain the expected financial flexibility for dividend initiation. However, the initiating companies are not signaling because they have high priced earnings during the announcement of dividend initiation. 

Reference 

Smith, D. D., & Pennathur, A. K. (2019). Signaling Versus Free Cash Flow Theory: What Does Earnings Management Reveal About Dividend Initiation?.  Journal of Accounting, Auditing & Finance ,  34 (2), 284-308.