Review of Accounting Studies, 6, 53–75, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Dividend Covenants and Income Measurement
Professor, Norwegian School of Economics and Business Administration, Bergen, Norway
Associate Dean & Professor, Yale School of Management, Box 208200, New Haven, CT 06520-8200
Abstract. This paper constructs a theory of dividend restrictions in incomplete markets in an attempt to better
understand the role of accounting constructions in optimal dividend restrictions. An entrepreneur, through his
company, borrows money from a lender, and repays the debt from a stream of stochastic cash ﬂows. Dividend
restrictions are used to balance insolvency costs against the costs of accumulating surplus cash. Of particular
concern is whether optimal dividend restrictions can be characterized as deﬁning an accounting-earnings-based
reservoir available for dividends, and whether earnings calculated for this purpose exhibit conservatism.
Keywords: Dividend restrictions, debt covenants, insolvency costs, accounting earnings
Protecting creditors against the actions of investors with limited liability has historically
been a major concern in the development of accounting. In Europe, accounting regulation
for the protection of creditors has been part of the commercial codes at least since the
17th century. In the U.S., lenders commonly protect themselves through covenants in loan
agreements tied to accounting numbers.
There is a large positive accounting theory literature on the effects of debt covenants,
particularly on managers’ accounting choices.
Our lack of understanding of the structure
of optimal covenants hampers our studies of their effects. In the case of dividend covenants,
it would be useful to know how income should be measured if the objective is to calculate
an upper bound on dividends. Given the importance of this concern, it is rather surprising
that accounting theory is almost silent on this issue.
The purpose of this paper is to construct a theory of dividend restrictions in incomplete
markets. Our particular interest is the relation of optimal dividend restrictions to accounting
constructions. We would like to make use of the simplest model that captures only the
essential features of the problem. To study interim dividends, however, a two-period model
A model for which the capital structure problem has an interior solution is also required.
The model is formulated to contain the most straightforward motives and opportunities for
borrowing: an entrepreneur (borrower) has both a higher discount rate than a lender and
access to a stochastic process that generates a stream of cash ﬂows. The entrepreneur’s
higher discount rate implies that there are gains to trading intertemporally cash ﬂows with
the lender. The entrepreneur’s stochastic cash ﬂows can be used to pay back debt.
A debt contract between the entrepreneur and lender speciﬁes an unconditional schedule
Ifthe entrepreneurcannot meetthe contractualpayments,
insolvency costs will be incurred. The source of these insolvency costs is not modeled. They