Dividends from Unrealized Earnings and Financial Distress (Job Talk)

The adoption of fair value accounting has provoked debate about a possible improper use of unrealized earnings arising from changes in fair values of assets and liabilities for private benefits that conflict with the interests of other stakeholders in the firm. In this study, we focus on a hitherto unexamined aspect of the ability to recognize unrealized revaluation earnings: does a distribution of the unrealized earnings as dividends to shareholders increase the firm's default risk? Using hand-collected data on Israeli firms’ unrealized earnings and debt restructurings, we reveal that the distribution of unrealized earnings as dividends increases significantly the firm’s risk of encountering financial distress, as captured by a higher likelihood to enter debt restructuring process. However, this enhanced risk is mispriced by the market as captured by an insignificant difference in the cost of debt of firms that distributed dividends from unrealized earnings, compared to firms that never did so.