Agency Conflicts, Dividend Payout, and the Direct Benefits of Conservative Financial Reporting to Equity-Holders

Posted: 21 Dec 2013

See all articles by Henock Louis

Henock Louis

Pennsylvania State University - Smeal College of Business

Oktay Urcan

University of Illinois at Urbana-Champaign

Multiple version iconThere are 2 versions of this paper

Date Written: December 17, 2013

Abstract

One principal reason for dividends is that they force managers to raise funds in the external capital markets to finance new projects, which presumably reduces their incentives to engage in empire-building activities. We posit that, because accounting conservatism can also mitigate managers’ incentives to engage in value-destroying projects, it could reduce dividends and the associated costs. Accordingly, we find that dividends are inversely related to conservatism. The conservatism effect holds even when we control for the underlying accounting factors that directly affect dividends, or limit the sample to firms that have no debt covenants pertaining to dividend payouts, indicating that the reason for the conservatism effect transcends the standard debt covenant restriction argument. This negative association between conservatism and payout is also robust to the use of alternative proxies for conservatism, and to controlling for the potential endogeneity in the relation between conservatism and payouts. More importantly, we find that the effect of conservatism on dividend payout is more negative when agency conflicts between managers and shareholders are potentially more pronounced.

This study is the first to empirically document the negative effect of accounting conservatism on payout policies. Although prior studies have extensively examined factors that affect payout policies, none has empirically analyzed the potential effects of accounting reporting policies on dividend payout policies, or even considered controlling for such effects. Our study shows that accounting conservatism is a significant determinant of dividend payouts. Moreover, most of the theoretical discussion in the literature about conservatism and dividend payouts is in terms of the direct link between conservatism and payouts that stems from contractual debt agreements. We show that the effect of conservatism on payouts transcends the direct and mechanical link. Finally, we contribute to the literature by identifying another mechanism through which accounting conservatism addresses shareholders’ needs. Watts (2003) and Ball, Robin, and Sadka (2008) maintain that accounting conservatism is driven mainly by debt contracting. Accordingly, most of the discussion about conservatism in the literature is about its role in mitigating conflicts of interest between owners/managers and debtholders, and in reducing the cost of debt. Our analysis suggests that accounting conservatism also mitigates agency costs related to incentive conflicts between shareholders and managers by reducing the need for dividend payments and the costs to shareholders resulting from such payments.

A copy of the paper can be found at: http://ssrn.com/abstract=2359031.

Keywords: Payout; Accounting conservatism; Agency costs

JEL Classification: M41; G35

Suggested Citation

Louis, Henock and Urcan, Oktay, Agency Conflicts, Dividend Payout, and the Direct Benefits of Conservative Financial Reporting to Equity-Holders (December 17, 2013). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2369052

Henock Louis (Contact Author)

Pennsylvania State University - Smeal College of Business ( email )

University Park, PA 16802-3306
United States
814-865-4160 (Phone)
814-863-8393 (Fax)

Oktay Urcan

University of Illinois at Urbana-Champaign ( email )

515 E. Gregory Drive
4009 BIF MC-520
Champaign, IL 61820
United States
217-265-0383 (Phone)
217-244-0902 (Fax)

HOME PAGE: http://business.illinois.edu/profile/oktay-urcan/

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