Aurora Borealis
1 July 2016 CFA Institute Journal Review

Unrealized Earnings, Dividends and Reporting Aggressiveness: An Examination of Firms’ Behavior in the Era of Fair Value Accounting (Digest Summary)

  1. Sonia Gandhi, CFA

A firm’s dividend payments increase following the recognition of unrealized gains. Dividends from unrealized earnings are positively associated with tax avoidance and book earnings management. Firms that pay dividends out of unrealized earnings have higher financial leverage and are less R&D intensive compared with their counterparts that do not indulge in this practice.

What’s Inside?

Because of the transition from cost-based to fair value accounting, firms have had the chance to increase their dividend payouts by distributing dividends from unrealized earnings. Dividend distributions from unrealized earnings lead to increased financial leverage, which is a significant factor in a company’s financial stability. Firms that pay dividends from unrealized earnings (DFU firms) are more financially leveraged and less innovative than firms that do not pay dividends from unrealized earnings. The former are also more aggressive in their book earnings management and tax reporting behavior. This increased aggressiveness is related to cash dividend payments from paper profits. Unrealized earnings only create cash flows when they are realized.

How Is This Research Useful to Practitioners?

Dividends are often used by management as a signaling mechanism, and management is usually very reluctant to cut the payout ratio. Various underlying factors are at play, however, when firms pay dividends from unrealized earnings. A clear understanding of the mechanics of these factors would be very useful for practitioners, tax accountants, regulators of corporate laws, accounting standard setters, tax authorities, auditors, investors, and other stakeholders in the firm.

The authors use a sample of 508 Israeli public companies that adopted International Financial Reporting Standards (IFRS) in 2007 to establish a sizable increase in dividend distributions in firms that recognize positive revaluation earnings, which is directly related to the revaluation gains recognized. But the authors find that DFU firms also increase their financial leverage—raising debt to finance the payment of cash dividends from unrealized profits.

DFU firms are found to be more aggressive in their book earnings management and tax reporting behaviors, leveraging grey areas in corporate law to behave in ways that contradict the legislation’s spirit. These firms inflate their book earnings and reduce their taxable earnings to facilitate the payment of dividends from unrealized earnings. This behavior has an adverse effect on stakeholders in DFU firms as well as on the public as a whole because the firms have an increased incentive to avoid taxes. Moreover, these firms are less R&D intensive, which suggests that firm innovation might suffer because of the increased dividend payout.

How Did the Authors Conduct This Research?

The authors collect data from 2001 to 2012 for a sample of 508 Israeli firms that adopted IFRS in 2007. Financial information for the sample is from the Bloomberg Professional database and information collected manually from the companies’ financial statements. Thirty-three percent, or 168 DFU firms, are identified. The authors perform univariate analysis of firm dividend payout policies in the pre- and post-IFRS-adoption periods. They find that, on average, DFU firms distribute dividends from unrealized gains three times during the six-year period (i.e., DFU firm-years) following the firms’ IFRS adoption. In that time period, dividend payments as a percentage of realized earnings increase from an average of 32% before IFRS adoption to an average of 115% following IFRS adoption. Other things being equal, a firm’s dividend payments increase after unrealized gains are recognized.

The authors run specifications of logistic regressions. Their dependent variable is an indicator variable that equals 1 for a DFU firm and 0 otherwise. A proxy for earnings management is added to test the hypothesis that an aggressive dividend policy is associated with aggressive financial and tax reporting behavior. Next, earnings are decomposed into managed earnings and unmanaged earnings. The first measure of book earnings management used is performance-matched discretionary accruals. The authors repeat the analysis using firm non-operating accruals.

As a proxy for tax avoidance, the authors use a firm’s book–tax difference and repeat the analysis using the firm’s cash effective tax rates. They find that dividends from unrealized earnings are positively associated with tax avoidance and that dividends from unrealized earnings are positively associated with book earnings management. The tests are further supplemented with multivariate dividend payout regressions. Further robustness tests are performed using an alternative DFU classification and with sensitivity analyses using firm-based coding instead of firm-year-based coding.

Abstractor’s Viewpoint

In an environment where firm management often finds itself under pressure to keep increasingly vocal shareholders satisfied, doling out dividends from unrealized earnings is becoming a tacitly acceptable practice. But this act of appeasement comes with its own concomitant costs and sometimes undesirable management behavior. The authors provide useful guidance on monitoring a company’s future financial stability. This research can also be an invaluable tool in the hands of boards of directors to enhance effective governance. Further research to investigate additional aspects of the impact of dividend payments from unrealized earnings on the financial health of a firm is highly recommended.

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