The Role of Accrual Accounting in Restricting Dividends to Shareholders
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania - Wharton Financial Institutions Center; CESifo Research Network
This paper addresses the question why net earnings and other accrual accounting numbers are frequently used to restrict dividends to shareholders. Even though this role of accrual accounting is widely accepted in the literature, a theory explaining the role of accruals in dividend restrictions is still in its early stages. Building on the principal-agent framework, I argue that basic features of the accrual process can be viewed as arising from the demand for dividend restrictions mitigating debt-related incentive problems. This explanation is consistent with the observation that, historically, debt contracting, dividend restrictions and the development of accrual accounting have been closely related. The basic idea is that the use of transactions and events in the accrual process leads to a contingent formulation of the upper bound on dividends in an earnings-based constraint. Transactions and events act as imperfect, but verifiable indicators for (unverifiable) determinants of debt-related incentive problems. In particular, by shifting cash flows through time, e.g. with provisions or depreciation charges, the accrual process can mitigate distortions in shareholders' investment decisions that regularly arise in a multi-period context. Several examples illustrating this are provided. Although the accrual process is not the only way to mitigate these distortions, an equivalent cash-based constraint requires a complex menu of payout parameters. Such a menu is generally not observed in practice.
JEL Classification: G35, M41, D23
Date posted: May 19, 1997
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