Dividend Covenants and Income Measurement

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.