Dividend payment is a major corporate decision that occurs regularly, involves substantial amounts of money, interacts with all other important company decisions, and has a significant impact on firm value. Our recent study, available here, examines whether financial reporting quality affects dividend policy.
Financial reporting quality, defined broadly as how informative financial reports are about a firm’s underlying economics, can affect dividend policy through three channels. First, reporting quality can affect dividends by mitigating the so-called free cash flow problem: managers’ incentive to underpay dividends and spend free cash flows on value-destroying projects that maximize their benefits at the expense of shareholders. There are, however, two competing views of the problem. The “outcome” view suggests that high quality reporting makes the value-destroying projects more visible and improves shareholders’ ability to monitor managers, thus curbing managers’ incentive to underpay dividends and elevating the relative appeal of dividend payments. In other words, higher reporting quality can lead to higher dividends. In contrast, the “substitute” view suggests that managers want a reputation for keeping the free cash flow problem in check so they can raise capital more cheaply. One way to create that reputation is to commit to paying dividends, but as high financial reporting quality mitigates the free cash flow problem, financial reporting quality substitutes for the need for managers to use dividends for building such reputation. Therefore, the “substitute” view suggests that higher reporting quality leads to lower dividends.
Second, reporting quality can affect dividends by mitigating financial constraints. Information asymmetry between firm managers and outside investors constrains firms’ access to external capital and increases management’s incentives to retain more earnings rather than pay them out as dividends. This financial constraint channel suggests that higher quality reporting can alleviate firms’ financial constraints and thus enable them to pay higher dividends.
Third, financial reporting quality can affect dividends by disciplining managers’ “quiet life” behavior. If managers lead a quiet life – forgoing value-increasing investment opportunities that require time and effort to identify and implement – the resulting underinvestment increases available cash flows, which managers could use pay more dividends. Therefore, the quiet life channel suggests that high quality financial reporting can mitigate firms’ underinvestment, thereby mitigating overpayment of dividends.
Looking at U.S. public companies’ financial reporting quality from 1994 to 2011 with Dechow and Dichev’s (2002) method, we found that a one standard deviation increase in financial reporting quality is associated with a 4.8 basis point increase in dividend yield (i.e., dividends paid divided by the stock price), which represents an approximately 5 percent increase over the average dividend yield of our sample firms. This positive relation is consistent with reporting quality leading to higher dividends by mitigating free cash flow problems (i.e., the outcome view of the free cash flow problem) and financial constraints (i.e., the financial constraint channel).
To determine which channels might account for this positive relation between financial reporting quality and dividends, we conducted further tests. First, we found that the positive relation between reporting quality and dividends is stronger for firms likely to suffer from free cash flow problems (e.g., those with larger amounts of cash flow from operations but fewer investment opportunities) and for firms with higher ownership by monitoring-type institutional investors (i.e., institutions that are top five shareholders, classified as “dedicated” institutions, and independent from management). Moreover, estimating firms’ under-/over-payment of dividends using a dividend determinant model, we also found that financial reporting quality is negatively associated with underpayment of dividends. These results primarily support the outcome view of the free cash flow problem. In other words, high quality financial reporting facilitates shareholders monitoring of management decisions, which constrains managers’ ability to underpay dividends and use free cash flows to benefit themselves.
We have then carried out two additional tests to uncover the direction of causal link between financial reporting quality to dividends. First, using granger-causality tests, we found that financial reporting quality helps predict future dividends, not vice versa. In the second, we took advantage of the increase in financial reporting frequency due to the SEC rule changes in 1955, which moved from annual financial reporting to semi-annual reporting, and 1970, which moved from semi-annual reporting to quarterly reporting. We found that, relative to matched control firms (those that voluntarily reported more frequently prior to the SEC mandate), companies that increased reporting frequency because of the SEC mandate exhibited a significant increase in dividends. These results collectively suggest that higher (lower) reporting quality leads to higher (lower) dividends. Additionally, we found consistent results when using a variety of alternative measures to financial reporting quality (e.g., the extent of disaggregated financial reporting, internal control effectiveness, financial reporting readability) and to dividends (e.g., dividend payout ratios, total payments to shareholders).
Our study suggests that higher financial reporting quality allows shareholders to better monitor corporate managers and thus makes it more difficult for managers to waste free cash flows for their own interests. As a result, higher financial reporting quality induces managers to pay more dividends to their shareholders.
This post comes to us from Professor David Koo at the University of Illinois at Urbana-Champaign, Professor Santhosh Ramalingegowda at the University of Georgia, and Professor Yong Yu at the University of Texas at Austin. It is based on their paper, “The Effect of Financial Reporting Quality on Corporate Dividend Policy,” available here.