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The role of accrual accounting in restricting dividends to shareholders

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  • Christian Leuz

Abstract

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 specification of the upper bound on dividends in an earnings-based constraint. Transactions and events used in the accrual process can be viewed as imperfect, but verifiable indicators for (unverifiable) determinants of debt-related incentive problems. This general idea is applied to incentive problems that regularly arise in a multi-period context. The paper demonstrates that the accrual process may mitigate distortions in shareholders' investment decisions using provisions and depreciation charges as examples.

Suggested Citation

  • Christian Leuz, 1998. "The role of accrual accounting in restricting dividends to shareholders," European Accounting Review, Taylor & Francis Journals, vol. 7(4), pages 579-604.
  • Handle: RePEc:taf:euract:v:7:y:1998:i:4:p:579-604
    DOI: 10.1080/096381898336204
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    References listed on IDEAS

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    1. Smith, Clifford Jr. & Watts, Ross L., 1992. "The investment opportunity set and corporate financing, dividend, and compensation policies," Journal of Financial Economics, Elsevier, vol. 32(3), pages 263-292, December.
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    7. Christian Leuz & Dominic Deller & Michael Stubenrath, 1997. "An International Comparison of Accounting-Based Payout Restrictions in the United States, United Kingdom and Germany," Accounting and Business Research, Taylor & Francis Journals, vol. 28(2), pages 111-129, July.
    8. Healy, Paul M. & Palepu, Krishna G., 1990. "Effectiveness of accounting-based dividend covenants," Journal of Accounting and Economics, Elsevier, vol. 12(1-3), pages 97-123, January.
    9. Duke, Joanne C. & Hunt, Herbert III, 1990. "An empirical examination of debt covenant restrictions and accounting-related debt proxies," Journal of Accounting and Economics, Elsevier, vol. 12(1-3), pages 45-63, January.
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    Cited by:

    1. Gao, Pingyang, 2013. "A measurement approach to conservatism and earnings management," Journal of Accounting and Economics, Elsevier, vol. 55(2), pages 251-268.
    2. Igor Goncharov & Sander Triest, 2014. "Unintended Consequences of Changing Accounting Standards: The Case of Fair Value Accounting and Mandatory Dividends," Abacus, Accounting Foundation, University of Sydney, vol. 50(3), pages 341-367, September.
    3. John Armour, 2006. "Legal capital: an outdated concept," Working Papers wp320, Centre for Business Research, University of Cambridge.

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