Earnings Management and Mandatory Dividend Payout Policy: Evidence from a Natural Experiment in China

• In Event: Earnings Management: International Evidence I

Abstract

We examine the effect of mandatory dividend payout policy on firms’ financial reporting choices and cash dividend payout in the context of a cash dividend payout regulation in October 2008 in China. The regulation we examine required that firms desiring to raise new equity capital maintain a cumulative dividend payout ratio of at least 30% over the prior three years. After this regulation, we find that firms with cumulative dividend payout ratios above zero but below this 30% threshold, on average, decrease their discretionary accruals. Reporting negative discretionary accruals has the effect of lowering the earnings number used to assess whether the dividend payout meets the 30% threshold, potentially moving firms that would otherwise be below the threshold closer to or above the threshold. We also find that this decrease is primarily driven by firms whose cumulative payout ratio is close to but slightly lower than the mandated dividend threshold (specifically, those firms with cumulative dividend payout ratios between 20% and 30%). In addition, these negative accruals are more pronounced in firms with larger cash flow deficits, firms with high recent sales growth and firms located in provinces with less well developed banks. Another regulation requires that Chinese firms maintain a return on equity of at least six percent in order to issue share rights to existing shareholders. We find that negative discretionary accruals are concentrated in firms that have a return on equity above this threshold but a dividend payout ratio just below the 30% payout threshold. We also find that neither dividend per share nor dividend yield increases for firms whose cumulative payout ratios are between 20% and 30%. This suggests that the increase in dividend payout is achieved through lowering earnings rather than by increasing dividends. Since mandatory dividend payout regulations have been suggested in the past literature as a possible substitute for otherwise weak regulatory and enforcement mechanisms, our results provide important policy feedback about the effectiveness of such regulations in increasing dividend payments to shareholders.

Authors

• Ning Zhang, Queen's University

• Michael Welker, Queen's University, Kingston

• Kangtao Ye, Renmin University of China