Signaling Versus Free Cash Flow Theory: What Does Earnings Management Reveal About Dividend Initiation?

Abstract

We examine earnings manipulation via discretionary accruals and real earnings management prior to the release of cash reserves back to shareholders. Previous research indicates that firms manage earnings upward when they increase dividends, creating a coordinated signal to the market. We study earnings management surrounding dividend initiation to determine whether management is manipulating earnings downward to avoid the discipline imposed by dividends in the years ahead or whether they are signaling to the market. We suggest that the aim of earnings management is not to reduce earnings but that earnings are more likely managed to preserve financial flexibility, create earnings reserves, and postpone shareholders’ expectations for initiating recurring dividends. Rather than signaling with upward earnings management, we find that dividend initiating firms manage earnings downward, consistent with the free cash flow theory. Our results explain findings in prior literature for the surprisingly stable earnings performance and accrual quality in the period just after dividend initiation. Furthermore, the market day stock price reaction is inversely related to earnings management, contradicting the purpose of signaling. We provide evidence that the managerial inertia for initiating dividends represents unique agency concerns compared with an increase in existing dividend payout and to the extent that downward real earnings management does not reverse, we identify a cost to shareholders for the quasi contract of recurring dividend payout.