| 1. Introduction This paper examines the association between dividend payouts and earnings quality within China’s institutional settings. Consistent with the information content of dividends hypothesis, this research finds that dividend payouts are associated with more persistent earnings, higher accrual quality, and greater earnings informativeness. More importantly, we identify the factors that distort firms’ incentive to pay dividends from conveying information to pursuing other aims and we show that such factors have a significant impact on the relationship between dividend payouts and earnings quality. Our research is motivated by the long line of literature on the hypothesis concerning the “information content of dividends” (Miller & Modigliani, 1961). The prior literature provides evidence that stock prices react to information conveyed by dividend payouts (Aharony & Swary, 1980; Asquith & Mullins, 1983; Healy & Palepu, 1988); however, the literature does not reach a consistent conclusion on whether dividends provide information about future earnings (Benartzi, Michaely, & Thaler, 1997; Grullon, Michaely, Benartzi, & Thaler, 2005; Nissim & Ziv, 2001). Recent research has begun to investigate the information content of dividends by examining whether dividend payouts per se provide information about earnings quality (Caskey & Hanlon, 2005; Skinner & Soltes, 2011; Tong & Miao, 2011). Building on the prior literature, we argue that since dividends are supported by a more stable cash flow and reduce free cash flow, as well as provide corroborative evidence to investors, dividend-paying firms have higher earnings quality than non-dividend paying firms, indicated by more persistent earnings, lower discretional accruals, and greater earnings informativeness. Besides the basic association between 2 dividends and earnings quality, we further argue that the association would change given factors affecting managers’ incentives to pay dividends. If firms pay dividends for other purpose rather than conveying information to the market, the information content of dividends would be reduced. In this case, such factors could also weaken the association between dividends and earnings quality. We examine the above inferences with data of China’s listed firms. We construct three proxies for earnings quality, which are earnings persistence, accrual quality, and earnings informativeness. We also construct both continuous and dummy variables to measure the dividend payout status. With the above sets of comprehensive measurements, we first document that firms paying dividends have higher earnings quality, which is consistent with the recent evidence from the US market (Skinner & Soltes, 2011; Tong & Miao, 2011). |