Article Review: “Unrealized Earnings, Dividends and Reporting Aggressiveness: An Examination of Firms’ Behavior in the Era of Fair Value Accounting”
In this article, Chen & Gavious (2016) argue that companies’ dividend policies have changed significantly following the introduction of fair value accounting rules. The study examines the case study of Israeli firms and their adoption of IFRS (International Financial Reporting Standards). Israeli firms are said to have undergoing exogenous changes, thus creating an ideal environment in which the present study can be conducted (Chen & Gavious, 2016).
Essentially, focus is on how their payout ratios have increased since their adoption of IFRS. The authors are interested in examining differences in reporting behaviors, with companies that pay dividends from earnings they did not realize exhibiting the highest level of rigor in reporting practices. Chen & Gavious (2016) point out that these paper profits arise from increase in the fair values of financial instruments. The diversity of the industries examined within the sample of 508 Israeli public firms that had adopted IFRS by 2007 creates a situation where findings can be generalized to diverse geographical contexts where IFRS are being implemented.
It is noteworthy that findings show that the ongoing switch to fair value accounting allows firms to increase dividend payouts from unrealized earnings as long as no legal provisions exist that prohibit such a practice. Many revaluation gains would have remained unrecognized if firms continued to rely on cost-based accounting. However, the increased aggressiveness in financial reporting behaviors among firms adopting the new approach may be a setback for the new trend because there may be a growing list of firms that choose to inflate their book earnings while reducing their taxable earnings in the process of creating a platform for high dividend payouts from unrealized earnings. Since divided distribution increases risk for firm’s shareholders, the findings of this article can provide crucial insights into the relationship between firms’ accounting practices, corporate governance, and financial soundness.
Chen, E. & Gavious, I. (2016). Unrealized earnings, dividends and reporting aggressiveness: An examination of firms’ behavior in the era of fair value accounting. Accounting and Finance, 56, 217–250.
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