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

We examine the role of accounting conservatism in mitigating the agency problem between managers and shareholders by analyzing the association between conservatism and dividend payouts. Prior studies suggest that conservative reporting practices limit dividend payments by reducing the earnings and unrestricted retained earnings used in debt covenants to constrain dividend payments (Watts 2003). Because accounting conservatism lowers current earnings, all else equal, the amount of dividends that a firm can distribute to its shareholders in a given year is likely to be lower when the firm's reporting practices are conservative than when they are not. Accordingly, it is often suggested that conservative financial reporting policies protect debtholders against expropriation by shareholders by constraining corporate payouts, and hence reduce the agency cost of debt (Ball, Kothari, and Robin 2000; Watts 2003; Zhang 2008). We posit that there is a more fundamental reason for the potential effect of conservatism on payouts, which transcends the traditional debt covenant restriction argument. More specifically, we argue that accounting conservatism can mitigate the agency problem between managers and shareholders, and hence reduce the need for dividend payouts and the associated costs.