Dividends from Unrealized Earnings and Default Risk

Using hand-collected data on Israeli firms' unrealized earnings and debt restructurings following adoption of the International Financial Reporting Standards (IFRS), we investigate whether and how dividend payouts based on unrealized revaluation earnings affect a firm's default risk. Our results indicate that in the era of fair value accounting, whether the dividend payment originates from unrealized or realized earnings has a significant effect on a firm's default risk above and beyond the effect of the extent of the payment. Specifically, controlling for various determinants of financial risk, including the amount of the dividends paid, we find that firms are four times more likely to subsequently require debt restructuring if they distribute dividends based on unrealized earnings. However, this enhanced risk seems to be mispriced by the market: cost of debt proxies are generally insignificantly different for these firms following payouts originating from unrealized earnings than for firms that never make such risky payouts