Real Earnings Management and Dividend Payout Signals: A Study for U.S. Real Estate Investment Trusts

Abstract

U.S. Real Estate Investment Trusts are required by federal law to distribute 90% of taxable income as dividends to common shareholders. We examine if firms subject to a binding dividend constraint, engage in real earnings management (REM) to reduce taxable income to meet dividend requirements. Since taxable income typically is not publicly reported by REIT's, we use dividend payout ratios based on FFO, a voluntary measure commonly used by the REIT industry, and net income, a measure required by GAAP, to serve as signals for the unobserved dividend-to-taxable income ratio. Using the dividend-to-FFO ratio to identify firms that may confront difficulties meeting dividend requirements, we find that these firms are more likely to participate in REM activities by reducing revenue and increasing expenses; both actions of which would reduce taxable income. We also provide evidence that firms generating less cash flow from operations and having fewer opportunities to obtain funding from the general capital markets are more likely to employ REM by selling fixed assets at a loss to generate the necessary cash flow for dividend payments, as well as to alter the dividend payment requirements. Overall, our findings suggest REM is a viable strategy that REIT managers utilize to meet regulatory dividend constraints. Managers are more likely to choose REM when there are limited alternative funding sources. We find that average returns in the three years following reduced income through REM are substantially positive, implying investors may not fully realize that current income reduction created by REM activities.