MSc Accountancy & Control, track Accountancy Faculty of Economic and business, University of Amsterdam
Master Thesis:
Does income from fair value adjustments of
investment property affect dividend policy
in UK?
Final Version
Panagiotis Georgios Siokis (10605118) 19th of June 2014
Supervisor Dr. Alexandros Sikalidis
Abstract
Following Goncharov and van Triest (2011) research, which examine the impact of income generated from fair value adjustments of investment property in Russia on dividend policy, I implement this research in UK. Lintner (1956) demonstrates that dividends should include only components of income which are persistent. UK regulators do not allow the distribution of non-realized income. I examine whether non-realized income generated from fair value adjustments of investment property is persistent and therefore distributable based on Lintner (1956) framework. In addition, I examine the impact of those income components on dividend policy and whether this is affected by corporate leverage, corporate governance and fraudulent activity. I find that income components of fair value adjustments of investment property are persistent and signaling for lower future dividends and that there is a negative association with fair value adjustments of investment property and dividends. Thus UK regulators ignore Lintner's (1956) theory, since unrealized income of investment property is persistent. Further, I find that the negative relationship between dividends and fair value income from investment properties is more pronounced in firms with high fraudulent activity and weak corporate governance structure.
Contents
1. Introduction ... 3
2. Theory ... 6
2.1 Investment property ... 6
2.2 Earnings Persistence and dividends ... 7
3. Institutional framework ... 7
3.1 United Kingdom and IFRS ... 8
3.2 United Kingdom and dividend distribution guidance ... 9
3.3 United Kingdom and distributable amount ... 10
4. Research Question and hypothesis development... 11
5. Research Design ... 15
6. Sample and descriptive statistics ... 23
7. Empirical findings ... 25
7.1 Persistence of income generated from fair value adjustments ... 25
7.2 The effect of fair value adjustments on dividend policy ... 26
8. Summary and Conclusion... 30
1. Introduction
With the IFRS adoption there is a trend towards fair value accounting (FVA) and measurement approach. FVA basically includes market expectations about future firm value and future cash flows in accounting numbers, leading to more relevant and transparent accounting information. Thus FVA helps investors by providing more relevant and transparent information, and assist them in their investment decision making process (Barth and Landsman 2001, Hitz 2007). The adoption of IFRS enhanced comparability and made similar things look alike without making different things look less different (Yip Young 2012). In addition balance sheet numbers, but not income statement numbers, became more relevant (Hail 2008). Since this approach improved relevance, those accounting numbers are more useful to investors, as they can use this information in order to make more accurate decisions. However FVA adds extra costs to entities and occasionally managers have difficulties to follow those rules adequately (Ball, 2006). Furthermore, there is evidence that the opportunistic behavior of managers was enhanced in settings where FVA is mandatory (Ramanna and Watts 2012). Apparently the move towards FVA caused, among others, an ongoing literature debate.
Apart from balance sheet, FVA also affects income statement. So far previous studies state that FVA has not increased relevance of income statement numbers (Hail 2008). Mark-to-market accounting includes transitory components in the income statement, and that action makes the income statement more volatile (Cornett et al. 1996). Including fair value adjustments in net income could increase noise in decision making (Ball, 2006), since that income is not based on actual cash flows and is not based on gains from ordinary operations, thus stakeholders should evaluate the composition of earnings components correctly (Hung and Subramanyam, 2007). In addition prior research has proved that investors fail to correctly assess the persistence of earnings components
(Hirshleifer et al. 2004). Those fair value adjustments can be the outcome, among others, of the investment properties treatment (land, buildings).
Lintner (1956) set up a theoretical framework where dividends should be based on earnings persistence. It states that entities seek of stability of their dividend policy, and in order to implement stable dividend policy, they need to clarify whether their earnings are persistent. So, it can be argued that if generated gains from fair value adjustments are persistent, then those gains should be distributed to shareholders. However dividends based on FVA may have some drawbacks. Including fair value adjustments in the dividend policy may lead to higher leverage, because managers distribute money according to gains that were not based on actual cash flows, and thus companies have to borrow money to increase the available cash (Enria et al 2004) and highly leveraged firms may be vulnerable to economic shocks (Eckstein and Sinai 1986).
UK regulators allow firms to use FVA but they do not allow the distribution of non-realized income generated from fair value adjustments. However there is only a maximum amount set as a limit from the regulators. Thus there is no specific formula to determine the distributional amount. One could argue that fair value adjustments could enhance managers’ confidence and increase this amount.
According to theory gains generated from fair value adjustments should be distributed to shareholders only if those earnings are persistent. However, UK legislation doesn't allow the distribution of unrealized gains. Since legislation does not take into consideration of that theory, it would be very interesting to know how this contradiction affects the distribution of earnings. From a literature perspective Goncharov and van Triest (2011) examined the impact of non-realized income from fair value adjustments of securities have on dividend policy. So far to my knowledge, no study has been conducted
on this subject. In addition, FVA is a debatable issue in academic literature. Therefore the findings of this study will contribute to this debate. Thus, this study will examine the impact of fair value adjustments of investment property in dividend policy in UK firms and this research is important from both empirical and literature perspective.
Sloan (1956) examined earnings persistence and Lintner (1956) argued that managers should consider the persistence of earnings regarding the amount of distribution. Based on those studies, Goncharov and Van Triest (2011) examined the impact of financial instruments in dividend policy in Russia and they found that there is no increase of the distributional amount in response to fair value adjustments. I examine first the persistence of unrealized income generated from investment property in UK. Further I use the model of Correia da Silva et al. (2004) to examine the association between dividend distribution and unrealized income generated from fair value adjustments of investment property. I examine this impact based on corporate leverage, corporate governance and firm's fraudulent activity.
I find that fair value adjustments of investment property are persistent and signaling for lower future dividends. Moreover, I find that this effect does not have a different impact based on positive or negative fair value adjustments, neither based on firm’s corporate leverage. However firms with high fraudulent activity and weak corporate governance structure, have a stronger negative association.
The rest of the paper is organized as follows: First I am going to present the theoretical background, and then the research question will be established. The methodology section where, I develop the main hypotheses will follow. Consequently, the research method will be explained. Further, the findings are illustrated and a conclusion is made.
2. Theory
2.1 Investment property
Investment property adjustments can affect income statement. Investment property is property (land or a building or part of a building or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both (IAS 40.5). Initially investment property is measured at cost, including transaction costs. Subsequently to initial recognition, entities are able to use one of the following models: fair value model and cost model. One of these methods should be chosen by the entity for all of its investment properties. The fair value model allows investment property to be re-measured at fair value. Gains or losses from this adjustment have to be included in the profit or loss account. Shall an entity choose the cost model, subsequently the investment property is measured at cost less accumulated depreciation and accumulated impairment losses. Following this rule, should entities choose the fair value model, income statement will be affected. However there is no specific guidance that determines whether this income should be distributed to the shareholders. Since there is no specific guidance from regulators, companies could easily not include this non realized income in their dividend distribution, because this income is not based on actual cash flows. However, one can argue that including this income in their dividends, would make investors more pleased and thus more investors would be interested investing in that company. This assumption leads to the conclusion that the treatment of income from fair value adjustments concerning the dividend policy is a subject of business strategy unless local legislation states otherwise.
2.2 Earnings Persistence and dividends
There is a strong link between earnings and dividends as many studies demonstrate both in US (Brav et al 2005, Jagannathan et al 2000) and outside of US (Goergen et al, 2005). A lot of studies followed Lintner's (1956) framework. Dividend distribution is related to earnings persistence while transitory components are not considered as distributable (Jagannathan et al 2000). In addition companies which have greater dividend distribution are those who have greater earnings persistence (Kormendi and Zarowin, 1996). Grullon et al (2002) found that increases in the persistence of earnings leads to greater dividend distribution. Lastly in UK managers reduce the amount of dividend distribution when earnings appeared to be less persistent (Grullon et al, 2002).
Since companies do not have specific guidance about treating income from fair value adjustments in their dividend policy, managers should check whether income from investment property is persistent and then decide whether companies should include this income in their dividends according to the Lintner framework (Lintner 1956). Sloan (1996) investigated whether stock prices reflect future earnings. In order to conduct that research he used a model which examined earnings persistence. Lintner (1956) established a framework which links earnings and dividends.
3. Institutional framework
IFRS regulators have not so far given specific directions whether income, which generated from fair value adjustments, should be distributed to shareholders. Thus each company should follow the local legislation regarding earnings distribution. Some countries require some sort of modification to be made (UK, Greece), others do not require any modification (Latvia, Lithuania) while there are countries that do not allow companies to distribute profit according to IFRS (France, Germany) (KPMG, 2008). The
legislation of the United Kingdom (UK) explains briefly that distributional profit is " its accumulated, realized profits, so far as not previously utilized by distribution or capitalization, less its accumulated, realized losses so far as not previously written off in a reduction or reorganization of capital duly made" (KPMG 2008). Regarding investment property, UK legislation allows investment property to be revalued on a fair value basis, but the gains that were generated from that action, must not be included in the realized profit available for distribution.
3.1 United Kingdom and IFRS
Deloite reports that UK started using International Financial Reporting Standards (IFRS) since 2005 when EC Regulation 1606/2002 (the IAS regulation) came into effect. The IAS Regulation requires companies with securities (either equity or debt) admitted to trading on a regulated market of any member state of the European Union to use ‘international accounting standards’ in preparing their consolidated financial statements.
IAS Regulation is applied only by companies which have consolidated financial statements. Listed companies with no subsidiaries, typically investment trusts, may continue to use UK GAAP under the law and the Listing Rules. Similarly, companies with securities admitted to trading on a regulated market may use UK GAAP in preparing their ‘company only’ financial statements.
The Companies Act 2006 allows companies, other than charities, to prepare their individual and/or consolidated financial statements in accordance with either UK GAAP or IFRSs. This is subject to certain constraints about consistency within groups as discussed above. Companies that are charities must continue to prepare their individual and group financial statements in accordance with UK GAAP.
So it can be said that companies with consolidated financial statements are required to use IFRS, and thus they use FVA, charities must use UK GAAP and the rest have a choice between them.
3.2 United Kingdom and dividend distribution guidance
Active companies in UK are able to distribute profits to shareholders under IFRS rules but some form of modification is required (KPMG, 2008).
Looking first at legislation of UK, at Companies Act 2006, issued by the Institute of Chartered Accountants of Scotland, is stated that a company may only make a distribution out of profits available for the purpose. Those profits are the accumulated, realized profits, which were not previously utilized by distribution or capitalization, less its accumulated, realized losses, so far as not previously written off in a reduction or reorganization of capital duly made.
Moreover on November of 2012 the Financial Reporting Council (FRC) of UK issued FRS 101 where there is a clarification of dividend policy which requires that only realized profits should be included in the profit and loss account. Further UK legislation states that investment property and living animals and plants that may under international accounting standards be held at fair value, may also be held at fair value in Companies Act accounts. Adjustments in the value of financial instruments, investment properties or living animals or plants are recognized in the profit and loss account, but the value of which should not be disclosed in a separate non-distributable reserve account. Thus it is forbidden to include unrealized income generated from fair value adjustments of investment property in the distributional amount.
3.3 United Kingdom and distributable amount
Under UK law, a company may not make a distribution if, at the time of the distribution or to the extent that immediately after the distribution, its net assets are less than the aggregate of its called-up share capital and (defined) un-distributable reserves (KPMG, 2008). Further under UK law (Companies Act 2006) a public company can only make distributions out of its accumulated, realized profits, so far as not previously distributed or capitalized, less accumulated, realized losses so far as not previously written off in a reduction or reorganization of capital. The maximum amount that can be distributed under this principle is determined by reference to the profits, losses, assets, liabilities and share capital and reserves as stated in the company's annual accounts. A distribution can be decided either by the directors or declared by the members in general meeting by a simple majority. In the last case the amount must not exceed that recommended by the directors.
So far, there is no specific guidance of a fixed amount that companies should distribute to shareholders under UK GAAP. Since there is only one restriction and this regards the maximum limit, managers can decide to distribute less than the allowed maximum amount. However one can argue that gains generated from fair value adjustments of investment property, could enhance managers optimism to distribute greater amount that would normally do. Previous studies suggest that overoptimistic managers are more likely to overestimate implications of current earnings for future earnings (DeAngelo et al 1996). Furthermore in periods when there is a peak of the economy stakeholders may be overconfident, which results fair value adjustments to be included in the decision making regarding dividend distribution (Enria et al. 2004). Thus
gains from fair value adjustments of investment property, potentially could affect dividend policy.
4. Research Question and hypothesis development.
As mentioned before, investment property can generate fair value adjustments which affect income statement and no specific guidance has given from regulators regarding the distribution of those adjustments. According to the Lintner theoretical framework (1956) dividend distribution should be based on persistent earnings. Further, UK, which started to use IFRS since 2005, does not allow this income to be distributed. However, higher income based on fair value adjustments could enhanced managers’ confidence and increase the distributable amount. Thus fair value adjustments of investment property could affect dividend policy. Based on the above the following research question is generated:
"Does income from fair value adjustments affect dividend policy in UK"
Investment properties' fair value adjustments generate gains not based on actual cash flows. Lintner's (1956) framework establishes that earnings which are persistent should be distributed. Based on that theory, if gains generated from investment properties' fair value adjustments are persistent, they should be part of distributable income. However, in UK unrealized gains raised from investment properties should not be included in the amount of the distributed dividend (KPMG 2008) meaning that regulators consider them as transitory. Therefore, in my first hypothesis I examine whether non-realized income from fair value adjustments on investment property is persistent and therefore distributable according to theory or not.
H1: Gains generated from fair value adjustments of investment properties in UK
companies, are not persistent.
Further, according to UK laws, managers have the option to choose the distributable amount taking into consideration only realized income, with a limitation to a maximum amount. Thus unrealized gains generated from fair value adjustments should not be distributed since the regulators consider those as non-persistent. This leads to the second hypothesis.
H2: Gains generated from fair value adjustments of investment properties in UK
companies, have no impact on dividend policy
Fair value accounting has an association with reliance on debt financing (Christensen and Nikolaev, 2013). Managers can implement practices which transfers wealth from debtholders to shareholders, such as increasing debt levels to distribute dividends to shareholders (Taylor, 2013). Thus it is less likely that debtholders will receive their full dues (Shivakumar, 2013). Moreover, firms can use fair value adjustments to reduce the cost of debt by signaling out liquidation values to lenders. Shareholders expect a minimum dividend payment based on those values of the income statement. This higher expectation can increase dividend payouts to the benefit of shareholders and at the expense of debtholders, potentially leading to an increased cost of debt (Shivakumar, 2013). Therefore, it is likely for debtholders to force mechanisms which aim to reduce potential wealth transfers (Leuz, 1998).
On the other hand, prior literature suggests that the distribution of non-realized income increases leverage, because non-realized income is not based on actual cash flows, which potentially leads some firms into financial distress (Enria et al., 2004). At a macro-level, increased dividend payouts due to positive fair value adjustments might
‘contribute to the procyclicality of the financial system’ (Laux and Leuz, 2009) and ‘amplify swings in the real economy’ (Goncharov and van Triest, 2011, p.2). UK
legislation, forbids the distribution of income generated from fair value adjustments if not realized. Since UK firms are not allowed to distribute that income, they do not need to increase their leverage for that purpose. From the above it can be concluded that there are incentives based on a firm's borrowing capacity which might affect the relationship between non-realized income from fair value adjustments and dividends. In order to assess this effect, I develop the following hypothesis.
H3: A firm's borrowing capacity has no impact on the association between dividend
distribution and fair value adjustments of investment property.
Corporate governance is an area that has grown very rapidly in the last decade particularly since the collapse of Enron 2001 and the subsequent financial problems at other companies in various countries (Barings Bank, Royal Ahold etc.). The development of corporate governance has been driven to a large extent by the desire for more transparency and accountability to help restore investor confidence in the world’s stock markets after financial scandals and corporate collapses have caused a loss of confidence. The Organization for Economic Co-operation and Development (OECD) gave a definition for corporate governance, which is “Procedures and processes according to which an organization is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization such as the board, managers, shareholders and other stakeholders and lays down the rules and procedures for decision-making.” Thus corporate governance is an important tool for shareholder's to monitor and receive information about executives' practices (Kalbers, 2009). One could argue that practices as taking into consideration income generated from fair value adjustments in order to increase the amount of the
dividend's, could give a signal to investors to trust more the managers and thus they are going to be more willing to invest in that company which applies those practices, especially if this particular type of income is persistent.
However, as mentioned before, corporate governance is a tool driven by the demand for more transparency and accountability. Since UK legislation does not allow companies to distribute income generated from fair value adjustments, it is logical to assume that rational investors are willing to invest in companies which are more complied with the law. In order for investors to be able to detect whether a company is legitimate, this company should apply strong corporate governance structures. Indeed investors are more willing to invest in companies with strong corporate governance mechanisms (Gugler, 2003). Prior research has provided evidence that investors reward firms with high quality of corporate governance and high ethical standards by valuing them highly (Baek et al., 2009; Choi and Jung, 2008; Epstein et al., 1994). Executives of companies with strong corporate governance mechanisms know that they are monitored and thus they will not include unrealized income in their dividend policy. In other words, firms with weak corporate governance structure will give managers the opportunity to be more innovative with the dividend policy, since shareholders will not be able to detect , due to poor monitoring, such practices. In order to examine the role of corporate governance on the relationship between non-realized fair value adjustments and dividends, the following hypothesis is formed:
H4: Firms with stronger corporate governance are less pronounced to distribute
unrealized income generated from fair value adjustments of investment properties.
Corporate governance philosophy is highly related to business ethics. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) provided
mentioned (COSO, 2004). One of the practices, that makes investors doubt about a firm's ethics, is the accrual earnings management. Managers can influence the information given to investors and other external users by altering the financial statements and thus affect the fair economic reality, practice known as earnings management (Roychowdhury 2006; Bens et al. 2003). One form is the accrual earnings management, where companies adjust the accrual part of earnings (Dechow et al. 1995). Following the previous hypothesis and prior literature, it is fair to assume that shareholders will value higher more ethical firms and thus more legitimate. Thus, since UK legislation does not allow unrealized income to be distributed, it is fair to assume that more ethical firms, and one could say firms with high quality of accruals, will not take into consideration income generated from fair value adjustments of investment properties to their dividend policy. Based on the above the following hypothesis is assumed:
H5: Firms with lower earnings management are less pronounce to distribute
unrealized income generated from investment properties.
5. Research Design
I test the hypotheses by employing an extension of Lintner’s (1956) model, according to which firms adjust dividend payments considering their defined payout ratio. Gugler and Yurtoglou (2003) and Correia da Silva et al. (2004) argue that the change in dividends based on the Lintner (1956) framework can be modeled for regression purposes as follows:
In the above equation, for any year t and firm i, ΔDi,t is the actual change in
dividends (D) from year t-1 to year t; net distributable earnings are E; αi is a constant term
which captures the drift in dividends through time; β1 and β2 are the model coefficients;
and εit is the error term.
Since the first hypotheses is conditional on the persistence of fair value adjustments, based on Sloan (1996) and Goncharov and van Triest (2011) research I test this condition by employing the following earnings persistence regression:
Where ROA_BFVi,t+1, (ROA_BFVi,t) is the ROA before fair value adjustments from investment for year t+1 (for year t); INVPR_REV is the fair value revaluation adjustment of investment property. All the above figures are scaled by total assets. I additionally control for industry and time. If fair value adjustments predict future income, they constitute earnings components that are persistent and should therefore be part of distributable earnings (Lintner, 1956). In which case, the adjustment coefficient α2 should
be different from zero. If the coefficient is positive, then fair value adjustments convey good news about future profitability while negative coefficients signal a decrease in future earnings.
The model for the multivariate analysis is based on equation 1 and the model of Correia da Silva et al. (2004). In detail, in equation 3 I use DDIFF which is the difference of total dividends between year t and t-1 over total assets, and Di,t-1 is the lagged dividend over total assets. I include the ROA_BFV (ROA before fair values) variable to substitute the E variable for scaling purposes and to constitute a profitability measure for historical income. I also include a fixed set of regressors in order to control for firm characteristics (past profitability, firm size, leverage, free cash flow, growth opportunities). In the model, the earnings components that are derived from fair value
In the above model, INVPR_REV is total value of non-realized revaluations of investment property over total assets; ROA_BFVt and lagged ROA_BFVt-1 are proxies for current and past profitability respectively and are defined as earnings before interest and taxes excluding total fair value revaluations over total assets; SIZE is the natural logarithm of the book value of assets and is a proxy for firm size; DEBT is the debt-to-asset ratio and is a proxy for leverage; CASH is the cash and cash equivalents-to-debt-to-asset ratio and is a proxy for free cash flow; and GROWTH is the percentage of sales increase and is a proxy for growth opportunities. Additionally, industry and year dummies are included. Following hypothesis 2, I expect α1 in model 3 to be zero. In this case, fair
value adjustments would not affect dividend distributions. On the contrary, a significant coefficient would suggest that fair value adjustments affect dividend payouts.
In order to assess the relative effect of types of fair value adjustments on dividend policy I replace the INVPR_REV with INVRP_REV+ and INVPR_REV-. The new model is as follows:
In the above model I separate the INVPR_REV with two variables PosINVRP_REV and NegINVPR_REV. PosINVPR_REV is equal to the INVPR_REV if it is positive and zero otherwise. NegINVPR_REV is equal to the INVPR_REV if it is negative and zero otherwise. Once again based on hypothesis 2, I expect α1 and α2 to be
zero. If fair value adjustments are persistent, the effect of positive or negative adjustments
DDIFFi,t = α0 + α1INVPR_REVi,t + α2ROA_BFVi,t + α3ROA_BFVi,t-1 + α4Di,t-1 + α5SIZEi,t +
α6DEBTi,t + α7CASHi,t + α8GROWTHi,t + ΣDIndustry + ΣDYear +ei,t (3)
DDIFFi,t = α0 + α1PosINVPR_REVi,t + α2NegINVPR_REVi,t + α3ROA_BFVi,t + α4ROA_BFVi,t-1
+ α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry + ΣDYear +ei,t (4)
should be the same and equivalent to the effect of current profitability measure (ROA_BFV)
In order to assess hypothesis 3 I use model 5:
In the above model, the variable DHighLEV (DLowLEV) is a dummy variable that distinguishes firms with high (low) leverage from others with low (high) leverage. Specifically, DHighLEV (DLowLEV) takes the value 1 if a firm's leverage ratio is above (below) the median leverage ratio of firms in my sample and 0 otherwise. According to hypothesis 3, α1 and α2 should be zero or at least approximately the same, because they
would have the same impact.
In the above regression I divide the sample in two parts and I distinguish the revenue of investment properties based on the amount of total Leverage. HighLev (LowLev) is a dummy variable where is equal to 1 if the total leverage is above (below) the median of total leverage and 0 otherwise. Based on hypothesis 3 I expect that dividend policy will not be related with Revenue of investment property (and thus α1 and
α2 should be 0), and the firm total leverage will have no impact on my regression, or at
least approximately the same, because they would have the same impact.
Based on the previous formula, and willing to assure that the results are accurate I decided to add more leverage proxies. Based on that, I created the following two formulas:
DDIFFi,t = α0 + α1DHighLEV*INVPR_REVi,t + α2DLowLEV*INVPR_REVi,t + α3ROA_BFVi,t +
α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry +
Christensen and Nikolaev (2013) wanted to examine if fair value accounting is more value relevant compared to historical cost accounting. They argued that leverage is one of the determinants for using fair value accounting and they used long term leverage as a leverage proxy. Thus, I divide the sample in two parts based on the long term leverage, and determine the dummy variable HighLongLEV (LowLongLEV) which is equal to 1 for long term leveraged firms which is above (below) the median and 0 otherwise. Further Christensen and Nikolaev (2013) determined another proxy for leverage, which is the total liabilities minus the long term leverage, which results the short term obligations. Thus I create another variable, HighShortLEV (LowShortLEV), which is equal to 1 for firms that have short term obligations which are above (below) the median and 0 otherwise. Once again, based on the hypothesis 3, I expect that dividend policy will not be related to the revenue generated from fair value adjustments of investment property (and thus α1 and α2 should be 0), regardless of the firms long or short
leverage or at least approximately the same, because they would have the same impact.
Bohren et al (2012) found that corporate governance is related to dividend policy. Specifically found that corporate governance practices are negatively related to dividend policy, thus the more corporate governance practices a firm performs, the less amount of wealth they will distribute. On the other hand Puleo et al (2009) found that there is no
DDIFFi,t = α0 + α1DHighShortLEV*INVPR_REVi,t + α2DLowShortLEV*INVPR_REVi,t +
α3ROA_BFVi,t + α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t
+ ΣDIndustry + ΣDYear +ei,t (7)
DDIFFi,t = α0 + α1DHighLongLEV*INVPR_REVi,t + α2DLowLongLEV*INVPR_REVi,t +
α3ROA_BFVi,t + α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t
relationship between good corporate governance and dividend policy in a regulated industry. Willing to identify whether and which companies perform practices as considering the fair value adjustments of investment property on their dividend policy, I wanted to examine firms corporate governance and if corporate governance practices is related to that consideration. Thus a formula is created as following:
Price et al (2011) found that auditors’ opinion is highly related with corporate
governance practices. Thus in the previous formula, the Unqual (Qual) is a dummy variable which stands for auditors opinion, and it is equal to 1 if the auditor made an unqualified report (qualified report or not audited firm) for the firm year t, and 0 otherwise. According to hypothesis 4, I expect for firms with good corporate governance practices, and specifically in this case unqualified auditor’s opinion, are less pronounced to consider fair value adjustments of investment property as part of their dividends, or to consider them significantly less than firms which had a qualified auditor opinion or firms that were not audited. Thus I expect α1 to be less than α2.
Based on the previous formula, and willing to assure that the results are accurate, I decided to add more corporate governance proxies. Based on that, the following three formulas were created:
(10)
DDIFFi,t = α0 + α1DUnqual*INVPR_REVi,t + α2DQual*INVPR_REVi,t + α3ROA_BFVi,t +
α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry +
ΣDYear +ei,t (8)
DDIFFi,t = α0 + α1DHighCCIS*INVPR_REVi,t + α2DLowCCIS*INVPR_REVi,t + α3ROA_BFVi,t
+ α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry
(12)
In the above formulas Compensation Committee Independence Score (CCIS), Auditing Committee Independence Score (ACIS), and Corporate Social Responsibility Score (CSRS) were used as corporate governance proxies. I determine the High (Low) Score as 1 if the score is above 70%. Once again, according to hypothesis 4, I expect for firms with good corporate governance practices, and specifically in this case with high scores, to not consider fair value adjustments of investment property in their dividend policy or at least to consider them significantly less than firms with low scores. Thus I expect α1 to be less than α2.
Prior literature considers whether firms manage earnings to meet important thresholds. Burgstahler and Dichev (1997) find that firms manage earnings upwards to avoid reporting losses and to avoid reporting earnings declines. The authors examine the earnings distributions of firms, and find an abnormally low frequency of small negative earnings and small earnings declines and an abnormally high frequency of small positive earnings and small earnings increases. DeGeorge et al. (1999) add to this literature by documenting that firms manage earnings to meet analysts’ earnings forecasts. Add a
paragraph based on the articles for discretionary accruals and the model.
DDIFFi,t = α0 + α1DHighCSRS*INVPR_REVi,t + α2DLowCSRS*INVPR_REVi,t + α3ROA_BFVi,t
+ α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry
+ ΣDYear +ei,t (11)
DDIFFi,t = α0 + α1DHighACIS*INVPR_REVi,t + α2DLowACIS*INVPR_REVi,t + α3ROA_BFVi,t
+ α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t + ΣDIndustry
Daniel et al (2008) implied that firms view expected dividend levels as important earnings thresholds and consequently, they manage earnings to meet expected dividend levels even though such earnings management behavior has no cash flow consequences and, therefore, does not affect the firm’s capacity to pay dividends. Kang et al (2010)
documented a positive relation between discretionary accruals and stock returns at the aggregate level.
Therefore discretionary accruals could be an indicator where managers include unrealized income in their dividend policy decisions.
I use the Jones (1991) model to estimate the discretionary accruals.
In the above formula Accruals is the total accruals, ΔRev is the difference in revenues from year t-1 to year t, PPE is the property, plant and equipment for year t. The residual e is the total amount of discretionary accruals. In order to test whether firms with discretionary accruals take into consideration unrealized income for their dividend policy I set the following formula:
Kalbers (2007) used discretionary accruals as a proxy for earnings management and found that discretionary accruals are associated with fraudulent activity and business ethics. One could argue that firms with fraudulent activity are keener to manipulate earnings illegally. Thus in our sample, those firms would be keener to not take into
DDIFFi,t = α0 + α1DHighDACC*INVPR_REVi,t + α2DLowDACC*INVPR_REVi,t +
α3ROA_BFVi,t + α4ROA_BFVi,t-1 + α5Di,t-1 + α6SIZEi,t + α7DEBTi,t + α8CASHi,t + α9GROWTHi,t
+ ΣDIndustry + ΣDYear +ei,t (13)
consideration UK legislation and include unrealized income in their dividend policy. In the above formula DACC stands for Discretionary Accruals.
Once again I divide the sample into two parts, into firms that have high amount of discretionary accruals (HighDACC) and low amount of discretionary accruals (LowDACC) based on the model of Jones (1991). HighDACC (LowDACC) is a dummy variable which is equal to 1 if the discretionary accruals variable is above (below) the median and 0 otherwise. Based on hypotheses 5, I expect that firms with high level of discretionary accruals will be keener to include unrealized income, generated from fair value adjustments of investments properties, into their consideration for the dividend policy. Thus I expect α1 to have a greater impact to my regression compared with α2.
6. Sample and descriptive statistics
Our sample covers firms which were active over the period 2005-2012. This timeframe was selected because 2005 is the first year when financial statements had to be produced according to IFRSs. The data collected through Datastream which originally provided observations of 5178 firms. I excluded the firm years which did not have the sufficient data, as long the firms which did not provided sufficient firm years observations. This resulted to 14.015 firm years observations. Table 1 summarizes the financial characteristics of our sample firms.
Table 1. Descriptive Characteristics
Mean Median St. Dev. p25 p75
DDIFF 0,001 0,000 0,106 0,000 0,001 ROA -0,071 0,039 1,206 -0,046 0,101 D 0,019 0,003 0,082 0,000 0,022 SIZE 11,011 10,913 2,309 9,433 12,498 DEB 0,197 0,111 0,976 0,000 0,277 CASH 0,164 0,087 0,202 0,029 0,215 GROWTH 20,462 0,084 2288,762 -0,073 0,319 ROA_BFV -0,069 0,038 1,205 -0,041 0,099 INVPR_REV -0,001 0,000 0,039 0,000 0,000
The mean (-0.069) and the median (0.038) return on assets before fair value adjustments of investment property (ROA_BFV), suggesting that there is a broad distribution of observations, and some of them with low or even negative return on assets which affect the mean downwards. An average firm would have a mean total debt over total assets ratio (DEBT) of 0.197, close to its median 0.111, and an a mean size over total assets ratio (SIZE) 10.913, close to its median 11.011. Regarding GROWTH, there is a big difference between the mean (20.462) and median (0.084), suggesting that there are firms with very high growth opportunities which affect the mean figure upwards. Since the years of the sample is between 2005 and 2012, I assume that the financial crisis of 2008 had a great impact on these results. For example, the great financial recession starting on 2008 and so on can justify the negative ROA mean and the low median.
7. Empirical findings
7.1 Persistence of income generated from fair value adjustments
In this section I examine whether fair value adjustments of investment properties are persistent and thus should be related to dividend. Following on the table two are the results.
Table. 2 Persistence of fair value adjustments
Dependent variable ROA_BFVt+1
Sample All firms Only firms with FVA
Explanatory variables Cf. Cf.
ROA_BFVt 0.381* 0.165*
INVPR_REVt -0.944 -0.094*
Intersept -0.003 -0.076
Industry / Year dummies Yes Yes
R2 0.06 0.06
Obs. 14015 14015
Note: The specification * indicates significance at the 5% significance level.
Table 2 shows that, for the whole sample, fair value adjustments are negatively associated with dividends (-0.944) but this number is not significant. However, when I examine only firms with fair value adjustments, I find that fair value adjustments from investment property are negatively associated (-0.094) but this number is significant. Thus, IFRS adoption leads to the inclusion of new income components that do not change the persistence of net income, and specifically those fair value adjustments signaling a decrease in future earnings. Therefore, since fair value adjustments are persistent, according to theory (Lintner,1956) the can be included in the dividend policy. However UK regulators ignore this theory, and decide the opposite. Thus the hypothesis 1 is rejected. Moreover, this is in contrary with Goncharov and van Triest results, which showed that fair value adjustments are not persistent. I explore this argument in the following sections.
7.2 The effect of fair value adjustments on dividend policy
I initially assess whether the revaluation of fair value adjustments generated from investment properties has an impact on dividend policy. The results of formulas 3 and 4 are illustrated in Table. Once again I run two regressions for each formula, one with the whole sample, and one only with firms which had fair value revaluations. In the first formula I examine if unrealized income has an impact on dividend policy. In the second formula I divide the unrealized income into positive and negative adjustments. Following are the results.
Table. 3 Dividend policy and fair value adjustments
Dependent variable DDIFFTt
Sample All firms Only firms with FVA Explanatory variables Cf. Cf. Cf. Cf. INVPR_REVt -0.031* -0.048* PosINVPR_REVt -0.126* -0.049* NegINVPR_REVt -0.025* -0.049* ROA_BFVt 0.002* 0.003* -0.056* -0.056* ROA_BFVt-1 0.002* 0.003* -0.475* -0.047* Dt-1 -0.855* -0.856* -0.356* -0.356* SIZEt 0.002* 0.002* 0.001* 0.001* DEBTt -0.001 -0.001 0.001* -0.023* CASHt 0.027* 0.277* -0.023* 0.020* GROWTHt 0.000 0.000 0.019* -0.001* Intersept -0.007 -0.007 -0.001 0.012 Industry / Year dummies Yes Yes Yes Yes
R2 0.438 0.438 0.253 0.253
Obs. 14015 14015 609 609
Note: The specification * indicates significance at the 5% significance level.
The coefficient of INVOR_REV is -0.031 for the whole sample and -0.048 and in both cases the number is significant. Further the coefficient for PosINVOR_REV is -0.126 and -0.049, and for NegINVPR_REV is -0.025 and -0.049 respectively, and in all cases the coefficient is significant, which means that unrealized income is negatively associated with dividend policy. Based on these results, both positive and negative unrealized income affect negatively the dividend amount, which means the bigger the
is not great, I conclude that fair value adjustments have an association with dividend policy, thus I reject the Hypothesis 2.
Table 4 reports the results after controlling the sample based on firms' corporate leverage (formulas 5, 6 and 7).
Table. 4 Dividend policy, corporate leverage and fair value adjustments
Dependent variable DDIFFTt
Sample All firms Only firms with FVA
Explanatory variables Cf. Cf. Cf. Cf. Cf. Cf. HighLev*INVPR_REVt 0.030 -0.011* LowLev*INVPR_REVt -0.302* -0.275* HighLongLev*INVPR_REVt 0,001 -0.033* LowLongLev*INVPR_REVt -0,046* -0.054* HighShortLev*INVPR_REVt 0.007 -0.141* LowShortLev*INVPR_REVt -0.187* -0.179* ROA_BFVt 0.003* 0,003* 0.003* 0.000 -0.055* -0.027* ROA_BFVt-1 0.003 0,003* -0.856* -0.028* -0.048* -0.038* Dt-1 -0.856* -0,855* 0.001* -0.483* -0.359* -0.446* SIZEt 0.002* 0,002* 0.002* 0.001 0.001* 0.001 DEBTt -0.001 0,000 -0.000 -0.011* -0.022* -0.014* CASHt 0.028* 0,028* 0.028* 0.004* 0.019* 0.015* GROWTHt 0.000 0,000 0.000 0.001* -0.001* -0.001* Intersept -0.007 -0,007 -0.007 0.008 0.010 0.013 Industry / Year dummies Yes Yes Yes Yes Yes Yes R2 0.440 0.438 0.439 0.516 0.257 0.429
Obs. 14015 14015 14015 609 609 609
Note: The specification * indicates significance at the 5% significance level.
Particularly, when including all firms the low amount of leverage has significant results (-0.302, -0.046 and -0.187 for low total leverage, low long term leverage and low short term leverage respectively) and all of them are negative. On the other hand, the high amount of leverage has positive results (0.030, 0.001 and 0.007 for high total leverage, high long term leverage and high short term leverage respectively) but all of them are insignificant. However when including in the sample only firms with fair value adjustments, we find a negative association with all kinds of leverage (total leverage, long term leverage and short term leverage) with dividend policy. Which results that corporate
leverage does not change the impact of fair value adjustments generated from investment property on dividend policy which supports the hypothesis 3.
Table 5 reports the results after controlling the sample based on the firms' corporate governance practices (formulas 8, 9, 10 and 11).
Table. 5 Dividend policy, corporate leverage and fair value adjustments
Dependent variable DDIFFTt
Sample All firms Only firms with FVA
Explanatory variables Cf. Cf. Cf. Cf. Cf. Cf. Cf. Cf. Unqual*INVPR_REVt -0.001 -0.029* Qual*INVPR_REVt -0.458* -0.056* HighCCIS*INVPR_REVt 0.003 -0.023* LowCCIS*INVPR_REVt -0.015 -0.027* HighACIS*INVPR_REVt -0.010 -0.019* LowACISINVPR_REVt 0.001 -0.035* HighCSRS*INVPR_REVt 0.014 -0.030* LowCSRS*INVPR_REVt 0.001 -0.011 ROA_BFVt 0.003* 0.161* 0.161* 0.190* -0.056* -0.007 -0.003 -0.023 ROA_BFVt-1 0.003* 0.043* 0.043* 0.023 -0.047* 0.037* 0.038* 0.002 Dt-1 -0.856* -0.980* -0.981* -1.000* 0.000 -0.768* -0.777* -0.880* SIZEt 0.002* -0.003* -0.003* -0.003 -0.001 0.002* 0.002* 0.003 DEBTt -0.001 0.062* 0.062* 0.106* -0.362* -0.013* -0.014* -0.017 CASHt 0.028* 0.051* 0.051* 0.076* 0.001* -0.019 -0.018 -0.030 GROWTHt 0.000 0.000 0.000 0.000 -0.023* 0.001 0.002 0.001 Intersept 0.015* 0.028 0.029 0.012 -0.001 -0.014 -0.013 -0.020
Industry / Year dummies Yes Yes Yes Yes Yes Yes Yes Yes
R2 0.439 0.495 0.495 0.508 0.260 0.688 0.690 0.798
Obs. 13951 2242 2242 1615 605 162 162 109
Note: The specification * indicates significance at the 5% significance level.
Based on the above result, when I include all the firms in the sample the only number which is significant is for the proxy Qualifies audit opinion (-0.458) which is negative and does not add much evidence to my research. However when I control only for firms with FVA, all the results are negatively associated with DDIFFT. Having a closer look, the coefficient for Qualified audit opinion is -0.056 and the coefficient for Unqualified audit opinion is -0.029. When firms have a high Compensation Committee Independence Score the coefficient is -0.023 and when they have a low Compensation Committee Independence Score the coefficient is -0.027. Last when firms have a high Audit Committee Independence Score the coefficient is -0.019 and when firms have a low
firms have weak corporate governance, the impact of unrealized income is stronger negatively associated with dividend policy. However I cannot make that assumption for CSR score, due to the fact only firms with high CSR score have significant result. On the other hand, firms with strong corporate governance keep considering fair value adjustments for the dividend policy decision making thus I reject hypothesis 4.
Finally, willing to test hypothesis 5 and fraudulent activity, following on the table the results are illustrated (formula 13)
Table. 6 Dividend policy, fraudulent activity and fair value adjustments
Dependent variable DDIFFTt
Sample All firms Only firms with FVA
Explanatory variables Cf. Cf. DHighDACC*INVPR_REVt -0.043 -0.037* DLowDACC*INVPR_REVt -0.050 -0.011 ROA_BFVt 0.016* 0.017* ROA_BFVt-1 0.002* 0.015* Dt-1 -0.881* -0.059* SIZEt 0.002* 0.001* DEBTt 0.007* 0.002 CASHt 0.031* -0.008 GROWTHt 0.000 -0.002 Intersept -0.012* -0.001
Industry / Year dummies Yes Yes
R2 0.481 0.509
Obs. 9709 109
Note: The specification * indicates significance at the 5% significance level.
When I include all the firms in my regression I get no significant results when I control my firms with high or low discretionary accruals. When I include only firms with fair value adjustments, there are significant results for firms with high discretionary accruals (-0.037). Discretionary accruals could indicate both fraudulent activity (accruals generated to manipulate earnings) and non-fraudulent activity (accruals generated by mistake, human error). Low discretionary accruals are more likely to indicate non-fraudulent activity and high discretionary accruals are more likely to indicate non-fraudulent
activity. The reason that I find significant results for the firms with high discretionary accruals could be because they are more likely to indicate fraudulent activity, and thus more likely to include fair value adjustments generated of investment property in their dividend distribution. Based on that assumption I conclude that only firms with high level of discretionary accruals, and thus are more likely to perform earnings management practices, allow fair value adjustments of investment property to affect the dividend policy decision making, which supports hypothesis 5.
8. Summary and Conclusion
I follow Goncharov and van Triest (2011) which examine the impact of fair value adjustments of financial securities in Russia on dividend policy, and I examine the impact of fair value adjustments generated of investment property on dividend policy in UK. UK has different characteristics from Russia, and different legislation. Lintner (1956) demonstrates that dividend's should include only components of income which are persistent. UK regulators allowed firms to use IFRS and FVA, however they did not allow to use income generated from fair value adjustments in their dividends. I examine whether income generated from fair value adjustments of investment property is persistent. In addition I examine the impact of those income components based on corporate leverage, corporate governance and firm’s fraudulent activity.
I find that fair value adjustments of investment property are persistent and signaling for lower future dividends and that there is a negative association with fair value adjustments of investment property and dividends. Thus UK regulators ignore Lintner's (1956) theory, since unrealized income of investment property is persistent. Further I find that this effect does not have a different impact based on positive or negative fair value
activity and weak corporate governance structure, have a stronger negative association than firms with low fraudulent activity and strong corporate governance policies.
There are two possible reasons for the negative association (firms with upward fair value adjustments increase their dividend significantly less than firms that do not record fair value adjustments). First could be that managers may use fair value adjustments opportunistically to justify a lower level of dividends. Managers have an intention for internal funds over sharing profits with outside investors, because this leaves more funds at their disposition (Pinkowitz et al. 2006). However, negative stock market reactions might be generated of sharing wealth below market expectations (Ghosh and Woolridge 1988, Brav et al 2005) and the firms' reputation might be damaged (Gomes 1996). To avoid this possibility, managers turn on fair value adjustments and unrealized and transitory fair value components as an explanation for lower wealth distribution. This assumption is supported from this study, because there is stronger evidence with firms which perform fraudulent activity, and Goncharov and van Triest (2011), did not have the sufficient data to perform this test. Second, could be that upward fair value adjustments may be correlated with an unobservable managerial response to high growth. Managers may realize that the high sales growth is unlikely to be persistent over a longer period due to a general mean reversion of growth or due to a reduction in consumer demand fuelled by cheap credit. In this case, maintaining a dividend payout based on the level of income before revaluations may increase a firm's riskiness, which may explain relatively lower dividends. Alternatively, high growth signals more investments and expansion. Based on investments needs, dividend policy decision making is made, and managers may pay relatively lower dividends in order to finance investments, leading to the negative relation between dividends and unrealized income generated from fair value adjustments of investment property.
This study has the following limitations. First the sample varies on every regression because Datastream did not provide all the data for every firm year observation, and this might have impaired overall the results. Second, starting from approximately 14 thousand firm year observations and finishing with barely 100, could have an impact on the results. I encourage future researchers who want to follow this study, to use more databases, or collect the data manually, in order to find more accurate results.
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